Scavenging For Quiet Bargains

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 |  Includes: CFI, NSIT, OME
by: Marc Gerstein

Summary

Stock Prices (market cap) can be allocated between the part coming from value and the part coming from noise.

We can profit by identifying low-noise stocks that have the potential to become noisier in the future.

Insight Enterprises can become noisier as investors come to recognize that they may be underestimating an enterprise IT replacement cycle.

Culp can become noisier as investors come to appreciate the merits of the replacement matters business.

Omega Protein can become noisier as investors tune into the growth potential from fish oil as a nutritional supplement.

There's a misconception to the effect that we should expect the price of a stock to equal its correct valuation; i.e., that P should equal V (however one wants to compute V). As I explained in a March 20 Seeking Alpha article, that's not the case. In fact, price typically equals value plus something else, which I referred to as noise. In other words, P equals V plus N. Investors who don't recognize this can easily get tripped up by assuming that N represents something fleeting that can be counted upon to vanish as Mr. Market comes to his senses, through better investor education, etc. That's not so. Noise always was, is, and will be part of the market.

Failure to recognize this can lead to poorly conceived sales, shorts or avoidance of high-noise stocks, as has tended to happen on occasion with such big-name noise stocks as Amazon.com (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) or Tesla (NASDAQ:TSLA), the latter having been discussed by me on April 5th. The notion discussed there, that noise is real and needs to be analyzed in order to distinguish high- and low-quality noise and that we could make money from the former, was unsettling to many. This article will be different. It will be consistent with what many would regard as a comfort zone; making money from low-noise stocks.

The amount of noise in a stock price is not likely to be random. Factors that influence its presence or absence include information costs, holding costs and transaction costs. The first item, information costs, is the one most likely to impact different stocks in unique ways. As information costs rise - i.e., as information becomes less disseminated making it more difficult to get a handle on value - noise is likely to become more prominent. A unique, idiosyncratic business that presents few or no analytic precedents is one example (see, e.g., TSLA). Another more mundane example is, simply, small size: smaller stocks that get less attention from analysts and the media are less likely to have much in the way of analyst coverage and estimates (yeah, yeah, everybody hates analysts - until they aren't around and you're left flying solo) and hence may have noisier stock prices. And if we bump up against a small-cap whose price doesn't include much noise - that actually might present an opportunity.

The investment strategy I build to implement this involves screening the Russell 2000 universe, one that is likely to be noisy on the whole, and look for aberrations; stocks that have much less noise than would seem likely given smaller size.

I start with a simple definition of value: I divide current NOPAT, net operating profit after tax, by the cost of capital. This is as basic as we can get. It's analogous to saying that if you have a bond that pays you $50 a year in interest, and the cost of debt is 5%, then the value of the bond is $1,000 ($50 divided by 5%). Similarly, if Company A generates $75 million in NOPAT and cost of capital is 8%, its value would be $937.5 million. If Company A's actual market cap is $1.7 billion, I'd say 55% of the price ($937.5 million divided by $1.2 billion) is based on value and the remaining 45% is based on noise. This is obviously a very conservative approach since I'm making no allowance for future growth (in other words, I'm acting as if all projections of future growth are the same as noise).

Within the potentially noisy Russell 2000 universe, I define as aberrant any stock for which noise accounts for 25% or less of market cap. (That turned out to be a workable threshold; only 10% of the universe satisfied that criterion.) I assume all such stocks have the potential to benefit from even mundane growth (since zero growth is priced in) and from the possibility noise may increase in the future, as might be expected given small size. Figure 2 as presented in my April 5th article supported this notion.

To make the strategy investable, I had to narrow the list. I did so by focusing on just stocks; those which ranked highest on the basis of the multifactor QVG (Quality-Value-Growth) ranking system available on Portfolio123.com.

Figure 1 shows the results of a ten-year Portfolio123 backtest of this strategy. The test assumed rebalancing of the portfolio every four weeks and 0.25 percent price slippage per trade. (And as is always the case on Portfolio123, the test was conducted using the Compustat point-in-time database, meaning there is no survivorship or look-ahead bias.)

