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This is the third article in a series of articles that focuses on finding attractive investment opportunities in a richly valued stock market.

Part I of this series of articles focused on the high valuation of the stock market and the risk associated with this high valuation. I do not profess an ability to predict stock market movements. However, I am a believer that the investment environment is 'a market of stocks and not a stock market'. As a value manager, I believe there are almost always attractive investment opportunities. Sometimes you have to search for them in unusual places (i.e micro-cap universe) and/or be patient. I think ADDvantage Technologies Group (AEY) offers a unique opportunity where its upside return potential is significantly more than its downside risk.

When looking at investment candidates I look at each potential purchase as if I was buying a business. I implement my 'three pillars' approach to determine whether the investment is attractive. These 'three pillars' approach involves assessing the valuation risk, balance sheet risk and business risk of owning a publicly traded company. It is the attractiveness of the three levels of risk that determines whether an investment is worth owning. Below is a summary of AEY's risk from my 'three pillars' perspective.

Pillar I - VALUATION RISK:

I believe successful long-term investing involves implementing a value based strategy and ignoring fluctuations in stock prices. All successful and famous, long-term investors such as Ben Graham, Walter Schloss, Warren Buffett, John Templeton, Michael Price and Seth Klarman have employed this strategy for decades. A key element for each investor's strategy is they bought undervalued stocks that were significantly below each company's intrinsic value.

What is intrinsic value? The first and I believe most accurate explanation appeared in the 1940 edition of Security Analysis, where Ben Graham defined it as:

… intrinsic value is an elusive concept. In general terms, it is understood to be that value which is justified by the facts, e.g., the assets, earnings, dividends, definite prospects, as distinct, let us say, from market quotations…

My investment process determines the intrinsic value of a company from the two primary financial statements of a company: the income statement or balance sheet. As a result, there are two ways I calculate a company's intrinsic value:

  1. The value of the company if it was acquired as the result of a merger or acquisition. (This intrinsic value estimate is calculated based on earnings multiples from a database of over 2,000 companies that have been acquired over the past 15 years. The intrinsic value estimate is dependent on the company's industry and the quality of a company's business.)
  2. The value of the company if it was liquidated. (This is calculated as the difference between a company's tangible assets less its liabilities on its balance sheet.)

I closely track about 800 small, mid and large cap companies and their stock prices compared to my intrinsic value estimate. When the company's stock price reaches a point where it sells significantly below (25 to 50 percent) my intrinsic value estimate, I view the stock as an attractive candidate for inclusion in my portfolio.

Most of my investment holdings involve companies selling at a discount to their underlying intrinsic value based on the earnings power of their business (item number 1 from above). Periodically I will find companies that are significantly undervalued based on the stock selling below the theoretical liquidation value of its balance sheet (item number 2 from above). ADDvantage Technologies Group meets this classification.

AEY is what I classify as a 'George Bailey' stock. I base this from the 1947 classic, It's A Wonderful Life. In the movie, George Bailey, the main character is broke and needs money to keep his bank in business. He goes begging to his arch nemesis Mr. Potter. Mr. Potter refuses George's request for money saying, "(you have) no securities, no stocks, no bonds, nothing but a miserable little $500 equity in a life insurance policy. You're worth more dead than alive." As you will see below, ADDvantage Technologies Group meets this 'worth more dead than alive' phrase.

(Note: AEY is not a 'buy and hold' stock in the mold of Johnson & Johnson (JNJ), Procter & Gamble (PG) or Coca-Cola (KO). However, I think the stock offers significant upside with very little downside. It is also a company whose stock price will probably move somewhat independently of the broader market.)

The most recent closing stock price was $2.30. Tangible book value was $3.63. Hence, the company sells for 63 percent of tangible book. Below is a summary of the company's Price/Tangible Book Value compared to its stock price since 1999:

(click to enlarge)

The orange circles in the chart indicate the points in time where the downside risk is somewhat limited. From a risk-reward perspective, AEY is much more attractive than the S&P 500 Index, which was detailed in Part I of this series of articles. The S&P 500 Index is near a valuation high. AEY is near a valuation low.

There have been two previous times since 2000 when the stock sold at less than two-thirds of tangible book value. While past performance is not necessarily an indication of future results, I take great comfort looking at a historical valuation analysis of company and its subsequent stock performance. Since the peak of the 2000 tech bubble, the stock has traded below two-thirds of tangible book value on two occasions. It happened in September 2001 on the heels of the 9/11 Attacks and in November 2008 during the financial crisis. In each case, an investor buying the stock at two-thirds of book would have been able to sell out at tangible book value in about 18 months with a gain of 70.5% in 2001-02 and 72.4% in 2008-2010.

