Alert: Corning To Buy Company I’ve Recommended

Alert: Corning To Buy Company I’ve Recommended

Note: I just sent versions of the following message to both Value Investing Journey and Press On Research subscribers.

Thanks for being a loyal email subscriber.

While working at the investment newsletter from September 2014 to February 2015 I recommended three companies to subscribers.

I wrote in my 2014 and 2015 Value Investing Journey and Press On Research Portfolio Reviews that while I couldn’t reveal the research or the names of those companies.  I may write new research reports about them at some point in Press On Research.

While doing research on them to write-up in Press On Research one of them ended up agreeing to a buyout offer from Corning (GLW).

Alliance Fiber Optic (AFOP) agreed to the buyout price of $18.50 per share.  A 22% premium to what I recommended the company at.

I can’t release the full analysis article I wrote but in short my thesis on the company was that it was undervalued by 22% to 65%.  That it had some minor competitive advantages.  That there was a huge $140 billion trend in the companies industry that could explode its shares.  And it crushed bigger competitors in terms of profitability.

Just to name a few margins that were spectacular it produced a 19.3% FCF/Sales Margin.  Had an ROIC of 34%.  And had an unlevered return on net tangible equity of over 100%.  The only time I’ve found a company whose margin was above 100%.  And this means it’s one of the best run businesses on the planet.

And this still wasn’t all…

Insiders owned 14% of its shares.  It paid a 1.2% dividend.  And planned to buy back 6% of shares outstanding.

I loved this company.  And its profitable operations were some of the best I’ve come across when evaluating companies over most of the last decade.  Especially considering it was only a $250 million company.

The buyout price of $18.50 per share in cash from Corning is a low-ball offer though.

AFOP is worth between $20 and $25 per share with no growth expected.  And like I said above there’s a huge $140 billion trend in the companies industry that could explode its growth and share price further.

At this point I’m not sure if shareholders will fight or not but lawsuits have been filed by at least two different law firms saying AFOP insiders breached their fiduciary responsibility to shareholders by not seeking a higher price.

I agree the price AFOP agreed to is low.  But it’s not egregious so I’m not sure if these lawsuits will continue or if shareholders will get any money at some point.

Either way the subscribers of the investment newsletter I worked for will gain ~22% in 14 months owning this great company.

If you’d like to see my other exclusive company recommendations where my picks have crushed the market over the last four years you need to subscribe to Press On Research.

And remember as Value Investing Journey subscribers you get a 50% discount on a one year subscription.  Full year price for you as a subscriber is only $49 instead of $97.  And newsletters similar to mine sell for several thousand dollars at prominent investment newsletter companies.

Thank you for being a subscriber

Jason Rivera

Value Investing Journey

Press On Research

Author of How To Value Invest

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To find out all the great companies I’ve recommended you need to subscribe to Press On Research.

And if you’re a Value Investing Journey subscriber remember you also get a 50% discount on a one year Press On Research subscription.

Similar newsletters to Press On Research sell for several thousand dollars at a big newsletter company.

If you have further questions about Press On Research please go to the link in this sentence or email me at jasonrivera@valueinvestingjourney.com.

Buffett’s Alpha Notes – The Power of Float – On Float Part 3

Buffett’s Alpha Notes – The Power of Float – On Float Part 3

The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day.  The hope being that our knowledge will continue to compound over time so we’ll have huge advantages over other investors in the future.

The aim of today’s post is to continue this process by talking about a topic few investors know about.  And even fewer understand.

Most people overlook float when evaluating companies because they either don’t know what it is.  Don’t know the power it can have within a business.  Or don’t know how to evaluate it.

This won’t be an issue here.

Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written.  But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.

Today’s post is a continuation of the earlier posts: Charlie Munger On Deferred Tax liabilities and Intrinsic Value – On Float Part 1. And What is Float? On Float Part 2.

Today I’m going to illustrate how powerful float is over time.

Buffett’s Alpha Notes – The Power Of Float

My notes aren’t in the quoted areas unless in parenthesis.  Bolded emphasis is mine throughout.

“Further, we estimate that Buffett’s leverage is about 1.6-to-1 on average. Buffett’s returns appear to be neither luck nor magic, but, rather, reward for the use of leverage combined with a focus on cheap, safe, quality stocks.”

“We show that Buffett’s performance can be largely explained by exposures to value, low-risk, and quality factors.”

“Looking at all U.S. stocks from 1926 to 2011 that have been traded for more than 30 years, we find that Berkshire Hathaway has the highest Sharpe ratio among all. Similarly, Buffett has a higher Sharpe ratio than all U.S. mutual funds that have been around for more than 30 years.

Sharpe ratio is a measure for calculating risk adjusted returns. I don’t use this metric but It’s talked about a lot in the Buffett’s Alpha PDF so you need to understand what it is to understand the context of the article even if you never use it.

Alpha is another metric I don’t use… It’s a measure of risk adjusted performance.  It’s the return in excess an investor/business generates when compared to an index.

For example if your stock picks have returned 20% every year over the last ten years while a comparable index has returned 10% every year for those ten years you’ve generated an alpha of ten percentage points every year.

“So how large is this Sharpe ratio that has made Buffett one of the richest people in the world? We find that the Sharpe ratio of Berkshire Hathaway is 0.76 over the period 1976-2011. While nearly double the Sharpe ratio of the overall stock market, this is lower than many investors imagine.

Adjusting for the market exposure, Buffett’s information ratio is even lower, 0.66. This Sharpe ratio reflects high average returns, but also significant risk and periods of losses and significant drawdowns.

If his Sharpe ratio is very good but not super-human, then how did Buffett become among the richest in the world?”

“The answer is that Buffett has boosted his returns by using leverage (FLOAT) and that he has stuck to a good strategy for a very long time period, surviving rough periods where others might have been forced into a fire sale or a career shift. We estimate that Buffett applies a leverage of about 1.6-to-1, boosting both his risk and excess return in that proportion.”

Thus, his many accomplishments include having the conviction, wherewithal, and skill to operate with leverage and significant risk over a number of decades.”

