Is Value Dead? Again?

For the past five years, value has trounced growth. The S&P 600 Smallcap Barra Value Index, for instance, is up an average of 13.1 percent per year during the past five years, versus just 5.4 percent for the S&P 600 Smallcap Barra Growth Index. For the past year, however, the gap has narrowed, with value barely beating growth (7.68 percent versus 7.62 percent). Are the days of value outperforming growth coming to an end?

The folks at Tweedy Browne & Co. recently sent a sobering letter to shareholders, which announced that both of the company’s funds, Tweedy Browne American Value, and Tweedy Browne Global Value will close to new investors on May 4, 2005. “What’s the big deal” you may wonder? Funds close all the time, usually because there’s too much cash coming in, and not enough places to put it and maintain the funds objective, right? True as that may be, in Tweedy’s case, it’s the stated reasons for closure that have this value investor scratching his head.

The letter quotes fund manager Chris Browne saying:

“Current stock market levels worldwide present few investment opportunities selling at an attractive discount to intrinsic value. Moreover, certain holdings of both Funds have risen to levels of full value in our view, resulting in both funds being net sellers of securities”.

As a long-time shareholder of Tweedy Browne American Value, and believer in the firm’s investment process, that statement is scary.

The fact that Tweedy can no longer find investment ideas that fit its stringent criteria, may mean that value is dead, at least Tweedy’s definition of value. While their honesty is refreshing—and I believe these guys always tell it like it is, a rare virtue in this industry—I can’t help but question whether to cut and run. Afterall, if they can’t find any suitable investments, does that translate into lackluster returns for these funds in the next couple of years?

Chris Browne’s comments continue:

“Since the collapse of the technology, media and telecommunications bubble in 2000 wrung out the grossly inflated excesses of the so-called growth sectors of the market, the more mundane value stocks have risen to levels at or near their private market values. The result is that the price difference between the most expensive and the least expensive stocks is narrower than we can recall in more than 30 years. Current cash levels at both funds provide more than enough “dry powder” to take advantage of buying opportunities when they present themselves. At the present time, having no limits on allowing new investors into the Funds could excessively dilute existing Funds shareholders’ investments in a limited pool of cheap stocks.”

To put Browne’s comments into perspective, thirty years takes us back to the mid 70’s, not a great time for investors. Browne’s words are certainly disheartening.

For those of you who are not familiar with Tweedy Browne, this firm once served as Ben Graham’s brokerage firm. They are true dyed in the wool value investors, seeking to buy firms well below intrinsic value: companies trading at low price to cash flow, low price to book, low P/E ratios, low price to sales ratios. They like management to have a stake in the company, and that insiders are buying, not selling. The Investment Research and Reports section of their website is a must for anyone interested in value investing. One report entitled "What Has Worked In Investing" provides excellent insight into the company’s investment philosophy, and even discusses one of the topics this site is devoted to—companies trading below their net current asset value.

The author has had a position in Tweedy Browne American Value for years, and continues to add to it on a monthly basis. The fund is not a high flyer, but provides decent risk adjusted returns. For the past 5 years through March 31, the fund has averaged 5.45 percent per year versus (3.16) percent for the S&P 500. That’s a spread of more than 8 ½ percent.

I think I’m coming back to my senses. Value isn’t dead, value never dies. Maybe it’s on hiatus. When it returns, the boys at Tweedy will pounce. I’m keeping my Tweedy Browne American Value shares. Thank you (managing partners) Chris Browne, Will Browne, John Spears, Tom Shrager, and Bob Wyckoff for your honesty. We need more like you in this industry.

Inforte Corp: Not Quite Below NCAV, but close, and compelling
Ticker: INFT
Price: $3.33
P/E: NM
Market Cap: $37 (million)
Net Current Asset Value (estimated): $31
Average daily volume: 38,000

Inforte is a Chicago based consulting company, specializing in customer management, business intelligence and analytics and operational stratregy. In 2004, according to the company’s 10K, the top 5 clients represented 39 percent of total revenue, while the top 10 represented 56 percent. Clients include NASA, Cadbury Schweppes, Guardian Life Insurance, Sony Pictures, and Vodafone, among others.

