Friday, June 29, 2007

Disney Part II: A Look at Current vs. Historical Valuations

Few would argue that Disney is an interesting combination of assets, from theme parks, and the 43 square miles of Florida land they sit upon, to ABC, ESPN, a mini-retail empire, somewhat recently acquired Pixar Animation Studios, and an incredible film catalogue, to name a few. However, just because a company owns valuable assets does not mean that is is worthy of purchase; there's another side of the equation that investors- yours truly included- frequently forget, that being the company's current market valuation, and whether that over or underestimates the true value.

Think of it this way: There's a beautiful home on the market, it has everything you've ever wanted, truly your dream home. It is worth $500,000, but the owners have set the price at $1,000,000. The fact that it is beautiful, that it is your dream home, that it is a very nice asset is not changed by the asking price. But you would not purchase it because the price is just too high relative to the value. We as investors often make the mistake of separating the value of an asset or company, with the current price, and sometimes we pay too much. But I digress.

Disney's Historical Valuation
One way to attempt value a company is to look at how it has been valued historically versus current valuations. A couple of colleagues and I did some work and published articles on this subject several years back. We'd developed a model designed to calculate a company's downside risk, or lowest potential value, based on where the company traded relative to a variety of historical ratios. Applying a similar methodology, admittedly not as complex, we've looked at Disney's historical price valuation ratios including Price/Earnings, Price to Book Value, Price to Cashflow, Price to EBITDA, and Price to Sales, going back to 1980, using Bloomberg data.

For each of these ratios, we'll show the high/low range, average at year end for the 27 year period, and calculate the value of Disney using that average. Scientific? Accurate? Not necessarily, but a simple way to put valuations in historical context.

Words of Warning
Fundamental valustions are not perfect, and the data used in this piece should serve as a small part of company evaluation. As a wise, well-known financial writer once told me: "Using historical fundamentals alone is like driving your car by looking in the rear-mirror."

Price Earnings
Hi-Low range: 153(1985)-10(1981)
Average closing P/E: 26.2
Average high P/E: 40.8
Average low P/E: 18.8
Current P/E: 19
Current trailing 12 month EPS: $1.80
Current value based on average:
Closing P/E: $47.16
High P/E: $73.44
Low P/E: $33.84

Price to Book Value
Hi-Low range: 7.5(1987)-1.1(1984)
Average closing P/B: 2.78
Average high P/B: 3.97
Average low P/B: 2.30
Current P/B: 2.13
Current Book Value: $17.04
Current value based on average:
Closing P/B: $44.55
High P/B: $63.63
Low P/B: $36.87

Price to Sales
Hi-Low range: 5.1(1987)-1.1(2002)
Average closing P/S: 2.09
Average high P/S: 2.98
Average low P/S: 1.75
Current P/S: 2
Current value based on average:
Closing P/S: $35.68
High P/S: $50.87
Low P/S: $29.87

Price to Cashflow
Hi-Low range: 18.2(2001)-4.5(1984)
Average closing P/CF: 9.7
Average high P/CF: 13.7
Average low P/CF: 7.9
Current P/CF: 10.6
Current trailing CF/share: $3.22
Current value based on average:
Closing P/CF: $31.24
High P/CF: $44.12
Low P/CF: $25.44

Price to EBITDA
Hi-Low range: 153(1985)-10(1981)
Average closing P/EBITDA: 7.8
Average high P/EBITDA: 11.1
Average low P/EBITDA: 6.3
Current P/EBITDA: 9
Current trailing 12 month EBITDA/share: $3.79
Current value based on average:
Closing P/EBITDA: $29.56
High P/EBITDA: $42.11
Low P/EBITDA: $23.88

Interpreting the Data

There are several ways to interpret the data, here is one: If we then take an average of closing valuations for each of the five ratios, weighting them equally, we arrive at a price of $37.64, roughly 10% greater than Disney's current price of $34.14. Does that mean Disney is currently undervalued? Not necessarily. There are many schools of thought on the validity of fundamental data. While we are strong believers in fundamentals, we also live in a world where certain markets, large cap markets especially, are relatively efficient. Disney is followed by many analysts, and owned by many institutions, so there's probably not a great deal of useful undiscovered information available on Disney. Still, conducting an analysis such as this can serve as one piece of the puzzle.