If you read the article linked below ignore the academic talk of beta, efficient markets, and other academic terms that have little to no relevance in value investing.

“Buffett’s genius thus appears to be at least partly in recognizing early on, implicitly or explicitly, that these factors work, applying leverage without ever having to fire sale, and sticking to his principles. Perhaps this is what he means by his modest comment:”

Ben Graham taught me 45 years ago that in investing it is not necessary to do extraordinary things to get extraordinary resultsWarren Buffett, Berkshire Hathaway Inc., Annual Report, 1994.

“However, it cannot be emphasized enough that explaining Buffett’s performance with the benefit of hindsight does not diminish his outstanding accomplishment. He decided to invest based on these principles half a century ago. He found a way to apply leverage. (FLOAT) Finally, he managed to stick to his principles and continue operating at high risk even after experiencing some ups and downs that have caused many other investors to rethink and retreat from their original strategies.”

I disagree with the high risk mentioned in this entire article.

The academic version of risk is a lot different from what we as value investors think of risk.  Most of the “excessive risk” mentioned throughout the article is attributed to volatility.  Which isn’t risk in what we do.

Why then does Buffett rely heavily on private companies as well, including insurance and reinsurance businesses? One reason might be that this structure provides a steady source of financing, allowing him to leverage his stock selection ability. Indeed, we find that 36% of Buffett’s liabilities consist of insurance float with an average cost below the T-Bill rate.” (FLOAT)

In summary, we find that Buffett has developed a unique access to leverage that he has invested in safe, high-quality, cheap stocks and that these key characteristics can largely explain his impressive performance.

Buffett’s large returns come both from his high Sharpe ratio and his ability to leverage his performance to achieve large returns at higher risk. Buffett uses leverage (FLOAT) to magnify returns, but how much leverage does he use? Further, what are Buffett’s sources of leverage, their terms, and costs? To answer these questions, we study Berkshire Hathaway’s balance sheet, which can be summarized as follows:

We would like to compute the leverage using market values (which we indicate with the superscript MV in our notation), but for some variables we only observe book values (indicated with superscript BV) so we proceed as follows.

The above means the estimated 1.6 to 1 leverage the paper states Berkshire gets from its float is a low estimate.  This is because they had to use book values as estimates for the wholly owned Berkshire subsidiaries.

These book values don’t represent any growth in value of the subsidiaries only the original purchase price in most cases.  And knowing what kind of companies Buffett buys these companies have gained a ton of value over time meaning more leverage according to the papers logic.

The magnitude of Buffett’s leverage can partly explain how he outperforms the market, but only partly. If one applies 1.6-to-1 leverage to the market, that would magnify the market’s average excess return to be about 10%, still falling far short of Berkshire’s 19% average excess return.

Berkshire’s more anomalous cost of leverage, however, is due to its insurance float. Collecting insurance premia up front and later paying a diversified set of claims is like taking a “loan.”

Table 3 shows that the estimated average annual cost of Berkshire’s insurance float is only 2.2%, more than 3 percentage points below the average T-bill rate.

 Hence, Buffett’s low-cost insurance and reinsurance business have given him a significant advantage in terms of unique access to cheap, term leverage. We estimate that 36% of Berkshire’s liabilities consist of insurance float on average.

Based on the balance sheet data, Berkshire also appears to finance part of its capital expenditure using tax deductions for accelerated depreciation of property, plant and equipment as provided for under the IRS rules. E.g., Berkshire reports $28 Billion of such deferred tax liabilities in 2011 (page 49 of the Annual Report). FLOAT

Berkshire Hathaway’s overall stock return is far above returns of both the private and public portfolios. This is because Berkshire is not just a weighted average of the public and private components. It is also leveraged, which magnifies returns.

While Buffett is known as the ultimate value investor, we find that his focus on safe quality stocks may in fact be at least as important to his performance. Our statistical finding is consistent with Buffett’s own words:

I could give you other personal examples of “bargain-purchase” folly but I’m sure you get the picture: It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price. – Warren Buffett, Berkshire Hathaway Inc., Annual Report, 1989.

Given that we can attribute Buffett’s performance to leverage and his focus on safe, high-quality, value stocks, it is natural to consider how well we can do by implementing these investment themes in a systematic way.

In essence, we find that the secret to Buffett’s success is his preference for cheap, safe, high-quality stocks combined with his consistent use of leverage to magnify returns while surviving the inevitable large absolute and relative drawdowns this entails.

Indeed, we find that stocks with the characteristics favored by Buffett have done well in general, that Buffett applies about 1.6-to-1 leverage financed partly using insurance float with a low financing rate, and that leveraging safe stocks can largely explain Buffett’s performance.

This is the power of float illustrated over a long time period.

The above means his excess returns are attributed only to smart use of float and buying cheap great businesses over a long period.

This is why we must understand what it is and how to use it to our advantage to become better investors.

If you want to read the full 45 page PDF that includes the math, examples, and references download the paper Buffett’s Alpha here.

Most of Buffett’s and Berkshire’s float comes from insurance companies.  But float can be found at any company.  And next up I’ll show you how by analyzing a company’s balance sheet to find float.

***

Remember if you want access to my exclusive notes, preliminary analysis, and access to all posts as they come out you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

What Is Float? On Float Part 2

What Is Float? On Float Part 2

The goal of this blog is to help us all improve as investors and thinkers so we’re a little wiser every day.  The hope being that our knowledge will continue to compound over time so we’ll have huge advantages over other investors in the future.

The aim of today’s post is to continue this process by talking about a topic few investors know about.  And even fewer understand.

Most people overlook float when evaluating companies because they either don’t know what it is.  Don’t know the power it can have within a business.  Or don’t know how to evaluate it.

This won’t be an issue here.

Press On Research subscribers already know this as I talk a lot about float in many of the issues I’ve written.  But I want to begin talking about it more here because float is one of the most powerful and least understood concepts of business analysis.

Today’s post is a continuation of the earlier post Charlie Munger On Deferred Tax liabilities and Intrinsic Value – On Float Part 1.  And we’re going to answer the question today, what is float?