Not Quite Below NCAV
Our initial research recently identified this company as trading below its NCAV. But after further research, we determined that the reason it appeared on our screen, is because the company recently paid a special cash dividend of $1.50 per share (or $17.3 million in total), which is reflected in the company’s price and market cap, but not in the company’s latest financial statements. Confused? There is a simple explanation. Companies file quarterly reports, so any transactions affecting the financial statements that are done between quarters don’t show up until the next quarterly filing. Meanwhile, transactions that effect price, such as a dividend, are reflected immediately. So, while Inforte’s price and market cap (an integral part of the NCAV equation) have dropped because of the dividend payment, it’s most recent balance sheet data (another integral part of the NCAV calculation) has not yet been adjusted. Feel free to e-mail us at Cheap Stocks if this still does not make sense.

The Numbers
Fiscal year 2004 sales were $50.5 million, up 35 percent from 2003’s $37.4 million. Net loss was $560 thousand in 2004, versus net income of $1.75 million in 2003. However, 2004’s net loss included an after tax loss of $1.3 million, so income from continuing operations was $.07 for 2004 versus $.16 for 2003. First quarter 2005 sales were down 21 percent to $9.5 million, from the same quarter last year ($12.1 million). Sales declines were due to the loss of a significant client, however, there was no surprise here. Management guidelines for sales were met.

The Balance Sheet
As of 3/30/05, the company had $46 million in cash and short-term marketable securities, $6.1 million in long-term marketable securities, and no debt. If we subtract the $17.3 million special dividend payment-we are assuming it was paid out of cash and short-term securities-that leaves $34.8 million in cash and securities, or $3.04 per share. Keep in mind that the stock is trading at just $3.48. All in all, this is a strong balance sheet.

The NCAV Calculation (in millions)
As we stated above, this company is not trading below it’s NCAV, but here’s the calculation, anyway
Current Market Cap: $37.1
Current Assets: $40 (estimated, after paying special dividend)
Current Liabilities: $9
Long Term Liabilities: $0
Net Current Asset Value: $31
NCAV/Market Cap: .84

The Street/Institutional Ownership
Currently, just two analysts are covering this company. There is however, some institutional ownership.
Fidelity: 9.7%
Dimensional Fund Advisors: 8.3 %
Bank of America: 8.1%
Royce & Associates: 6.8 %
Vanguard: 1.7%
Bridgeway Capital: 1.6%
(Several Others are at or below 1%)

Conclusion
2004 showed nice sales growth for this company. However, as 2005’s first quarter displayed, one of the risks here is the dependence on a handful of clients. Lose one or two, and sales will take a hit. On the positive side, Inforte’s balance sheet is rock solid, and offers a great deal of downside protection. If you purchase the stock at todays closing price of $3.33, you are theoretically buying $3.04 in cash and securities, and getting the business, and its other assets for $.29. That’s the kind of story that we like here at Cheap Stocks.

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

What Should Warren Buffet Buy Next?

Warren Buffet’s
annual letter to shareholders is a must read. The content is both informative and entertaining. The Oracle of Omaha truly has a way with words. This is not your ordinary letter to shareholders from any ordinary Chairman. This is 24 pages of financial poetry, from the man who has led Berkshire Hathaway to an average annual gain of 21.9 percent from 1965-2004. To put that into perspective, a $100 investment in 1965 would now be worth more than $275,000!

Buffet is classic because he pulls no punches. His honesty is refreshing, his common sense approach to investing is timeless. He assigns no blame for what went “wrong” (???), other than to himself.

