Fructivore Investments

If you have been following this blog for some time, you may recall the first move I recommended was the bonds of Bon-Ton Department Stores, which I suggested could be hedged by shorting an equivalent dollar value of the stock. At the time the bonds were at 46 and the stock was at $4. Now, the company has announced that they are not as doomed as previously thought, so the bonds have shot up lately to around 90 and the stock to almost 12. The bonds have paid their semiannual coupon since then, so they have properly speaking shot up to 95, but the follower of this move would have made $500 on the bonds and lost $800 on the short. I think that $12 for a company that is still having all of its earnings eaten up by interest is too high of a price, so these results have not diminished my enthusiasm for capital structure arbitrage (which is the formal name for this move), or for junk bond investing. Ben Graham wrote that even an unattractive form of investment, like a bond that is inadequately secured, can be attractive at an attractive price. Even though they are unlikely to appreciate past par, especially because most bonds these days are callable, they can still produce attractive returns.

However, the majority of junk bonds are junk for a reason, and they require careful screening. Consider the bonds of Callon Petroleum Co., which pay 9.75% and are trading at 60, currently yielding 16%. They fall due in December of 2010, but most of those bonds will never be redeemed, because the firm was forced to institute a tender offer because what with two hurricanes and a drop in the price of oil they were forced to discontinue a large operation in the Gulf of Mexico. Their other operations are barely able to cover their interest. The terms of the tender offer are  replacing the $1000 9.75% bonds with $750 13% bonds (thus actually saving nothing on interest), plus what works out to 37 ½ shares of stock. The new bonds fall due in 2016. The company is pleased to report that they have over 90% participation in the tender offer.

However, there is a small problem with their plan. Although the company is presently able to cover their interest, and possibly even with a few pennies left over for the shareholders, the firm’s long term strategy is in doubt. Unlike Linn Energy or Breitburn Energy, which focus on properties with a long development life, most Gulf of Mexico properties have a development life of only a few years, with most of the production heavily front-weighted. So, they have to acquire, explore, and exploit properties with considerable frequency. However, with no spare income and also no shareholders’ equity left (even with the bonds discounted and the nonrecourse debt from the discontinued operation moved off the balance sheet, they are below even), it is hard to determine what the company will use to acquire these new properties. They claim to be looking into longer-lived properties and joint ventures, and best of luck to them. Otherwise, they are potentially doomed beyond the assistance even of the Chapter 11 that they are trying to prevent with this tender offer.

As is often the case in distressed debt, the decision of whether to tender the bonds is a prisoners’ dilemma situation; if enough bondholders accept the exchange, the company will be able to redeem the non-tendered bonds without difficulty, so the holders who rejected the tender offer will make a windfall. But if not enough holders accept the tender offer, the company will be forced into bankruptcy. This is why, as Moyer wrote in Distressed Debt Investing, firms tend to require over 90% participation in any tender offer, a provision they can waive if necessary. Here, there is legitimately over 90% participation, so that hurdle is not an issue. Based on the current prices, apart from about $90 (discounted) in coupon payments due between now and the payoff date, the bondholder who rejects the offer is looking at $900 (discounted) for a price of only $510 per bond. This implies that even now there is an expected 57% chance of no recovery, assuming that 60 is also a fair price for accepting the tender.

The tender offer expires on Monday, and it is clear from the overall prospects of the firm, that it would be best to reject the tender offer and take our chances with the 2010 payoff. However, this firm does not appear to be another Bon-Ton stores, so the wise fructivore should consider a purchase very carefully.

The Greek word for marketplace is “agora,” so the word “agoraphobia” literally means “fear of the marketplace,” and Congress seems to be suffering terribly from it lately. Given what has happened over the last couple of years their reaction is unsurprising.

Indexing, long touted as the safe long-term option for the passive investor, has shown itself to be riskier than we all imagined, producing a negative 10-year return. If stocks always beat bonds over the long term, claim the authors of Dow 36000, then they are in fact less risky than stocks and thus the Dow deserves to be at 36000. If, however, they are more risky, then the index fund industry has some explaining to do.

Of course, after the dot-com collapse, the Nasdaq fell from 80% from top to bottom amid much less wailing, but I get the impression that there was a better sense of the speculativeness of those ventures, whereas the recklessness of financial institutions came as much more of a surprise. As Keynes wrote, “A speculator takes risk of which he is aware; an investor takes risks of which he is unaware.”