But before we get to that next is an excerpt from the July 2015 Press On Research issue where I talk about float extensively.

The Biggest Investment Secret In The World

How Warren Buffett Got So Rich And How You Can Too

Warren Buffett’s admired around the world for his philanthropy as he’s going to donate 99% of his $70 billion plus net worth to charity when he dies.

He can donate so much money because of how great an investor he is.  But almost no one knows how Warren Buffett made his fortune.

Yes, most investors know about his investments in Coke (KO), Johnson & Johnson (JNJ), and Wells Fargo (WFC).  But this isn’t how he built his fortune.

Investor’s who’ve studied Buffet know he built his partnership, and then Berkshire Hathaway, buying small companies.

But this still isn’t the true secret to Warren Buffett’s success.

Today I’m going to tell you how he grew $100,000 into more than $70 billion.  And tell you how we can start doing the same.

But before we explain the exact companies Buffett built his fortune on.  We need to talk about why Press On Research concentrates on small caps.

A University of Kansas student asked Buffett about this in 2005:

“Question: According to a business week report published in 1999, you were quoted as saying: “It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”…would you say the same thing today?”

Here’s Buffett’s answer emphasis is mine:

“Yes, I would still say the same thing today. In fact, we are still earning those types of returns on some of our smaller investments. The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today’s environment because information is easier to access.”

Yes, I’ve said this before many times.  But it’s an important concept to understand.

Small ultra safe investments that produce a ton of cash.  Have little to no debt.  Pay dividends and buy back shares.  And are cheap are my favorite investments.

These kinds of businesses are what Value Investing Journey and Press On Research is all about.

Today’s recommendation has no debt.  Owns more cash and cash equivalents than its entire market cap.  And just its net cash and cash equivalents make up 77% of its market cap.

This doesn’t count any of its property, plant, and equipment, future premiums earned, or cost-free float.  And this company is undervalued by 29% to 70%.

But this still isn’t all…  It’s also much more profitable than competition.

Today’s pick isn’t just a great company with all the above traits.  It’s also in Buffett’s favorite industry to invest.

Investing In Insurance

Most people won’t research insurance companies.  I wouldn’t early in my investing journey.  And many professional analysts stay away too.

This is because insurance companies are hard to understand at first.  Have new and confusing terminology to learn.  And normal profit metrics don’t matter much for them.

But if you learn how to evaluate them not only will you learn they’re easy to evaluate once you know what you’re doing.  But you can use the same repeatable process on every insurance company.  And Buffett has continued to buy into insurance – his favorite industry – constantly over the decades.  And it’s why he’s so successful.

In reality insurance companies are easy to understand.

Insurance companies take money – premiums, the insurance version of revenue – as payment for insuring things like businesses, equipment, health, life, etc.

The insurance company doesn’t have to pay you a dime of the money it earns over the years until there’s some kind of damage or theft of whatever’s insured.

When this happens they pay the agreed upon insurance rate out to the policyholder.

While the company continues to earn money – premiums again – it invests some of it so it can pay back your policy in the future.  And also make a profit in excess of the amount earned, invested, and paid out.

If the company writes its policies and invests well over time it will earn underwriting profits.  And grow the assets it can use to write more policies and invest more money.

If it doesn’t, the company will go out of business when a major disaster strikes.

Think of insurance companies like investment management companies.  But instead of only earning management fees.  Insurance companies earn premiums on top of investment earnings.

These effects can double profits over time…  If management is great at what they do.

The insurance business while easy to understand is one of the hardest businesses to be great at.

Other than being a low-cost operator like GEICO.  Owned by Berkshire Hathaway.  There are no competitive advantages in this industry.  And it also experiences wild swings of huge profitability than massive losses.

But if the company writes policies and invests money well over a long period they can grow to great sizes at almost no extra costs.  The only new costs may be to hire more staff.

Insurance companies also hold the greatest secret in the investment world…  Float.  This is how Buffett built his fortune.  And how we’ll start to build ours.

But before we get to this we need to know why float is so important.

Brief Berkshire Hathaway History

Buffett began buying Berkshire Hathaway stock in 1962 when it was still a textile manufacturer.  And when he still ran his investment partnership.

He bought Berkshire stock because it was cheap compared to the assets it had.  Even though the company was losing money.

He continued to pour millions of dollars into Berkshire to keep up with foreign and non union competition.  But none of this worked.

In time Buffett realized he was never going to make a profit again in the textile industry.  So whatever excess funds Berkshire did produce he started buying other companies.

The first insurance company Berkshire Hathaway bought was National Indemnity Company in 1967.

Since then Berkshire’s float has grown from $39 million in 1970 to $77 billion in 2013.

Float compounds like interest does if you use and invest it well.  But not only does float compound, if you use it right it also compounds the value of the company that owns the float.

Since 1967 when Berkshire bought National Indemnity, Berkshire’s stock price has risen from $20.50 a share to today’s price of $210,500.  Or a total gain of 10,268%.

This is the power of insurance companies when operated well.  And today’s recommendation is an insurance company that operates the right way too.

But before we get to that I need to explain how float makes this possible.

The Biggest Investment Secret Revealed

‘Float is money that doesn’t belong to us, but that we temporarily hold.”  Warren Buffett

Float is things like prepaid expenses.  Billings in excess of expected earnings.  Deferred taxes.  Accounts payable.  Unearned premiums.   And other liabilities that don’t require interest payments.
But they are the farthest thing from liabilities.

MY UPDATED NOTE HERE… I’LL TALK ABOUT THIS MORE IN DEPTH IN A LATER POST AND DETAIL WHAT I MEANT TO SAY AND DIDN’T EXPLAIN WELL ENOUGH HERE.

Instead of paying this money out now like normal liabilities.  Companies can use these “liabilities” to fund current operations.

Float is positive leverage instead of negative leverage like debt and interest payments.
Think of float as the opposite of paying interest on a loan.  Instead of paying the bank for the cash you’ve borrowed.  The bank pays you interest to use the money you loaned.  And you can use this money to invest.
Using cost-free float to fund operations can improve margins by up to a few percentage points.