Perhaps the most interesting part of this years letter was a list of acquisition criteria that he and Charlie Munger (Vice Chairman) will be using in their pursuit to spend some of the Berkshire Hathaway’s massive amount cash--$43 billion at year end 2004. The following is from Berkshire Hathaway’s 2004 annual report:

BERKSHIRE HATHAWAY INC.
ACQUISITION CRITERIA
We are eager to hear from principals or their representatives about businesses that meet all of the following criteria:
(1) Large purchases (at least $75 million of pre-tax earnings unless the business will fit into one of our existing units),
(2) Demonstrated consistent earning power (future projections are of no interest to us, nor are “turnaround” situations),
(3) Businesses earning good returns on equity while employing little or no debt,
(4) Management in place (we can’t supply it),
(5) Simple businesses (if there’s lots of technology, we won’t understand it),
(6) An offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily,
about a transaction when price is unknown).
The larger the company, the greater will be our interest: We would like to make an acquisition in the $5-20 billion range.We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.
We will not engage in unfriendly takeovers. We can promise complete confidentiality and a very fast answer —customarily within five minutes — as to whether we’re interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. We don’t participate in auctions.
Charlie and I frequently get approached about acquisitions that don’t come close to meeting our tests: We’ve found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: “When the phone don’t ring, you’ll know it’s me.”

We at Cheap Stocks were excited when we saw this. It presented us with a challenge; to try and identify companies meeting Buffet’s criteria. Unfortunately, there are a lot of unknowns here, and we can’t get inside Buffet’s mind. That’s where the true selection criteria live, that’s where the decisions are made. It’s not all about the numbers, it’s the gut, the experience, the intelligence that Buffet possesses. But we thought we’d take a crack at it anyway.

We narrowed our list based on the following criteria:
1. Pretax income of at least $75 million—we screened for this in both 2003 and 2004
2. High returns on equity—-we looked for at least 20% ROE in 2003 and 2004
3. Simple businesses——we eliminated any technology companies, or any others that lack simplicity, in our minds, anyway.
4. Cost of Acquisitions in the $5-20 billion range—For this, we used enterprise value (Market cap + Debt – Cash), because that is a better representation of how the market currently values a company, than market cap alone. We also assumed that the offering price would include a premium. So instead of searching between $5 and $20 billion, we set the criteria between $ 3 and $17 billion. This allows room for a premium over the current enterprise value
5. Relatively low level of debt-We eliminated companies that have a total debt to equity ratio of more than 50 percent.
6. High level of profitability-Net profit margins had to be at least 10 percent for the latest trailing twelve months, fiscal year 2003, and fiscal year 2004.

The Results

Twenty one companies made the initial cut, 12 of which we eliminated as being either too complicated, or not Buffet’s style (in our minds, anyway). Those we eliminated included the following: (Prices are as of 4/13 close)
Mcgraw Hill (MHP), $83.96
Adobe Systems (ADBE), $65.07
Electronic Arts (ERTS), $49.64
St Jude Medical (STJ), $35.25
Forest Labs (FRX), $34.77
Biomet (BMET), $37.86
Rockwell Collins (COL), $45.35
Varian Medical (VAR), $33.68
American Pharmaceutical (APPX), $56.5
Lincare Holdings (LNCR), $43.72
Eaton Vance Corp (EV), $22.45
SEI Investments (SEIC), $34.365

The Final List
That left us with nine companies. Some of these may be a stretch as well. For instance, we know WB has bought retailers in the past (See’s Candy, Nebraska Furniture Mart, Dairy Queen), but would he be interested in a clothing retailer? I’m not convinced that he would, but we’ll leave them on the list anyway. Remember, this was for fun.
Harley–Davidson (HDI) ($48.93)-Well-known motorcycle manufacturer
Wrigley (WWY)($64.7)- Extremely profitable gum powerhouse. The author has a small position in this stock)
Apollo Group (APOL)($74.89)-On-line secondary education pioneer
Coach Inc (COH) ($27.57)- Marketer of leather goods, premium handbags
Mattel (MAT)($20.69) - Toy manufacturer best known for the Barbie line, Matchbox cars, and Fisher Price products
Abercrombie & Fitch (ANF)($57.68) - Retailer of casual apparel.
Chico’s FAS (CHS)($27.71) - Retailer of casual women’s clothing
Brown & Brown (BRO)($44.30) - Insurance and reinsurance products
Paychex (PAYX)($32.16) - Payroll and recordkeeping services.