In conclusion, we are intrigued by the Disney story, and at the very least, believe that it is not fully valued at current levels

As always, do your own homework before investing in any security.

*The author does not have a position in Disney. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only
Cheap Stocks Named to List of Eight Best Investing Blogs
Many thanks to Geoff Gannon from Gannon On Investingfor putting Cheap Stocks on his list of best investing blogs.

Friday, June 22, 2007

Judging the Book by it's Cover: Reflections on Disney (DIS) Part I

Readers familiar with legendary fund manager Peter Lynch may recall one of the more interesting components of his investment process: checking out companies with hot new products, retailers with long lines at the checkout counter, or those that got the attention of his wife and/or kids. Lynch made it sound easy, and it certainly was for him. But he possessed a gift for investing, a gut that was frequently right, and a brain that never stopped working (the last attribute I can attest to having had the opportunity to interview Lynch with a couple of colleagues in the late 90’s. Lynch was on overdrive the entire time, and he could not get the words, or better described as streams of consciousness, out fast enough.)

I thought of Peter Lynch often during our recent vacation at Disney World. I thought of the many vacationers who were simultaneously having Peter Lynch-like thoughts as they forked out 3 bucks per bottle of water, 8 bucks for yet another Disney pin for junior, hundreds per person for a park pass, hundreds more for dinner within one of the four major Disney theme parks. Not to mention the wheelbarrows full of cash required to stay at one of Disney's 17 resort hotels.

I could see the wheels turning, the thoughts of those who wanted to own a piece of the money making machine they were observing, and willingly contributing to. I wondered how many would put in a buy order for DIS upon returning to their hotel?

While all the Peter Lynch wanna be's may have been onto something, their analysis based solely on their Disney vacation experience would have obviously been incomplete. The potential decision to buy just on what they observed at Disney Theme parks would have been premature- not necessarily unwise- just not based on all of the facts, a frequent mistake that many of investors (myself include) make. This reminded me of all the movie-goers who walked out of Disney's latest blockbuster Pirates of The Caribbean: At World's End as the credits were rolling. They missed perhaps the most pivotal scene of the movie, perhaps of all three of the Pirates movies, shown at the very end of the credits. (We were tipped off by a review we read prior to seeing the film, and were the only ones in the theater once the credits rolled.)

In Disney's case, many would be surprised to know that theme parks actually comprise less than 30% of revenue and 24% of operating income. In terms of operating margin, parks rank 3rd out of Disney's segments. While the Parks take in a great deal of cash (they certainly took enough of mine last week) the costs to run and maintain these are also very high, and the margins are not as strong as one might think.

2006 Revenues:

Media Networks $ 14,638 (43%)
Parks and Resorts 9,925 (29%)
Studio Entertainment 7,529 (22%)
Consumer Products 2,193 ( 6%)
Total 34,285

Segment operating income (operating margin%):

Media Networks $ 3,610 (24.7%)
Parks and Resorts 1,534 (15.5%)
Studio Entertainment 729 ( 9.7%)
Consumer Products 618 (28.2%)
Total 6,491 (18.9%)

While Disney's theme parks are perhaps the most visible part of the company, they are window dressing to a complex, and interesting empire. As a side note, the theme parks are part of the 43 square miles of land that Disney owns in Florida- a fact that certainly got our attention.

In our next post we'll look at Disney's current valuation in historical context.

