Friday, June 29, 2007

Looking Smart or Misery Loves Company

Buffett remarked that success in investing does not necessarily correlate with IQ. Thank God! I easily could have ended up doing something I don't enjoy as much as this.

The real key to success in this business is avoiding the influence of others (especially the market.) If you are easily swayed by others opinions, you can easily head down the wrong direction. If consensus is what you crave, value investing of the contrarian variety will drive you up a tree!

Discipline is incredibly important, but don't bury yourself in the details. I can recall Buffett describing his spending about half an hour in his analysis of General Dynamics submarine business shortly before buying a 15% stake in the company.So many investors get caught in analysis paralysis or intellectual need to execute to own. Analysis and thinking is required but the obvious bargains are...obvious!

A great idea is often a lonely idea.Ugly performance over the near term is frequently part of this approach. Your friends wonder what the hell you are thinking...your clients wonder if you are thinking at all !

A lack of sentiment, an iron clad ability to say no, and a tendency toward being intuitive and introverted doesn't make you popular in the cocktail party circuit. Buying unpopular stocks that everyone "knows" are going nowhere doesn't help your popularity either!

Other iconoclastic investors have joined me in a few of my investments. Geoff Gannon highlighted Legg Mason (LM) and our previous posts. Bill Ackman's Pershing Square has accumulated about $200 million (1.9%) of the stock. Bill Ackman has a terrific record in finding value and creating more value.

As well, ValueAct Partners has augmented its position in Advanced Medical Optics (EYE) another position that was recently posted. ValueAct is another group of outstanding investors who apply their unique thinking to unusual areas of value investing such as technology and biotech. ValueAct now owns 12.2% of EYE.

How unpopular are these stocks? There are three Wall Street analysts with buys or outperforms on LM; nine analysts in the non-committal, we really don't like it because it's dead money "hold." EYE has one brave soul with a buy, six with holds, and two with the dreaded "sell" or "underperform."

A client this morning told me that despite the flat response that these stocks have had since purchase that I am looking pretty smart. That sort of praise generally occurs after you have made them a lot of money not now. Smart has nothing to do with it...rational does. I am pleased that some very rational investors are aligning themselves in companies that many view as miserable, as going nowhere, or as dead money. Maybe its just that misery loves company. By the way, those guys are smart too.

I think both of these companies represent decent value in a market that is not making it easy to find bargains.

Disclaimer: I, my family, or clients own a current position in Legg Mason and Advanced Medical Optics.

M&A Activity to Continue at Accelerated Pace

The merits (and demerits) of private equity have been debated by market participants, and unfortunately neer-do-well politicians in much of the first half of this year with a recent crescendo in the debate. I think this article highlights some of the dimensions around the issue and provides a number of useful data points. Though some of the frenzied activity especially regarding cov-light loans prompts some concern, the outlook, at least according to this article, is still optimistic. As always, leveraging a poor business with inadequate cash flows is an unmitigated disaster. The trick is always to buy a business utilizing leverage to achieve optimal capital efficiency in order to maximize return.

According to PWC, deals in the first five months of this year totaled $845 billion representing 10% more than the deal value for all of the first half of 2006.

Interestingly, private equity accounted for 48% of M&A value versus 32% of last year's comparable period.

A PWC partner, Bob Filek indicated that he believes this M&A market may surprise on the upside, noting, "History shows that default rates trend up as the peak of M&A activity approaches, but default rates are still holding at moderate levels. While a liquidity crisis or rapidly rising interest rates could change that in a hurry, things look strong into '08." Currently, the default rate on U.S. speculative-grade loans remains at its lowest level since the early '80s-1.3% compared with 1.9% last year. However, 50% of all new high yield debt issued in the first two months of 2007 was rated B- or lower, compared with 32% in 2006 and 36% in 2005, according to Standard & Poor's Global Fixed Income Research. The average size of the most speculative loans has increased to $581.2 million in 2007 from $351.6 million in 2005. The vast majority of defaults over the last 70 years have been speculative grade loans."