If nothing else, this exercise has done one thing: Identified a list of highly profitable companies, both in terms of net profit margins, and ROE’s, with low levels of debt. We’ll see what Warren Buffet ends up buying in the coming year, if anything.

I do have one suggestion for him. Your editor is a shareholder of a highly profitable, well-known brand name company that he could probably pick up for between $2 and $ 3 billion. It’s business is fairly simple, it’s profit margins are consistently above 15 percent, and it’s owners may be looking to get out. Sound like anything you read about in a previous Cheap Stocks post? If you guessed Tootsie Roll, you’d be correct. WB loved Dairy Queen, and ultimately bought the company. Wonder if he likes Charleston Chews, Tootsie Pops, Dubble Bubble gum, or Andes mints? We can only hope.

Company Update
Tootsie Roll Industries
Ticker: TR (A shares), TROLB (B shares)
Price: $32.27(A shares)

Shares of Tootsie Roll were up more than 8 percent yesterday ($2.47) based on a Business Week article that echoed sentiment we featured in our January 28th column Rolling Towards a Takeover that presumed that due to aging owners, and a very strong brand name, Tootsie Roll may be an attractive takeover target.

The Business Week article quotes Elliot Schlang, an analyst with LJR Great Lakes Review who follows the company, projecting a takeout price of between $35 and $37 per share. Your editor has taken a position in Tootsie Roll within the past two months, but is not satisfied with the takeout range Schlang suggests.

A caution here for readers who are interested in this company. While Tootsie Roll had a nice gain yesterday, this was due to the Business Week article, obviously. There is no new information to suggest that a takeover is imminent. While we at Cheap Stocks expect it in the future, no one knows when (or if, for that matter).

While we are happy to be up 12 percent since purchasing the shares in the $29.50 range (return includes the recent 3% stock dividend, and $.07 cash dividend), we would not be surprised to see shares pull back once again, when the markets realize that while the Business Week article has merit in principle, the timing is uncertain.

Company Update:
PICO Holdings
Ticker: PICO : $26.10
Market Cap: $322.76 million
Average Daily Volume: 18000

We featured PICO Holdings in our January 21st column: PICO Holdings, Mini Berkshire Hathaway?, and wanted to give an update, based on a recent event.

On April 5th , the company’s subsidiary Vidler Water Company, announced an agreement to sell 15,470 acres of Arizona land, along with 42,000 acre feet of water, to an unnamed Arizona developer, for $95.25 million in cash, or $6157.10 per acre. The carrying cost of the assets being sold is $35 million.

That’s a $60 million capital gain for PICO. More relevant, though is the purchase price, relative to PICO’s market cap of $323 million. I continue to be impressed by PICO management, and their ability to identify and purchase undervalued assets, and ultimately convert them into cash. (The author does have a position in PICO Holdings)

It is not clear, at this point, the tax consequences of the property sale. Nor is it clear how PICO will utilize the proceeds. There really are just four possibilities: A share buyback (unlikely), acquisitions, institution of a dividend (also unlikely), further investment in undervalued (in management’s eyes) securities, or a combination. Stay tuned.

*The author has a position in this stock. This is neither a recommendation to buy or sell this security. All information provided believed to be reliable and presented for information purposes only.