Figure 1

Click to enlarge

It had its good times and bad times, but the times when the model didn't deliver were times when little else did. It seems, though, that the good times were more than sufficient to make the bad times worth having tolerated.

Some Low-Noise Ideas

Is this, essentially, a branch of value investing? Yes, of course it is. But I like this value-plus-noise framework not just because it helps me stay non-judgmental and recognize what the market is doing as opposed to what some book said it should be doing, but also because of the way it helps me avoid falling into the trap of acting like a Michelin restaurant critic, as so many commentators, gurus, etc. tend to do. I'm not looking for the perfect situation (which is just as well because that doesn't really exist) so I won't rant and jump up and down because I find some negatives. I'll stick to the two key themes of value-noise analysis: (1) the possibility of any growth at all given that nothing is priced into the stock, and/or (2) the prospect of an increase in bullish noise (e.g., sentiment) going forward.

NOTE: The methods of computing the percentages of market cap allocated to noise and value are detailed in the Appendix below.

Insight Enterprises (NASDAQ:NSIT)

I have to confess to an emotional angle about the investment case for this provider of enterprise IT solutions. When I was a novice analyst at Value Line (too long a time ago), I, along with many of my peers, felt considerable frustration about companies that wouldn't return calls and was itching to call them out publicly. Companies had, and still have, a right to refuse to communicate in any manner beyond the bare-bones SEC filings. But I felt back than that a company that had a worthwhile story should want to support shareholders by communicating to the fullest extent allowed by law, and that those who chose silence must have had something to hide. At this stage of my career and given all I've seen, I now understand how that was a naive point of view; investor relations, conference calls, guidance, etc., can be a treacherous minefield given the way lawyers and competitors hang on every word and the tendency of investors and the media to overanalyze everything. So in a sense, I tip my hat to companies that choose to clam up.

I talk about this in connection with NSIT because they follow what strikes me as a minimalist approach to investor relations, and this may become a source of opportunity. It's not obvious that they do this. The 10-K has a lengthy discussion of the company's business. The investor relations section of the corporate web site has all the usual reports, lots of conference call transcripts and a recent 25-slide corporate presentation. But at the end of the day, pretty much everything said (except for the bare-bones company recitations of numbers) reminds me of a report I wrote when I was just starting in my career that was kicked back by an Associate Research Director who complained that "you could have said the exact same thing about every company in the field; there's nothing here telling me what makes this company unique."

Here's what I can tell about NSIT. It helps enterprise clients (public and private sector) make sense of all the hardware and software available to them nowadays and put it all to productive use in the context of their own organizations. I also know that selling hardware and software is the vehicle through which NSIT interacts with clients (we might almost consider NSIT an upscale enterprise-level analogy to Best Buy and Geek Squad). Another thing I know is that this can be a nicer business to be in than many realize. Windows XP, the long-time standard environment for many business users, is no longer being supported. That, plus a plethora of aging desktops coupled with hardware innovation (such as 2-in-1 laptops), suggests at least some sort of replacement cycle on the horizon. And given how skimpy enterprise IT spending has been in recent years, a lot has changed since the last major hardware cycle (not just Windows 8 but mobile, the cloud, cyber-security, etc.) meaning that many firms that once confidently knew what was what in terms of their computing aren't nearly as equipped to go it alone as they might have presumed. So just from macro factors, the rising tide that lifts all boats, I think it would be easy to argue that we have room to rise above a valuation that's based on trailing 12 month operating profit of $138.1 million, which is below the 2011 peak of $153.9 million.

Figure 2

And given that the level of noise in this stock is low - it amounts to 19.5% of market cap - it seems reasonable to assume the stock should rise at least in tandem with operating profit.

