Important Updates for Investors
Carla Pasternak's Premiere Issue of High-Yield International Just
Released
Income expert Carla Pasternak's debut issue of High-Yield
International covers a Taiwanese manufacturer yielding 9.5%... a
rare Mexican monopoly yielding 13.4%... and other top-performing
investments yielding up to 19.0%.
Government's Biofuel Timetable Could Spell +15,900% Growth
+15,900% growth might seem far-fetched... but it's not. In fact, it
is mandated by law. And I've identified the ONLY stock positioned to
capture this growth.
The
Silver Lining to a Falling Dollar
Despite the U.S. national debt, there is a silver lining for income
investors. This massive spending, combined with movement out of U.S.
Treasuries, is going to take its toll on the dollar, and
international income investors could reap the rewards in the form of
higher dividends. |
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| Using
Mean Reversion, Enterprise Value and Contrarian Investing to Find Undervalued Micro-Caps |
Published: March 7, 2005
In my last guest
article I identified the most fertile ground for finding great
investments -- small and neglected stocks. When searching for these
high-quality micro-caps, I first use advanced screening techniques to
help narrow the vast investment universe down to just a short list of
high-quality stocks that meet many of my stringent investment criteria.
From there, I dig deep into each company's fundamentals in order to
evaluate its future business prospects. In the process of doing this
analysis, I always keep the following items in mind:
-- Securities that have underperformed in recent trading action are
likely to outperform in the months and years ahead. As such, it's often
valuable to take a contrarian approach by looking for beaten-down,
neglected stocks.
-- Investors often analyze companies without taking their debt levels
and cash balances into account. However, this can be very misleading.
Before investing, it's extremely important to analyze the full value
that investors have attached to a firm.
With this in mind, in today's guest article I'm going to explore the
following important investment concepts...
-- Mean Reversion
-- Enterprise Value
(Please remember these ideas should not be used in isolation, but
instead should be employed in conjunction with other time-tested
investing principles.)
--------------------
Mean Reversion
--------------------
Many academic studies of Wall Street's behavior have demonstrated strong
evidence of something statisticians call "negative serial
correlation." Very simply, this means that stocks that performed
well in years past actually tend to underperform going forward.
This anomaly is most likely created by investors' tendency to overreact
to positive or negative news. Based on all historical data, it's clear
investors are incapable of insulating themselves from their emotions and
embracing logic. The majority of investors tend to follow the crowd.
Instead of acting in a logical, well-thought-out way, most investors are
pulled along by fear and greed. I seek to capitalize on this irrational
behavior.
"The product of the extremes tends toward the means."
You may have heard this old saying back in grade school --and for good
reason. After all, there's quite a bit of truth to it, and it applies to
a variety of different aspects of our lives. For example, on average,
the offspring of tall parents are not as tall as their parents.
Meanwhile, the offspring of short parents are generally not as short as
their parents.
Why is this important for investors? Well, as you'll soon see, this
principle also applies to the stock market when measuring returns over
long periods.
Although the trend might indeed be "your friend" in the
short-term, over the long run (let's say three years or longer) the reverse
is actually true. Stocks that have delivered stellar returns over the
past three years or so will often regress to the mean and underperform
their peers in the coming years.
This concept is supported by a wealth of academic research. For example,
in an important study, economists Richard Thaler and Werner De Bondt
studied stocks that outperformed or underperformed the market averages
over a three-year period. After doing so, they came to the conclusion
that "extreme returns of stocks listed on the New York Stock
Exchange were subsequently followed by significant price movement in the
opposite direction."
With this in mind, instead of trying to ride outperforming stocks
higher, I often prefer to look for unloved stocks that have
underperformed the market in recent months or years. After all, while it
may be tempting to latch onto today's hot trends and market darlings,
these stocks carry a great deal of risk and are often prone to sharp
reversals. I try to remind myself that trees grow upwards but never
reach the heavens.
-------------------------
Enterprise Value (EV)
-------------------------
When attempting to gauge the overall value Wall Street has assigned to a
firm, investors often look exclusively at market capitalization
(calculated by taking the number of outstanding shares and multiplying
this figure by a stock's current share price). However, in most cases
this is not an accurate reflection of a company's true value. Instead,
enterprise value is a much better gauge, as it measures the total value
that all investors -- both equity holders and bondholders -- have
assigned to a firm. Enterprise value essentially represents the current
purchase price of the entire company.
Enterprise value is a simple, yet often overlooked, financial measure.