Trading Below Net Current Asset Value:
Nu Horizons Electronics
Ticker: NUHC
Price: $7.03
P/E: 37
Market Cap: $119 million
Net Current Asset Value: $120.1 million
Average daily volume: 38000

Nu Horizons Electronics is a small, Melville, New York based electronics distribution company. Products include microprocessors, memory chips, transistors, diodes, fiber optic components, and other semiconductor related items.

We recently identified this as a profitable company trading below NCAV. (Finding a company trading below NCAV that isn’t profitable is relatively easy. Those that are simultaneously generating a profit are few and far between.)

The Numbers
Fiscal year 2004 sales were $346 million, up 15 percent from 2003’s $302 million. Net loss was $850 thousand in 2004, versus a loss of $2.5 million in 2003. However, for the trailing 12 month period (through the third quarter of 2005) the company has managed net income of $3.38 million, on sales of $456 million

The Balance Sheet
As of 11/30/04, the company had $17 million in cash and $40 million in long-term debt. Current ratio stood at a very health 6.56, while quick ratio was also solid at 3.1. All in all, a decent, but not great, balance sheet. (If you’ve read our NCAV reports in the past, you know how much we here at Cheap Stocks love cash, and dislike debt in our NCAV companies)

The NCAV Calculation (in millions)
Current Market Cap: $119
Current Assets: $192
Current Liabilities: $29
Long Term Liabilities (primarily LT debt) $42
Net Current Asset Value: $121
NCAV/Market Cap: 1.02

The Street/Institutional ownership
Currently, just one analyst is covering this company. There is however, a great deal of institutional ownership.
Wasatch Advisors: 9.3 %
Royce & Associates: 8.8 %
Wellington Management: 8.2 %
Dimensional Fund Advisors: 7.8 %
David L Babson & Co: 5.4 %
Fidelity: 3%
Delphi Management: 3%


Conclusion
If anything, this is an interesting story. But then again, anytime you identify a profitable company trading below it NCAV, it’s interesting. Sales for the past three quarters have been picking up nicely versus prior year/same quarter numbers, and the company has been in the black for 5 consecutive quarters. An improving economy and renewed interest in the tech sector should help move this company forward.

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

Trading Below Net Current Asset Value:
Discovery Partners
Ticker: DPII
Price: $3.36
P/E: 20.94
Market Cap: $87.8 million
Net Current Asset Value: $92.7 million
Average daily volume: 80000

It’s been awhile since our report featured a company trading below its NCAV, so this week, it’s back to our roots, back to the original purpose of this site.

Discovery Partners is a small, San Diego based company which specializes in products and services that help pharmaceutical and biopharmaceutical companies in the drug discovery process. For more information, the following is from the companies 10K.

“Despite numerous technological advances in combinatorial chemistry, high throughput screening, genomics and proteomics, the process of drug discovery remains slow, expensive and often unsuccessful. In order to make the drug discovery process faster, less expensive and more likely to generate a drug candidate, we offer products and services such as assays, synthesis automation, design and synthesis of proprietary libraries of compounds, high throughput screening, lead optimization, drug discovery informatics and toxicology. These products and services can be provided individually or as an integrated solution, depending on our customers’ requirements.”

(Ten cents to anyone who can tell me exactly what that means…I’m a numbers guy)

In any event this company was recently identified as a profitable company trading below NCAV. Finding a company trading below NCAV that isn’t profitable is relatively easy. Those that are simultaneously generating a profit are few and far between.

The numbers
Fiscal year 2004 sales were $51.6 million, up 3.5 percent from 2003’s $49.8 million. Net income was $3.9 million in 2004, up 268% to 3.9 million, from $1.06 in 2003. Net profit margin for 2004 was 7.6 percent in 2004. Not too shabby for a sub NCAV company.

The balance sheet
Here’s where the story gets interesting. As of 12/31/04, the company had a rock-solid balance sheet with $80 million in cash and marketable securities, and no debt. That’s $3.23 per share in cash: this at a time when the stock trades at $3.39 per share. Theoretically to a buyer, that’s like getting the business for $.16!