Figure 3

As to whether or not we can get more out of the stock from a prospective rise in noise, even a modest rise, I think the answer is "yes." We don't generally like to think a lackluster investor relations should matter; we like to think we're above that sort of thing. Well guess what. We aren't. Information matters, not just numbers but even qualitative information. I get what the company does. But I wish I didn't have to re-read the corporate material as much as I did to recognize how much product sales figure into NSIT's business; to figure out that essentially, NSIT is a vendor that helps customers make proper and effective use of what they buy. Based on the first internet description I saw, I thought the business was more akin to those of Accenture (NYSE:ACN) or Infosys (NASDAQ:INFY). And as to financial reporting, the numbers are all there but the accompanying text is long on saying "what" happened but atypical compared to most firms, there's almost nothing on "why."

The information "deficiency" is a double-edged sword. Normally, skimpy information leads to a decrease in noise. Here, however, I think the opposite is occurring. When it comes to all things computing, it's the consumer view that dominates because that's the one most investors know - in terms of themselves. And in this regard, IT looks to be a dead business with Windows 8 being badmouthed all over the place, PCs consigned to buggy-whip status, and smartphones and dropbox being the last word in connectivity in the minds of so many.

I think there's room for noise to play an increasing role in NSIT's stock price if the company can more effectively communicate its longer-term prospects. And it's not unheard of for companies struggling in this area to eventually get their acts together. The key is to get investors to understand that there's more to IT, even the selling of hardware and software, than capturing the fancy of an iPad waving twenty-something. It would also help if NSIT more effectively communicates that which makes it unique within its highly-fragmented market. And we assume there's something worth telling given that returns on equity here (10.49% for the trailing 12 months and 12.72% for the last five years on average are better than those of the tech sector; 6.42% and 5.42% respectively). Larger rival CDW Corp. (NASDAQ:CDW) earns more on its equity but that's because it has significantly leveraged up its balance sheet; on the basis of Return on Investment, a metric that neutralizes differences in capital structure, NSIT has been better. Another possible area for improvement could be better communication by NSIT regarding the opportunities it sees in certain verticals in which it has chosen to focus including K-12 education, healthcare, service provider and public sector, areas that despite all the rhetoric about automation remain almost comically primitive.

Remember, though, that we don't have to assume this business is about to become hot, with a growth rate of, say 15%-20%. With noise being as low as it is, with a simple zero-growth valuation accounting for 80.5% of market cap, all we need is for the market to come around to the view that NSIT and its field are better than complete duds.

Culp (NYSE:CFI)

If you thought NSIT was sleepy, just wait till you check CFI. About 57% of its revenue comes from making mattress fabrics. (Bad pun, but I couldn't resist.) The balance comes from upholstery fabrics. Based on the noise-value framework, I'd say 93.8% of the stock's market cap is attributable to stand-in-place valuation and the rest, 16.2%, to noise.

Figure 4

It's not a no-brainer to suggest the company can grow: Operating profit in 2013 was at peak levels, $21.9 million. But I think we can argue for at least some growth.

Figure 5

Not surprisingly, CFI's business was hammered badly during the late-2000's financial-housing crisis. On top of the cyclical issues, upholstery fabrics turned out to be especially vulnerable to low-priced competition from Chinese producers.

The company is a lot different today.

For one thing, the upholstery fabrics business has been significantly restructured. Going into the 2000s, this segment contributed to about 80% of revenues, and was served by 14 U.S. based plants employing 3,500 domestic workers. By 2013, it had one U.S. plant, four China plants and 464 employees in China. It contributed 43% of CFI's 2013 revenues (38% from product made in China and the rest from domestic product) with the declining percent coming not just from issues in this business but also from growth of mattress fabrics. Given the state of the business cycle and CFI's new operational profile, upholstery fabrics is a much more viable business for the company now than was the case just a few years ago.

Mattress fabrics, the more interesting growth opportunity, is a domestic business and is likely to remain that way. Labor costs are a modest part of the total, thereby conferring no real advantage to developing-country manufacturers. Also making life tougher for overseas firms are high shipping costs and the fact that much of this business, development cycles, production cycles and shipment to retail, tends to be just-in-time.

