When Cheap Ain't Good Enough
(Guest Commentary by Rick Konrad – June 19, 2008)
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 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.
In this commentary, Rick will be offering his thoughts on the kind of stocks that are attractive in this tough economic environment, and advise us to be especially careful when buying “cheap stocks,” as these can turn quickly into value traps. Obviously, this commentary won't be complete without detailed examples – and as usual, Rick does not disappoint. 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 “Marrying Various Investment Themes” 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. You can also email Rick at the following address should you have any questions or thoughts for Rick after reading his commentary. 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.
These are certainly interesting and challenging, if not dangerous times. The economic backdrop exhibits all kinds of cross-currents as well with tides of inflationary and recessionary evidence buffeting opinions. Traders' opinions seem to see-saw from day to day. Bruce Cockburn, a Canadian songwriter in lyrics written 25 years ago described the roller coaster of love in a way that I think is quite applicable to today's environment:
“Don't the hours grow shorter as the days go by
You never get to stop and open your eyes
One day you're waiting for the sky to fall
The next you're dazzled by the beauty of it all
When you're lovers in a dangerous time
Lovers in a dangerous time”
It is easy to be drawn into the live-die noise of today's markets…to fall in love on those beautiful up days and wonder about the sky caving in on those terrible down days. In a period of market neutrality that Henry has depicted, it is a dangerous time to let your assertions and assumptions get too decidedly cornered. Though most value investors describe their desire to concentrate positions, I much prefer building positions slowly at times like this, as well as allowing myself the luxury of having a more diversified portfolio.
Let's look at some of the companies that I have considered recently.
Valuation as the only criterion can draw us into many value traps. A great example of this is a little company, Lifetime Brands (LCUT). Lifetime Brands, Inc. designs, develops, and markets branded household consumer products in North America. The company primarily offers various food preparation, tabletop, and home decor products. Everything from cutlery and bakeware to crystal. The company sells its products to mass merchants, specialty stores, national chains, department stores, warehouse clubs, home centers, supermarkets, and off-price retailers, as well as directly to the consumer through company-operated factory and outlet stores, mail order catalogs, and the Internet.
The company does have well-recognized brands:
Farberware®, KitchenAid®, Pfaltzgraff®, Wallace Silversmiths®, Cuisinart®, Kamenstein®, International Silver® and Towle®.
The company recently announced the acquisition of Mikasa, a leading provider of dinnerware, crystal stemware, barware, flatware and decorative accessories. Mikasa's products are distributed through department stores, specialty stores and big box chains.
Year to date, the stock is down some 32% and trades at a prospective P/E of merely 6.4 times. The recently reported first quarter demonstrated the effects of a tough retail environment. Once again, LCUT saw a decline in sales as a result of the adverse retail environment. Revenue of $98.2mm fell 5.4% YoY primarily driven by weakness in its Wholesale segment (-9.9% YoY). Gross margin of 39.3% was down 180 bps YoY.
The company appears to be losing money in its Direct to Consumer operations with 34 Farberware outlet stores and 44 Pfalzgraff outlets. Some 21% of the company's sales go through Wal-Mart, not a place where one can expand gross margins. Over 60% of sales go through the ten largest customers.
Return on capital has come in at a painful 1.5% for last year. Though equity market cap is just under $100 million, long term debt is about $150 million, Cash was less than $1 million. Not terribly comforting in this environment.
The company seems to have earned an economic return (where ROIC exceeded cost of capital) only 4 years in the last decade.
Bankruptcies among retailers such as Linens and Things and Fortunoff are bound to make it tough for stretched suppliers. The company has been on an acquisition binge for the last five years and seems to have very little to show for it. Dominance in sterling silver flatware may be ill-timed in today's environment where a $700-plus per place setting is not on anyone's priority list. The company will have to sell a lot more down to earth spatulas and knife blocks to make up for this. About 22% of the stock is held by insiders, leaving about 9.9 million in the float. The short position has built significantly and about 19.5 % of the float is currently short.
I, my family or clients do not have a current position long, or short in LCUT.
Another company that I have considered is Dean Foods (DF). Much publicized milk price hikes have cut this company in half. The market cap is about $2.8 Billion, but $4.8 billion in debt and relatively modest cash of $41 million works out to an Enterprise Value of about $7.6 Billion. Once again, ROIC is struggling at about 1.6%. The company does not appear to have earned an economic return in the last five years, whereas in the years prior to 2000, the company earned very respectable returns.
Here is an interesting discussion of DF that was recently published.
At about 11 times consensus earnings for FY2009, the stock on some levels seems to have some appeal to deep value buyers looking for contra-commodity plays. But in my view, there is plenty of time to cogitate and see some evidence of value creation.
I, my family, and clients do not have a current position long or short in DF.
What sorts of companies intrigue us?
Imation (IMN) is a provider of data storage media products which are sold in some 100 countries. Originally part of 3M, this company was spun off in 1996. Following the acquisition of Memorex and TDK Life on Record, the company seems to have focused on international growth and brand extension.
The stock is down some 30% versus a year ago, having been down as much as 60% but has had a relatively good 2008, being up 23% YTD.
Since going public, the company has been masterful in trying to hold back capital investment with assets growing only in three years since 1996. This is a tough biz where gross margins have been falling. I believe that there is some stabilization occurring, with first quarter gross margins improving to 18.6% up from 16.5% two quarters earlier but still down from historic 25-26%. Operating margins are holding in just under 4%. Revenues seem to have kicked in with a 26% improvement YoY, with international expansion starting to provide some margin improvement.
I, my family and clients do not have a current position long or short in IMN.
Here is a screen that I find useful. It highlights companies where the free cash flow exceeds the stated earnings per share. To “make” the screen also requires that the company show improvement in return on assets.
As you can see, this is a wonderfully eclectic list of names many of which will not provide much of a margin of safety. Yet others, such as Anheuser Busch (BUD), Ansoft (ANST), Applied Biosystems (ABI), and BCE (BCE) are involved as potential takeover candidates.
Cheap stocks can be very beguiling. Half price specials may seem like a bargain especially on a deceptive basis such as Price to Earnings ratio. But deeper analysis of the economic performance and an understanding of the corporate strategy can provide great entry points into cheap stocks. Changes in economic performance lead to changes in market performance as night follows day. Wealth creation in your portfolio is always a function of the economic wealth creation of your investments. Cheap alone won't cut it. Cheap alone ain't good enough!