The NCAV Calculation (in millions)
Current Market Cap: $87.8
Current Assets: $99.9
Current Liabilities: $7.1
Long Term Liabilities (deferred rent) .16
Net Current Asset Value: $92.7
NCAV/Market Cap: 1.06 (times)

The Street/Institutional ownership
Currently, just one analyst is covering this company. There is however, a great deal of institutional ownership. Heartland Advisors, Royce & Associates, and William Blair and Co each hold about 12 percent. While Strong Capital Management and Wells Fargo each hold about 10 percent. Dimensional Fund Advisors holds about 6 percent. Several others own 3 percent or less.

Risks
The company has been cautious on 2005 numbers, suggesting a less than stellar year. Also, the contract with Pfizer (which represented more than 50% of revenue in 2004) will be expiring. Will it be renewed?

Conclusion
Yet another one to keep your eye on. Its very hard to ignore the sizable amount of cash and marketable securities on this company’s balance sheet. The big question is, will the profits continue? For the theoretical price of $.16 cents per share, it may be worth a shot.

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

Update: Hanover Foods Corp
Ticker: HNFSA
Price: $116

A lot of activity in this stock the past two weeks, that's if you consider volume of 3000 shares significant. (For Hanover, with average daily volume below 100, any volume is significant.) In any event the stock is up nicely since our initial report. Stay tuned. (Your editor does not have a position in Hanover.)

Mistakes

“Everybody makes mistakes.” That sentiment extends into our investing lives, and your Cheap Stocks editor is no different. That being said, today I bare my soul to readers with one of the biggest investing miscues I’ve made in recent years. The point is, you too will make mistakes. We all do. Even the great Peter Lynch has admitted to investing faux pas in his books. Lynch once wrote that out of 5 stocks that you buy, odds are one will tank, one will rise significantly, and 3 will go nowhere. And that’s from one of the greatest portfolio managers of our time.

The mistake I’m speaking of involves Hansen Natural Corp(ticker: HANS), the Corona, California based marketer and distributor of natural sodas, fruit juices, and energy drinks. I picked up shares back in 2001 in the 3 5/8 range, with the belief that one of the bigger players would ultimately take over Hansen. At the time, annual sales were in the $80 million dollar range, and the company was profitable. However, there was little excitement about Hansen. It was a $40 million market cap company, which had been around since the 1930’s, and had a nice following in California. But in my mind, the only real driver was that a larger company would want to get their hands on this small, regional player.

The stock traded sideways for a couple of years. Then in January, 2003 Hansen started to take off. When it hit the $10 range in early late 2003, I sold. There was no reason, that I could find, that this stock would go any higher. I’d made 3 times my money, and was happy. It then trended down slightly for the next couple of months, and I was proud of the trade. I know, once you sell a stock, you should not look back. But I felt vindicated…for a while.

After hitting the mid 7’s in January 2004, the stock went on a wild ride, hitting $47.49 in February 2005. Hansen’s sales had exploded with the introduction of new products, and its earnings followed suit. Third quarter 2004 sales, for instance were up 58 percent, from $33.3 million to $52.6 million, while earnings per share jumped 158 percent, from $.19 to $.49. When year end numbers are in, Hansen could well hit $175 million in sales for 2004. This is a far different company then the one I purchased in 2001. Currently trading at 37 times earnings, its current market cap is nearly $470 million. It was a $40 million company when I bought in.

What did I learn from all of this? I’m still not sure. Maybe I should have had a trailing stop on the shares, which could have been raised periodically as the share price climbed toward the stratosphere. Maybe I really don’t have the stomach to be a growth investor. Hey, wait a second. What am I whining about? I did triple my money. And left a brand new 2005 red Mazda Miata on the table.