However, the response strikes me as excessive in some areas. Even though the the decision by the Fed to guarantee all commercial paper after the fall of Lehman Brothers was a stroke of genius (took in plenty of guaranty premiums without a single payout, not to mention saving the economy and I say that without exaggeration), we have to weigh that against Chairman Cox’s decision to outlaw short selling of financial stocks, which was a  knee-jerk reaction that demonstrated a fundamental lack of comprehension of market dynamics that one would not expect from the head of the SEC. In fact, in terms of ignorance it ranks alongside Alan Greenspan finding his “flaw.” Short sellers are a source of liquidity, and illiquidity in the face of panic selling produces a price collapse. Furthermore, shorts taking profits, which they certainly had in plenty last year, are a source of buying pressure that would mitigate the price collapse.

And what, may we ask, is so wrong with a price collapse? If the price drops and sets off a chain reaction of panic selling and margin calls, this will only push the price below even the most pessimistic fundamental estimates, at which point the sensible fructivores will start buying. It is the basis of all value investing, and we actually look forward to it. What distinguishes the commercial paper workout from the ban on short selling is that in the commercial paper arena what we were facing was a complete loss of confidence in the entire market, whereas the short selling ban was nothing more than an artless attempt to prop up prices. As an aside, I read somewhere that a CEO who blames shorts for the low share price of his company tends to give up on average 2% a month in share prices for the next year, and if the CEO blames a conspiracy of shorts, 4% a month.

So, apart from the fact that it’s the Baby Boomers’ retirement, what harm is there in coming to a sudden realization that the markets are riskier than we (most of us, anyway) all thought? Yes, too big to fail institutions are a problem and ideally should be broken up, or better still, forced to pay through the nose into an emergency liquidity fund to clean up the mess when they do fail. Beyond that, though, I don’t see what is the use of having measures designed to reduce volatility or the apparent riskiness of the market–and much of the effects of these measures will stop at appearance only. Optimizing capital structures using leverage does, it must be admitted, increase risk, but it also increases the amount of available capital in the economy, which is good for the GDP, and any mistakes normally work themselves out in bankruptcy court.

It is disturbing, though, that the regulators still embrace value at risk, which assesses the risk of loss on a financial asset by applying a stochastic process based on volatility that has been observed over a certain period, typically less than five years. Of course, the five years before 2008 were extremely boring in terms of volatility. Value at risk could perhaps be preserved if the period surrounding the collapse of Lehman Brothers was used as representative, but it would be quicker to abandon the stochastic myth, since security prices stop behaving as though they follow a stochastic process just about when panic strikes and every market participant wants them to be stochastic. In a book I read called Lecturing Birds on Flying, Pablo Triana suggests a Levy distribution, whereby events that are 6 standard deviations away from the norm may be predicted to occur every couple of decades instead of every couple of eons. I’ve never been that swayed by quantitative analysis, but if regulators are going to use a quantitative method they could at least use one that hasn’t been demonstrated not to work.

I suppose it is the embracing of the Capital Asset Pricing Model’s conflation of volatility and risk that informs much of the love of quantitative analysis. Volatility is neutral; by chance alone it can put prices in the wrong place, but exploitably and allowing for the likelihood of reversion. Risk is not neutral; it is negative and its effects tend to be more or less irrevocable, unexploitable for most people, and, of course, largely invisible. As an analogy for illustration, suppose that in a hand of Texas Hold’em, I have flopped a straight against my opponent who has flopped a set. There is about a 1/3 chance that he will improve to a full house or better. That is volatility. There is also an unknowable but nonzero chance that he will pull out a gun, rob everyone at the table, and vanish into the night. That is risk. But because it is hard to separate their effects during a the chilling moments of financial panic, Congress and the regulatory bodies feel bound to do something.