At a time when there is growing doubt about the continuation of these trends, the article predicts that, "any eventual slowdown is likely to be a soft landing, rather than a hard crash like the one occurring in 2001. Large private equity funds, which are more diversified than they were at the start of the decade, are well positioned to profit from a downturn. While buyouts may eventually slow and returns upon exit may be lower, other private equity transactions such as distressed debt deals and workouts are likely to increase. Other market dynamics that will cushion any slowdown include diverse and expanded funding sources for M&A, a steady stream of targets for both value and growth plays, and the many roles hedge funds are playing in the M&A market."

Here is a link to this very interesting article: ...dedicated exclusively to the asset-based lending industry

For a completely different point of view, please check out a Wall Street Journal blog post from yesterday: Is Private Equity Out of Gas?

Tuesday, June 26, 2007

Invest in Value- An Interesting New Valuation Site

I have just come across a new website called Fans of classic Benjamin Graham investing will find the site quite useful.

First of all, it is free. At this point, some 1200 stocks are covered, but what makes this particularly interesting is the international breadth of coverage. Not only U.S. and Canadian stocks are featured but also stocks from the U.K., France, Germany, Japan and Hong Kong.

The valuation basis of the website is the Graham formula:

Intrinsic Value = Current E.P.S. x (8.5 + 2 x Expected Annual Growth Rate)

Consequently, intrinsic value is a function solely of the current level of earnings and an estimate of the growth rate. The website presents both a consensus view of earnings growth as well as a linear regression of earnings growth based on the last ten years of earnings.

There is a comparison of a simple discounted cash flow model valuation with Graham's formula.

The screening filters for conservative versus enterprising investors are also presented. A margin of safety is calculated based on the discount of current market price to the determined intrinsic value.

As a value investor, I have a high regard for methodologies that emphasize margin of safety. As a portfolio manager, I have always been somewhat leery of approaches that utilize regression fits for determining growth rates. The last ten years may or may not reflect the future growth rate. Competitive landscapes change, capital structures change, and hence earnings growth rates will be affected. Current e.p.s. may be bloated or understated depending on accounting choices.

Despite these inherent flaws, the Graham formula has always been an excellent starting point in considering the valuation of a business. But cyclical businesses in the late stages of an economy will have a very high earnings base that is used as the basis of the valuation. Balance sheet leverage is also not considered in the valuation. Businesses that are currently loss-making are worth zero in this analysis.

This raises another important reminder. Valuation is an incredibly imprecise art. In some ways, the development of the spreadsheet was one of the most dangerous inventions of the twentieth century. Extrapolating data into the hereafter without consideration of its reasonableness, without consideration of competitive advantage periods, and without considering something other than linear growth has often provided ridiculous results.

Though elegant spreadsheet models may create an illusion of precision, their complexities do not necessarily suggest greater accuracy than the Graham model. I do prefer free cash flow based valuation models but like every model, the valuation is entirely dependent on the input assumptions. Man have I gotten a lot of those wrong over time, but the spreadsheet sure looked impressive.

I think the website is definitely worth a look and a spin. You may or may not agree with the valuation it accords your stock, but at least it should make you think about the reasonableness of your assumptions. If it achieves that, it's a great site.

Friday, June 22, 2007

Thank you Geoff!

As you know, Geoff Gannon writes an incredible blog always presenting thought-provoking commentary and disciplined thinking. His acumen and perception are highly regarded by most of us in the investment section of the blogosphere. As you can see, Geoff is the first link that I have in Value Discipline. He properly describes his blog as being built upon insights of intrinsic value, margin of safety, competitive advantage, and protection of principal. That, dear readers, is the crux of the investing process in my opinion. There are no other building blocks that you need to attain wealth in the capital markets.

Geoff has achieved a unique recognition in the blogosphere. Just mentioning his first name is generally sufficient direction for readers to know who it is you are talking about!

I am deeply honored to be included in Geoff's assessment of "The Eight Best Investing Blogs." As Geoff says, "to make the list a blog had to offer something of value to investors." Value Discipline is in great company when I peruse his other selections.