Getting Around Sarbanes Oxley:
Follow up to 12/22/04 report
Hanover Foods

Since our first report on this subject, in which we discussed the growing trend of smaller companies opting out of filing with the SEC, and avoiding Sarbanes-Oxley compliance in the process, more companies have taken the same road, and this report will focus on one of them.

As our 12/22/04 column stated, due to the relatively high costs of filing documents with the SEC (including sending reports to shareholders), as well as the additional costs associated with Sarbanes-Oxley compliance, small companies are making good use of a loophole. To avoid filing, and complying with Sarbanes, they need to have less than 300 shareholders. Those that are below that level simply need to file form 15-12G with the SEC, and no longer need to report. Those that are nominally above 300 have found interesting ways to reduce their shareholder rolls (namely through the combination of reverse stock splits, and buying odd-lot shareholders out. Whether you own 100,000 share or 1 share, you are still just one shareholder.)

Hanover Foods Corp
Ticker:HNFSA, HNFSB
Price: $90.50 (Class A)
Market Cap: $97.3
Shares Out: Class A non-voting: 288,000(actual)
Class B voting: 781,600(actual)
Average daily volume: 59 (actual, Class A)
No recent trades (Class B)
Book Value per Share: $99.09
Dividend Yield: 1.21%

Hanover Foods Corp is a small Pennsylvania based processor of and distributor of vegetables, founded in 1924. Still, the company ranks as the largest independently owned food processor in the eastern US. Fiscal year 2004 sales were $318 million, up 10 percent from 2003 ($290 million). Net income was $11.4 million in 2004, up 13 percent from 2003 ($9.9 million).

The company had about $3 million in cash, and $21 million in long term debt as of its last reported quarter (Aug, 2004). Currently, the company trades below its most recently reported book value of $99.09.

Admittedly, this is not the most exciting company, but by now avid readers of this site are used to that. It is, however, a consistently profitable one-17 straight profitable quarters-and that’s as far back as the data goes, (that I can find, anyway), so the run may extend far beyond that.

What is interesting about this company, though, is how they went about achieving the sub 300 shareholder plateau. In December, 2004, the company announced its intention to ultimately end filing with the SEC, commencing a tender offer to any shareholders holding 15 shares or less. At a time when the stock was trading around $84, the company offered $131.00 per share, a 55 percent premium! Although, this was not going to make anyone rich, as it only applied to shareholders owning 15 or fewer shares, it was still a nice premium.

The company was very clear about its reasons for the tender offer, and intentions to terminate registration of its stock, and with that, end SEC filing responsibility. It was also clear about the associated cost savings of doing so: The following is from the company’s SC 13E3, dated 12/6/04:

"We estimate that the costs of compliance have been at least $80,000
annually, in addition to onetime increased costs to document and test our system
of internal control over financial reporting, estimated to be approximately
between $344,000 to $961,000 in fiscal years 2005 and 2006 and ongoing increased
annual costs to document and test internal controls estimated to be
approximately $198,000 on an annual ongoing basis. Our management (in particular, Gary Knisely and Pietro Giraffa) has periodically and informally discussed with members of our board of directors the relative advantages and
disadvantages of being a reporting company for a number of years. The estimated
one-time costs to document and test our system of internal control over
financial reporting, the estimated ongoing costs to document and test our system
of internal controls and our estimated expenses of compliance as a reporting
company are as follows:"



ESTIMATED ONE-TIME INCREMENTAL COSTS TO
DOCUMENT AND TEST OUR SYSTEM OF INTERNAL CONTROL
--------------------------------------------------------------------------------
Estimates from Consultants to Establish Internal
Controls and Documentation Procedures(1) ............. $ 174,000 - $561,000
Hanover Staff(2) ..................................... $ 120,000 - $200,000
Additional Audit Fees(3) ............................. $ 50,000 - $200,000
--------------------
TOTAL INCREMENTAL COSTS .............................. $ 344,000 - $961,000
ESTIMATED ONGOING ANNUAL COSTS TO
DOCUMENT AND TEST OUR SYSTEM OF INTERNAL CONTROL
--------------------------------------------------------------------------------
Hanover Internal Staff Time and Expenses ............... $ 133,000
Internal Controls Audit Fees ........................... 65,000
-----------
TOTAL ESTIMATED ONGOING COSTS .......................... $ 198,000
===========




