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In the Gurus' Footsteps

(Guest Commentary by Rick Konrad – May 17, 2007)

Dear Subscribers and Readers,

For those who had wanted to learn more about picking stocks, evaluating companies, and other issues related to the stock market, we have again brought in one of our regular guest commentators, Mr. Rick Konrad for a quick guest commentary.  Rick is one of our two regular guest commentators (besides Bill Rempel) and usually writes for us every third Wednesday of the month. Thanks, Rick, for writing for us again.

In this commentary, Rick will be offering his thoughts on the perils of following your favorite stock market guru and why it is important to always to do your own analysis and come up with your own conclusions.  Without further ado, following is a biography of Rick:

Rick is author of the excellent investment blog “Value Discipline,” founder of “Value Architects Asset Management”, and is a regular guest commentator of MarketThoughts (please see “Rick Konrad on Financial Services Companies” for his last guest commentary).  Prior to his current role, Rick has been a professional portfolio manager for institutional investors for over 25 years.  You can view a more complete profile of Rick on his blog and should you have any questions or thoughts for Rick after reading his commentary, you can also email him at the following address.  Rick is a very genuine teacher of the financial markets and treats it very seriously.  Case in point: Rick has also been responsible for running the education program for the CFA Society in Toronto (which is the third largest CFA society in the world besides the New York and London Societies) and had also been responsible for grading CFA papers. 

Disclaimer: This commentary is solely meant for education purposes and is not intended as investment advice.  Please note that the opinions expressed in this commentary are those of the individual author and do not necessarily represent the opinion of MarketThoughts LLC or its management.

A few years ago, Matthew Feshbach, a famed short-seller, described in an interview (in Value Investor Insight May 2005) some of the enduring principles that he learned from Phil Fisher about investing most of which was gleaned from a two hour interview. I think there is considerable value in reviewing his thoughts.

First, he believed no one can really understand more than five to eight stocks. He says in one of his books that if you own more than 10 stocks you're an imbecile. I must confess, for both my own dough and that of most clients, I am an imbecile.

Second, he believed in buying stocks in companies that were out of favor, but that were also at an inflection point, where the company was going through a product transition or a new strategic plan. The goal was to buy when it looked like they were through the most difficult period, but the stock was still depressed.

Finally, he liked to buy companies based on their earnings power. He defined that by saying he wanted to buy companies trading at 3 to 5 times their after-tax earnings power two to three years out. That's a massively powerful concept.

In today's markets, such companies are very hard to find, particularly those that meet the third criterion.

I share some of Henry To's concerns about the extended nature of this market. It seems to me that some investors who may be nervous about the market are seeking shelter by latching onto some activist investors' picks in the hope that being a disciple of a guru will somehow lead to Nirvana. Real value investors are supposed to do extensive homework, digging deep into a company's financials. As a group, we tend to abhor chasing hot stocks.

Why not follow in the footsteps of the great ones? Put simply, an activist investor's time horizon may be considerably different from your own. Some activists seek sensationalism and are out to bully a management into an agenda. Witness, for example, Nelson Peltz and his actions in Heinz (HNZ) and CBRL (CBRL.) Others, such as Relational Investors, use long term moral suasion to get results.

Ultimately, activism requires a well above average understanding of the underlying business. For example, one should benchmark the company against peers and try to get to the bottom of why its gross margin or operating margin is too low and how they can potentially improve. Another way to add value is by analyzing the capital structure and the capital management of the company. It's a tried-and-true activist approach to say “You have too much cash” or “You're over-leveraged.” Despite the rise of private equity and the growing acceptance of share buybacks, about 30% of the non-financial S&P 500 companies have cash and equivalents in excess of total debt. This is difficult to understand in today's low interest environment.

But sometimes, there is a decent rationale for not having too much financial leverage. A case in point is Granite Construction, (GVA.) Granite Construction Inc. is a heavy civil construction contractor in the United States. The Company serves both public and private sector clients. Within the public sector, it primarily concentrates on infrastructure projects, including the construction of roads, highways, bridges, dams, canals and airport infrastructure. Within the private sector, the Company performs site preparation and infrastructure services for residential development, commercial and industrial buildings, plants and other facilities. It owns and leases aggregate reserves and owns a number of construction materials processing plants. Granite operates in two segments: the Branch Division and the Heavy Construction Division (HCD). The Branch Division consists of branch offices that serve local markets, while HCD is composed of regional offices and pursues infrastructure projects throughout the United States. Granite also purchases, develops and sells real estate through its subsidiary, Granite Land Company.

The stock is up about 44% in the last 52 weeks and 28% year to date. Why the excitement? A 13D from Daniel Loeb of Third Point is one of the triggers, filing on 7.7% of the stock.

The business is selling at about 16 times (EV/EBITDA) or 28.5 times (EV/EBIT.) Compare this with Fluor (FLR) at 17 times and 23 times or Washington Group (WNG) at 15 times and 26 times respectively.

Let's look at some growth rates:

  Revenues EPS Capex
GVA 13.92% 9.36% 12.24%
FLR 9.43% 12.85% 13.05%
WNG -3.41% NA 11.71%

As you can see, Granite has grown somewhat faster than most major participants in the industry and has seen little earnings leverage.

Return on capital for the last twelve months and the last five years compares as follows:

GVA 9.02 9.69 12.23 12.29
FLR 10.54 11.02 14.92 16.59
WNG 7.87 NA 9.47 NA

Where do these differences in profitability arise?

  Gross Profit Margin (TTM) EBITDA Margin Operating Margin Total Debt/ Cap
GVA 10.25% 5.30% 2.93% 10.2%
FLR 3.90% 3.55% 2.66% 9.8%
WNG 4.50% 3.35% 2.31% 0

Most recently, GVA has shown better margins in every category noted above versus its competitors. Its leverage is low not unlike its competitors as well. Ordinarily, one would expect that low leverage would be the ideal type of capital structure in what has been a fairly cyclical business over the long run.

Here is a link to further applicable ratio analysis for these companies:

As you can see, there appear to be fairly minor differences in profitability among these businesses over time, and if anything, GVA has been one of the more profitable companies. Hence, the likely desire of the activists here is increased leverage.

What is this business worth? I have put together a DCF model.

I have projected long term sales growth of 12%, slightly below the 14% CAGR of the last 5 years. I have used an EBITDA margin of 8%, slightly better than its historical average and well above that of the industry. I have assumed modest improvements in working capital and capex intensity, both categories where the company already appears to be doing well.

Finally, I discounted the derived cash flow stream back at an 8% discount rate. I view this as a very heroic assumption, given the cyclical nature of the business and a current cost of debt of 6.77%. With greater leverage in a cyclical business, I have provided only a very modest risk premium for the cost of equity.

The analysis suggests that at current prices and given what I believe are rather generous assumptions, GVA is about $10 overvalued.

Now Dan Loeb, et al may well see some hidden value and perhaps other improvements. There are significant differences in the operating performance of the two major divisions and certainly a downsized company with one of the segments jettisoned could prove attractive. Heavy construction gross and operating margins were negative in the most recent quarter on an 18% drop in revenues. There is a history of bidding unprofitable jobs between 2002 and 2004, not unusual but certainly not acceptable in large scale construction projects.

But based on my analysis, at current prices, one is already paying for the forthcoming improvements. We do not meet the third test that Mr. Fisher cited, at least in my opinion.

Following the leader is a game for children. Following a guru or an activist still requires us to do some fundamental analysis. Child-like faith in gurus can provide some thrills but also spills. As always, do your own analysis and understand what it is you are paying for!

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