Friday, December 29, 2006

Fingerprint Identification and Cogent

Caught this article regarding terrorism and fingerprint identification in the December 27th edition of The Christian Science Monitor.Thought those who are interested in Cogent (COGT) and the industry might find it useful:

CSMonitor article

Thursday, December 28, 2006

Opportunistic and Contrarian Investing-Be An Idiot!

The Wall Street Transcript regularly presents interviews with analysts, corporate managements, and portfolio managers. In a recent Wall Street Transcript interview (subscription required) Gary Furukawa describes his firm's approach to investing:

We have a strong contrarian bias that helps us be opportunistic in our approach. While we recognize that the market is very efficient in discounting information, investors as a group can form incorrect opinions, biases, or assumptions regarding the prospects for a particular company. We like to question those core assumptions and assess how we would view those assumptions differently than how the Street might be viewing them. At some point in time, whether it be through an internal catalyst, through some type of exogenous event, or whether it just be through the passage of time, sentiment usually begins to swing back toward the company.

Mr. Furukawa and his firm are quite right. Isn't this the essence of buying a turnaround situation or optimizing the short-sale of an expensive stock? Very early in my career there was an unshakable belief in the ever-present threat of inflation and the inevitability of higher energy prices. Those 1970's and early 80's beliefs were congenitally implanted into portfolio managers' DNA. You were an idiot, not to accept those assumptions.

I was an idiot...thank God, I built a career out of questioning what was a ubiquitous mainstream assumption. The ability of the consensus to delude itself entirely and miss the obvious is one of those features of human behavior that you can overcome and master to create investment performance.

Assess the critical assumptions that you endorse when you select a security. How reasonable is a 30% or 40% growth rate when that represents the consensus? What would the valuation look like if a more "normal" 10-15% growth rate were the future growth rate? What can go wrong in your assumptions?

Here is a screen of companies that have high estimated growth rates greater than 20% and have appreciated YTD greater than 30%: Spreadsheet link

Bottom line, know what you own and why. Don't deceive yourself into accepting assumptions that are arbitrary or indiscriminate.

In yesterday's (subscription required) Henry To presents my post on self-deception. I think one of the keys to successful portfolio management is the ability to avoid self-delusion. If all of us are operating with the same assumptions in thinking about a business, why would any of us expect to garner an advantage?

As I say in the article,

Guard yourself against the possibility of self-deception. Wishful thinking is not a subset of thinking; it is merely a substitute for thinking. Don't succumb to the seduction of conventional wisdom and elegant theories. Remember, mankind has subscribed to a belief in a flat earth for much longer period of time than the modern viewpoint. But for many years, the prevailing wisdom assumed the tenets of flatness! Theories tend to rely on simplifying assumptions…theories represent an approximation of reality.

More on this topic in a later post and book review!

Happy New Year to All!

Wednesday, December 27, 2006

Is Cogent A Turnaround Candidate for 2007?

Beaten down stocks can often be value traps and turnaround candidates often take much longer to turnaround than one expects. The danger of being too early can result in significant underperformance, confidence can take awhile to be restored, and dead money is frequently the result. However, a bit of patience, a bit of care, and an understanding of competitive advantage can provide the courage to buy the turnaround security. A decent balance sheet provides the comfort of knowing that delays in a turnaround can be absorbed without having to resort to new debt covenants and higher interest costs or worse.

I believe that Cogent Systems (COGT) fits this bill. Cogent sells Automated Fingerprint Systems (AFIS) used for immigration and border crossings, national ID programs and voter registrations. Cogent's AFIS system is regarded as the fastest and most accurate biometric database search system. This system generates rapid and accurate real-time searches with its state of the art image processing, neural networking, and parallel processing capabilities.

The year 2006 has been difficult for the company as revenues have dropped off some 35-40%. As a result, the shares have fallen off a cliff, down some 50% YTD.

Governments around the world have captured millions of images of various biometric markers such as fingerprint or facial recognition images in order to secure border crossings, monitor elections, and provide national ID systems. Consequently, the demand for biometric data mining has grown substantially. A trade organization, the International Biometric Group estimates that the AFIS market will grow at a 25% compound rate to 2008.

Historically, two principal customers for Cogent have been the U.S. Department of Homeland Security and the government of Venezuela which together represent about three quarters of sales in 2004 and 2005. Unfortunately, both customers pulled back from the market in 2006. Homeland Security had but one contract award in 2006 which was taken by a competitor, Sagem. COGT management questions Sagem's ability to meet the technological needs stipulated by some contracts.