It is calculated as follows:
Market Capitalization + Total Debt - Cash = Enterprise Value
The formula subtracts cash from market capitalization because if an
investor were to actually buy the entire company, then that investor
would acquire all of the firm's cash. This would, of course, reduce the
cost of the purchased company. (Note: At times I also like to go a step
further and adjust stock prices for current accounts receivable and
liquid inventory.)
The media, Wall Street and major corporations often report certain
statistics -- such as P/E ratios -- without mentioning the impact of
debt obligations and cash. This is very misleading! Some companies may
seem to have stellar financial numbers. However, when debt holders'
claims are added into the calculations, these numbers sometimes prove to
be very unimpressive, or in many cases even horrible. By contrast, some
companies have healthy cash and accounts receivable balances, liquid
inventory and little debt. However, ratios like P/E multiples don't take
these important items into consideration at all, as the
"price" value in this ratio reflects only the value of a
firm's equity. At the very least, cash and debt must be included to
adjust the reported price per share. Instead of looking just at equity
prices, I strongly recommend investors always compare earnings, sales,
etc... to enterprise value when analyzing a company's intrinsic worth.
Academic research also supports this view. For example, Nobel Prize
winning economists Modigliani and Miller theorized that the effective
capital structure of a company was the market value of its equity plus
its debt. They proposed there was no optimum capital structure and
concluded it makes no difference whether a company uses debt or equity
to finance its business.
With this in mind, we must equally analyze both debt and equity when
making an investment decision. Whether a company chooses to recognize
its value all in debt, all in equity, or a combination of both, is the
firm's choice. There is no capital structure that results in a higher
total valuation. When calculating and comparing financial ratios,
investors must include a firm's debt per share minus its cash per share.
Given all of this, we can see that the real, economic purchase price of
a company at any given moment is the value of its stock (its market
capitalization), plus the debt the company has incurred, minus its cash
on the balance sheet. So, instead of looking at earnings in isolation,
it's always wise to examine the total returns a business generates in
relation to the cost of acquiring it.
Micro-Cap Investing Ideas
When searching for quality micro-cap investing ideas this week, I paid
careful consideration to the key concepts of mean reversion and
enterprise value. Below you will find an analysis of three of today's
most promising micro-cap plays...
---------------------------
InfoNow (INOW, $0.95)
---------------------------
InfoNow provides complex automated technology and service solutions to
some of the most recognized companies on Wall Street. More specifically,
the company's software helps firms organize their distribution channels,
as well as gather information on who is reselling their products (and at
what prices). Firms then use this information to manage their
distribution networks and to generate new partners. InfoNow's client
roster consists of over 70 blue-chip companies, including such
high-profile names as Apple Computer, HP, UPS, Shell Canada, Bank of
America, Visa, Avaya and many more.
InfoNow's customers are using the firm's products more than ever before.
For example, in January 2005 the company's distribution channel
management web site logged more than one billion hits -- over 2,000 per
minute. In addition, the firm's clients tend to show an impressive
increase in customer access after using InfoNow's solutions. That growth
was measured at a +25% compound annual rate since the firm began
tracking these statistics back in 2000. This statistic gives credibility
to the significance of InfoNow's software products, as well as their
importance to the firm's clients.
INOW's management is convinced that its products will ultimately
revolutionize the way channel-focused companies operate. Currently, the
firm is focusing the majority of its sales and development efforts on
expanding its distribution channel software and becoming the dominant
provider of this technology. Management believes this is a multi-billion
dollar opportunity and the company is well positioned to capitalize on
it. Even better, the firm boasts that no competitor can match the depth
and breadth of the information it provides.
From a financial point of view, INOW has a market cap of just $9.4
million. However, this should be adjusted downward for an impressive
cash balance of $3.9 million and accounts receivable of $1.5 million.
The firm's total liabilities amount to just $2.2 million. So, for a
company with an enterprise value of less than $8 million, investors are
getting annual sales of $11.4 million and gross profits of $6.8 million.
When we couple these statistics with the firm's diverse customer base
and its recurring revenue business model, we see a powerful platform for
further growth. INOW has been profitable and cash flow positive since
2002, and I think the stock would make an excellent addition to a
well-diversified portfolio.