ESTIMATED ANNUAL REPORTING COMPANY EXPENSES
Annual Audit Fees ......................... 45,000
Annual Legal Fees ......................... 25,000
SEC EDGAR Printer Costs ................... 10,000
---------
TOTAL ESTIMATED ANNUAL COSTS .............. $ 80,000
====================

In summary, this move saves the company $278,000 per year pretax, plus one-time costs from between $344,000 and $961,000-not insignificant amounts for a company which earned $11.4 million last year. The filing goes on to mention other savings, specifically management’s time and attention:

“In addition, management devotes a significant amount of time and
attention to the preparation of the periodic and current reports required under
the Exchange Act and to compliance with the SEC rules and regulations
promulgated under the Sarbanes-Oxley Act. We estimate the time devoted to tasks
associated with public reporting as approximately 10% for the Chief Executive
Officer, 28% for the Chief Financial Officer, 37% for the Chief Accounting
Officer and 10% for the Treasurer. Management believes this time could be spent
more efficiently on operating our business and evaluating business
opportunities.”

Finally, the company cited cost reduction of no longer having to administer small shareholder accounts:

“The expense of administering the accounts of small shareholders is
disproportionate to their ownership interest in us. As of the record date, we
had 287,996 shares of our Class A common stock outstanding. We had approximate
101 shareholders of record that held 15 or fewer shares of our Class A common
stock, holding an aggregate of approximately 718 shares. As of the same date,
estimated 265 shareholders of record held 16 or more shares, holding an
aggregate of approximately 287,334 shares of our Class A common stock. As a
result, approximately 33% of the administrative expense relating to our
shareholder accounts relates to the administration of shareholder accounts
constituting .2% percent of our outstanding shares.”

The Offer itself
Perhaps the most interesting part of this entire story is the tender offer price, and how it was derived. The company hired Gocial Gerstein LLC to calculate a fair market value for Hanover’s Class A shares. In summary, based on Hanover’s EBITDA(earnings before interest, taxes, depreciation, and amortization), sales, book value and operating cash flow, as applied to selected multiples, total equity value was placed at $138.9 million. A 25 percent marketability discount factor was then applied, to arrive at $104.17 million. Then, Gocial Gerstein made some further adjustments to arrive at $100.12 million. That figure was divided by shares outstanding, to arrive at $138.00 per share. Finally, a 5 percent discount was applied to account for the fact that Class A shares do not have voting rights. The result? $131.00.

What are the shares really worth? Well the market says $90.50, the current trading price. But these shares trade on the pink sheets, and trade infrequently. Does the market have it all wrong? Are the shares really worth $131.00, the price Hanover was willing to pay to small shareholders? Are they worth more? Time will tell.

The end result of this story is that after the tender offer, Hanover was able to reduce its number of shareholders to 289, filing its Form 15-12G on January 10th, 2005. This is a story we’ll no doubt be following.

You probably won’t read about this company, or this story, anywhere else. Analysts have no reason to cover this stock, and for the most part, institutions are not interested because of the company’s size, and small float. But we here at Cheap Stocks see the potential opportunity in situations such as this. It is our purpose to educate our readers about “off the beaten path” investment concepts and ideas, such as this.

That being said, please understand the risks of investing in illiquid securities such as Hanover. Only a small portion of your portfolio should be dedicated to such investments. Such companies may be difficult and expensive to buy, and sell. When investing, be careful not to place a market order for illiquid stocks, as the bid/ask spreads tend to be wide.

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