The latest proposal from the Senate Finance Committee is a plan to reorganize regulators, create provisions to split up banks that are too big to fail, and create a clearinghouse for derivatives. I agree that too big to fail should mean too big to exist, and as for the regulators, in my view whoever does the regulation is less important as long as they have teeth and the regulations are effective. However, I worry that stripping the Federal Reserve of its power over banks is just anti-Fed hysteria. My issue, however, is with the derivatives clearinghouse. The problem is that so many fancy derivatives these days are over the counter, which allows their terms to be customized. To trade via a clearinghouse, they would have to be standardized and commoditized, which might make them less useful. Furthermore, as happened with equity options and mortgage securities, these arcane instruments would be “domesticated,” and thus acquire an aura of safety and familiarity that is inconsistent with how bad of a mess they can make. Thus Congress, in an attempt to limit their impact by instituting these controls, may wind up causing them to expand, thus exacerbating the problem they intended to solve.

As some of you may recall, I called Coinstar an attractive short target some months ago, and it didn’t exactly go so well. In fact, it did go exactly as high as $38.28, when I called for the short at $25.91. Of course, that was during a massive stock market rally; one of the purposes of short selling is to reduce your exposure to broader market movements, which tends to work against you when you have short something that is highly correlated with the indexes during a rally.

However, with their recent earning announcement last Thursday/Friday, Coinstar very kindly gave up $3, dropping back to $29, and despite today’s rally they have regained none of that ground. And all this, despite beating analyst estimates for the quarter by a considerable margin. Of course, I’ve never understood the obsession with beating analyst earnings; if the company fails to beat the estimates the stock gets punished as if it’s the company’s fault rather than the stupid overoptimistic analysts’.

But as for Coinstar, it is true that they have increased their sales by $90 million since the same quarter last year, but do you happen to know by how much they increased their profits? Less than $2 million. So it is clear that we are dealing with a low profit margin firm, and now one that is facing increased competition from Blockbuster kiosks, as well as having to deal with Netflix and several antitrust suits that I don’t think they’re going to win. As I mentioned before, when Coinstar bought out its co-owners the price paid implied a value of $300 million for the entire Redbox division, and the counterparty was a sophisticated seller that had access to inside information, that probably concluded that the business was not likely to generate excess returns from any more capital put in, and based on these margins I am inclined to agree. Their other divisions have been more or less flat, so I remain unconvinced that this company is going to produce the kind of growth that will justify their still-optimistic valuation.

Accordingly, I continue to short Coinstar and suggest that the rest of you, if you do short, short this one too.

P.S. I couldn’t miss out on this little gem from the conference call. From seekingalpha.com

“We closely track consumer satisfaction by measuring our net promoter scores. As you can see on slide five, we continued to hoverer [sic] north of 80%, which puts us with such companies as Apple, Google and Amazon.com, iconic brands that have been established over a much longer time.”

http://seekingalpha.com/article/171699-coinstar-inc-q3-2009-earnings-call-transcript?source=yahoo&page=2

Yes, I suppose they are comparable to Apple, Google, and Amazon.com…in this small and almost completely irrelevant aspect.

Windstream (WIN) has just announced that they are acquiring yet another phone company, NuVox, for 280 million in cash, about 180 million in stock, and 180 million in assumed debt, total 640 million. 

NuVox focuses specifically on business, which makes it a desirable fit with Windstream’s plan to offset landline loss with high revenue customers. NuVox claims to produce $115 million in “adjusted” earnings, the adjustment being to smooth out nonrecurring charges and to put $80 million in depreciation and amortization back in. So, as adjusted the purchase has a P/E ratio of 5.6, but eliminating depreciation and amortization charges is an old trick invented in the 80s to make mergers and buyouts look more attractive, and it didn’t work then. And yet, most phone companies have depreciation charges that exceed their capital expenditures so not all of the $80 million may have to be put back in. Of course, since NuVox is private I have no concrete information to work with. Windstream also claims that the combined firm will have $30 million a year in synergy, but for synergy the wise investor says “I’ll believe it when I see it.”

In addition to being a good strategic fit, management claims that the acquisition will be accretive to cash flow. Accretiveness to cash flow is the easiest thing in the world: just buy a company with a lower P/E ratio than yours. And, if you put all the depreciation back in and indulge management’s view of $30 million in synergy, (canceling one optimistic assumption with one pessimistic one about depreciation), you get a P/E of 11, which is a little bit below WIndstream’s unadjusted trailing P/E ratio, but of course Windstream’s cash flow is significantly higher. So, the actual accretiveness is up in the air.