*The author does not have a position in Disney. This is neither a recommendation to buy or sell this securities. All information provided believed to be reliable and presented for information purposes only

Tuesday, June 12, 2007

Companies Trading Below Net Current Asset Value: A Refresher and Recent Study

"It always seemed, and still seems, ridiculously simple to say that if one can acquire a diversified group of common stocks at a price less than the applicable net current assets alone - after deducting all prior claims, and counting as zero the fixed and other assets - the results should be quite satisfactory."

-Ben Graham

Ben Graham, the most legendary value investor of all-time, was the first to bring forth the notion that it was prudent for investors to purchase securities that brought with them a margin of safety. One way Graham defined this concept was through his Net Current Asset Value calculation. Here, Graham believed there was a potential margin of safety in companies whose current market value was less than 2/3 of their NCAV, defined as:

(Current Assets - Current Liabilities – Other Long Term Liabilities – Preferred Stock )

Note that the margin of safety came on two fronts, reflected in the conservative nature of this formula. First, any long-term assets, such as property plant and equipment were not considered in the calculation, yet all liabilities were included. Second, Graham’s application of 2/3 to this formula also placed a large discount to the value of the company. The effect of the two can be a powerful combination, having a potentially geometric effect on the size of the discount, depending on the company, and its structure. Essentially, by purchasing a net/net, you are theoretically getting the long-term assets for free- assuming there’s any value to those assets.

For the most part, this technique has been long forgotten, and is no longer utilized in practice. Perhaps the major reason being that it has been difficult in recent years to identify many companies trading at less than 2/3 NCAV. However, with a slight adjustment to Graham’s formula, the concept lives on, and at times is a potentially profitable way to generate alpha.

The History

In my work in helping to build and manage the Equity Fundamental Database of a major market data provider in the 1990’s, I began to experiment with Graham’s formula, and quickly discovered that by dropping the “2/3” factor from the formula, and screening for companies trading below 1 times their net current asset value, I could generate a reasonably long list of US companies. Most if not all were typically deep into the microcap space; many were on this list for a very good reason. Companies that appear to be cheap may be well on their way to bankruptcy. The trick is to try and distinguish between the “cigar butts” as Ben Graham referred to them, and the companies that have some true value, that will ultimately be recognized by the markets.

My research resulted in a few published articles on the subject, and interestingly enough, a segment on a call in radio show in 2002. Still, other than a notable mention in the excellent Tweedy Browne report “What Has Worked in Investing”, (which referenced perhaps one of the last studies done on the subject- Professor Joseph Vu from DePaul, 1988), the topic has remained on the fringe of investment techniques.

When I started the Cheap Stocks site in 2003, I focused primarily on net/nets. This was at a time when there were a few hundred companies trading below their net current asset value, as the markets began to awake following the bursting of the tech bubble. This is not atypical. When there is a bull market in equities, the rising tide lifts all boats, and subsequently, the ranks of net/nets shrink considerably. That is certainly the current state of the net/net market. Currently, there are less than 80 such companies, with an average market cap of TK: very slim pickings in terms of legitimate candidates. (See appendix for a current list)

The Study

Starting with a list of net/nets as of February, 2003, I reviewed the top 50 in order of market cap, in order to evaluate returns in the subsequent four years. The results surpassed my expectations. The average annual return was 22.29%; the average cumulative return for the four year period was 117 percent. The market caps of the 100 ranged from a high of almost $1.4 billion (Circuit City), down to 69 million, with an average of $158 million. Not exactly an institutional investors dream in terms of liquidity and company size, but potentially profitable for some investors. Of the 100, 10 companies were acquired sometime within the four year period.

Words of Caution

No research piece on net/nets is complete without a discussion of the risks inherent in investing in such securities. Often, these companies are cheap for very good reasons. Some are a few quarters away from bankruptcy. Others may show up in a stock screen due to quarterly balance sheet data which lags a recent fall in price. In these situations, the market cap may have dropped off considerably due to a recent event, but the fundamental data utilized in the net/net calculation is up to three months old. Once the new 10q OR 10k is released, it becomes very evident that there has been a degradation in the company’s balance sheet, and the company is not a net/net after all.

