Any time I buy a stock I know I am purchasing an ownership interest in a business. This is not unlike purchasing a partnership interest in a local small business. If fact, I think the decision making framework is largely the same.
For instance, if you were going to buy into a business partnership as a minority partner, what would you want?
Would you want to have general partners and managers whose interest was aligned with yours, who wanted the sames things you did out of the business?
My guess is yes.
And this is why it’s important to do proper diligence when purchasing a stock. Simply because the market allows you the ability to sell your interest on a whim should not factor into your purchase decision. If you made every decision with a “well, if I change my mind I can just dump it tomorrow” thought process, you wouldn’t get very far in life.
For me, it’s very important to read the footnotes of the financial statements and the Proxy (DEF-14) Statement from each public company I consider buying into. It is here that you will find evidence of “value traps.”
Value traps – for purposes of investing – are defined as: “situations in which shareholder value exists but is never realized in the form of market appreciation in stock price to roughly equate with intrinsic value, dividends or legitimate share repurchases.”
Basically, a company’s stock could be trading at a significant discount to intrinsic value, but you’ll never make any money on it.
When analyzing a potentially undervalued stock, the little details are what can make you or break your returns.
For example, recently a small company called Books a Million (NASDAQ: BAMM) came across one of my screens for further analysis.
This company boasts a strong balance sheet, stable cash flow and a nice dividend yield. It’s trading at or around 52 week lows, indicating some level of market pessimism about the company’s prospects.
A closer look at the numbers reveals that BAMM, trading at $3.25/share, is available for slightly less than it’s net working capital (current assets less total liabilities). While this figure includes inventory (and thus not an approximation of liquidation value), I think it is safe to say the market is not valuing the ongoing earning power of this company. What I mean by “not valuing” is that the market is attributing a big fat zero to the prospects of anything more than existing surplus capital being paid out to shareholders over the remaining life of this business.
Looking at the most recent quarterly reports, market pessimism is somewhat justified by declining sales volume. Although sales volume is not “falling off a cliff,” it is perhaps justifiable to say, given BAMM’s business model (retail book and ebook sales), that it’s ongoing earning power is going to be limited (witness Barnes _ Noble and Borders Books et. al).
There is little doubt that BAMM is losing steam. Often, types of companies are overly beaten down by the market and can present value play opportunities.
So the question in this case is…is this company going to disappear soon?
Doubtful, based on it’s balance sheet. Although it goes without saying this business won’t likely see an increase in it’s earning power. But that doesn’t mean it’s worthless. In a very tough economic environment, BAMM is doing OK. Their plodding along.
Therefore, a compelling value play is possible.
Why do I say ‘possible’ and not probable?
For one major reason: this is a micro-cap, closely held company. These companies can often be ‘value traps’ – wherein shareholder value is under-realized (or never realized) because the incentives of management/majority owners are not in alignment with minority shareholders. In many of these cases a minority shareholder only benefits from either: a larger, active investor going in a 13-D type situation for board seats and agitating change or a large increase in the company’s earning power and the stock price increases respective to the increase value.
To find out if you have a value trap or not, you have to go beyond just the numbers. You have to dig into the details of the company and look for the warning signs of a value trap.
Here are a few common “value-trap” indicators:
- High “quick asset” balances, net of all liabilities (on and off balance sheet liabilities) combined with ongoing losses/low returns on invested capital AND no dividends or share buy backs. Management is thus committed to burning through cash indefinitely and not returning any of the excess capital to shareholders. This is one of the worst situations.
- High management salaries and stock incentive plans that don’t commensurate with any positive performance in the company (e.g. are the managers being paid well “no matter what”?)
- Closely held, family ownership – while this is not always bad (their shares are only worth something if the company is worth something), it can often mean entrenched managers who prefer high salaries and stock options to dividends. Look for insider buys versus sells of stock here also as an indicator.
- Different classes of share ownership with preferential dividends or dilution rights. For instance, a large block holder of convertible preferred that can effectively dilute common shares significantly or publicly traded B shares where insiders control the A shares
- “Poison pills” – provisions in company by-laws which serve to bleed the company of cash in the event of change in majority control.
- Board crony-ism – vendors of the company have board seats, etc.
- Related party transactions – the company does business with shareholders or managers. Does the company buy supplies from the CEO? Does it rent office space from one of the board members? These are some of the issues you should look for.
- Outlandish commitments: does the company have purchase, lease, financing commitments or debt covenants (or other operational restrictions) which could prevent unlocking of shareholder value? Sometimes you will see what appears to be a pristine balance sheet of a company trading below net current asset value, but then come to find out that they have enormous long term lease commitments which – in my view – should be put on the balance sheet as a liability.
- Can the company pull a revolver? Do they have a line of credit that is unused, but could be freely accessed for the frivolous? This is kind of like a loaded gun management has for an ill-advised acquisition or other wealth destroying non-sense if they are inclined. Company and management history should be evaluated to see if this is a potential problem, but I’ve seen quite a few businesses with large cash piles quickly run up debt for an acquisition and wind up paying the piper out of shareholder profits for many years.