In terms of strategic fit, I keep thinking back to those Fairpoint rumors. Fairpoint had a market that was almost completely unsaturated with profitable high speed services, and their intention was to fill that gap in the market, thus earning sufficient profits to pay off the ridiculous debt they took on to make the purchase. Of course, they were too busy dealing with integration issues to make any headway, forcing them into bankruptcy. With this acquisition, much of the penetration work has presumably been done, thus making Windstream’s post-merger work easier, but also entitling NuVox to a premium in its purchase price.

In the final analysis I am neutral towards this merger, since unless the depreciation is in fact greatly in excess of the capital expenditures I’m not convinced that Windstream is getting anything that hasn’t been paid for in full.

As I stated yesterday, American Lorain has announced that they have sold stock and warrants totaling 5 million shares for $2.40, 1.75 million shares worth of warrants at a price of $3.70 that become exercisable six months after the transaction closes and have a term of 5 years thereafter, and 500 thousand shares worth of additional warrants with the same terms except that they only run for two and a half years, all for the price of $12 million.

As anyone can see, though, $12 million is simply 5 million shares times $2.40; the warrants seem to have been thrown in for free. These warrants, which are essentially call options, according to the Black Scholes formula using a high volatility assumption, and based on $3 a share, are worth $1.16 and 76 cents respectively. Now, of course writers smarter than I ( as well as less smart) have criticized the Black Scholes, since it is inaccurate for valuing options that are long-dated or far from the strike price and is based on an unrealistic view of asset price behavior, but it is undeniable that the warrants are worth more than nothing. In fact, I believe the consensus is that the Black Scholes tends to undervalue such options, in which case this was definitely a poor arrangement for American Lorain. And, since I think the company was undervalued before the deal was finalized, this price is even more indefensible.

Of course, since I think that a price of $5 is minimally adequate for the company, I see it more that the firm has just given away more than $1 per warrant. I can only assume that the price was negotiated around a month ago when the stock was trading at less than $2.40, since at $3 before the announcement it seems like a ridiculous deal.

Even going by market prices, at $3 a share, the company loses 60 cents times 5 million shares, $1.16 times 1.75 million in the 5-year warrants, and 76 cents times 500 thousand in the 2-1/2-year warrants, total $5.41 million. Before the deal was announced, the firm was trading at  $3 a share with 25 million shares outstanding, total $75 million. After the announcement yesterday, the share price dutifully retreated to $2.70, total market cap $67.5 million. It fell further today, of course, but what didn’t?

Now, the company will receive $12 million from the sale proceeds, but be diluted by 5 million additional shares. If the warrants are not exercised, there will be no further dilution, so ($75 million plus $12 million sale proceeds – $5.41 million in discounts), divided by 30 million shares, comes to $2.72 a share.

If the warrants do get exercised, as I think they will be, the company takes in an additional $3.70 per warrant, or $8.325 million, at the cost of further dilution. It also suggests that the share price of $2.40 was an even bigger discount, so I’ll just use the warrant price of $3.70 instead of $3 (for making this modification I am relying on no financial authority but myself, but it seems to me to have a certain logic). So, (75 million + 12 million + 8.325 million – 5.41 million in old discount – 3.5 million in new discount)/32.25 million shares comes to $2.68. So, with the warrants exercised or without them this new equity offering has diluted the company by 30 cents a share.

(It is curious, though, that the closing price $2.69, settled right between the above-calculated diluted values; I would never imply that the markets are efficient, but at the very least they are paying attention).

Si Chen, the firm’s CEO and majority shareholder (at least for now (unless he has an interest in the buyers of this offering in which case some shareholder derivative lawsuits would be in order, so I doubt this is the case)), is “very pleased with our ability to acquire this type of equity financing given the nature of the tight global markets. It speaks well of how the investment community views American Lorain.”

However, since the firm’s P/E ratio was 4.67 as of yesterday, this represents a cost of capital of 21.4%. Although I commented before on the high interest rates they get in China, the worst one in their last report was a “mere” 13.1% and curiously their cost of long-term financing is much lower than their short-term financing (although there could be subsidies at work; I’m not an expert on China’s internal investing environment). Of course one expects the cost of debt to be less than the cost of equity, but this year’s earnings to date are on par with last year’s,  and last year their interest payment was covered 7.5 times; it was covered 6.2 times the year before that, and year to date it is covered 4.5 times for a company that claims to see higher demand in the second half of the year. This coverage ratio, although not iron-clad, is consistent with investment-grade credit and it seems to me that raising the capital by borrowing, even though the firm would be pushed to the lower end of investment-grade, would be preferrable to giving up 8% in cost of capital and submitting to dilution.