I was particularly touched by his kind words, "If I was limited to reading only one investing blog, this would be it." Geoff describes our posts as "heavy on facts and reason and light on self-important assertions."

I have always had very high regard for my audience whatever their investment background. Many are fellow analysts and portfolio managers, many are avid students of the market, all have a deep respect for value investing as a discipline. Some are former co-workers who are well aware of my foibles and cigar butt stocks that evanesced into bad memories and vapors. Facts and reasons have always held up better than my ego-driven assertions. The separation of facts from opinion is important to me and I suspect to my readers. I hope to keep things that way.

The headline to this blog reads, "A celebration of value thinking, a salute to common sense and straightforward logic." Probably makes me more pedantic than most, less entertaining than most, but hopefully less BS than most too. I apologize for those times when I had nothing posted. I was either busy at work or I had nothing to say and did not want to waste your time or mine. Voltaire put it best, "One always speaks badly when one has nothing to say!"

Like Geoff Gannon, Value Discipline did not make the cut at 24/7 Wall St's 25 Best Financial Blogs. Frequency of posting may have done us in. Congratulations to those that made the cut. I am a loyal reader of most of these as well and they truly represent the creme de la creme.

Thank you to my readers who endure the quirks that I bring to this blog. Your loyalty is appreciated. Congratulations to those who made the cut in Gannon on Investing! And a hearty thank you to Geoff for the recognition! I will try to live up to your kind comments!

Wednesday, June 20, 2007

Nuveen Takeover-Think about Legg and Federated

Nuveen Investments (JNC) announced this morning that it was being taken over by Madison Dearborn for $65 per share. JNC has assets under management (AUM) of about $165 billion roughly half of which is equities. The takeout valuation is 16 times trailing EBITDA and about 3.4% of AUM.

I think other asset management companies look starkly cheap in the light of this transaction.

Readers are aware of our positive views on Legg Mason (LM) It is trading at only 11 times TTM EBITDA and about 1.4% of AUM.

Janus Capital (JNS) though frequently rumored as a potential takeover looks fairly full at 16.6 times TTM EBITDA and about 3.2% of AUM.

Another fairly cheap asset manager is Federated (FII) which despite its 5% move this morning is trading at 11.3 times EBITDA and 1.8% of AUM.

Some previous posts on Legg Mason:
Falling Out the First Storey Window

Legg Mason-Is It Time to Start Looking?

LM manages just under $one trillion in assets consisting of about 35% in equities, 49% in fixed income and the balance in money market (lower margin) assets. Federated, with about $240 million in assets is much lighter in the higher fee equity proportion with only about 16% of AUM in equities and about 74% of assets in fixed income.

Disclaimer: I, my family, or clients have a current position in Legg Mason and Federated Investors.

Tuesday, June 19, 2007

Leucadia: Ian Cumming on Commodities, Globalization, and China-Secrets of Success

In yesterday's Guru Focus ( there was a wonderful post that quoted from Leucadia's Ian Cumming, the chairman of Leucadia National ICorp (LUK) Gurufocus provides a great deal of information about highly successful and well-known investors ranging from Buffett to Wally Weitz. It is well worth your attention!

The Leucadia record or scorecard as Cumming and his partner Joseph Steinberg refer to it is an incredible example of disciplined investing at its best. Over 29 years, wealth creation of 20.9% has occurred ex dash dividends or spin-offs, just slightly less than the returns of Berkshire at 21.4%.

From the letter to LUK shareholders, the approach is expressed simply and elegantly:

We tend to be buyers of assets and companies that are troubled or out of favor and as a result are selling substantially below the values which we believe are there. From time to time, we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your company with an undue emphasis on either quarterly or annual earnings. We believe we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated.

The "Rules of the Road "are another great enunciation of sensible investment practice:

1. Don’t overpay, no matter what the madding crowd is up to.

2. Buy companies that make products and services that people need and want and provide
them as cheaply as possible with consistently high quality. Lower cost and higher quality
is a relentless and never-ending task.