MY NOTE HERE: I’LL EXPLAIN THIS BETTER IN A FUTURE POST TOO.
The best way to explain why float is so important is with the following quote:

“Leaving the question of price aside, the best business to own is one that over an extended period can employ large amounts of free – other peoples money – in highly productive assets so that return on owners capital becomes exceptional.”  Professor Sanjay Bakshi adding to something Warren Buffett said about great businesses.
I said in last month’s issue: “When a company’s float/operating assets ratio is above 100% it means the company is operating with “free” or cost-free money.”

But this isn’t true with insurance companies.

For an insurance company to operate on a cost-free basis it has to produce underwriting profits for a sustained period.

I look for underwriting profits of at least five years straight to consider its float cost-free.

And the company I’m going to tell you about today has earned an underwriting profit every one of the last 10 years.

When you come across companies that are able to do this on a consistent basis you should expect exceptional returns in the future.

This is because when a company operates its entire business on a cost-free basis it means several things. 1)  It’s a great business.  2.)  It’s an efficient business.  And 3.) float magnifies profit margins.

So what is this great company?

I go on here to detail the company I recommended – and bought for the portfolios I manage – in July to subscribers.

So What Is Float?

To summarize the above float is anything listed in the liabilities section of its balance sheet you don’t pay interest on.

Interest based liabilities – NOT FLOAT – include capital leases, and short and long-term debt.

Most of the time these are the only interest based liabilities on a company’s balance sheet.  Make sure by checking the off-balance sheet transactions and total obligations notes – if any – in the companies footnotes.

Examples of non interest based liabilities – FLOAT – include prepaid expenses, accounts payable, taxes payable, accrued liabilities, deferred tax liabilities, unearned premiums, etc.

These vary more but remember if the company doesn’t have to pay interest on the liability it’s float… Money the company has to pay later but in the mean time can use to invest in and grow the business.

Think of float as normal debt without the negative effects.

In the short to medium-term – long-term for most insurance companies – float while listed as a liability on the balance sheet should be considered an asset to the company.  Why?  Because while the company owns the float it can use these “liabilities” to invest and grow the business.

How though?

Because while the company lists the liability on its balance sheet – and still owns the liability – it can use the float as positive leverage to grow the company or invest in other businesses.

Sometimes at a better than cost free basis as mentioned above… But we’ll talk about this in a future post on float.

Next up I’ll go through a company’s balance sheet to separate float from non float.  And show you how to value and evaluate it.

What do you think of float at this point?  Do I need to explain anything better?  Let me know in the comments below.

***

Remember if you want access to my exclusive notes and preliminary analysis you need to subscribe for free to Value Investing Journey.  And this isn’t all you’ll get when you subscribe either.

You also gain access to three gifts.  And a 50% discount on a year-long Press On Research subscription.  Where my exclusive stock picks are evaluated and have crushed the market over the last four years.

October Press On Research Issue – The Next GE?

October Press On Research Issue – The Next GE?

I don’t hype investments.  And my biggest fear while the investment newsletter was courting me last year was I would have to hype.  Use hyperbole to explain how you’d gain 10,0000% owning XYZ stock in the next three days.  Or even outright lie.

But I got lucky.

While I learned a ton of investment newsletters are terrible.  And will lie and promise returns they can’t hope to deliver.  The investment newsletter I worked for wasn’t one of those.

One of the biggest rules all analysts had to abide by was “Write about the biggest returns you want and the investment time frame you want.  But you have to be able to prove the investment thesis and returns out or we can’t use them.”  In other words don’t promise what you – or we in that case – can’t deliver.

I was relieved when I found out this was one of the biggest rules analysts had to follow the company.  And while I still don’t hype investments.  I learned it’s not hype if you can prove your thesis out.

Even though you might think a title of The Next GE? for an issue is hype its not. In the October 2015 Press On Research issue releasing today I prove that this company could become the next GE.

If this still isn’t enticing enough how about an excerpt from the upcoming issue where I lay the groundwork for my thesis.  The unfinished excerpt below is from the October 2015 Press On Research issue being sent out to subscribers today.

October 2015 Press On Research Issue

By Jason Rivera

Press On Research Volume 1 Issue 7

The Next GE Pays You A 10% Dividend Now

While We Earn 34.5% In The Next Year

If you’ve studied business and management you’ve read or seen GE from the early 1980’s talked about a huge amount.  And have learned how Jack Welch saved the company by introducing a radical concept.

GE was going to number one or two in each business it operated.  Or it was going to sell or close down the businesses.

This was a drastic – but necessary decision – because GE had become an inefficient bureaucratic nightmare.

Quoted below from Wikipedia.  Emphasis is mine.

“During the early 1980s he was dubbed “Neutron Jack” (in reference to the neutron bomb) for eliminating employees while leaving buildings intact.

In Jack: Straight From The Gut, Welch states that GE had 411,000 employees at the end of 1980, and 299,000 at the end of 1985.

Of the 112,000 who left the payroll, 37,000 were in businesses that GE sold, and 81,000 were reduced in continuing businesses.

In return, GE had increased its market capital tremendously. Welch reduced basic research, and closed or sold off businesses that were under-performing.”

And this changed fortunes for GE shareholders in a huge way going forward  During Welch’s tenure from 1981 to 2001 the company’s share value rose 4,000%.

That’s not a typo.

Whether you thought his slash and burn tactics were humane or not; for GE shareholders Jack Welch’s tenure was amazing.

And because of how well GE did during his tenure Mr. Welch is regarded as one of the best business leaders of the 20th century.

But why did this approach work so well?

Because it enforced strict competition standards within GE.  It forced every subsidiary to work towards becoming the best company it could be.

GE employees at all subsidiaries knew if they didn’t work towards becoming great.  And achieve those goals.  That its business may be sold to another company.  Downsized.  Or shut down.

This led to more innovation.  Better productivity.  Less bureaucracy and more efficiency at all subsidiaries and GE.  And this led to better margins, compounding of value within the company, and higher returns for shareholders.