Nor, to my knowledge, has American Lorain stated what they intend to do with the proceeds. As of last year their return on assets was 15.3% and their return on equity was 23%, so at a 21.4% cost of capital even if they did realize these results from their new capital (which is questionable because of diminishing marginal returns) they hardly produce any benefit that would justify this level of dilution. Even paying off their debt would significantly improve their already fairly strong credit profile.

Accordingly, I think this offering was entirely ill-priced, and should constitute a black mark on the market’s perception of the talents of American Lorain’s current management.

As some of you may recall, I suggested getting out of Capstead Mortgage (CMO) on the grounds that its fat dividend (currently 17%) couldn’t last forever and that, at a price of $14.60 and a book value per share of $11.50,  the price represented well over a year of excess dividends, and the Federal Reserve is not likely to keep interest rates low for that long.

Now, the price has fallen back to $12.80 as of yesterday and $13.30 as of today. However, their latest report indicates a book value per share of $12.20. However, the principal value per share is, I believe, sitting at around $10 per share, since adjustable-rate mortgages tend to keep their value in over time the face of interest rate movements and these are explicitly guaranteed by the US government, thus producing a nice premium over principal value. The principal value is important because mortgages are prepaid at their principal value, and last quarter Capstead Mortgage’s prepayments were running at a 23.5% annual rate. The prepaid securities can be replaced, but at the same premium which, based on the latest results, is 3.5%.

At any rate, $13.30 set against an unmodified book value of $12.20 is only six months’ of excess dividend, which seems to be long before the Fed will consider raising rates  (even though the economy is officially growing again) and even after interest rates rise, as long as they stabilize in a reasonable range Capstead Mortgage will be able to earn reasonable, if not their current outsize, returns. However, the mob in the marketplace will probably react to a diminution of the dividend as a sign of disaster, selling until the stock represents no premium at all, or even a discount, to book value. As I stated before, that is the time to really pile on Capstead Mortgage.

P.S. I know that American Lorain has just made a potentially dilutive equity offering. I’ll collect my thoughts on the matter and let you all know.

Well, it’s official: Fairpoint has filed for bankruptcy. As Moyer’s Distressed Debt Investing states, the actual filing of a Chapter 11 is never a surprise. Although it may seem curious that its creditors reduced the size of their claim from 2.7 billion to 1 billion, the reality is that the creditors are going to become the beneficial owners of Fairpoint no matter what the size of their claim. In fact, most bankruptcies involve some pre-filing negotiations of this type and it is rare but not impossible that these early maneuvers obviate the need for bankruptcy, although they did not in this case.

I still haven’t seen anything to confirm the rumor that Windstream is buying up Fairpoint’s debts in order to carry some of Fairpoint’s more lucrative operations. But I will repeat the necessity of caution; buying more than one could afford was what killed Fairpoint to begin with–how anyone can expect a telephone company to pay off a debt at 13% interest is beyond me.

I may be in the minority among the financial community and the public, but I do not assign any mystical economic or investing qualities to China or any of the companies in it. There was a similar hysteria in the 80s over Japan, and we all recall how that ended. I find it similarly unlikely that China has discovered how to repeal the ordinary rules of economics. Furthermore, although I have no direct proof of it, I suspect that the astounding growth figures in China are exaggerated, considering that they are still reporting high GDP growth in the face of articles from earlier this year about exports dropping and migrant laborers going home.

However, these sentiments should certainly not disqualify a Chinese company from consideration for investment; Warren Buffett (and presumably other investors as well) noticed that South Korea sits in the shadow of North Korea’s missiles and its accounting rules make Japan’s look like a model of transparency. This resulted in a number of stocks drifting around to a P/E ratio of 3. But, with careful analysis, it became clear that among the mess a few of those stocks were legitimately offering those kinds of P/E ratios.

