Unsuitable for Managers who are not Warren Buffett (CCA Industries)

October 12, 2009

Damodaran on Valuation claims that unnecessary financial assets, such as stocks or bonds or other securities of other corporations, have no effect on a company’s valuation, since the risk-adjusted discounted cash flow they produce is equal to their present value, so there is no incremental benefit to owning them or decremental drawback from getting rid of them. Of course, this position assumes that markets are efficient which is at odds with both the central theory of value investing and presumably Damodaran’s own purposes in writing, since he did call his book Damodaran on Valuation, rather than Damodaran on Giving up and Becoming an Actuary.

6a00d83451cfe069e200e54f5a9c6d8833-800wiHowever, he does raise a good point; why should the shareholder pay management fees and submit to double taxation for a firm to hold financial assets that the shareholder could just go out and buy if the company had just issued a dividend instead of paying for the assets? The only possible explanation is that the firm is in fact capable of producing better investment results than the majority of its shareholders. Damodaran cites Berkshire Hathaway as a rare example of this firm; most corporate managers who are not Warren Buffett realize that investing in securities to produce above-average returns is difficult to do well and indefensible if done badly. Just ask any failed investment bank.

So, what do we do with a firm that does not seem to be aware of this principle? Specifically, CCA Industries Inc. (CAW), a tiny firm that makes low-end toothpaste and beauty products, reports that of its approximately $33.5 million in assets, $14.5 million are short-term investments or marketable securities. Year to date income produced by these investments has been $212 thousand, resulting in an annualized return of a bit under 3% as of the May 31 reporting period. However, for their actual operations, the other $19 million in assets has produced pretax earnings of $1.29 million, which is a return on assets of 13.6% if it is doubled to fill out the year. (And this assumes that all the cash on their balance sheet is needed for their operations). So, it is pretty apparent that the financial assets they hold are superfluous. In fact, if they did distribute all of their excessive assets, the market cap, currently 29.5 million, would drop to 15 million, which would be amply supported by $1.7 million in after-tax earnings (apart from accounts payable they have virtually no debt to speak of).

This being the case, how has CCA gone this long without some enterprising investor raiding it? According to the writeup at the Value Investor’s Club, it is because the firm is controlled by two old men in their 70s. There was a deal proposed last year to take the firm private, but it fell through. Otherwise, the stock seems to be entirely under Wall Street’s radar.

If Damodaran is correct, and the unnecessary financial securities do not produce any actual value to the company, then buyers of this company are in fact buying $19 million in actual capital, $2.6 million in operating earnings, and $14.5 million of excessive holdings taunting them. Unfortunately, as long as the two old men control the company there is no realistic way to force the distribution of the excessive assets, and in the meantime the firm’s aggregate return on capital will be suboptimal, resulting in a depressed share price. We hope for the sake of the noncontrolling shareholders that the company’s owners will listen to reason.

P.S. They pay a 6.7% dividend, although the dividend history has been somewhat erratic.

Edit: The firm just announced earnings, but without the concrete detail that breaks down operating versus investing earnings. When I have those, I will do an update.  I don’t expect too much to change in my analysis, though.

Update:  Their interest and dividend income is up to 245 thousand year to date, producing a return on capital investments of 2.3% on an annualized basis (although they also have some capital gains which pushes the total to 2.8%). Their return on assets from their actual operations is 14.0% pretax. QED.

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