Follow up to the small cap post - and some notes on SuperValu

My blog post suggesting that small-cap stocks were mostly to be avoided roused the animosity of many readers. The problem was that many of my readers see themselves as value investors. A surprising number run small funds and my post was an attack on their world view.

Their logic is that it is impossible for a small fund manager to add value by analysing Hewlett Packard*, Vodafone*, Google* or Total* but by being small and diligent and nimble they can add value by picking small caps. They tell themselves (and possibly their clients) this story every day - it brings meaning to their life. They can add value. By saying just avoid small caps I was asserting that their rationalizations were bullsh-t. No wonder they bristled.

My restrictions were somewhat limited - I was only wanting to avoid buying small caps where the possibility of a go-private transaction was underpinning the price. In other words small caps in safe jurisdictions with good balance sheets and open registers were mostly to be avoided. Private equity mostly can not or will not buy financial institutions (with rare exceptions such as JCFlowers) - and there is some value in smaller financials. Likewise some companies that are already so levered that a debt-financed private equity bid is impossible are potentially interesting. Some German two-class-of-shares mid-caps are also interesting. But even these are at best partial exceptions to my rule of small caps being relatively expensive.

Still the rationalizations of the small cap value managers reminded of Woody Allen's zinger about rationalizations being more important than sex. "When was the last time you went 24 hours without a rationalization?"

Most of the comments posted wound up revolving around SuperValu - the grocer that owns Albertsons and others and which has been distressed and whose stock price reflects that distress.

One of my readers points out just how cheap it looks relative to potential. He figures the pain (and there has been considerable pain) is more or less over and the stock should race. Without a lot of work I can't even express an opinion on that.

But I will note that the first question when analysing a business is "what will they look like in three, five, ten years". Warren Buffett tells us that when he buys businesses he likes to look out decades. I am a little more flighty than that (and I can always dump the stock) so I tend to look 3-5 years out. Call it the "Wayne Gretzky school of value investing" - look at where the puck is going to be and ask if it is cheap against that.

And when you look out three to five years the biggest determinant of how they will look is what the competition will do to them.

Whatever: on this metric SuperValu is difficult. The grocery market is not growing much in aggregate in the US except through food inflation. And the competition at the bottom end is fierce. I would rather wrestle grizzly bears than compete head-to-head with Walmart. And at the top end the competition is also evil. (The Wholefoods store in Chicago where I irregularly shop is very nice. Certainly nicer than the average Albertsons.)

Sales are going backwards. That does not look like it is going to change - although plausibly the rate of decline may drop. This unquestionably a difficult story where a strained company is fighting with superior competitors. When small caps are cheap (and they do get there fairly regularly) there is no need to take on difficult stories. When to find value you need to go headlong into difficult stories then you are probably deluding yourself about there being value there in any general sense (although there may be value in specific instances).

The focus on SuperValu (a truly difficult story) was confirmatory of my view that on-average small caps are particularly difficult at the moment. [I should note however that SuperValu is something that would not appeal to most debt-funded private equity shops. The company is shockingly levered - and my general restriction against small-caps does not apply here.]

Metrics

I have a few metrics I think about with grocers. The main one is EV (meaning market cap plus debt) to sales. My rough rule of thumb is that an EV to sales of under 0.25 is outright cheap (and only seen either when the whole market is distressed or an individual company is distressed). You have to have a very high quality company to want to pay more than 0.5 times sales. These numbers have to be adjusted for retailers that own much of their property (Walmart, Tesco).

The logic is as follows: grocery retailing is a 5 percent margin business give or take a bit. $100 of sales at an EV to sales of 0.5 is $50 of EV. That $50 of EV would have $5 of operating profit associated with it (5 percent margin on $100 of sales). Now imagine the company had no debt and thus no interest bill. Take out tax at 30 percent and you have $3.50 in after tax earnings. That is for $50 of EV (which in this case is $50 in market cap). The price earnings ratio would be just over 16.6.

To pay more than 0.5 times sales you have to argue that unlevered this company is worth more than 17 times earnings. That is possible if there is a lot of growth potential or the margins are sustainably fat. But 0.5 times sales is a price above which I need to be finding rationalizations to maintain my interest.