American Lorain (ALN on the Amex), sadly, doesn’t have a P/E ratio of 3. But it is 5.26 as of this writing, which is not bad. It is an American-registered firm that, through a multi-tiered capital structure, owns four operating subsidiaries in China, one of which is shared 80:20 with the Chinese government. They produce a wide variety of chestnut products and other processed foods in a number of markets, primarily China, but including the rest of East Asia and various other nations. Although they claim to control various proprietary technologies including a method for permeating a chestnut with syrup without altering its texture, I don’t believe that they are blessed with any sort of durable competitive advantage, although they claim to be the largest chestnut processor in China. Operations-wise, they seem to be fairly dependent on bank debt, and based on their SEC filings short-term interest rates in China are surprisingly high; between 5 and 10% for their various short-term borrowings, which they have expanded considerably in anticipation of the third and fourth quarters when they see their highest demand. Their balance sheet does also count more than $2 million worth of “landscaping, plant and tree” as an asset, which seems like kind of a stretch.

The company also does not have a long operating history, having only been in operation in its current form for a couple of years since its effective IPO and having only been listed on an exchange since last September, although the actual business has been in operation since 1994. They have also had issues with getting their SEC filings in on time.

At any rate, if any of you have an appetite for investing in China, American Lorain is a suitable candidate; it is a firm in a relatively stable industry, with reasonable growth potential, that is manifestly underpriced both in terms of P/E ratio and return on equity, even without consideration of any supposed China premium. I don’t necessarily believe in international equity and currency exposure just for the sake of having the exposure, but international underpriced exposure is a different matter entirely.

Warren Buffett once wrote that in financial analysis, having an IQ above 125 is wasted and that success in investing is largely a matter of temperament. This tells us two things, one, that the world’s greatest investor thinks that dispassionate adherence to investing principles is more important than fancy quantitative models, and two, that Warren Buffett’s IQ is 126.

The most dispassionate method is the “net-nets” recommended by Ben Graham. These are firms whose working capital (cash and short term investments, receivables, and inventory) exceeds their total debts, and which are selling to a discount even to that. In other words, the current assets of the firm will pay for the purchase of the entire firm, and the firm’s longer-term assets and the future earning power they represent are available for free, or in fact, the current shareholders are paying you to buy them. The Snowball, Warren Buffett’s biography speaks of Benjamin Graham’s employees wearing lab coats and filling out forms to calculate whether a net-net existed. Nowadays, with SEC filings available online and the Excel spreadsheet having been invented, one would expect that these opportunities are harder to find, and indeed they are, and upon seeing them one might be curious as to why.

In theory, a diverse portfolio of these investments could be purchased without any further analysis, but as I’ve stated there may be something other than a depressed market at work. USEC Inc., for example, sold at less than its net working capital for a long period, but it was actually stockpiling cash in order to build its centrifuge plant, and we all know how that worked out.

Anyway, some kind person on the Internet has a screener to identify these opportunities. Most of them are over the counter or penny stocks, which are difficult to trade and subject to liquidity issues, which does suggest that neglect by the market is still a significant cause of these net-nets appearing. Some of them are in danger of delisting, which in theory does nothing to a firm’s operations, but usually does adversely affect its share price and also its access to capital markets. More troubling than trading difficulties, though, are operational difficulties; if the firm has a negative operating cash flow, it is quite conceivable that it will burn through the discount it sells for, thus robbing these issues of their apparent safety. Another issue is firms that reclassify their long-term investments to short-term, as with Asta Funding, a debt recycler on the list, has reclassified all of its portfolio of debts as receivables, when in reality they hold the debts for multiple years. Other firms may have inventories that need writing down.

But a firm that can avoid these troubles is almost by definition an attractive investment. Key Tronic Corporation (KTCC), manufactures circuit boards and other electronics. They have positive operating earnings, although they are a bit low in terms of return on capital, but more importantly they have 61 million in current assets, 27 million in debts, and 24 million in market cap, leaving a discount to current assets of $10 million, producing a 42% discount which makes a very decent margin of safety. Hence, this firm is worth more liquidated than it is valued at as a going concern, and when the economy improves and they have more orders, their return on assets should dramatically improve.

So, clearly fine returns can be made off what the market overlooks, if you do a little homework to make sure the market isn’t actually right.

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.

However, 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.