Chris DeMuth Jr Interview: Valuable Insights

by: Chris DeMuth Jr.


Who is Valuable Insights and what has he been working on? I will answer one of those questions.

"I expect value investing to continue to work as an investing discipline until human nature changes, which I don’t see as likely." - Valuable Insights.

"If I didn’t know a given stock price, what do I believe it is worth based on my view of the company and its fundamentals?" - Valuable Insights.

Valuable Insights' Picks


Long Chipmos / IMOS

Long Crossroads / CRDS

Long J.W. Mays / MAYS

Long Namtai / NTP

Long Radcom / RDCM

Short Plug Power / PLUG

Short Proto Labs / PRLB

Short Unilife / UNIS

Short Veeva / VEEV

Short World Acceptance / WRLD

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Valuable Insights is an analyst and fund manager with almost twenty years of investment experience. He covers a variety of industries with a focus on technology. He spends his time looking for value stocks, poorly understood or under-followed situations where he can bring a contrarian perspective. During his career as an investor and writer on Seeking Alpha, he has earned an impressive reputation as a strong generator of ideas and performance. He has been both an idea source and a friend. Unless otherwise cited, all quotes are his.

Turning to Valuable Insights, your contribution to value investing ideas on Seeking Alpha through the years has been much appreciated. I know that they have been both interesting and lucrative for me.

Thanks Chris, I appreciate the kind words.

What is the most overvalued and undervalued area or specific security in the market today? Where are you looking? What are you finding?

I tend to take a bottom-up approach to stocks, so I'm not usually looking at broad sectors. That being said, on the long side, Korean preferreds continue to trade at a sizable discount to common - although that's been true for some time. On the short side many Internet, SaaS, 3D printing and Fuel Cell/Alt Energy companies appear to have ambitious assumptions baked in. I'm currently short Veeva, Proto Labs (PRLB - which is actually a prototype manufacturer and, according to the risk factors in their 10-K, potentially harmed by the emergence of 3D printing) and Plug Power.

Communism in the north and cheap prefs in the south

I expect that VEEV will have a rough month as the lockup on insider sales expires on April 13th. As for PRLB, I am astonished that the price has held up as well as it has so far. That is still very actionable. Anyone interested in reading more about that one should read a great earlier article from late last year that lays it out well. On the long side, there are great Korean prefs, including some liquid, well-known names. For a lazy way to exploit that opportunity for a personal account, you can always buy shares of the Weiss Korea Opportunity Fund (LON:WKOF). Andrew Weiss is a great investor and I expect his fund to do well exploiting the underpricing of Korean prefs relative to their common shares.

Dr. Andrew M. Weiss, a brilliant economist and investor expert in Korean prefs

Probably the two most undervalued securities I own, looking at it from a pure pennies-on-the-dollar for hard assets basis are J.W. Mays and Namtai. I bought Mays after reading a presentation from Rhizome Partners. Mays is a former retail chain that went bankrupt and emerged focused on its real estate holdings. The company owns numerous properties with below market rents, but should ultimately see at least 100% upside over the next three to four years. Namtai is another real estate play that will also likely take three to four years to fully play out, but should be worth several times the current price. With shares around $6 and the company with $6 of cash and $8 of book, there is limited risk of permanent capital loss. I realize this is a China-based NYSE-listed company, but with Peter Kellogg (of Spear, Leeds, Kellogg fame) the company's largest shareholder and on the Board for over a decade, and Namtai paying dividends for 18 of the last 20 years, the likelihood of anything unseemly is minimal. Namtai has approximately three million square feet of former manufacturing space to develop near Qianhai, Shenzhen's new special economic zone, which is on Namtai's books at 1993 prices. This is not a bullish call on China - my view on China is mixed - but reflects the first three rules of real estate: location, location, location. I've been to Shenzhen several times and it's an extraordinary city growing by almost one million people per year, and just a thirty-five minute ferry ride from Hong Kong. The stock should start to work as construction moves forward over the next year or two.

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Qianhai, Shenzhen

Chris, as an aside, I went to Shenzhen last year where I met with several real estate developers to get their view of Qianhai, the build-out of Shenzhen, comp values, and probable outcomes for NTE. My view on NTE comes from my own on the ground work and not a secondhand source.

More broadly, on the long side I'm looking where I always look: spins, changes in management, changes in strategy, possible unit or asset divestitures, insider buying, and activism. On the short side I'm looking at a lot of business models where I can't figure out how the company is going to make money and where there appears to be investor euphoria. I've also been looking at companies that seem overly promotional - I'm short Unilife, for example. I also recently got short World Acceptance Corp., which seems to have a too good to be true business model, and reminds me a lot of the for-profit education sector, before the government cracked down on them. The stock looks cheap, but if the government goes after them, things will likely rapidly deteriorate.

UNIS and WRLD are two of my favorite shorts, too. I had a good talk with Rick Pearson earlier this week, who I spoke with for an upcoming article that will touch on his research regarding Unilife among other stock promoters. As for me, on the long side I am looking at minority positions in foreign closely-held companies where there are attractive provisions for the minority. On the short side, mostly biotech. Tax inversion opportunities are probably coming towards an end. Valuations are high - in fact so high that many are already trading above their value to strategic acquirers. Turning to the world of hedge funds, what do you think that it will look like in the future?