When non-distressed grocers with solid market positions trade at 0.25 percent of sales (which is very rarely) they are half that price which is cheap by most measures.

Here is the last quarterly balance sheet for SVU:

	December 3, 2011				February 26, 2011
		(Unaudited)
ASSETS
Current assets
Cash and cash equivalents		$	196			$	172
Receivables, net			747				743
Inventories			2,616				2,270
Other current assets			226				235
Total current assets			3,785				3,420
Property, plant and equipment, net			6,226				6,604
Goodwill			1,306				1,984
Intangible assets, net			887				1,170
Other assets			581				580
Total assets		$	12,785			$	13,758
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities
Accounts payable and accrued liabilities		$	2,720			$	2,661
Current maturities of long-term debt and capital lease obligations			396				403
Other current liabilities			643				722
Total current liabilities			3,759				3,786
Long-term debt and capital lease obligations			6,203				6,348
Other liabilities			2,078				2,284
Commitments and contingencies
Stockholders’ equity
Common stock, $1.00 par value: 400 shares authorized; 230 shares issued			230				230
Capital in excess of par value			2,860				2,855
Accumulated other comprehensive loss			(379	)			(446	)
Retained deficit			(1,450	)			(778	)
Treasury stock, at cost, 18 and 18 shares, respectively			(516	)			(521	)
Total stockholders’ equity			745				1,340
Total liabilities and stockholders’ equity		$	12,785			$	13,758

The last SuperValu balance sheet had $396 million of short term maturities and $6.2 billion in long term debt. There is a couple of hundred million in cash - which is such a minimal number I am going to ignore it. (There is 200 thousand dollars cash per store - a number that looks small relative to obvious cash needs including just balances in the till.)

$6.5 billion in debt give or take a little. The market cap is 1.35 billion according to Yahoo! EV is thus 7.8 billion. Last year sales were something like 37 billion (and on a very steep decline of about 10 percent per annum). This year they will be something like 35 billion. EV to sales is just over 0.2 - and will be probably close 0.25 when (and if) they can stabilize sales. This is the bottom end of my EV to sales range but is not an outright distress type figure. Given most this EV is debt I would not be much interested in the debt at par (even though it yields 8 percent). That seems like not much upside and in distress this retailer is going to be worth less than 0.25 times sales.

If perchance the debt were to trade at 70c - implying an EV to sales in the mid-teens - then I might get interested in the debt.

The equity is another issue - one I address below.

My second metric for retailers is how much of a lean they are taking on suppliers. Grocers sell stuff fast - many sell their stuff faster than they pay the suppliers meaning they get free funding from them. If they get into trouble (or they want the cheap finance) they let their supplier obligations blow out. I wrote a post once about an Australian wholesaler (Davids Holdings) which let its supplier obligations blow out and nearly went bust. Not nice.

A rough rule of thumb is as follows. Most suppliers give you 30 day terms. If your payables are more than 30 days of sales you are taking a lean on your suppliers. If you take too big a lean they start getting stroppy and ask for cash-on-delivery or letters of credit or the like. Too much of a lean is pretty tightly defined: most grocers have payables of about 35 days of sales.

In the above table payables are 2.7 billion. That is less than a month of sales - SuperValu is clean on this measure. However note that the accounts payable have gone up as sales have gone down. Whilst the level is not a sign of distress the direction is not good (the reduction of debt is not as impressive as it looks).

Finally - and this is the measure that most bugs me - inventory turn is falling. Inventory is up year on year. Sales are down. For a grocer this is unremittingly bad news. Not only are they using capital less efficiently (getting less aggregate margin per square foot for instance) but slowly and surely the store is turning into one of those places you shop only if you like your groceries pre-packaged and just a touch stale.

Whatever - on the numbers as given this is not that cheap relative to EV and the metrics are going the wrong direction.

You could add - and one of my readers did - that the company is underspending on stores. Tired old stores with slow inventory turns and stale product - that is not the way to take on Whole Foods. And unless you are going to shave margins to nothing it is hardly a way to take on Walmart.