But Press On Research is about small, safe, undervalued companies, which have management I can trust.  And we can’t buy GE from the early 80’s today.

So why am I talking about it in Press On Research?

Because today’s recommendation operates using Jack Welch’s rule of being number one or two in each business unit it operates in.  And because of a multi trillion trend within its industry could become the next GE over time.

But before we get to what the company is.  I need to tell you what it does.

Investing In Picks and Shovels

“During the Gold Rush, most would-be miners lost money, but people who sold them picks, shovels, tents and blue-jeans (Levi Strauss) made a nice profit.” Peter Lynch

In the August 2015 Press On Research issue I told you about a great company in the tech sector that works with some of the biggest tech companies in the world.

But it wasn’t a typical tech company…

It didn’t have a social network.  Introduce a new game or app.  Or even improve graphics or processing speed for games and computers.

It operates in what’s referred to as the picks and shovels part of the technology industry.

What does this mean?

The picks and shovels part of any industry is something that’s necessary to the survival of the industry.  But most people don’t think about.

To continue the example from the Peter Lynch quote above; when people flocked to the gold rush they wanted to get rich by focusing on finding gold.

But most people didn’t.  And the people who didn’t lost fortunes and became destitute.

The people who made out best during the Gold Rush were people who sold things like tents, jeans, picks, and shovels.

The same thing is happening in today’s tech arena…

Everyone is focusing on the next big app, game, or social network.  But most of these ventures fail.  And while we have greater social and economic safety nets today than we did in the 1800’s.  Vast fortunes are still being lost today chasing the quick cash.

That is unless you’re in the picks and shovels part of the industry.  And like (NAME REMOVED) from the August 2015 Press On Research issue.  Today’s company operates in that same necessary semiconductor and processor packaging industry.

Handle With Care Part 2

The number one tenant of value investing is buying companies selling at a discount to their intrinsic – or true – value.

This is done so that even when making a mistake in our analysis we still have a good chance of making some money.  Or at least not losing much.

Different value investors also incorporate things like profitability.  Management trustability.  Cash generation.  Trends.  Etc. into their analysis.

But the biggest thing for value investors after buying a company with a margin of safety is the ability to understand the business the company operates in.  And the stability of that industry.

These two concepts are why most value investors keep away from investing in the tech industry.  Where valuations are higher than average.  And the industry changes at a rapid pace.

The best kinds of businesses are ones that are necessary.  Today’s business is.

As with (NAME REMOVED) in August, today’s pick packages microchips and processors for the tech industry.  And as I said in the August 2015 Press On Research issue:

Companies manufacturing parts going into computers and other electronics have to make sure the parts work when finished.

Since most of these hardware manufacturers have assembly lines set up only to make chips, processors, and memory. They have to outsource the testing of their products to third parties

Without third-party specialists like our pick today testing and packaging products.  The part and product manufactures would have to test them in-house.

This would take money away from R&D for new products.

So not only does outsourcing save the tech giants and manufactures money and time.  But it also brought to life an entire specialized packaging, testing, and assembling industry.

Combined this industry does billions of dollars worth of work.  And saves the tech giants billions of dollars.

This industry will experience wild swings when giant chip makers like Intel and Micron slow down.  But it will remain necessary for the foreseeable future.

This is one of the reasons why I have no problem investing in “tech” for the second time as a strict value investor.  But there are a lot more great things about this company.

Today’s pick is a $640 million company.  It has better margins than (NAME REMOVED).  It could turn into the next GE in time.  It’s undervalued by as much as 40% now.  Will pay us a 10% dividend while we wait for its shares to rise.  And produces and has a ton of cash compared to little debt.

All the above combine to make this an ultra safe investment. None of this considers the huge trend that could explode its shares.  And turn the company into the next GE.

But before I tell you what the company is let’s do a quick comparison…

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*Repost* Strattec Security Corporation $STRT: Potential Double From Today’s Stock Price

*Repost* Strattec Security Corporation $STRT: Potential Double From Today’s Stock Price

Introduction, Overview of Operations, And Brief History

The company I will be focusing on in this article is Strattec Security Corporation (STRT).  Strattec is a nano cap with a current market cap around $75 million and it is in the very boring and shunned automotive parts industry.  The company has expanded to become a worldwide auto parts supplier through its various joint ventures and alliances.

The company makes and sells various automotive parts such as: Keys with radio frequency identification technology, bladeless electronic keys, ignition lock housings, trunk latches, lift gate latches, tailgate latches, hood latches, and side door latches.  With its acquisition of Delphi Corporation’s Power Products in 2009 it is now also supplying power access devices for sliding side doors, lift gates and trunk lids.

In 2001 Strattec formed an alliance with Witte-Velbert Gmbh.  The alliance allowed Strattec to sell Witte’s products in the US, and allowed Witte to sell Strattec’s products in Europe.  In 2006 the alliance expanded to include ADAC plastics and a joint venture with all three companies owning 33% was formed called VAST or Vehicle Access Systems Technology.  ADAC makes such products as door handles.  The VAST Alliance has helped Strattec become a worldwide auto parts supplier as the alliance allows all companies involved to market and sell each other’s products in various jurisdictions around the world including in the US, Europe, Brazil, China, Japan, and Korea.  The VAST Alliance should have its first profitable year as a company this year which would help Strattec’s bottom line.  Full complement of VAST’s products can be viewed here.

VastPlacemat

Picture taken from ADAC Plastics which shows how the VAST Alliance is structured.

ADAC and Strattec have formed a separate company, ADAC-Strattec de Mexico, ASdM,  whose operations are in Mexico due to cheaper labor prices, where the two companies separate expertise are combined to manufacture some of the above products for sale. In Strattec’s fiscal years ending 2012 and 2011, ASdM was profitable and represented $31.0 and $25.2 million, respectively of Strattec’s consolidated net sales.

With the help of VAST and its other joint ventures, Strattec’s export sales have risen to 37% of total sales which amounts to $107 million.  In 2001 exports only accounted for 14% of its sales which amounted to $29 million, which illustrates Strattec’s worldwide growth since then.