------------------------------------------
Midwest Air Group Inc (MEH, $2.66)
------------------------------------------
I can safely say investing in an airline stock should be considered a
contrarian idea. Today I'm going to ignore the obvious industry troubles
here, including rapidly rising oil prices, a stagnant economy,
distressed labor agreements, excess capacity, increased competition,
lingering effects of 9/11, costly security measures, negative cash flows
and large debt loads. The fact is that all of these items have already
been priced into Midwest Air's shares over the past few years.
If the industry can make improvements on any of these current concerns,
then MEH appears poised to capitalize on these positive changes.
Although MEH lags its competitors in terms of top-line growth and profit
margins, the firm's balance sheet looks fairly solid. This strong
financial position, coupled with Wall Street's overreaction to the
downside throughout the past several years, has provided investors with
an interesting buying opportunity.
MEH is a small and ignored stock, and any positive industry or
company-specific news is likely to move its price higher. It's also
worth noting that several successful value funds, including Heartland
Value and Al Frank Fund, have already invested in MEH. Although the
stock is not for the risk-averse, investors with well-diversified
portfolios may want to consider a small position in MEH.
------------------------------
Catuity Inc. (CTTY, $3.85)
------------------------------
Catuity provides loyalty application software and services to retailers,
as well as to companies that provide services or hardware to retailers.
The firm's programs provide real-time marketing services to customers at
the point of sale. Large retailers use these solutions to help track and
reward their most profitable customers.
Although the firm has a rocky past, including the loss of a large chunk
of its revenue from key customers Target and Visa last year, Catuity is
now in the very beginning stages of a turnaround. Catuity's long-term
promise for investors lies partly in the value of several key patents.
These relate to the storage and management of applications in offline
consumer devices, as well as the systems used to manage those
applications. Some of the most successful companies in their respective
industries have been attracted by the value of Catuity’s solutions,
most of which are based around these patents.
At this point the company is starting at ground zero with a newly
developed and unproven strategy. The board has hired John Racine -- a
proven industry turnaround specialist -- and appointed him CEO. Although
at this point the company has not proven it can generate sufficient
revenue to produce a profit, we nonetheless believe this stock has many
merits as an investment.
Catuity has tiny market cap of only $3.0 million. However, we need to
adjust this number to come up with the firm's enterprise value, which
will give us a better sense for the total value investors have assigned
to the firm at this time. Along those lines, CTTY has $2.6 million in
cash and only $674,000 in total liabilities. By following the equation
for enterprise value (shown above), we see that the company can be
purchased for about $1 million (I also considered off balance sheet
items such as lease obligations).
On the positive side of the ledger, I like a number of things about
Catuity. For starters, the firm has demonstrated a strong desire to stay
listed on the Nasdaq and Australian exchanges. For example, the company
recently executed a 15-to-1 reverse split in order to meet the Nasdaq's
listing requirements. Catuity also boasts the following positives:
-- Strong team of employees in both management and technology
-- Operating loss carry-forwards of $20,000,000 should help the firm to
save on taxes for years to come
-- Three registered patents
-- Enough cash and little debt to give the company time to execute its
turnaround strategy
-- Turnaround specialist John Racine, as well as the addition of
experienced new board members
-- Several motivated key shareholders
Although these positive factors should help support the stock price
going forward, keep in mind that CTTY is a fairly high-risk play. In
addition, the company continues to lose money, posting a net loss of
$0.71 per share in the most recent quarter. While it remains to be seen
how long it will take the firm to reach breakeven levels, we are
optimistic that Catuity will reduce its losses in the coming quarters.
The bottom line is that CTTY has some solid merits as an investment, and
risk-tolerant investors might be wise to consider taking a small
position here.
-----------------------------
Important Note: The above article
was merely a small excerpt from a recent issue we sent to subscribers of
our premium value investing service -- Margin-of-Safety
Investing. In each issue of that newsletter, editors Nathan
Slaughter and Paul Tracy deliver an in-depth look at a variety of other deeply discounted
stocks that should provide investors with a solid margin of safety at
current prices. To receive your copy of our most recent issue of Margin-of-Safety
Investing, as well as other guidance similar to this twice per
month, you'll need to subscribe to this publication. To learn more,
please visit:
https://www.streetauthority.com/subscribe-msi.asp
Thanks for reading!
|
Nathan Slaughter
Editor
Half-Priced Stocks, The ETF Authority
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Investing Doesn't Get Any Easier Than This |
Stock picker Amy
Calistri's strategy is as simple as investing gets -- just one idea
a month designed to make money in today's market. Invest this way
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Go here to learn about Amy's simple investing strategy.
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