Lessons

Here you will find some lessons I have learned (the hard way) over the years.  Some of these lessons are a rite of passage for investors. I mean how many times have you heard about investors using trailing numbers to value cyclicals or relying on management’s forecast for valuation reasons. Other lessons are specific merit badges that I alone seem to find. Some failures are epic and some not so much. Please feel free to browse through and comment on anything you would like.

Cyclicals

WJA in 2007

I owned WJA.to around $10-14 in late 2006 and early 2007.The company did have some trouble slowly passing on rising fuel prices to customers, but their largest competitor (Air Canada) was, well… a bumbling idiot. WJA was stealing market share and there wasn’t much Air Canada could do about it.

WJA_buy_and_sell

It was actually one of my first success stories as shares quickly approached $20 (I had a fair value placed at $20-22) a year after I bought. I remember analysts tripping over themselves to raise target prices. I was caught trying to catch the last 5%.

WJA was still a company with a fair amount of debt and in major expansion mode in a capital intensive business. A friend of mine asked me about WJA after shares went from $20 to $17 about how you get comfortable with a cyclical. I brushed off the concerns as a futile effort to predict the future.

Fast forward 5 years and WJA has now just broken through $20 again. I did end up averaging down somewhat and didn’t loose money on WJA overall, but I still failed to realize how cyclical WJA is. As a capital allocator, this was a major fail.

Net-Net Investing

I would assume that the majority of the followers of this blog understand what a net-net is and why investing in them is supposed to generate superior returns. The theory is easy to understand, at least the way I interpreted it anyway. Buy something no one else wants (based on a discount to some sort of liquidation value) and wait patiently for “something good” to happen to sell your shares into. Risk is low as valuation is already so depressed, that all the “bad news” is supposed to be factored in.

I have not had great luck with net-nets. Maybe it’s because I try to take a look under the hood rather than just mechanically buy shares based on valuation. I am going to profile a few net-nets I have held. It should be noted that it may be too early to call each example a winner or loser, but all of them have tested my ability to remove emotions from investing. The real test with any net-net is likely patience, as they tend to be dinky little businesses with no real competitive position. As the market grinds higher, you have the sense that you are missing out and hold an illiquid little company that no one really cares about. It’s certainly not sexy.

To be clear, I have nothing against net-net investing as I continue to hold shares in companies that trade at a discount to NCAV. I am just stating some of my experiences.

ADDvantage Technologies Group, Inc. (AEY)

I bought AEY way back in Q2 & Q3 2011. I sold over 6(ish) months in 2012. Average performance was a loss of 16%. To be fair I bought mostly at NCAV, not at a discount to NCAV (which is what Graham was doing and is recommended). A quick summary of the stock at the time:

  • about 50% of assets were in inventory
  • major debate as to true value of inventory as they carried quite a bit and sales were weak
  • heavy insider ownership
  • working towards a net cash position (cash – debt)
  • end users (major cable companies) were hesitant to engage in major projects
  • recent change in agreement with Cisco was likely negative and creating uncertainty
  • Family owned and controlled, though compensation was reasonably fair and insiders where incentivized to realize larger profits

All of these factors led to a stock at NCAV. FWIW management seemed to “get it” for the most part as far as executing a business potentially in decline and one that definitely that had a ton of uncertainty in front of it.  They made a small acquisition to push some slow moving product through, they mentioned not chasing revenue but profit, and paying down debt. What they didn’t get (as is true with most net-nets) is capital allocation. No desire to buy back shares below NCAV, no special dividend, no marketing of the story to increase valuation.

After a few painful conference calls, I decided to sell. I have moved on and haven’t really looked back until today. I was sure that the top line wasn’t going to move anytime soon and figured the inventory would eventually be written off, which would remove my margin of safety. The inventory has not been written down since I let go of the shares, but the top line has struggled.

Here is what it would have looked like had I held onto the shares since my original purchase or if I had bought (and held onto) an ETF that tracks the S&P500.

AEY_vs._SPY

LGL Group (LGL)

I still own a small position in LGL Group. As with AEY, I bought most of my shares at NCAV, not at a discount to NCAV. This sums up the stock at the time of my original purshase (Q3 2012):

  • discount to NCAV
  • stable backlog, dropping top line
  • major markets for products were soft
  • 30% of total assets in cash
  • 13-15% of total assets in accounts receivable
  • 18-20% of total assets in inventory
  • some PP&E on the books that may hide additional value
  • significant owners of the stock that may pressure for management action
  • CEO that owned very little of the company

Since purchasing there were some positives to show that management was willing to right size the organization to survive. A reorganization was done to reduce costs, a strategic review was conducted, and moderately stable gross margins.