3. Earnings sheltered by NOLs are more valuable than earnings that are taxed!

4. Compensate employees for performance and expect hard work and honesty in return.

5. Don’t overpay!

I will have further comments on Leucadia in subsequent posts. In the interim, I highly commend the letter to your attention. Leucadia Letter link

Disclaimer: I, my family, or clients have a current position in Leucadia.

Monday, June 18, 2007

Ecolab- Consistency Comes at a Price

Ecolab (ECL) is a model of consistency. The company develops and markets products and services for a wide array of markets including hospitality, foodservice, healthcare and general industry .This includes providing cleaning and sanitizing products and programs, as well as pest elimination, maintenance and repair services primarily to hotels and restaurants, healthcare and educational facilities, quick-service (fast-food and other convenience stores), grocery stores, commercial and institutional laundries, light industry, dairy plants and farms, food and beverage processors, and the car wash industry. Here is a recent newspaper view of Ecolab.

The company enjoys steady demand from the continuous efforts of business to comply with sanitary requirements particularly with regard to germs such as Salmonella. The company has been recognized for its ethical leadership and corporate social responsibility.

Despite what seems like a fairly mundane business, at least superficially, the business has shown excellent growth with revenues compounding at 16.1% over the last five years and e.p.s. at about 14.6% over the same period. About half of its sales are made outside of the US.

The company retains some 90% of their clients largely because of a business model that emphasizes high-touch service from their salespeople who work directly with their clients ' employees. The CFO of the company explains the repeat business with great simplicity and straightforwardness..."the moment you clean it up, it gets dirty again." The authenticity of what makes a simple business successful rings so clearly doesn't it?

Frequently, this provides the opportunity to cross-sell additional products and services. Internationally, the full scope of service and product offerings is not yet complete, and hence operating margins and working capital management tends to be somewhat less than the domestic business. But, this also represents a significant opportunity for improvement since margins trail by about 400 basis points on roughly half the business.

On a valuation basis, the stock is a little rich selling at about 30.2 times sustainable earnings per share. On a free cash flow basis, the stock seems a lot more palatable at 22.5 times FCF or a 4.4% FCF yield.

With an enterprise value of about $11.5 Billion, debt represents only about $800 million. EV/EBIT is about 18.3 times, again not terribly cheap. Return on invested capital is healthy at about 16.5% and revenues per dollar of invested capital have improved steadily over the last few years. Return on equity is about 23%, in-line with its historical averages. Operating working capital now represents only about 4% of revenues whereas it had been averaging around 9 to 10%. The cash cycle has improved quite dramatically to turn every 12 days, down from about 20. Capex now represents about 8% of revenues, in line with the past.

The current dividend yield is 1.25%. The five year dividend growth has been about 9.5%. In addition, the company has returned capital to shareholders through share buybacks. These have totaled about $173 million in the first quarter and about $283 million for all of last year.

Here is a look at the cash flow drivers

As well, here is a look at the valuation ratios and analytics courtesy of Reuters.

The most recent Wall Street Transcript included an interview with Dmitry Siulverstein who covers specialty chemical research at Longbow Research. (TWST subscription required)

As he says:

I like Ecolab - it's hard not to like the company. You have to be selective when you buy the stock because it never looks cheap, but to the extent you can buy it on a dip, even if it's a small dip, you will enjoy nice long-term gains with the stock. I think the biggest appeal of Ecolab is predictability. The company gives you a very narrow guidance for earnings for the year, and a $0.02 range for earnings in the quarter. Quarter-in and quarter-out, they deliver results at the top end of their guidance. This predictability and sustainability of results, combined with the company's excellent position in its market where they are continuing to gain market share and growing significantly above the growth rate of their industry, makes this somewhat of a growth name.

Ecolab is the biggest player in this industry, but despite their size and scale, they still represent less than 20% of the market.

Bottom-line, not a great deal of downside unless a recession really demolishes discretionary spending in the hospitality industry. International opportunity for improvements still exist. Not quite as cheap as I would like but clearly on my watch list for now.