If I had to make a bet on this my guess is that it will have to restructure in some form. This might be a sale (for debt reduction) of a large part of the business or it may be Chapter 11. Whatever - this is not easy and not an obvious value stock.

Would I short the stock?

There is a big short interest in the stock. I think the company is probably going to continue to have a rough time. I am a short seller. The obvious question is "would I short the stock?"

Here the answer is surprisingly no. The company in aggregate is not cheap (EV to sales is going to wind up somewhere near 25 percent) but the equity is cheap. Why? Well if things go right (and things always can go right) and the company gets say 100bps more margin - then the stock looks staggeringly cheap.

There are 35 billion in sales. 1 percent margin increase is 350 million per annum. That is very meaningful relative to a market cap of $1.3 billion. Add in a big short interest and the stock could be very strong.

The leverage that makes this whole thing problematic works both ways. If the management can right this ship the stock could be a big winner.

Have the management done a good job

My bullish commentator thinks the management have done a good job. As far as I can tell he is right. They have shrunk the business (a lot), paid off a lot of debt, and it appears been pretty straight-up-and-down about it. I am a little irked by the falling turnover (it will make the product stale) but that might just be the hand they were dealt.

I have not done a lot of work. I have not walked around these stores. I have not done any apple-freshness tests. But on the numbers I see no reason to believe management have not been pretty good.

That is a blessing and a curse. Good management will be necessary to salvage this situation. But if these stores have been well managed then getting a new broom in can't save the situation. You have to play the cards that are dealt.

Summary

If SuperValu is proof that there is value easily detectable in companies under $5 billion in market cap then - frankly - I think I will take my large caps.

I would not be long this without tangible on-the-ground evidence (from surveying up to 30 stores in different locations) that this really has turned around. Because at the moment this does not pass the Wayne Gretsky test of value. In five years it looks really really bad.

And I would not be short it either with that leverage without a decent understanding of their day-to-day liquidity and just how short-dated the situation is.

This one belongs in the too-hard basket. And half a day is wasted looking at another stock that ultimately I don't care about.



John


*For disclosure purposes we were once short Hewlett Packard but have covered, we are long Vodafone and Google - two of our biggest positions, and we were once long Total but have sold.

In praise of Frank Lowy

Wayne Swan the Treasurer of Australia (in UK parlance the Chancellor of the Exchequer, in US parlance the Secretary of the Treasury) has been publicly criticizing the new Australian billionaires and their political influence warning that they are a risk to the Australian ethos of the "fair go".

He is quoted as follows:

"A handful of vested interests that have pocketed a disproportionate share of the nation's economic success now feel they have a right to shape Australia's future to satisfy their own self-interest."

Swan's critics have accused him of "class warfare".

This will be highly familiar to American readers who have got used to living in a world where lots of money gives you better access to speech. I have barely met an American who disagrees with this sentiment but mainly when the said pile of money disagrees with them.

To liberals in America the Koch brothers are evil incarnate.

Several conservatives think the same thing about Warren Buffett when he argues the rich should pay more tax. Governor Christie's comments were just plain angry. George Soros induces apoplexy in some conservatives.

And most Americans think there is something unseemly about K-Street and the influence peddling lobbyists of Capital Hill.

Money politics - American style - is settling in in Australia. Wayne Swan knows it.

But in Australia it is potentially much more dangerous than in America. Our new-era Australian billionaires - the ones Wayne Swan rails against - are all billionaires from resource extraction. They all get their money by digging up things that potentially belong to all Australians and selling them to foreigners. And they railed against the resource rent tax (a tax whereby the rest of us got paid something for their bounty). As well they might. And they rail against carbon trading schemes.

Indeed American style money politics in Australia is far more insidious than in the US because our billionaires are far less diverse. A diversity in billionaires (and in the way they make their money) gives us a diversity of billionaire opinion. You can get the Koch Brothers and George Soros in one system - and to some extent their opinions (and the money with which they foist them onto the rest of us) offset each other. The balance is preserved.