The issue was that the continued weak top line and small reduction in what was likely a very bloated expense line has led to operating losses. I am currently underwater by about 20% on the name and undecided what to do. The strategic review did nothing to close the gap between the share price and liquidation value. The following chart sums up the recent poor performance.

LGL_asset_values

The valuation has bumped around 1x NCAV, while NCAV has fallen. My margin of safety continues to erode. Recently the CEO resigned and there have been some board changes. Maybe this will be the catalyst to unlock value, but I am considering this one an (expensive) lesson.

Bri-Chem (BRY.to)

I had watched BRY for about a year or so before taking the plunge after a 30% drop over the course of a year, (I still own). Here’s a summary:

  • CEO owns about 5%, about 2 years salary
  • Director & former President to a subsidiary (Brian Campbell) owns 25%
  • Essentially 2 companies: one fast growing (fluids) and majority of revenue and one slow growth (steel pipe) and dragging down consolidated results
  • high debt load, no cash
  • 45-50% of assets in inventory
  • 30% of assets in accounts receivable

Since my purchase I am down about 8%. Several things have happened to change the story. First of all due to them being debt heavy and light on cash, they issued shares (fairly dilutive) at a discount to NCAV. A couple of things have brought encouraged a more scrutinized look at the balance sheet (strategic review and LOI to purchase the manufacturing facility of the steel pipe division) have brought down NCAV from almost $2/share to just over $1/share now. Yikes.

BRY_asset_value

I also bought the shares with an idea that they were trading at a discount to the sum-of-the-parts. The fast growing fluids division was growing steadily with increased oil & gas activity in the US and steady activity in Canada. There was some organic growth and some acquisitions. Both seemed to require capital and I never paid attention to how cash strapped the company was.

The steel division consisted of manufacturing and distribution. I didn’t pay enough attention to how poorly the business was performing and how little management (or analysts) seemed to care. Here are the last 9 quarters of sales versus production.

BRY_steel_production

They obviously overestimated the likelihood of success with this venture and were slow to respond to lack of demand for their product. They stated a 25-30% gross margin target in late 2012, then 20-25% in Q3 2013 and 15-20% now.

There may still be value here. The fluids division has a current run rate of about 10 mil in EBIT vs. the enterprise value of 100 mil. As mentioned there is a LOI to purchase the steel manufacturing division, but not the distribution part of the steel pipe division. Though management was confident both would go in the sale. Depending on the price, we could see some cash freed up for further fluids expansion and a re-rate in the company valuation to peer level. Even though the top line is extremely seasonal, I am holding my small position until there is some more color on the steel pipe division sale.

Sangoma Technologies (STC.v)

I wrote up STC here. Currently I am up about 40%. Most of this is due to the recent attention the company received from this blog. Here is a quick summary:

  • 23-25% of total assets in cash
  • 25-29% of total assets in accounts receivable
  • 17-18% of total assets in inventory
  • former CEO owns 20% of company
  • current CEO (from Q2 2011 until present) owns very little
  • transitioning from old legacy product to new products. split between revenue 50-50
  • CEO made it apparent that top line growth is priority 1
  • revenue is lumpy
  • small player in a large market
  • at the very least they have been break even from a cash flow standpoint over the last few years if you just include maintenance capex

STC_TB_&_Rev

They actually took a large write-down since I purchased shares, but it was all Intangibles and Goodwill, so my margin of safety was never compromised. I continue to hold and might even add as I think the lumpiness in revenue has the market spooked. But they are slowly executing on transitioning to more and more “new products” and with 65% gross margins, there is quite a bit of operating leverage.

Conclusion

What seems to be a large disconnect between investors and management in the land of asset based investments is timeframe. The CEO should be looking out several business cycles and making strategic business decisions based on all sorts of inputs. What levers to pull are more important than the markets current perception of the organization. Investors (generally) want to make a quick buck. They seem to be more interested in liquidating or putting lipstick on a pig to sell to an institution. Which isn’t a bad thing per se, it’s just a different set of priorities. The CEO is losing his source of income and I don’t think it would look good on his/her resume or LinkIn profile to say that the last job was something that was pressured to break up or liquidate because even after 10 years at the helm, the company was worth more dead than alive.

Many times these net-nets are family controlled and have been in the family for several generations. They are more precious to this family than a 1963 Corvette in mint condition. It’s their legacy.

So whether it’s right or wrong to try and cherry pick net-nets, I will be at least putting even more time to do some detailed research on them. I should note that I haven’t mentioned all net-nets I have interacted with, but just pointed out 4 examples of what you could be getting yourself into if you purchase a net-net.

So far I would like to see at least:

  • growing sales or at least flat sales
  • some cash position (preferably the largest current asset)
  • no cash burn from operations

Anyone have any thoughts on net-nets they would like to share?

 

Dean

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