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

Monday, June 11, 2007

Applied Industrial Technologies (AIT)

This weekend's Wall Street Transcript (subscription required) features an interview with David Pugh, the CEO of Applied Industrial Technologies, (AIT)

This company has a long history dating back to 1923 and has been public since 1953. The company is a value-added distributor of industrial products, fluid power products and engineered products that keep manufacturing systems going. From what originally was a focus on maintenance and repair parts, the company has expanded into power transmission and fluid power products.

This has been an impressive company in terms of its continuous improvement in its basic blocking and tackling. Here is an excerpt from the interview:

The goal would be a continuous increase in return on invested capital. We want to make sure that all of our assets are working properly for us. To do that, we watch many things. We've had an emphasis on gross margins. We've had an emphasis on top-line growth. We've had an emphasis on getting more efficient with receivables. We've certainly had an emphasis on inventory management. Our return on invested capital has continued to go up. In fact, over the past four years, we have been growing this metric at a compounded annual rate of a little over 40%, which would rank us pretty highly with regard to the best in class.

I am impressed with the commitment to ROIC. Again, from the Wall Street Transcript interview:

The single most important one is return on invested capital. That is one that we heard very loudly and clearly about four years ago. We have transformed this company from looking at return on sales to return on invested capital. There was a point in our history where how many assets we had to throw at something to get to the next half point of market share didn't bother us. We changed that and became much more expeditious in closing down under-performing assets that were providing us sales, but no income. We have a stated strategy that we are going to grow profitably in North America within our current product domain - that tells you what we are going to do and what we are not going to do. Getting that focus has helped us take the value of this company up.

Note the improvement that has occurred in ROIC:


Sustainable Free Cash Flow per share has improved to $1.64 per share on a TTM basis. Applied's Board of Directors has authorized the purchase of up to 1,500,000 shares of the Company's common stock. This authorization replaces the previous one under which 1,401,000 shares were purchased through March 31, 2007. The new authorization represents approximately 3% of the shares currently outstanding. Prior buybacks have been effective in reducing fully diluted shares outstanding to a current 44.41 million from about 46.6 million two years ago

At current valuations, AIT has a market cap of $1.2 billion. With $85 million in cash on the balance sheet and $76 million in total debt, the company has an enterprise value also of roughly $1.2 billion.

Enterprise Value/EBITDA is about 8.5 times.

The market dynamics of consolidation push smaller competitors out of the marketplace. Though the migration of the US manufacturing base offshore is an ongoing concern, specialization and consolidation emphasize the triumph of service over product price. There remains upside in margin. The company is ramping up its government related business which tends to be persistent and anti-cyclical.

The combination of a sensible M&A strategy that respects return on invested capital looks like a winning approach to me. Combine that with a reasonable valuation, I believe spells opportunity.

Disclaimer: Neither I, my family, nor clients own a current position in AIT.

Sunday, June 10, 2007

Advanced Medical Optics (EYE)- In Need of Focus

It's been quite some time since I have last posted and I apologize for the disruption. But rather than create random drivel, I prefer to post when I believe I have something interesting to discuss.

Advanced Medical Optics (EYE) is such an idea. Clearly, the company is terribly out of favor, with the stock down about 26% over the last year, having suffered two fairly significant problems in this period of time.

The company announced on May 25th that it was recalling its Complete MoisturePlus contact lens solution globally because of health concerns. The voluntary recall was initiated because of concerns over eye infections from Acanthamoeba, a naturally occurring water-borne organism which can contribute to serious corneal infections potentially leading to blindness or more likely, a corneal transplant. The company responded quickly and conscientiously to data from the U.S. Center for Disease Control and Prevention (CD) that showed that it had interviewed 46 patients who had developed Acanthmeoba keratitis (AK) infections reported since January 2005. A total of 39 of these patients were soft contact lens wearers, 21 of whom reported using complete MoisturePlus products. AK infections are usually found among individuals who improperly store or disinfect their lenses, swim/use hot tubs/shower while wearing lenses, etc. The CDC has received reports of 138 cases of confirmed AK infections but only 46 have provided complete patient data. There are many types of keratitis and consequently the diagnosis of AK requires a significant effort on the part of the treating eye care professional to isolate organisms from corneal cultures or to detect cysts on the histopathology.

