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Special situations, long-term horizon, value
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There are very few investment opportunities I can find these days. The stock market indexes remain overvalued. 0% interest rates is making everyone a speculator. I'd rather not be a speculator and instead be an investor.

Allow me to quote from the book "Money and Man" written by Elgin Groseclose, on pg. 43 when he refers to the Roman Empire in around 300 a.d.:

The disintegration continued, and there seemed no power great enough to stop it. The Treasury was empty, agriculture prostate, industry demoralized, trade stagnant, and the only commercial activity was a maddened, consuming, parasitic speculation.

This sounds an awful lot like where we are today. But let's be clear on the distinction between an Investor and a Speculator. An Investor buys an asset for its income while the Speculator buys an asset in the hopes of selling it at a higher price.

Cash is paying you next to 0% in savings accounts. Less than 1% for 2 year Treasury notes and only around 3.5% for 5 year AAA corp. bonds.

Meanwhile, year over year inflation is 2.72% per the CPI and we know it's really higher than that.

So, investors have it very tough. Speculators are sweating it out trying to trade in and out of the markets knowing the odds of them succeeding are against them.

What's someone with capital to do?

Seek hard to find undervalued stocks that you could buy and feel comfortable holding throughout the ups and downs of the general stock market because you know the cashflows are building value. American Oriental Bioengineering (AOB) (Herein after AOB) is such a buy at the current price.

Like all businesses, the sole purpose is to make a profit via the generation of cash flows from the operations for the owners. Since AOB was founded in its present form, in 2001, the cash flow from operations has been growing very steadily:

Cash flows from operations for AOB: Note: all figures obtained from Reuters ProVestor Plus Company Report

2001: $1,015,000
2002: $2,021,000
2003: $2,530,000
2004: $8,326,000
2005: $11,401,000
2006: $29,093,000
2007: $45,100,000
2008: $77,757,000

2009: $44,325,000* First 9 months of fiscal year 2009

Total cash flows Generated since 2001: $221,478,000

AOB management, like management of all corporations, can choose to do up to 4 things with the cash flows from the business:

  1. Pay dividends to shareholders
  2. Pay down debt
  3. Buy back shares
  4. Leave funds as retained earnings and reinvest back into the business.

AOB management chooses not to pay dividends or buy back shares and instead retains all earnings to be reinvested back into the business to help it grow. Funds can go to making acquisitions and or investing in R&D for new products to launch.

This sets up for an investment where I want to try to determine a future liquidation value in 10 years' time. Liquidation value is more or less the worst case scenario for the valuation of a company.

If ever an asset is selling below its present liquidation value, it’s probably an opportunity to buy and then liquidate and sell to make a profit. Typically, companies don’t sell below net tangible asset value. So to a fair degree, to surmise a future value at liquidation value, I’m reducing my risk for the worst case scenario value.

Of the $221,478,000 generated from operating cash flows as of September 31, 2009, AOB has created a net tangible asset value of $174,271,000 of which $179,501,000 has been retained from cash flows.

As the cash flows from future operations continue to come in and add to retained earnings and add to the net tangible asset value, this will help bring about a higher future price.

The growth in cash flows for AOB since 2001 has been phenomenal. Those growth rates will not likely persist. However, given that AOB operates in a country where there is a higher growth rate than the rest of the world, achieving 7% growth in cash flows for the next 10 years may be a reasonable estimate to work with.

Starting with a 2010 estimate of $75 million in cash flows from operations to be retained in the business and used to grow the company so to generate even more cash flows, the following years' cash flows may be as follows:

2010

$75,000,000

2011

$80,250,000

2012

$85,867,500

2013

$91,878,225

2014

$98,309,701

2015

$105,191,380

2016

$112,554,776

2017

$120,433,611

2018

$128,863,963

2019

$137,884,441

The total cash flows generated over the next 10 years may be $1,036,000,000. Adding that cash flow total to the current net tangible asset value gives us a future net tangible asset value of $1,210,271,000. With the current 78,321,000 shares outstanding, the future value per share in 10 years' time could be $15.45 per share.

$15.45 per share in 10 years discounted at a rate of 7% per year gives us a present value of $7.86 per share. In other words, at $7.86 per share, if it was to grow 7% per year for the next 10 years, then in 10 years' time the value would be $15.45 per share.

The idea is to buy stocks when they are selling at a discount to the net present value. Since I calculated AOB’s net present value to be 7.86 per share and the current price in the stock market is now 4.10 per share as I write this, AOB is selling at close to 50% of my calculated present value. This rings the buy bell in my opinion from a quantitative analysis perspective.

That is just one way of valuing AOB. Assuming AOB will be an ongoing business in 10 years' time, and assuming AOB meets those estimates, if I were to put a price to cash flows ratio in line with the S&P 500 average, which today is 14.6, then as AOB can generate $137,884,441 in cash flows in 10 years, at a price to cash flows of 14.6, the future value is $2,013,000,000 or $26 a share. If I discount $26 a share at 7% per year, the present investment value of AOB becomes 13.06 today. At the current price of 4.10, this is selling at a monster discount.

I conclude that somewhere between $7.86 and $13.06 is what AOB is worth today. Over the last 5 years, AOB’s share price has swung in price dramatically, like many stocks do. Stock markets are both inefficient and estimating future cash flows is extremely difficult. So great swings in share prices are to be expected and should also be considered impossible to predict in the short term.

I'll leave you with a chart I created showing the past 5 years and my projected 10 years out. Note: not to scale

As with any investment, do your own due diligence and create your own projected future cash flows estimates to help you determine what you think the stock is worth.
Disclosure: Long AOB for myself and clients
Source: American Oriental Bioengineering - A Value Investment