The US-VISIT program of Homeland security initial stage was completed in 2004 with capture and processing at fifty ports of entry. Cogent management believes that spending on US-VISIT will pick up again in 2007 as a result of conversion from two-fingerprint scanning to ten-print scanning. The more involved the database requirements are, the greater the need for a Cogent system.

Cogent, as I mentioned previously also is involved in election systems. Venezuela, representing about 35% of sales in 2005, established a Cogent system for national elections in 2004 and has expanded that system for regional elections. Mexico, Brazil, Bolivia, and Uruguay are all apparently considering voter AFIS systems. National ID systems are being considered in Argentina, Thailand, Italy, Russia, and the UK.

Beyond international interest, there also appears to be growing interest by law enforcement agencies in the States to upgrade their systems. The California Department of Justice and the FBI are considered to be interested in upgrading their AFIS capabilities.

Cogent is hardly alone in the AFIS market. The major players are Motorola (MOT) with its Printrak division, the Japanese major NEC, a private company Sagem, and Cogent. However, Cogent appears to be the largest pure-play in the area.

Cogent has pursued various contracts through a relationship with Northrop Grumman (NOC) in the past. In 2005, NOC began to work with Sagem and successfully bid on the EU-VISIT program. Cogent is now suing NOC under the belief that NOC utilized Cogent's intellectual property in its bid for the EU-VISIT program. The trial date is set for May 22, 2007. Cogent is seeking over $200 million in damages and states that NOC owes royalties for not only past use of the intellectual property, but also damages for the negative competitive impact of using this IP. Potentially, this could represent a significant financial settlement. In the meantime, the company bears the increased legal costs associated with this lawsuit.


The company demonstrated tremendous sales growth from a base of only $14 million in 2002 to $160 million in 2005. Sales this year, given the lack of contract awards, will likely be somewhere around $95-$100 million.

Gross profit margins which had ranged between about 63% and 69% between 2002 and 2005 dropped to about 51% in the most recent quarter. Operating margins in the most recent quarter came in at 19%, a very respectable level for most businesses, but well below the norm for COGT which has been north of 30% for the 2003-2005 period.

The market cap for COGT is $1.04 billion. There is no long term debt and there is a cash balance of about $300 million hence, the enterprise value is about $700 million. Enterprise value is about 19.6 times EBITDA and about 20.5 times EBIT which at first glance does not seem terribly cheap; however, this is measured against depressed earnings.

System maintenance revenues ordinarily constitute some 20% of revenues, but given the lumpy nature of contracts, this can swing widely. The company has forecast fourth quarter gross revenues of between $46 to $56 million, a significant improvement from the first three quarters of this year, but has indicated that revenues may get pushed into the 2007 year depending on the timing of purchase orders. The company has also indicated that gross margins for the fourth quarter should show improvement relative to the third quarter.

The balance sheet has no long term debt. On a TTM basis, the company has generated some $35 million in free cash flow.

Return on invested capital is at a depressed 8% on a TTM basis compared to last year's 14.2% and the prior year's 19.2%.

For a relatively small stock, there is a considerable amount of analytical coverage, 14 estimates for 2006 and 2007. The 06 estimates range from 30 to 38 cents. For 07, eps estimates range from 37 to 62 cents. Long term growth rates are estimated by nine analysts with a range of 20 to 40% and a mean of 27.23%.

At current prices, I believe the market is imputing a long term growth rate of 9 or 10%, well below the estimated growth rates and well below the 37.9% growth rate of earnings on a trailing five year basis.


Cogent, after some incredibly rapid growth has been hit by postponement of contracts and some pricing competition. Gross profit margins dropped but operating margins cratered earlier this year. Operating margins have improved recently as revenues have started to pick up; clearly the company demonstrates significant operating leverage.

The stock which had peaked last year at about $37 has reflected the disappointing revenue stream and the choppiness of the contract awards. In my view, expectations are quite low for this unique business.

Despite the choppiness, my sense is that we should see some improvement in contract awards through next year. The company has started to diversify its client base with various state and municipal awards. Recent experience demonstrates that because of technological superiority, COGT can displace Sagem systems. Successful resolution of the lawsuit could not only relieve the company of its legal expense burden but also provide a large financial boost.