During the recession three of Strattec’s biggest buyers filed for bankruptcy protection, and the overall auto industry went to the brink of death before being saved by the US federal government.  Because Strattec’s major buyers were having so many problems, it also faced some very serious problems and had its only unprofitable year in 2009, lost more than $40 per share in value during the recession, about 2/3’s of its share price in total, and its share price has not recovered since.

Since that time Strattec restructured, improved its operations and expanded its product lines, signed various joint venture and alliance agreements which have allowed the company to become a worldwide auto parts supplier.  The restructuring, expanded product lines, and worldwide operations have helped Strattec become a more diversified auto parts manufacturer and has grown its sales and margins in the ensuing years.  With the help of VAST and its other joint ventures Strattec is a truly worldwide company with operations now in the US, Europe, Brazil, China, Japan, Korea, Canada and Mexico.

Strattec was spun off from Briggs & Stratton in 1995 as an independent company.  After Strattec was spun off from Briggs & Stratton, and through most of its entire history, it enjoyed massive market share of over 60% in the US and a 20% market share of the world’s vehicle lock and key operations.  With its huge hold of the market the company was able to dictate high prices to its buyers which enabled the company to enjoy a competitive advantage for a long period of time.

However, shortly after Strattec was spun off there were massive changes in the lock and key industry which deteriorated the company’s market share and competitive advantages. Due to Strattec’s managements excellent foresight and planning, it was well prepared for the change from basic locks and keys and the diminishing of the amount of locks and keys needed per vehicle, and has transitioned into the electronic key arena as well as expanding its operations into various fields though its partnerships with the VAST Alliance including: Door handles, power doors, trunk latches, lift gate latches, tailgate latches, hood latches, side door latches, ignition lock housings, sliding side doors, lift gates and trunk lids.  Since Strattec’s restructuring during the Great Recession, along with its VAST Alliance and other joint ventures, improved operations, and expanded product lines, Strattec’s sales and margins have both been growing and improving.  The trend of growing sales and margins should continue unless another recession hits.

Excellent Management

Due to the excellent leadership of Harold Stratton II, former CEO and current chairman, current CEO and board member Frank Karecji, and the other members of Strattec’s management team and board of directors, it has been able to adjust its original lock and key operations and changed massively to become a truly worldwide auto parts supplier with the products listed above.

Normally I do not talk much about management in my articles because I usually deem management to be either average or subpar, and as Charlie Munger says I want the business to be simple enough to be able to be run by the proverbial “idiot nephew” so management is generally not a factor in my analysis unless they are doing things that bother me quite a bit.

In this case I wanted to point out that I believe Strattec’s management to be excellent and I think that will continue now that Mr. Stratton has transitioned out of the day to day operations and handed the handling of those over to Mr. Karecji.  For the full view of why I believe Strattec’s management to be excellent I recommend reading its annual reports from 1999 to the present to get the true view of why I think its management has been fantastic, and to get a glimpse of the obstacles management has helped the company overcome to become an even stronger company.  Here is a profile of Mr. Karecji, Strattec’s new CEO from 2010 right after he joined the company.

For those who do not want to read all that information I will list a few pluses from management in recent years that I have not already talked about.

  • Strattec has bought back and reduced its shares outstanding by 3.66 million, or more than 50% of its original shares outstanding after being spun off, at a cost of approximately $136 million.
  • Most purchases have been at what I think are good prices to do buy backs.  I think now would be an even better time to buy back more shares (Strattec management has authorization to buy back more shares) because of Strattec’s current undervaluation which I will get to later, but I understand that it wants to put money into expanding its operations and product lines.
  • Another reason Strattec has not bought any shares back in the past couple years as it has been concentrating on reinstating its dividend and expanding its VAST Alliance operations. The company currently only has 3.3 million shares left that are outstanding.
  • Management compensation is fair and straight forward in my opinion which is another plus for management.

Insider and Fund Ownership

  • GAMCO Investors-Collectively Mario Gabelli’s Funds-Own 18.6% of Strattec.
  • T. Rowe Price and Associates through its Small Cap and Small Value funds own-15.5% of Strattec.
  • FMR-Fidelity Management and Research Company own-12.2% of Strattec.
  • Vanguard Horizon Funds own-6.2% of Strattec.
  • Dimensional Fund Advisors, a Small Cap Value Fund, owns-5.8% of Strattec.
  • Insiders Own-7.82% according to Reuters.
  • The above insiders and funds own a combined 66.12% of Strattec which partially explains why there is a very low average daily trading volume of around 2,000 shares per day in the stock.

Like I have said in my various other articles I love to see high insider and value oriented fund ownership of the companies I invest in so this is another plus for me.  Another possibility that might arise in the future is that due Strattec only having 3.3 million shares outstanding, its small overall size as a company, and some of the other factors I will mention or have mentioned in the article, I think that Strattec could be taken private or become a potential buy out target for one of the bigger automotive supply companies.

Competitors

The company faces stiff competition from the following three companies.

  • Magna International (MGA)-I talked about Magna a bit in my Core Molding Technologies (CMT) article and how I did not think that Magna was a major threat to CMT’s area of operations.  The story as it pertains to Strattec’s operations is different however.  Magna competes with Strattec in several of its product lines including the power access area and Magna appears to be a major player in those areas.  In 2009 Strattec bought the Power Access portion of Delphi’s business segment after it went bankrupt and renamed the unit Strattec Power Access.  For fiscal years ending 2012 and 2011, Strattec Power Access was profitable and represented $62.7 and $62.8 million, respectively of Strattec’s consolidated net sales.  Just for comparison Magna did $1.2 billion in sales just in its closure systems (power access) business in 2011.  Magna could present a problem for future growth of Strattec’s product lines as it will have to compete vigorously on price and quality for contracts.  It could also present a potential opportunity as with CMT, I could see Magna possibly buying out Strattec to expand its operations into more product fields.  This makes further sense since Strattec is such a small company in comparison to Magna and it being an $11+ billion market cap company.
  • Huf huelsbeck & fuerst-Huf and its various subsidiaries including Huf North America is a privately held company with operations worldwide and whose product lines compete directly with Strattec’s on almost every product around the world.  This company presents the same problem as Magna does to Strattec, but the same potential buy out opportunity exists as well.
  • Tokai Rika-This is a Japanese publically traded company who competes directly with Strattec on several products and who also has operations around the world.  Tokai Rika, like the two companies mentioned before, also dwarfs Strattec in size which could present problems to Strattec’s growth.