The bottom line is that no one can explain what caused the higher incidence of AK cases among the people who reported to the CDC and there are a wide variety of potential factors that relate to the general increase in the number of AK cases and the apparently higher incidence of cases related to MoisturePlus.

The product generated sales of about 10% of the firm's total revenue. The costs of recalling the product will be high, as well as the settling of potential product liability lawsuits. The company will also face costs of advertising and marketing as it attempts to re-establish the brand with new formulations.

The fact of the matter (at least according to a recent Bear Stearns conference call) is that there does not appear to be an effective multipurpose no rub contact lens solution for killing AK. Older technologies of "rub" products and hydrogen peroxide products seem to work better. Strangely, EYE could benefit from a move back to older technologies, as it is a major player in the hydrogen peroxide space.

The "other" problem that I refer to is a manufacturing problem from November that resulted in a recall but with no adverse health reactions reported. The problem facility has cleared inspections and is currently on stream. This created the initial break in the stock price and in my opinion, lowered expectations dramatically.

So much for the bad news...what does the company do right? EYE sells a full range of cataract products to surgeons. Some 76% of surgeons who use the company's lens-removal system will use an EYE Intraocular lens implant. The company is readying a new multi-focal IOL to compete with market leader Alcon (ACL.)

EYE acquired VISX which gives it market leadership in LASIK surgery. The company has a unique franchise in selling both LASIK and refractive intra ocular lens, an ability for the eye surgeon to cross-sell. LASIK equipment is sold to surgeons but EYE receives an additional licensing fee that is calculated per procedure. Custom LASIK procedures which are gaining share provide about twice the licensing fee of standard LASIK.

The company acquired a major competitor in microkeratomes, the cutting device that creates the corneal flap in LASIK surgery with the purchase of IntraLase, the leading manufacturer of a laser keratome.

In summary, EYE is the largest player in refractive surgery, it is #2 in cataract surgery, and is #3 in contact lens solutions. This company has made several transformative acquisitions since its spin off from Allergan (AGN) in 2002. The balance sheet is somewhat leveraged with $1.6 billion in total debt. However, EBITDA/Interest paid is about 6.5 times based on trailing twelve months of EBITDA.

Operating margins could well expand from TTM levels of about 11% to levels approaching 20% plus as the LASIK market expands and refractive Intraocular lens replacement grows. Some reports suggest that custom LASIK could represent over 80% of the total LASIK market versus its current roughly 50%, another significant boost to profitability.

The company, just prior to its AK recall news had announced that it was potentially interested in purchasing Bausch & Lomb (BOL) a company that is the target of a $3.7 billion takeover by Warburg Pincus. EYE needs to focus on its own issues at the moment and continue the integration of prior businesses rather than build itself some new obstacles. I suspect that management will back away from its BOL dreams, at least for now.

BOL's current valuation (at a premium to the Warburg Pincus bid) is about 16 times EV/EBITDA. EYE is valued at about 10.3 times on this basis.

Return on equity is about 11%, a function of high leverage rather than great asset or capital management. ROIC is an embarrassingly low 5%, an issue that will no doubt be addressed by some activist shareholder involvement.

I am encouraged by a 13-D filing by ValueAct Capital Management, a highly regarded activist firm who have built their ownership position in this company to a current 9.86% as of their most recent May 29th filing. ValueAct has a long history of responsible activist investing which has focused on healthcare and technology companies, a track record I greatly admire.

There is no cheery consensus here...of 8 analysts that follow, there is one sell, six holds, and one lonely buy. Management has a long strong of acquisitions that have built a significant market position business with three easily fungible parts but below WACC returns.

Insiders own about 0.6% of the stock (which goes a long way to explaining some of the acquisition history) but about 4% on a fully diluted basis (through options.)

Dare I speak of a lack of focus or an inability to keep the eye on the ball? All punning aside, I am comfortable with the stock at current valuation. Expectations are nil and the Street wants to wait and see (sorry.) Smart outside ownership is coming in for the cure.

Disclosure: I, my family, or clients have a current position in EYE.

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