Moreover, this is a generally good business, one that is underappreciated. Hence it can support more product growth beyond the trailing 12 month level as well, eventually, as more favorable sentiment (stock-market noise). CFI is not subject to the intense competition among the big brands - Sealy, Simmons, Serta, Tempur-Pedic, etc. - since it sells to all of them, among others. And it benefits from the fact that about 70 percent of mattress sales are for replacement, a factor that lends an air of stability to this business. And it looks as if when it comes to sleep, consumers are thinking beyond price; they are embracing innovation and a lot of growth is coming from the more-expensive mattresses that don't use inner springs.

CFI earns great returns on (18.28% in the trailing 12 months) and generates a lot of surplus cash flow, helped by tax-loss carryforwards (which means our valuation, which imputed a tax rate, was conservative for a second reason, beyond the standard no-growth assumption). The company is in the process of reducing the not-burdensome debt load and has instituted a common dividend. At a yield of about 1.1%, that's not a big deal. But CFI has also paid one special dividend and left the door open for others, and it's buying back shares.

Omega Protein (NYSE:OME)

Noise needn't go just one way. At OME, I estimate that value, based on trailing 12 months operating profit of $63.9 million, accounts for 140% of market cap, meaning noise is contributing minus 40%. Put another way, the investment community is not buying into the sustainability of the recent level of operating profits.

Figure 6

I think Mr. Market is reasonable in his caution. The company catches menhaden, a wild-herring-like fish and harvests various protein and oil products used mainly for animal (fish and swine) nutrition. This is a decent business given that seafood and pork are in high demand as food. But it's hard to predict annual fishing trends. Lately, in this regard, pretty much everything has gone OME's way, with demand for the feed products it produces strong and with supply of menhaden stable. The company is looking to stretch good times; it used forward contracts to lock in 2013 pricing dynamics through much of 2014. Management believes the recent trends are representative of the industry's long-term dynamics, but cautions that in the short term, fishing results are hard to predict.

Working backwards, if I want to assume that noise is accounting for 25% of market cap rather than minus 40%, I'd have to be assuming operating profits, the starting point in the calculation, were about $34 million, rather than $63.9 million. That would still allow OME to make pass my screen. If operating profits were at $23 million, noise would account for about half of market cap, a more neutral Russell 2000 allocation. To put this into perspective, consider that operating profit trend in Figure 7.

Figure 7

So to this point, considering the first aspect of our noise-value framework, whether the company can grow beyond that stuck-in-place valuation, I'll come down as neutral. Based on the forward contracts and management's guidance, I'm willing to assume 2014 will be a pretty good year. But longer term, it would seem safer to treat OME as if noise were accounting for 25%-50% of market cap, in other words, as a neutral small cap selection.

But the second part of our framework, whether noise might increase in the future, might paint a different picture.

OME is in the process of building a second business from its fish-based proteins and oils, one focused on human nutrition. This business is small, only 15% of 2013 revenues, but it is growing briskly. Revenues from this area were $15.3 million, $22.0 million and $31.1 million in 2011, 2012, and 2013. In the first quarter of 2014, human nutrition revenues were $8.2 million, up 25% year to year. Gross margin in the quarter for this business was 16.9%, versus 13% a year earlier.

There are three components to OME's human nutrition area; protein products, Omega-3 fish oil ingredients, and other nutraceutical ingredients. Omega-3 is, at least at this stage, the main event here. Since the early 2000s, various health organizations, including the FDA and American Heart Association, have been supportive of a link between omega-3 fatty acids and cardiovascular health benefits. Moreover, oil from menhaden is the only marine source of long-chain fatty acids affirmed directly by the FDA as GRAS (generally recognized as safe) for human consumption. It looks, therefore, like there may be some legitimate growth potential here.

APPENDIX

Here is the method of allocating market cap among noise and value:

Operating Profit * (1- Tax Rate) = NOPAT, Net Operating Profit after Taxes

NOPAT / Cost of Capital = V

Market Cap - Valuation = N

Percent of Market Cap attributable to Valuation = V / Market Cap

Percent of Market Cap attributable to Noise = N / Market Cap

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.