Strattec faces much stiffer competition from multiple much bigger competitors, sometimes directly on the same products than CMT did, who I thought carved out a bit of a niche in its industry.

Strattec’s Margins

Gross Margin TTM 18.50%
Gross Margin 5 Year Average 15.32%
Gross Margin 10 Year Average 18.25%
Op Margin TTM 6.20%
Op Margin 5 Year Average 0.44%
Op Margin 10 Year Average 5.18%
ROE TTM 12.11%
ROE 5 Year Average 3.59%
ROE 10 Year Average 9.91%
ROIC TTM 11.90%
ROIC 5 Year Average 3.49%
ROIC 10 Year Average 9.85%
My ROIC Calculation With Goodwill 25.90%
My ROIC Calculation With Goodwill If EBIT% Reverts to 3 Yr Avg 15.41%
My ROIC Calculation Without Goodwill 25.82%
My ROIC Calculation Without Goodwill If EBIT% Reverts to 3 Yr Avg 15.37%
FCF/Sales TTM 2.25%
FCF/Sales 5 Year Average -3.49%
FCF/Sales 10 Year Average 1.71%
Cash Conversion Cycle TTM 54.43 days
Cash Conversion Cycle 5 Year Average 48.97 days
Cash Conversion Cycle 10 Year Average 42.42 days
P/B Current 0.9
Insider Ownership Current 7.82%
My EV/EBIT If EBIT% Reverts to 3 Yr Avg 5.77
My EV/EBIT Current Unadjusted 3.43
My TEV/EBIT If EBIT% Reverts to 3 Yr Avg 8.09
My TEV/EBIT Current Unadjusted 4.81
Working Capital TTM $46 million
Working Capital 5 Yr Avg $48.6 million
Working Capital 10 Yr Avg $60 million
Book Value Per Share Current $25.25
Book Value Per Share 5 Yr Avg $24.54
Book Value Per Share 10 Yr Avg $24.78
Float Score Current 0.53
Float Intensity 0.77
Debt Comparisons:
Total Debt as a % of Balance Sheet TTM 0.88%
Total Debt as a % of Balance Sheet 5 year Average 0.66%
Total debt as a % of Balance Sheet 10 year Average 0.33%
Current Assets to Current Liabilities 1.79
Total Debt to Equity 45%
Total Debt to Total Assets 22%
Total Obligations and Debt/EBIT 2.1
Total Obligations and Debt/EBIT If EBIT Reverts To 3 Yr Avg 3.53

All numbers were taken from Morningstar or Yahoo Finance unless otherwise noted.  Final four debt calculations are including total debt and obligations.

Margin Conclusion Thoughts

  • The very first thing that popped out to me from the above margins is that across the board Strattec has improved its margins, sometimes by multiple percentage points, in comparison to its 5 year and 10 year averages.  Looks like the restructuring that took place during the recession, the various joint ventures including the VAST Alliance, and branching out to new product lines has helped the company immensely.  Improvements in operating margin, ROE, and ROIC have all been especially impressive
  • My ROIC calculations make the company look even better as even if Strattec were to revert to its 3 year average EBIT, which I don’t think it will unless another recession happens, I am estimating it to have an ROIC of 15.37% without goodwill.  If Strattec is able to keep up its EBIT margin to current levels I estimate that without goodwill its ROIC is 25.82%, an astounding ROIC margin.
  • Also positive as it pertains to ROIC is that in Strattec’s case it is not being artificially inflated by high amounts of debt.
  • The cash conversion cycle has gotten worse over the years, meaning less efficiency in the company, which I generally do not like.  That is to be expected in a company that has expanded operations overseas though so no red flag there.
  • Its P/B ratio at 0.9 is less than half that of its industry P/B at 2 which means that at least on a relative basis Strattec is undervalued in comparison to its industry.
  • My current unadjusted EV/EBIT ratio estimate for Strattec is 3.43.  Unadjusted TEV/EBIT estimate is 4.81.  Generally I like to buy companies selling at an EV/EBIT ratio of 8 or less so again Strattec appears to be undervalued.
  • Even if Strattec’s EBIT margin were to revert back to its three year average, which as above I do not think it will do unless there is another recession, its EV/EBIT ratio is 5.77 and TEV/EBIT is 8.09, again undervalued or about fairly valued at worst.
  • Book value per share has grown slightly over time, and should grow further with its improved operations.
  • The company has minimal debt and even if we include its total contractual obligations and debt its total obligations/EBIT ratio is a paltry 2.1.  Much improved from some of the other companies I have evaluated and its current total debt and obligations should be nothing to worry about going forward.

Below numbers in graphs are taken from Morningstar.

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121012_2114_1.png

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As you can see in the above graphs Strattec’s share price has not improved as its operations and sales have.  The last year Strattec had comparable margins to what it had this year is 2006, when Strattec was selling for between $33 and $50 a share. As I found after doing my valuations, which I will show below, I think Strattec should be selling somewhere in that range now.  Sales are actually almost $100 million more than they were in 2006, and margins should continue to improve as Strattec’s now worldwide operations and expanded product lines become more efficient.

Valuations

These valuations were done by me, using my estimates and are not a recommendation to buy stock in any of the companies mentioned.  Do your own homework.

Valuations were done using 2012 10K and 2013 first quarter 10Q.  All numbers are in millions of US dollars, except per share information, unless otherwise noted.