Here we risk no balance. And so I am writing a post to tell you just how important Frank Lowy has become. Frank is an opinionated billionaire who made his money from property management and shopping centres. He is "Mr Westfield". He is also highly opinionated and funds his own think-tank (the Lowy Institute). I have in the past disagreed with him strongly - but at the moment I am just darn pleased that he is there.

Lowy is fighting with Clive Palmer (a resources billionaire) about of all billionaire disputes - the business of owning football teams. But I hope that is just the start of it. He is our most opinionated non-resource billionaire, one with a global perspective - and suddenly he is part of the future of Australian democracy.

Frank Lowy (despite the high quality think-tank) has never shown the intellectual depth and breadth of vision of George Soros. I am just as familiar with his influence on local councils (getting his projects approved and his competitor projects rejected) than I am with his global vision. But Frank is all we have got. Billionaire visions are pretty thin around here.

I never thought I would say this. Frank Lowy - your country needs you.




John

PS. I am a hedge fund manager. My job is to find rich people, invest their money and make them richer. The rise of an Australian plutocracy is thus in my interests but I would prefer a plurality of plutocrat clients.

When your tool fails your stock drops 35 percent

Houston American Energy yesterday announced a problematic exploration well. They had (drilling) tool failure. The stock fell 35 percent.

I read a lot of press releases: this one is amusing.

HOUSTON, March 1, 2012 /PRNewswire/ -- As reported in Houston American Energy Corp's (NYSE Amex: HUSA) Quarterly Report on Form 10-Q for the quarter ended September 30, 2011 and in Form 8-K on December 19, 2011, drilling operations on the Company's first well on the CPO-4 block in Colombia, the Tamandua #1, with a projected target depth of 16,300 feet, commenced in July 2011 and was subsequently sidetracked to address drilling issues associated with high pressure and inflows of hydrocarbons and fluids into the well bore. As of December 19, 2011, the sidetrack well had been drilled to 13,989 feet and efforts were ongoing to control the well bore while continuing drilling to the target depth.  

Subsequently, and as of March 1, 2012, the Tamandua #1 sidetrack well had a 7 inch liner run to 13,913 feet and was drilled to total depth ("TD") at 15,562 feet.   Upon drilling the well to TD, the well encountered Paleozoics which was a clear indication that the TD had been reached.    

While the well exhibited oil shows while drilling, and other indications of hydrocarbons such as log analysis that indicate possible productive sands, hole conditions have prohibited sufficient testing on the bottom hole sections.  There have been many attempts to evaluate the well resulting in tool failures and stuck pipe, and current conditions are such that the operator has made the decision not to try to reenter the bottom hole sections.  As a result of these developments, the decision has been made that without the ability to effectively test the lower zones, the most prudent course of action is to plug back the well and to further evaluate the C-7 and C-9 Formations.  As previously reported and indicated by the Logging While Drilling data, the well encountered approximately 200 feet of net resistive sands in the C-7 formation and approximately 140 feet of net resistive sands in the C-9 formation (resistive sands do not necessarily mean pay).  

Results of the further evaluation of the C-7 and C-9 formations will be announced as soon as they are available.  After attempting to complete the well, the rig is expected to be moved to one of two locations that are currently permitted and ready to receive the rig.  In addition, the Operator has five additional locations that are in various stages of permitting, location and construction. 

John

And a follow up question: can anyone explain to me what is meant by "net resistive sands"? The phrase does not appear anywhere in the Google database not linked to this company.

Post script: There is a Bloomberg article which quotes the CEO as follows:

“I would like to make it clear to our investors that the Tamandua #1 well is not being abandoned,” John F. Terwilliger, chief executive officer of Houston American, said in an e-mailed statement today. 

“Current ongoing operations are to make a completion attempt in the C-9 and C-7 sands,” he said. “As previously reported, the Tamandua #1 well exhibited hydrocarbon shows in the C-7 and C-9 sands, and logged approximately 200 feet of net resistive sands in the C-7 formation and approximately 140 feet of net resistive sands in the C-9 formation. We are eagerly awaiting the results from these completion attempts.”

This corrects a previous article which unambiguously suggested the well was dry.

Why I do not like small cap stocks much at the moment

I run a small hedge fund.