Insider ownership is very high at 54%, held primarily by the CEO Ming Hsieh. Holdings of management outside of the founder's stake are insignificant. There are 3.7 million stock options outstanding representing dilution of about 4%. Interestingly, no stock options were issued in 2005.

Though the board has not instituted a dividend program, a share repurchase plan is in place to buy back up to $30 million in shares over a period of six months following its Aug 2006 announcement. So far, merely $3.9 million has been bought back.

The long term prospects for the business seem strong and margin recovery could well take place over the next several quarters. In my view, the company could easily return to a high teens to low twenties kind of a valuation.

The risks as with any technology company relate to obsolescence. Biometric solutions exist beyond fingerprinting and facial recognition. Voice, iris pattern and retinal blood vessel solutions could reduce COGT's market opportunity. Contract awards and revenues are lumpy and revenue recognition of maintenance revenues can provide deferred revenues. Pricing pressure appears to have developed to some degree in this marketplace.

Disclaimer: Neither I, my family, or clients have a current position in Cogent.

Sunday, December 24, 2006


Whatever your language, whatever your belief, take a moment to breathe in the Peace and Joy that we feel at this festive season. From the bottom of my heart, I wish you:

Merry Christmas & Happy New Year!

Joyeux Noël et Bonne Année!

Fröhliche Weihnachten und ein glückliches Neues Jahr!

Seng Dan Fai Lok, Sang Nian Fai Lok!

Vrolijk Kerstfeest en een Gelukkig Nieuwjaar!

Shinnen omedeto. Kurisumasu Omedeto !

Buon Natale e Felice Anno Nuovo !

Wesolych Swiat i Szczesliwego Nowego Roku!

Boas Festas e um feliz Ano Novo !

Pozdrevlyayu s prazdnikom Rozhdestva i s Novim Godom !

Saturday, December 23, 2006

Going Bananas- Chiquita Brands

CQB is a global diversified brand with over $4 billion in sales in over 70 countries. Some 44% of sales are bananas, 31% are “Fresh Select” fresh fruit and vegetables other than bananas, and 24% are “Fresh Cut,” packaged salads. The Fresh Express acquisition, completed in June of 2005, diversifies the company’s business and accelerates revenue growth in higher margin value−added products. Importantly, it balances the mix of sales between Europe and North America, which should reduce the company’s susceptibility to risks unique to Europe, such as the recent changes to the European Union (“EU”) banana import regime. The company operates a joint venture through which Chiquita operates in the Far East market selling approximately 10% of bananas imported into Japan.

About 85% of its North American sales are through long term contracts of at least one year. Such contracts stabilize demand and pricing over the year and reduce the company’s exposure to volatile spot market prices and supply and demand imbalances. About 30% of the bananas sourced by CQB are produced by its own subsidiaries and the remainder is grown by independent growers, many of whom are contracted for multi-year periods. The company purchases over 150 types of fruit and produce from independent growers. CQB also owns or charters about 70% of its shipping capacity.

Interestingly, the company is a champion of environmental performance with CQB’s entire Latin American banana farm operations certified under the Rainforest Alliance, an annual certification which CQB has achieved since 2000. About 83% of its independent growers comply.

The European Union (EU) has imposed a new restrictive importation regime for bananas which commenced in January of this year. It eliminates the quota that previously applied to the import of Latin American bananas. In addition, it gives a tariff preference to certain African, Caribbean and Pacific (“ACP”) sources, which in many cases are former EU colonies, while it imposes a higher tariff on bananas imported from Latin America and other non−ACP sources. Increased tariffs could cost up to $110 million per annum. To some degree, this is offset by a $40 million elimination of licensing quota costs. Nevertheless, there are sovereign complainants that this regime is a WTO (World Trade Organization, successor to GATT) violation. Importantly, the Chiquita brand allows it to sell at premium pricing, and the company has enjoyed leading market share across the EU.

Chiquita is a significant brand. US consumer surveys have shown that Chiquita is one of the top brands in the food industry. In Europe, where the company devotes the majority of its Chiquita brand advertising, the brand is even stronger.

Pricing of bananas has improved with a 5% price increase in the EU, and 4% in the US. However, there have been significant supply issues which have reduced the volume of bananas available. Consequently, the price improvements look unsustainable as the supply situation resolves itself with the new crop. Profitability is also impacted by the higher costs of bunker fuel.