I don't expect the world of hedge funds to change dramatically. With the opportunity to earn 2 and 20 and create vast personal wealth, there will continue to be new fund managers, some of whom will be spectacularly talented, others less so. In my view, if anything is going to change, and I don't think it will, it has to come from asset allocators, who I believe frequently drive sub-optimal investment outcomes. Specifically, the focus from many of them on month-to-month returns and their aversion to volatility can hurt investing decisions. If more allocators took a multi-year view, I'd suggest that hedge fund industry performance would improve. As things stand, most hedge funds have an outsized focus on short-term events. They also tend to hold too many stocks to help smooth returns. There is no way a portfolio manager's fiftieth best idea is as good as his first. I'd expect that until the assessment tools change, most portfolio managers will continue to manage to satisfy allocator criteria.

Of course for some of them, it is worse than that: their fiftieth best idea is exactly as good as the first… What other opportunities do you see?

I believe there is a substantial opportunity and inefficiency in small caps given they tend to have a limited institutional following, with most institutional investors lacking the time, energy, resources and tolerance for volatility to research them. I also think that over cycles, value investing will continue to succeed as a strategy, and the short-term nature I just noted will be among the contributors to continued opportunities. I also think we're at a unique time where many segments of technology have matured, creating a vast increase in value opportunities in a sector that, for the most part, has traditionally been followed by growth investors. The combination of small-cap tech-value strikes me as a very compelling opportunity, with relatively little institutional competition, and is where I spend most of my time.

I have read your articles on Seeking Alpha since the beginning of 2012. Over the past years, what has your favorite idea been?

My favorite idea has been Chipmos, a stock I've written about numerous times. I like it because it exemplifies my approach to value investing, and because, despite it going from no coverage to two solid analysts, it remains mispriced. I first took note of Chipmos in September 2011 because they announced an option grant - an event that in my experience often precedes an improvement in fundamentals. The company was trading at just over $5 and was generating over $3 in annual free cash flow, and was quickly reducing debt. However, because of high depreciation from cap-ex from several years earlier, it was losing money on a GAAP basis - something that would change as depreciation rolled off, and in my view would cause shares to appreciate, but was causing the stock to be ignored. Other than on cash flow, which many tech investors ignore, the stock screened terribly. I suggested the stock to many colleagues, but the constant response was that it must be a Chinese fraud (the company is Taiwanese) or was too small ($150 million market cap at the time) to look at. It was so cheap people came up with explanations to explain its cheapness, instead of digging in and doing the work. In fairness, there was a complex corporate structure, but a situation that was well worth doing the work. A huge validation came last summer with Baupost becoming the largest shareholder. Here we are 2 ½ years since those option grants, the stock up 4-fold, and despite excellent coverage from Cowen and Craig-Hallum, it's still too cheap, trading at just over 3x EV/EBITDA vs. 5-6x times for peers - I think this is a $30+ stock. There is a discrete event, an uplisting/IPO from the Gre Tai exchange to the Taiex, next week, on April 11th, that I believe will result in a 10-20% move in IMOS in the days that follow. Of course, improving fundamentals and excess capital that should result in dividends or buybacks later this year doesn't hurt either.

Value investors can be so skeptical of sell side research that I don't think I've ever before heard one refer to "excellent coverage from Cowen and Craig-Hallum". Which is the least priced in, as of this moment?

Besides ChipMOS, I remain particularly excited about Crossroads and Radcom, two of my top ideas from the past year. Neither is a conventional value stock in terms of trading at a discount to assets or offering a compelling free cash flow yield, however each trades at a substantial discount to my estimate of expected value.

Crossroads has pending litigation against Cisco (NASDAQ:CSCO), Dell, Huawei, NetApp (NASDAQ:NTAP) and others. They have a rich patent portfolio and have never lost a case. They also have a storage technology called StrongBox in which they invested tens of millions of dollars and are now selling through Fujifilm (OTCPK:FUJIY), Hitachi (OTCPK:HTHIY) and other large players. I believe Crossroads could win a substantial verdict or receive a meaningful ongoing royalty in their litigation. Then again, they could get nothing. My expectation is they will get something, and note that even a few million per quarter would be about $0.10, or $0.40 annually. StrongBox currently generates less than $1 million per quarter in sales, but given its corporate sales partners who I suspect wouldn't take on a product that didn't have many millions in revenue potential, and the product's utility, I could see it becoming very large. If it grew to $5 million in quarterly revenue in a few years (and I believe it could be much bigger), it would generate about $0.20 in quarterly EPS. With 80% gross margins and substantial follow-on sales (recurring revenue) this would be a very high multiple business. Again, this could fail to play out. My confidence is bolstered by CRDS Chairman Jeff Eberwein's recent purchase of over one million shares at a slight discount to current prices in a private placement (to regain NASDAQ compliance). I'm not sure how this will play out, but in my view there is a reasonable probability of an exceptional outcome and a good probability of a very good outcome. In other words, I don't see the distribution of outcomes as a bell curve, but see a fat tail. The bottom line is that my expected value for CRDS is several times the current share price. I contrast this with many biotechs where there is similar uncertainty, but where the market appears to be pricing in very favorable expectations and prices exceed expected value. In a worst case scenario I believe I would recover most of my investment in a sale of the '972 patent portfolio and rights to the company's technologies.

