In his books "The Intelligent Investor" and "Security Analysis," Benjamin Graham coined net-net investing, the practice of investing in a company's stock when it is trading below liquidation value.
The thesis is simple. You invest with a significant margin of safety. If the company's prospects improve to the point where enterprise value matches the value of working capital you already made 50% on your money. If the bull case doesn't work out, an investor can liquidate the company at a profit because the liquidation value of current assets alone is worth more than liabilities and market capitalization combined. Your downside is very well protected.
Graham explained that after the 1929 market crash and after the second world war there were a large number of opportunities to invest in companies trading below liquidation value. In 1957, during a time when the market level wasn't low, according to Graham, there were around 150 opportunities of this kind. Graham-Newman Corporation carried a wide diversification and invested in at least 100 different issues of net-current asset stocks at a time.
In a 1985 Barron's article, Walter Schloss, one of Benjamin Graham's disciples, indicated that after the 1950s these opportunities were disappearing. With the economic uncertainty of today, I wanted to revisit whether things changed since the Barron's article.
I set up an equity screen to filter for companies domiciled in the United States with a market capitalization of more than 50 million. The screen is defined as market capitalization greater than cash plus 85% of accounts receivable and 65% of inventories less total liabilities. To keep matters simple, I am also excluding banks and insurance companies.
Heelys, Inc. (HLYS)
Heelys, Inc. manufactures specialized footwear. The Company produces shoes with a removable wheel in the heel. HLYS markets itself as a lifestyle products manufacturer, but I am worried that the product is a fad. A quick look at the 10-K confirms this. In 2007 the company sold 6.5mm pairs of shoes, but only 2.6mm pairs in 2008 which lead to revenue declining from $183mm down to $71mm. Since then, revenue declined to $33mm for the last twelve months. From a balance sheet perspective, the company has $58mm of cash equivalents and $16mm of accounts receivable and inventory compared to a market capitalization of $52mm. Liabilities are a very small amount.
The company realizes two thirds of its sales internationally with Italy accounting for 20% and France accounting for 17% of 2011 net sales. The Q1 investor call brings to light that the company's largest shareholder, Capital Southwest, recently registered its shares leading to a significant decline in the stock price. With Capital Southwest owning one third of outstanding shares, the market is worried about near-term selling pressure.
The company had around $8mm of negative cash flow in 2011, but managed to break-even in Q1 2012 on a 20% top-line increase. At the same time profitability declined due to restructuring charges from closing down its offices in Belgium. The growth strategy is based on expanding stores in South America and Southeast Asia, as well as pursuing new online partnerships.
Due to the decline of the underlying business, this is hardly a situation to get excited about. However, at the current trading price significantly below net working capital, it would be worth spending more time to figure out whether the uptick in Q1 2012 is a sign of growth to come or whether the company could even become profitable at current revenue levels.
Pacific Biosciences of California Inc. (PACB)
Pacific Biosciences of California Inc. has developed a novel approach to studying the synthesis and regulation of DNA, RNA and protein. The Company's system enables real-time analysis of biomolecules with single molecule resolution.
The company was taken public in October 2010 at a share price of $16 and is still covered by JPMorgan, Morgan Stanley and Deutsche Bank among others. Since the IPO, the share price has declined to $1.85. The market capitalization of the company is $99mm compared to $161mm in cash equivalents and $3mm of debt.
The company's topline grew from $2mm in 2007 to $44mm LTM, however free cash flow in 2011 was negative $112mm and even worse in 2010. Another year with a similar performance would bring the cash balance closer to 0. Without additional financing, this company could run out of cash soon. Due to those levels of cash burn, this is a very risky investment and doesn't qualify under the Graham rule. In "The Intelligent Investor," Graham stated that stays on the sidelines when a stock trades below liquidation value, but either has only small operating gains or even operating losses.
Gencor Industries Inc. (GENC)
Gencor Industries Inc. manufactures asphalt plants, soil remediation plants, combustion systems and screening equipment for the construction industry. The Company is a global manufacturer serving North America, Europe, the Middle East, and Asia.
At first sight the balance sheet looks conservative, however a look in the 10-K under contractual obligations reveals that GENC is financing some equipment under operating leases. The payment under the operating leases for the next twelve months is $46mm. Since a lease can be rejected in a liquidation at one-year rent, I am including that amount on the liability side. The company only has $108mm in current assets compared to $66mm in market capitalization. Adjusting the balance sheet for the operating lease results in net working capital being lower than the market capitalization. In other words, the margin of safety that Graham preaches is not available here.
A stock screen provided me with three stocks that qualified under the Graham criteria. One of those I would flag for follow up, one is quickly dismissed because of a lack of profitability and the last one I dismissed because of off-balance sheet financing. In conclusion, there are still some opportunities to be found when screening for net-nets. However, investing in these kinds of opportunities with diversification of risk is not possible. Graham suggested to diversify holdings to at least thirty opportunities to reduce risk, but I was only able to identify a single opportunity worthy of follow-up. I will continue to monitor these opportunities and report back when there is more to report on.