Chiquita is transforming itself from a pure commodity seller of bananas to a value-added food company wtih products that carry higher gross profits, have some patent protection, and carry strong brand loyalty. It seems strange to talk about product innovation in a produce company, yet this company has brought Chiquita minis, small bananas designed for kids, Chiquita to go, which are singly packaged banans distributed through convenience stores, amd Chiquita Apple slices, single serving non-browning apple slices.

Consumer trends away from unhealthy sugar-packed snacks to healthier products seems well entrenched. No less an authority than the FDA suggest 13 servings of fruit or veggies daily. Bananas rank fourth in human consumption globally, behind suchstaples of rice, wheat, and corn. The average American eats 28 lbs of bananas per year, making it the number one fruit in America...yes, ahead of apples!

Fresh Express, which is the number 1 salad maker in the world was never implicated in the recent tainted spinach E. coli outbreak. Fresh Express has 48% of the packaged salad market.

Chiquita's recent results have been plagued by a series of non-recurring charges which include the spinach recall, the imnpact of the EU, and the ongoing impact of the 2005 hurricane season which forced incremental costs into 2006. Complete with a writedown of goodwill, 2006 will be viewed as an "annus horribilis." The worst should be over as December 2006 draws to a close.

The company has significant financial leverage...long term debt is about 35% of assets. Operating margins were negative 7 in the most recent quarter versus last year's plus 5%. Returns on capital last year were around 7.5% versus red ink this year.

The stock is down about 21% YTD but has shown some slight recovery in the last month or so.Insiders own about 1.5% of the stock and have another 3% with options.

On a TTM basis, the company has generated about $67 million in free cash flow, well down from last year's $180 million, but nevertheless respectable in this punk year.

The company has underperformed virtually everything in the food processing industry over the last year. Contrast CQB with Hain Celestial (HAIN) for example. Hain is up about 50% for the year and sells on an EV/Sales of 1.64 times. CQB sells at merely 0.35 times revenues. Hain earns close to a 9% operating margin, my guess, long term, CQB will be closer to 7% on a normalized basis.

The market has generally been kind to the food processing industry this year, as sector rotation into non-cyclicals has predominated "thinking" about next year's prospects. In my view, many of these names are priced for perfection and I believe could disappoint. Not so with CQB in my view.

Despite the levered balance sheet, in my view the stock appears attractive at current levels.

Disclaimer: Neither I, my family, nor clients have a current position in Chiquita Brands.

Sunday, December 03, 2006

Traditional Indexation, Fundamental indexation, and Market Spirits

Not exactly a subject that makes your socks roll up and down. Most value “guys” don’t give a moment’s thought to indexation...we believe that through application of our discipline, we can achieve superior results. But for those who want to buy portfolio “management” for the lowest possible cost, and who do not have the patience to accept the occasional poor relative performance of a disciplined value manager, I suggest that you look into index funds, but NOT traditional cap weighted index funds.

I am a proponent of active equity management as opposed to passive indexation. My view of “active” management does not imply anything about trading or momentum. It merely implies stock selection on an active basis rather than merely accepting a “laundry list” composed by an index committee.

Rex Sinquefield, a strong proponent of passive management, described passive management most clearly about ten years ago when he said:

“Passive management when applied to a client's entire portfolio is really asset class investing. This means investing literally in asset classes via passive portfolios that capture, in their entirety, the asset class or classes under consideration. For most asset classes there are long-time series of historical data that allow us to form reliable estimates of the risk of a given class and how closely the behavior of that class correlates with the behavior of other classes. An advisor can estimate the risk of different combinations of asset categories and find the overall portfolio strategy that best suits the circumstances and risk tolerance of his or her client.”

Many financial planners and brokers rely on this notion of equities behaving as a “class.” Projections of long term returns on an “asset class” rely on long term extrapolations of past history. The “Ibbotson-Sinquefield” numbers which describe the performance of various equity asset classes, based on market capitalizations are often used expectationally, anticipating that past performance is prologue.

The beauty of indexation is its low cost, which is a function of scale and low trading costs. Management fees are very low as a result of scale, and as a result of little “tampering” by professional portfolio managers, Research analytics and portfolio management skills are not called upon to follow a list, merely administrative adherence to a formulaic list, Regrettably, a large part of the actively managed “professionalism” is dissipated by non-disciplined, follow the leader behavior. Save for perhaps 10% of the actively managed profession (and I may be generous,) most investment managers subtract, rather than add to the performance by their actions. This has resulted to a lemming-like mindless embrace of traditional indexation as a solution to investment problems.