- Does the company have any legal proceedings which could be damaging? Small companies are more vulnerable to legal suits (whether they are shakedowns or not) then large companies with in-house legal departments.
- Are there any pension and OPEB liabilities which could be an issue – this is another off-balance sheet liability that destroys value
This is by all means not an exhaustive list of value traps, but represents the most common ones I run into when analyzing businesses.
Perhaps I should briefly cover why these value traps must be so closely scrutinized. With larger cap companies, value realization can come from the market waking up and realizing the true value of the security. With an unloved company’s stock dropping for overall pessimism or temporary (but not long term earning impairing) bad news, institutional and other buyers will re-enter the stock until it reaches full intrinsic value (or some range thereof).
With smaller cap stocks with light trading volumes, institutions are not inclined to take a position – even a small one for them – as the trading spreads can be large and erratic and their capital will move the stock price dramatically. Often an institutional position takes place over weeks and sometimes months in big companies. It is also hard for an institution to unload small/micro-cap stocks and thus exit their position profitably.
This is not to say there are no value traps with larger cap companies, but the catalysts for value realization are often different and must be considered.
Back to BAMM…
Reading the financial statement footnotes and shareholder proxy statement are often indicative (provided no fraud exists – another matter to cover for another time) of how the company is managed and what, if any, conflicts exists between management and shareholders.
Since the numbers for BAMM look good, it’s time to dig deeper and see if there are any value traps present
Taking a look at their most recent 10-Q discloses not just some, but quite a few related party transactions. Here’s a snapshot from the 10-Q
As you read these (sorry for the production quality of the pictures), you can see that the CEO and effective majority control owner has BAMM doing a lot of business with other companies he owns. Is this necessarily problematic? No, it’s problematic if he’s “juicing” BAMM to profit in his other companies…not if he’s selling for cheaper. But no matter what, this just doesn’t look good.
Another issue un-earthed upon closer evaluation of BAMM is the beneficial ownership structure. Here it is (as per the most recent proxy statement):
From this part of the proxy statement, you can see that Charles C. Anderson effectively controls a majority of the voting shares of BAMM. This pretty much rules out any kind of outside pressure being brought to bear upon shareholder value realization.
So far that’s 2 strikes.
And we also found a “change in control” provision that seems a bit shareholder unfriendly:
The total cash liability for this change in control provision would cost about $4.4 million one time and about $58k per year ongoing. While this is not really that onerous, it is worth noting.
After reviewing these potential value traps with BAMM, we can better determine if taking a long position is a good idea or not.
For me, the question comes back to this: given the above information, do I want to be partners with the owners and managers of BAMM? Would I buy into BAMM if it was a privately held company?
The good news about BAMM is that the company pays a dividend. And BAMM has paid a dividend since 2005. Additionally, BAMM has repurchased shares in all but 1 of the past 10 fiscal years. This shows some commitment for providing value to shareholders.
Based on current market cap, inclusive of all the above (and a lot more behind the scenes diligence), here are the conclusions I have come to on BAMM:
I am valuing BAMM at it’s net working capital ($3.62/share) – on the basis that the business has going concern value with a discount to that figure and an addition for the ongoing earning power of this company. Most of this net working capital is inventory, so a discount of 30% is applied (inventory is not WIP or raw material input, so a lower discount factor than normal can be applied). This leaves us with net working capital value of $2.71/share.
In terms of ongoing earning power estimation and valuation, I have assumed a somewhat pessimistic scenario of a 50% decline in free cash flow. This would be a pretty big drop for any company that doesn’t manufacture VCR players or buggy whips. In the case of BAMM, their business model risk is significant, but it’s not likely consumer will suddenly stop shopping in retail stores (if this is the case, better start shorting any REIT that owns mall properties as well as all retailers). Amazon, Apple and the rest will continue putting pressure on retailers, but I don’t think BAMM will disappear into the night next year, save for a huge management blunder (although this does happen on occasion).
The 10 year average free cash flow for BAMM is $16.2 million. Stripping out fiscal year 2008 where a large special dividend was paid, BAMM has paid an average of $2.4 million per year in dividends since 2005.
It is reasonable to justify an assumption of $7 million average per year in free cash flow, with no growth rate at all.
Further assuming you’d be willing to pay 5 times cash flow (a conservative multiple) for the business, the “earning power” value of BAMM would be $35 million ($2.29/share). If you’re willing to pay 7 times free cash flow, the “earning power” value of BAMM would be $49 million ($3.12/share).
Combined value range:
Discounted net working capital/share = $2.71
Earning power value/share = $2.29 (low) – $3.12 (high)
= Value of : $5/share to $5.83/share
Current market price (prior to open on 6/14/11) = $3.30/share
If I required a 33% margin of safety on my purchase price from my lowest estimation of value, I would be willing to pay up to $3.30/share.
However, because of some of the issues I have with the governance of this company, I am looking for a higher margin of safety – in the 40% range. My strike point for BAMM would be $3/share.
I have no position in BAMM at the time of publishing this writing. I do plan on taking a long position in BAMM within the next 72 hours.