On April 17th, I discussed the Art of Selling Your Stocks and briefly mentioned my investment in Graham Corporation (GHM). In doing so, I caught some feedback and lashings from a few visitors. David asked if this was a "cigar butt" investment; [MikeR] posted a Charlie Munger quote about assiduity — the art of sitting on your ass and doing nothing because your companies are great or the markets are not offering any wonderful opportunities. Was GHM a cigar butt? Did I forget to practice my assiduity?
First, let's revisit a quote from Buffett's 1992 Letter to Berkshire Hathaway Shareholders:
The investment shown by the discounted-flows-of-cash calculation to be the cheapest is the one that the investor should purchase — irrespective of whether the business grows or doesn't, displays volatility or smoothness in its earnings, or carries a high price or low in relation to its current earnings and book value.
GHM is not one of the finest businesses in the world. Quite the contrary — by virtually all measures, GHM is very forgettable as a business. Revenues, profits, and owner earnings have been very cyclical over the past ten years. With just 5 million shares outstanding and a market capitalization of roughly $175 million when I purchased it, GHM is a very small, very boring company by Wall Street measures.
Then again, it is still a business — one with a value, and one that can be purchased if it is the cheapest relative to other investment opportunities. It hasn't really grown; it displayed volatility in its earnings; it had a high price in relation to its current earnings.
Still, it appeared to be cheap.
Investing In Small Fish
Graham Corporation is what I call a "Small Fish" — a tiny company. Small Fish can be very nimble and quick. Then again, Small Fish can be swallowed up by larger competitors who control pricing, supply, and name brand appeal. A Small Fish can go one of three ways:
- it can grow to become a "Middler" (and then an "Industry Leader");
- it can struggle by as a Small Fish;
- it can fail and fall off the face of the Earth.
Small Fish can carry a great deal of uncertainty. The value of a business lies in its future. If you can't predict the future of a Small Fish with any degree of accuracy or confidence, you can't know the value and you shouldn't invest. If you can predict the future with a degree of accuracy and confidence, you might find some very attractive opportunities in Small Fish.
Still, you need an iron stomach. Small Fish present a great number of grossly mispriced opportunities. Then again, Small Fish are usually extremely volatile. If you equate volatility with risk, you should stay away. If you believe that risk is found in the business and your investment strategy, some Small Fish can look very appealing.
The Impact of Cash Flow on Small Fish
Coca-Cola has $45 billion in assets and does $30 billion in annual sales. It is growing; still, the $5 billion of excess cash the business generates will only go so far. It can be used to pay off debt or buy back shares; it can serve to increase the sales force or pay dividends. At the end of the day, Coca-Cola's business would not change dramatically if it generated an extra $20 million...or $20 million less.
With Small Fish, $20 million can mean the world.
Over the past ten years, Graham Corporation spent an average of $920,000 a year in Capital Expenditures, regardless of whether it was generating $41 million or $66 million in sales. Assuming it could maintain that level and handle larger or more sales, $20 million would drastically change the face of the company.
Think of it this way: A small, privately owned real estate brokerage helps people buy and sell $200,000 homes in the area. One day, Donald Trump walks in and asks the broker to negotiate a ten million dollar building. "Do good on this one, and you'll handle all of my real estate investing," says Trump. The broker does a great job; The Donald is pleased.
A whole new business is born.
If you truly understand how the ability to generate excess cash makes the difference between growth (or sustained operations) and contraction (or failure), you can begin to see how great of an impact that can have on Small Fish.
A Watchful Eye: For Growth and For Problems
In Small Fish, growth can happen quickly. Conversely, Small Fish can quickly run into trouble if large customers leave. Because of that, you can't just look at Small Fish over various multi-year timeframes; you must look at and watch what is happening on a quarterly basis. It's a much more active and in-depth approach, but it can pay off handsomely.
Prior to June 30, 2007: Graham has not been a stellar company for the past ten years; still, the value of GHM lies entirely in its future. If things start happening for the company, it can really take off. So, I'll keep a watchful eye on its operations and see if something good starts happening. If not, I'll stay away.
June 30, 2007: GHM reports having generated $3.5 million of owner earnings (based on average capital expenditures of $230,000, one-fourth of $920,000 annually). In the entire 2007 fiscal year (ended March 31, 2007), GHM generated just $3 million of excess cash, up from $2.7 million the prior year. Did something special happen at Graham? Or, is the business staring to move? And what is management going to do with all that extra cash the business generated?
September 30, 2007: Graham Corporation generates another $2.1 million in excess cash, bringing the total for the six months up to $5.9 million. In these six months, GHM has generated more cash than in the entire two years prior. Other than the fact that it is getting larger and larger contracts and orders, there is nothing miraculous going on in Graham's business. That's a good thing. We don't want miracles; we want business as usual.
December 31, 2007: GHM has its best quarter ever, generating another $7 million in excess cash. Over the past nine months, GHM has generated a total of $12.6 million in owner earnings and appears to be using that cash to fuel sales. Maybe it's printing better marketing materials; perhaps it has added more sales staff.
Whatever is happening at Graham, the company has generated more cash in the past nine months than it had in the previous ten years. The best part is that it appears to be "business as usual" at Graham Corporation. Larger sales, but more or less "business as usual."
The Value of Graham Corporation
Assuming the next quarter continues as "business as usual" at Graham, owner earnings might be around $4 million — or roughly the average of the past three quarters. It may be higher or lower, but I'm happy saying GHM might generate $17 million this year in owner earnings. If it's higher, I'll be pleasantly surprised; if it's lower, I'll have a margin of safety to protect me.
I'm not going to go crazy with GHM. Rather than assuming it can continue to grow its ability to generate cash by 500% a year or that its CROIC of 53% can be sustained as a growth rate, I'll assume business as usual going forward. That is, with these new contracts and contacts, it should be able to grow over time, but I'm not going to pretend it will be a billion dollar company in three years.
Assuming Graham can double its ability to generate cash in the next six or eight years — from $17 million to $34 million — its growth rate would be somewhere in the range of 9% to 12%. Let's call it 9%, and we'll assume it will slow down from there. Graham experienced a few quarters of rapid growth, but I'm not quite ready to crown it the best company in the world!
Using these assumptions, the future value of Graham's cash for the next twenty years would be $321 million. With another $31 million in Shareholder Equity, the intrinsic value of Graham Corporation is about $352 million, or $71 a share, for an investor looking to earn 9%. With its stock selling at and under $36 a share, it was pretty much a no-brainer for me. If I am (or was) way off base and Graham's growth was much slower (say, none), I'd be paying a very fair price for the company — a company then worth just $38 a share.
And Then, The Sale
Once Graham hit that "intermediate level between the price [I] paid and the intrinsic value," it was time to get out. I didn't really know if Graham was a $60 or $80 per share business (Based on my data and reasoning, Graham was a fat guy. I didn't have to know how much it weighed.) which is why I was comfortable buying in the mid-$30s but not comfortable holding in the low-$50s. Because only time will tell whether or not Graham can grow, I wasn't going to sit on the business and hope for growth.
Will I kick myself for selling if Graham continues to expand rapidly and the stock price and value soar through the roof? No more than I would praise myself for selling before the bottom fell out, if that ends up being the case. I saw value, and I made two business decisions — buy grossly mispriced value, then sell when price met value or when I wasn't quite sure what to do.