Low Estimate Of Intrinsic Value

Numbers:
Revenue:

284

Multiplied By:
Average 3 year EBIT %:

3.77%

Equals:
Estimated EBIT of:

10.71

Multiplied By:
Assumed Fair Value Multiple of EBIT: 8X
Equals:
Estimated Fair Enterprise Value of STRT:

85.68

Plus:
Cash, Cash Equivalents, and Short Term Investments:

12.94

Minus:
Total Debt:

1.5

Equals:
Estimated Fair Value of Common Equity:

97.12

Divided By:
Number of Shares:

3.3

Equals: $29.43 per share

Base Estimate Of Intrinsic Value

Assets:                  Book Value:                    Reproduction Value:
Current Assets
Cash And Cash Equivalents

16.3

12.94

Accounts Receivable (Net)

45.1

38.34

Inventories

25.5

15.3

Other Current Assets

17.1

8.6

Total Current Assets

104

75.18

Deferred Income Taxes

9.7

4.9

Investments In Joint Ventures

8.4

4.2

Other Long Term Assets

0.5

0

PP&E Net

47.6

28.6

Total Assets

170.6

112.88

Number of shares are 3.3

Reproduction Value

  • 112.88/3.3=$34.21 per share.

High Estimate Of Intrinsic Value

Cash and cash equivalents are 12.94

Short term investments are 0

Total current liabilities are 57.8

Number of shares are 3.3

Cash and cash equivalents + short-term investments – total current liabilities=12.94-57.8=-44.86

  • -44.86/3.3=-$13.59 in net cash per share.

Strattec has a trailing twelve month EBIT of 18.

5X, 8X, 11X, and 14X EBIT + cash and cash equivalents + short-term investments:

  • 5X18=90+12.94=102.94/3.3=$31.19 per share.
  • 8X18=144+12.94=156.94/3.3=$47.56 per share.
  • 11X18=198+12.94=210.94/3.3=$63.92 per share.
  • 14X18=252+12.94=264.94/3.3=$80.29 per share.

From this valuation I would use the 8X EBIT+cash estimate of intrinsic value of $47.56 per share.

I discounted the cash a bit in the above valuations because about 55% of Strattec’s cash is in Mexico so if Strattec wanted to bring the funds to the US it would have to pay taxes on that portion of cash.

  1. Strattec is undervalued by 23% using my low estimate of value, which assumes that Strattec will revert back to its 3 year average EBIT margin, which as I stated above, I do not think will happen unless there is another recession.  This is the absolute minimum I think Strattec should be selling for.
  2. Strattec is undervalued by 33% using my base estimate of intrinsic value on a pure asset reproduction basis.
  3. Strattec is undervalued by 52% using my high estimate of intrinsic value with EBIT and cash at current levels.  Now that Strattec has restructured itself and made itself a worldwide company with expanded product lines and improved operations I actually think that EBIT should rise over time meaning Strattec’s intrinsic value could continue to grow and it would become even more undervalued.

Pros

  • Strattec has excellent management.
  • The company is undervalued by every one of my estimates of intrinsic value above and relative valuation estimates such as P/B, EV/EBIT, and TEV/EBIT.
  • Strattec restructured before and during the recession to cut costs, expand product lines, and became more efficient and less dependent on one single product line.
  • Strattec signed joint ventures, and created the VAST Alliance with two other companies that now allow Strattec to compete on a global scale.
  • Strattec’s margins have improved across the board in comparison to its 5 and 10 year averages and margins should continue to improve.
  • Sales have also been improving along with margins.
  • Strattec has almost zero debt.
  • Strattec management owns just fewer than 8% of the company.
  • Most importantly as it pertains to management is that I trust that they have shareholders best interests in mind.
  • Various value and small cap oriented funds own more than 50% of the company, including Mario Gabelli’s funds.
  • The VAST Alliance as a company should have its first profitable year this year which should help Strattec’s profitability even more.
  • My personal estimates of ROIC show that Strattec is even more profitable than I originally thought while looking at Morningstar’s numbers.
  • Strattec has a $25 million revolving credit facility if it wants to do any acquisitions, which the new CEO has said he will look into, or the $25 million could be used in an emergency situation if one arises.
  • Margins are not artificially inflated by debt so margins show a true picture of how Strattec is running.
  • Strattec has drastically reduced its share count in the past decade at what I think were good prices to be buying at.
  • Strattec is currently authorized to buy back more shares if it chooses to.
  • Strattec recently reinstated its quarterly dividend.

Cons

  • Strattec is highly dependent on only a few customers for its orders as General Motors, Ford, and The Chrysler Group combine for 68% of sales.
  • Strattec is highly dependent on how well the automotive industry and the overall economy as a whole are doing which can be seen in the above graphs.
  • Due to the cyclical nature of Strattec, if there is another recession or major problems in the auto industry again, its sales and profitability will be highly affected.
  • The company has some very stiff and much bigger competition.  The competition could possibly mean further price cuts on products in Strattec’s product lines if some kind of price war starts.
  • Due to competition and the overall cost reduction plans put into place by the big automotive companies, Strattec has had to drop prices on its products in recent years.
  • At this point I do not see any kind of long term sustainable competitive advantages within Strattec.

Catalysts

  • Since Strattec is very small in comparison to its competitors it could become a potential buy out candidate.
  • Strattec’s margins should continue to grow which could lead to the unlocking of value.
  • The new CEO Frank Karecji has said that he would like to do some kind of acquisition in the short term.
  • Strattec is authorized to buy back more shares.

Conclusion

With all of the above taken into account, I think that the absolute minimum Strattec should be selling for is $29.43 per share which assumes that Strattec’s EBIT margin will revert to its 3 year average.  I think that Strattec’s true intrinsic value is somewhere between $35 and $45 per share.  None of that is even taking into account that its sales and margins should continue to grow which would also grow the company’s intrinsic value.

The company does face some headwinds to future growth as I outline above, the biggest ones in my opinion is that Strattec has to compete with various bigger companies and I do not see any kind of long term sustainable competitive advantages within the company.

Normally I would want some kind of sustainable competitive advantage within a company that I am buying as a long term value hold, but at current valuations, with Strattec’s good and rising margins and other factors listed throughout the article, I think the risk/reward is in my favor by a substantial margin and I have already bought shares for my personal account and the accounts I manage making this only the fourth company I have bought into this year.