Most people that do that want to use their (lack of) size to find (and exploit) value-priced small cap stocks.

The problem is that almost any company with a market cap of $200 million to $5 billion has teams of private equity (PE) buyers looking at it.

The competition is fierce.

The PE guys have two advantages I do not. They have access to cheap loan funds in quantity. And when they do a transaction they can get inside the company, look at the books and do proper due diligence.

Those are winning advantages - advantages that I would not want to compete against.

One arguable offset to those advantages is that many PE executives are surprisingly inept. They look good in their suits - but I have met a few along the way who really are empty suits. You know the type - straight out of their big-name business schools but without the depth of experience and the humility to know that business can be difficult. For the purposes of investing they are stupid.

Their stupidity however is masked because mistakes are not marked-to-market. A bad transaction can be buried a long time and a few good ones (with lots of leverage) can offset a lot of ills.

I don't understand why so-called "value investors" are drawn to small caps. Trying to find cheap stocks against stupid people backed by seemingly limitless cheap funds and no market discipline does not seem like a good way to construct a value portfolio.

John

When you think you made a great purchase (Warren Buffett edition)

I consider myself a bit of a Buffettphile - but I did not even know Berkshire had a sizeable agricultural machinery operation. Sure agriculture has been good and because the capital equipment is a lean off that it has been very good. But this throw-away quote from the annual letter is astounding:

Vic Mancinelli again set a record at CTB, our agricultural equipment operation. We purchased CTB in 2002 for $139 million. It has subsequently distributed $180 million to Berkshire, last year earned $124 million pre-tax and has $109 million in cash. Vic has made a number of bolt-on acquisitions over the years, including a meaningful one he signed up after year end.

This business has - in a decade - distributed well over 100 percent of its purchase price in cash to Berkshire and its pre-tax earnings are roughly the acquisition price. 

Of the thousands of listed companies in the world how many have been that good in the last decade. Surely not many.

John

Senseless Chinese capital expenditure: Trina Solar edition

The one thing we know about the solar panel industry is that it is glutted. Solar panel prices are collapsing as has been observed many times on this blog.

Trina Solar reported yesterday. Bad numbers as expected. To quote them as to the glut:

Despite this achievement [which in Trina's case was increased sales], growth in worldwide module capacity and peaked channel inventory resulted in significantly lower product prices which adversely affected our bottom line results, whereby our cost reduction was not sufficient to offset lower ASPs [ie average selling prices].

I promise you I am not telling anyone anything new here. If you are an investor in the solar-panel industry and have not noticed a supply glut then you are completely non-observant.

What is strange though is that despite the supply glut the capital expenditure in this business - that is building new plant and machinery - goes on regardless.

Here is a line from the balance sheet:

Trina Solar Limited
Unaudited Consolidated Balance Sheets
(US dollars in thousands)
		December 31,		September 30,		December 31,
		2011		2011		2010
Property, plant and equipment		919,727		783,328		571,467

Property plant and equipment at Trina went from 571 million to 920 million in one year. And in the year when the industry became hopelessly oversupplied.

Moreover the rate of increase accelerated in the fourth quarter when the oversupply was obvious to anyone to see - when anti-dumping cases against loss-making Chinese solar panel makers became vogue.

There are lots of things that might be going on here. The company might have a great new technology which is worth investing in even though the industry is glutted (indeed the company points to its "honey" technology). Or the company might be insane. I have my thoughts but I do not have enough knowledge to be certain.

But one friend suggested that this is just an analogue for all of China. Who cares if office buildings are glutted? Just build more. Who cares that the high-speed-rail between two cities you have never heard of, a railway line that consumed valuable steel and concrete by the millions of tonnes is mostly run at a third capacity with empty trains? Build more.

"Build it and they will come" may be the Chinese mantra. Usually only works in Hollywood films.



John

PS. I should disclose that Bronte still has a short-biased straddle on Trina - but it is a much smaller position. We closed a fair bit for profit - but traded that bit not so well. I should have covered the short end more aggressively when the stock was $6.