Liquidity Issues

Furthermore, when dealing with micro caps, liquidity is often an issue. Companies may trade infrequently, and have very wide bid/ask spreads. When evaluating such companies, it is imperative to be aware of daily trading volume, and the spread. Placing a market order can be very dangerous, so limit orders should be considered.

Asset Quality

The composition and quality of a company's current assets is also an important factor in assessing an individual net/net. All else being equal, the greater the amount of cash and marketable securities as a percentage of current assets, the better. In terms of true value, it goes downhill quickly for the other current asset accounts. Accounts receivable, for instance, must be collected in order for value to be realized, and there are no guarantees this will happen. Inventories may be worth pennies on the dollar if they needed to be quickly converted into cash, plus there are storage and maintenance costs. Cash, on the other hand, has a fixed value. What you see is what you get.


While now may not be the best time in terms of identifying net/nets, the study does raise an interesting point. While it is always prudent to evaluate net/nets individually, it may also be rewarding to assemble a portfolio of such companies, essentially an index, without a great deal of individual scrutiny, when there are enough available to make such an endeavor feasible. Given current market conditions, and the small number of available net/nets, it is more prudent to evaluate single security candidates in order to determine investment merit, than to blindly buy, say the top 20 sight unseen.

The List
If you are interested in obtaining the list of 2003 net/nets referred to in this piece, please e-mail us.

Wednesday, June 06, 2007

It must be April Fools Day…

That was my first thought upon reading my Wall Street Journal this morning, specifically the story on page A3, entitled “FTC Deals Setback to Whole Foods”. But I checked, and my WSJ is definitely dated June 6, 2007. So there must be another explanation.

It seems that our esteemed Federal Trade Commission has decided to block Whole Foods Markets Inc (WFMI) $565 million acquisition of Wild Oats Markets (OATS). Apparently the FTC is very concerned that the new entity will monopolize wheat germ, organic produce, tofu, and you name any of the other healthy products these stores sell. Wow, thanks FTC, for trying to protect us. I can’t imagine how tyrannical this newly formed entity would be, forcing the poor, healthy consumer to shell out many times the going rate for grass-fed beef, and buckwheat pancake mix.

To think that this acquisition could create a health food monopoly detrimental to the consumer is utterly ridiculous. FTC, we still operate in a free market, and with relatively low barriers to entry, a successful monopoly in this area would be highly unlikely.

To make matters worse, here is a quote from Jeffrey Schmidt, Director of the FTC’s Bureau of Competition, printed in the Journal article:

“If Whole Foods is allowed to devour Wild Oats, it will mean higher prices, reduced quality, and fewer choices for consumers. That is a deal consumers should not be required to swallow.”

Are you kidding me? That’s the same kind of flawed logic, and misinformed view of free market economics that stopped the proposed Staples-Office Depot merger from occurring several years ago. Thank goodness the FTC put a stop to that merger. We’d no doubt have pencil and pen shortages if that deal had been blessed.

Perhaps Mr. Schmidt and company at the FTC need to bone up on the intensely competitive and low margin retail food market (WFMI's net profit margin was a whopping 3.6% in 2006; OATS had a net loss), or better yet, free market economics. To that end, I’d suggest spending a few hours with my former economics Professor, Dr. Hans Sennholz. He’d set them straight in short order.

I’ve never been to a Whole Foods store, and I‘ve never been to a Wild Oats store. I’ve never evaluated or owned stock in either company, and lets face it, I’m not the poster child for healthy eating. But I can spot the flawed logic in this decision from a mile way. FTC, spend your time (and our tax dollars) on something worthwhile.

*The author does not have a position in any of the stocks mentioned in this report. This is neither a recommendation to buy or sell these securities. All information provided believed to be reliable and presented for information purposes only.