As a supportive measure, the company also sells at an attractive valuation when looking at it from an earnings perspective. The company sells at an enterprise value to free cash flow (5 yr. average) ratio of 3.4. Below is a chart since the late 1990s that compares EV/FCF against its stock price. The current valuation is at an all-time low.

(click to enlarge)

ADDvantage Technologies Group is extremely cheap on a balance sheet and earnings basis. It's one of the cheapest stocks I have ever seen. From a valuation perspective, AEY rates very favorably.

The company now has net cash on its balance sheet equal to 16.7 percent of its equity. I view this deleveraging of the balance sheet as a big positive factor. This strong balance sheet and the elimination of debt have dramatically reduced the possibility of bankruptcy and downside risk for equity owners. AEY rates favorably from the perspective of balance sheet risk.

Sales trends have been flat to down over the past five and 10 years. Despite this trend, the company generates consistent free cash flow. (Free cash flow removes the potential accounting gimmickry associated with earnings. As a result it will usually be more erratic than earnings. However, free cash flow is a more accurate representation of the true profitability of the business.) The company has posted positive free cash flow for 17 consecutive years.

Despite flat sales, the business has exhibited decent growth in intrinsic value per share over the past five years and 10 years. Due to the nature of its business, I believe the base way to measure intrinsic value is by tangible book value per share. Tangible book value per share has grown at 8.4% per year over the past 10 years and 12.0% per year over the past 10 years. It is also a stable business. It has earned 11.2 percent on capital over the past decade. This is about what an average business earns over its lifetime.

I think ADDvantage Technologies Group rates favorable under my 'three pillars' approach to evaluating investment candidates. It is rare to find a 'George Bailey' stock that has been profitable for 17 consecutive years, has no net debt and sells 37 percent below its tangible book value. I think AEY is a very attractive risk reward proposition.

(click to enlarge)

Pillar III - BUSINESS RISK:

Valuation risk and balance sheet are best measured with quantitative metrics. Business risk tends to be measured from a quantitative and qualitative perspective. From a quantitative perspective, below is a table summarizing key financial data for AEY over the past decade:

Pillar II - BALANCE SHEET RISK:

If a company passes my valuation criteria, I move onto the balance sheet to assess the risk in how the company is financed. I believe a strong balance sheet is a requirement when buying small and economically sensitive companies. If the company does not meet this risk requirement, I will not buy the stock - no matter how cheap it is.

In the quarter ending 9/30/12, the company established a net positive cash position for the first time since the late 1990s. Since 2008 the company has favorably restructured its balance sheet from a net debt position of $20.5 million to a net cash position of $3.5 million. Below is a summary of their balance sheet position over the past decade:

(click to enlarge)

Another way to quantitatively measure the health of their business is to look at the year-over-year (YOY) change in receivables and inventories. Growth in inventories would be a sign of possible obsolescence of its product line. Growth in receivables would be a possible sign of distress of one of its customers. The YOY change in receivables are +1.7%. The YOY change of inventories is -10.1%. The most recent YOY change and the trend of this change both indicate from a quantitative standpoint a fairly stable business. Overall, from a quantitative perspective, the business is average at best.

From a qualitative standpoint, there are four points to note about AEY's business. First, the company is a distributor and servicer of hardware for the cable TV industry. As a result, I do not believe they have any competitive advantage over their competitors. Second, their products are also subjected to technological change. As a result, they are prone to inventory write-downs. Third, the company could be negatively impacted by a deteriorating economic environment. This is due to the fact that historically cable subscription volume is inversely correlated to employment and economic growth. Fourth, the company is not significantly dependent on any one customer. Sales to their largest customer equaled about seven percent of total 2011 sales. 22 percent of sales were derived from their five largest customers. From a qualitative standpoint, I would rate the business as below average

Overall, based on a qualitative and quantitative analysis, I rate the business as below average.

CONCLUSION

I think ADDvantage Technologies Group rates favorable under my 'three pillars' approach to evaluating investment candidates. It is rare to find a 'George Bailey' stock that has been profitable for 17 consecutive years, has no net debt and sells 37 percent below its tangible book value. I think AEY is a very attractive risk reward proposition.

Source: ADDvantage Technologies: An Undervalued 'George Bailey' Play For A Richly Valued Market - Part III