Traditional indexation based on “size” solely determined by market cap in my view is complete nonsense. Size, when defined by market cap really captures two effects, “size” as measured by book value, or earnings, or sales, multiplied by respectively, the Price to Book Value, the P/E, or the Price to Sales ratios. Consequently, market cap captures not just size but also what I best can describe as “Market Spirits.” Market Spirits is the desirability or the overall market’s assertion of how much it likes a particular other words, a “Value” effect, how the market values the security. Recognition of the incorrect measure of size that market cap suggests has led to what is known as fundamental indexation.

Rob Arnott, the very bright and talented editor of the Financial Analysts Journal, has written extensively about this topic. As he points out in an editorial in the Sept 2005 FAJ, Disentangling Size and Value, there are two ways to have a large market cap, either be a big company, or be a small company with a lofty valuation multiple, i.e. market spirits. He demonstrates that “value” effects are far more powerful than most people realize when “size” effects are appropriately measured.

In a paper published in March of 2005, Arnott ( with Hsu, and Moore) demonstrate that fundamentally constructed index portfolios outperformed their traditionally constructed market cap index analogs. The measures of “size” that were used consisted of:

• book value (Book),

• trailing five-year average cash flow (Cash Flow),

• trailing five-year average revenue (Revenue),

• trailing five-year average gross sales (Sales),

• trailing five-year average gross dividends (Dividends) and

• total employment (Employment)

Returns produced by fundamental indexes were on average about 2% higher per annum than that of the S&P 500 for the 43 year period that was measured in the study. Though that seems to many people to be a rather small incremental return, over time that increment amounts to substantial accumulated wealth. This resulted in an ending value for the period that was more than twice that of the S

How is this possible? What is the fundamental problem with market cap indexation? Very cap approaches tend to overweight the over-valued and underweight the under-valued securities. Having a heavy weighting in a portfolio of extremely expensive stocks is a sure way to wealth diminution and this is an unavoidable consequence of traditional indexation. Fundamental indexation relies on size measures that are not propelled and elevated by “market spirits,” irrational exuberance, etc.

Perhaps the difference in returns for the two approaches was already understood by Benjamin Graham many years ago. In the short run, the market is a voting machine, but in the long run, it is a weighing machine.

A early draft version of the Arnott, Hsu, and Moore paper can be accessed here.

There are several providers of fundamental index product. Rob Arnott’s firm Research Affiliates LLC has teamed with PowerShares and FTSE to produce the ETF which trades as PRF that focuses on the large size firms. Small to mid size firms can be accessed through PRFZ.

Sector portfolios using this approach have also recently appeared:

Basic Materials (PRFM), Consumer Goods (PRFG), Consumer Services (PRFS), Energy (PRFE), Financial Services (PRFF), Healthcare (PRFH), Industrials (PRFN), Telecom Tech (PRFQ) and finally Utilities (PRFU) are all available since September.

Pimco has also instituted a fundamental indexation product using Rob Arnott’s approach in its Pimco Fundamental IndexPLUS TR fund, PIXAX .This is a balanced fund that combines Pimco’s active fixed income style with a passive equity component that is fundamentally based.

WisdomTree employs a dividend based fundamental indexing methodology that weights companies based on the amount of cash dividends that is paid out. WisdomTree’s website features an excellent article first published in the Wall Street Journal in June of this year on the topic of fundamental indexation . The article, written by Jeremy Siegel of Wharton highlights the truism that the market prices of stocks may not always be the best estimate of the underlying value of the firm. He describes fundamental indexes as the next “wave” of investing.

Like PowerShares, WisdomTree offers numerous ETFs as well. The large ”Cap” dividend fund (DLN) the Total Dividend Fund (DTD) the Mid “Cap” Fund (DON) and the Small “Cap” Fund (DES) are the broad core funds that are available.

Sector funds are available from WisdomTree, however, they are international rather than domestic. I will have comments on International Indexing in my next post.

Please keep in mind that the net return that you realize from any of these approaches is dependent on the cost efficiency and scale of these ETFs. Being relatively small, they have yet to achieve the cost efficiency of the large index managers such as Vanguard. Consequently, their management expenses are considerably higher than that of managers such as Barclays iShares or Vanguard but below that of most actively managed funds.

Disclaimer: I am an investment manager who relies on disciplined stock-picking and portfolio construction to achieve returns. I, my family, and clients do not currently own any index funds mentioned in this post.

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