Monday, June 04, 2007

Thanks Cheap Stocks Readers: 283 Subscribers, 10000 Hits

After hovering just under 10,000 hits/months for the past quarter, we finally broke through the 10,000 hit level in May. Thanks to our growing list (283) of subcribers for making this little website a worthwhile pursuit. We are passionate about research and investing, and appreciate our readers interest.

Friday, June 01, 2007

Viewing PICO Holdings through Pink (Sheet) Colored Glasses

You can tell a lot about a manager by the securities in which he invests, and that being said, this week we take an off the beaten look at PICO holdings. PICO has recently become a darling of the investment world as the focus on its water business goes from the underground to the mainstream. (Fidelity taking a stake and a push from a major newsletter provider will tend to turn the spotlight on you)

You don’t hear a great deal about PICO’s insurance subsidiary, Physicians Insurance Co of Ohio. Currently in run-off, Physicians does not write any new policies, but must still settle claims of existing policies. The company generates revenue and pays claims from its investment portfolio. Typically, this contributes income to PICO, as the portfolio generates more income than the liabilities consume.

From PICO's website:
Administering our own “run off” also provides us with the following opportunities:
we retain management of the associated investment portfolios. After we resumed direct management of our insurance company portfolios in 2000, we believe that the return on our portfolio assets has been attractive in absolute terms, and very competitive in relative terms. Since the claims reserves of the “run off” insurance companies effectively recognize the cost of paying and handling claims in future years, the investment return on the corresponding investment assets, less non-insurance expenses, will accrue to PICO. We aim to maximize this source of income; and
to participate in favorable development in our claims reserves if there is any, although this entails the corresponding risk that we could be exposed to unfavorable development.

Thanks to the Schedule D filing, as reported to the NAIC, and available on Bloomberg, we were able to take a gander at Physician’s portfolio as of 12/31/06. The most striking thing about this $69 million+ portfolio was that some of the names are high-quality pink sheet(or OTCBB) companies, including the following:

Bank Utica NY (BKUT)
JG Boswell (BWEL)
Case Pomeroy (recently acquired)
Farmers & Merchant/CA (FMBL)
Hanover Foods (HNFSA)
Laaco (LAACZ)
Limoneira (LMNR)
Ohio Savings Finl (OHSF)
Queen City Investments (QUCT)

While we make no specific judgement on these companies (we do currently own BWEL, and have reported on HNFSA in the past), we find it interesting that PICO management continues to find value in some interesting places. This is one of the reasons we were attracted to PICO in the first place.

The stock has had a nice run up since the market pullback and private placement in February, but may be a bit ahead of itself. As we mentioned earlier, after going unrecognized for years, there has recently been a PICO frenzy of sorts. The focus is on water, the “new oil”, and while we believe there is a great deal of value there, we would not be surprised to see the shares pull back a bit in the short-term.

Other Random PICO Notes
Going Mainstream

For their part, a couple of equity research firms have joined the party. In a May 11th research report Merriman, Curhan and Ford analysts Jesse Herrick and Brion Tanous suggested that PICO is fairly valued in the $58-$64 range. ThinkEquity Parnters recently initiated coverage, and analyst David Edwards rated the stock a “buy”, with a $59 target. As a shareholder, we like those numbers…but still believe the stock may getting ahead of itself.

Major Departure
Chairman Robert Langley, half of the dynamic duo (CEO John Hart, is the other half), recently announced his retirement, effective 12/31/07. He will remain on the Board through at least 2008. It remains to be seen how this will effect PICO, but suffice it to say that this management team, whether or not you believe they are grossly overpaid, has made some brilliant moves (Hyperfeed aside) over the years. Stay tuned as PICO names a successor. I’d be happy to throw my name into the hat.

*The author has a position PICO, and BWEL. This is neither a recommendation to buy or sell these securities. All information provided believed to be reliable and presented for information purposes only.