Eberwein's purchase is reassuring; he is a savvy investor. We have both invested in SWS and CPE and I've really benefitted from his thoughts on those and other investments. Since he moved nearby recently, we have met to discuss ideas.

Radcom grew revenue 30% last year while cutting op-ex 7%, but otherwise screens poorly and is money losing. However, despite shares being up substantially from where I originally wrote about them, I think they still offer dramatic upside, and have limited downside. I believe the product, MaveriQ, they discussed on their most recent conference call (I'm not sure how many besides me listened to the call) is a complete game changer. MaveriQ is a more software-centric solution for Quality of Service (QoS) and network monitoring for 4G LTE build-outs than Radcom's previous offering. What this means quantitatively is that gross margins are now expected to be at least 75% vs. 61% last year. When asked on the call, management said that applying future gross margins to most recent quarterly results would have added $0.10 to EPS. In other words, based on 4Q results and go forward GMs, the company would have earned $0.12 or $0.48 annualized. At 14x trailing run-rate earnings, shares no longer look so expensive or like they have much downside. Importantly, management noted that its 4Q bookings were of the new product and will reflect the new margin profile. I believe by 3Q, GM should approach 75% and by 4Q should be 75%. Also notably, according to the "Trend" section of the recently released 20-F, after tepid telecom activity in the 1st half of 2013, they saw a meaningful acceleration in the 2nd half, but that these bookings have yet to show up in revenues. With over 70 customers, no single 10% customer, and with strong ties to China and South America, Radcom would appear exceptionally positioned for the 4G LTE build-out. I don't know if they grow 10% or 20% or 30% this year, but the signs seem extremely positive. If they can grow 4Q revenue 30% y/y to $7.5 million, quarterly EPS would be about $0.25, or $1 annualized and RDCM is likely a $20 stock. If it takes until 4Q 2015, that's fine too. If I'm wrong, and there's no growth, but new margins take hold, there's probably limited downside. If I'm right, huge upside and if I'm kind of right, very likely an excellent return as well. In a market that has euphoric expectations baked into tons of stocks it's nice to find ideas that could fall short of my estimates and still provide more than satisfactory returns.

A quick aside: for both CRDS and RDCM I am giving untaxed EPS numbers given their sizable NOLs. If they fully utilize their NOLs then things have likely gone extremely well.

Finally, is value investing something that is inextricably linked to a moment in history or is it something that you expect will continue to work into the future, such that you could build a career based upon its precepts? Which parts are you taking with you? Any parts worth discarding?

I expect value investing to continue to work as an investing discipline until human nature changes, which I don't see as likely. The work of Kahneman, Tversky, Thaler and other behavioral economists demonstrate human biases that influence what are often irrational decisions, and by extension, create investment opportunities. Whether it's hedge funds worrying about short-term performance, or an individual investor's impatience or tendency to trade too much, there will continue to be time-arbitrage opportunities. Amazingly, despite Joel Greenblatt writing about the outperformance of spin-offs (based on academic studies) in You Can Be A Stock Market Genius, in aggregate, spin-offs continue to outperform. Finally, there is the creative side of value investing - to me, the really fun part. Identifying companies with money losing units that can be sold or shuttered, companies with assets that aren't reflected in their financials. I think the ability to identify such opportunities is timeless. Of course there is the more traditional, formulaic side of value investing - looking at price-to-book, dividend growth, etc. I don't dismiss this at all, but it's not an area where I feel like I have an edge.

Thank you very much for taking the time to discuss these with me. I touched on ideas, hedge funds, Seeking Alpha, and value investing; anything else that you're thinking about or working on these days of interest to fellow investors?

First, I just want to state my admiration for the work of Richard Pearson. I'm extremely impressed by his important work.

Second, as always, my ideas and opinions are my own, and I encourage everyone to do their own work independently.

Third, I will not trade any of the securities I've mentioned for at least three trading days following this publication.

Lastly, a question I always ask myself is: "if I didn't know a given stock price, what do I believe it is worth based on my view of the company and its fundamentals?" With many sectors reminding me of '99-'00, it's a particularly useful exercise. I'm not sure how many investors are employing it.

Despite numerous overlapping positions, books, and interests, it seems that one of the strongest characteristics of value investors is to do one's own work and to do it largely on the basis of primary sources. Such is clearly true in this case. At the same time, I am glad to have you in my "seamless web of mutually deserved trust" as Munger puts it.

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Making one's own path on Rangeley Lake

Infrequently Asked Questions With Chris DeMuth Jr

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This is part of a larger interview series which includes the following conversations:

Taking Questions…

Seeking Answers…

Disclosure: I am long IMOS, CRDS, MAYS, NTE, RDCM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Disclosure: The author is long NTP.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.