Titanium Asset Management - notes on paper trading and murder

There is a story in the Sydney Morning Herald today about Titanium Asset Management - a funds manager in Western Sydney that operates as part of the Titanium Financial Group.

Titanium has been on my must-look-at list for some time. I found them when researching Astarra/Trio - a funds management fraud shown to me by one of my readers which I reported to the regulatory authorities. Titaninum had agreed a white-label deal distribution deal with Astarra, a deal which to the best of my knowledge was never consumated with real money. Titanium said that there was no relationship with Astarra but one Titanium entity wound up in the hands of the Astarra/Trio liquidators. [Someone has suggested in the comments that the Titanium entity in the hands of the Astarra/Trio liquidators is not related to the Titanium financial planners and that no money ever changed hands with the agreed white-label deal linked above. I see no reason to disbelieve that - especially as the article is dated within a month of the demise of Astarra/Trio.]

What amazed me though was the returns of Titanium Asset Management. It was limited according to its documents to being long-short the stocks in the ASX200 (an index of the top 200 companies in Australia). These were the monthly returns as reported:

These returns are astounding. 40 percent in October 2008, 20 percent in February 2009. Magic numbers really.

So I rang the fund manager - Peter Rice - to try and work out how he did it. I did not understand - at least it did not make sense to me so I reported my concerns to ASIC.

I did make an effort though. I found an interview with Peter Rice on Sky News (repeated below). That made no sense either.



Anyway I put it out of my mind.

A couple of weeks ago I looked again. Here are later returns.

The early months had all gone. (No more 40 percent months!)

The return in February 2009 had gone from plus 20 percent to minus 7 percent.

I was puzzled.

I rang the auditor as listed in the original product disclosure status. He sounded sorry for me - wondering if I was an investor in the fund. He told me he had never been the auditor and had gone to some lengths to let the regulator know that he was falsely listed as the auditor.

I rang Peter Rice and he told me the original returns came from "paper trading". I wondered why he did not tell me that the first time I rang and he said that he did not believe he was under an obligation to disclose that. (Indeed when I rang him the first time he told me that he had an independent back office and used Citigroup as his prime broker - both things that would not occur if the profits were from paper trading.)

I sent it all to the Sydney Morning Herald. (My job is to manage money - not explore these things...)

I think Michael West did a great job of the story.

He also pointed out something that truly surprised me. Andrew Blanchette who controls Titanium (at least is listed on the license and is the owner of the domain names) was once the boyfriend of Sydney model Caroline Byrne. She was found dead at the bottom of Sydney suicide spot The Gap. Maybe suicide. Maybe murder.

Caroline's death was the subject of much gossip in Sydney - the prime suspect was Gordon Wood. Wood was Caroline's boyfriend at the time of her death and was also the chauffeur to Rene Rivkin a colourful Sydney stockbroker. Rivkin has since committed suicide.

Wood was convicted but since then Australia's highest profile current affairs program has thrown that conviction into doubt.

This mostly proves that Sydney is sometimes a very small town. No more.



John

Why Falcone's plan B should be rejected

I have an old computer under my desk. Its a Toshiba laptop from about 1998. I run Puppy-Linux on it because it can't run anything more powerful.

Its good for purpose - a low powered device.

I am told by the physicists that if I use it for high-powered uses I will blow circuits and destroy my the local network.

So I go to the Department of Defence and say can I swap my old low-powered device for your high-powered supercomputer?

Of course they would laugh.

Now the WSJ is reporting that Phil Falcone has a Lightsquared Plan B. He wants to swap his spectrum which is specifically only available for low-powered use for the Department of Defence's spectrum, spectrum which is available for high powered use.

The Department of Defence should just laugh.

If this gets past the just-laugh stage I worry for American democracy. If this actually happens we know the scope for corruption in America is unlimited.

If the DOD wants to part with its valuable spectrum just auction it. Giving billions of dollars to fading - soon-to-be-bust hedge funds. That is beyond any semblance of decency.

Phil, for the sake of decency and because you are ultimately a patriot - just put Lightsquared in Chapter 11. Leave the corrupt obtaining of public assets to Chinese billionaires and Russian Oligarchs. You are better than that.



John