Monthly Archives: March 2009

Selling is Harder than Buying: A Comment on XTNT

Value investing takes discipline. A buying strategy for most value investors is simply buying a company at prices significantly below the intrinsic value, or the fair value the business would sell to a rational buyer. A lot of the companies that we explore are not only usually trading significantly below intrinsic value, but are also secondary stocks that have usually been left for dead in the market. So buying is easy as long as there are enough companies that qualify our criteria.

 

However, the difficult part comes in selling. When is it right to sell? Do we sell when the gap between value and price has closed, or do we adjust the value of the company based on improved expectations as perceived by the general market? At ValueHuntr, we prefer the first, except when the underlying fundamentals of the business may justify an adjustment to our estimated intrinsic value, such as in the case of winning litigation, federal tax refunds, etc. So the positive side of this discipline is that we, as rational buyers, know at all times that we sell the business when value has been realized. On a negative note, there is no natural law that prevents the company’s stock to continue climbing only because the gap estimated value and price has been closed. This is exactly what happened with our position in XTNT, which we closed on March 25, 2009 for a 77% return after only two weeks of having added the company to our ValueHuntr Portfolio.

 

We added XTNT to our portfolio because the company was trading below liquidation value, and the company had engaged Piper Jaffray & Co. to help the company pursue strategic alternatives which may include the sale of some or all of the company’s assets or other types of merger or acquisition transactions intended to maximize shareholder value. We estimated that the company was worth no more than $15M at liquidation. At eh time, the company was selling for $9M, so as long as the company traded below its liquidation value, chances were that we would still be able to realize some gains in the near term. Two weeks later the company was trading at $17M, and we decided to close our position.

 

Five days after we closed our position, XTNT is now a $33M company, so its value has doubled since we close our position five days ago. Though we believe the company does not deserve to be trading higher than its net asset value because of its poor earnings prospects, the company is now trading at 1.3X book value. We would have loved to have realized this additional 100% growth in market value that occurred after we closed our position, it is also clear that XTNT’s underlying fundamentals are not consistent with the company’s current price of $1.45/share. Do we wish we kept XTNT for longer? Yes. But keeping the position meant going beyond, if not disengaging, our discipline of paying bargain prices for neglected, secondary businesses. Overall, we prefer to sell early than to buy late, so we are happy with our 77% gain.

 

 

xtnt_missed

Trident Microsystems Inc. (NASDAQ:TRID)

We are adding Trident Microsystems to our ValueHuntr Portfolio. TRID is a company whose stock is trading substantially below its net-cash value. According to its latest SEC filing the company held nearly $212M in cash with $56M in total liabilities, for a net-cash value of $156M as of December 31, 2008.  However, TRID’s market price is only $95M, nearly a 60% discount to its net cash.

 

About

TRID is a leader in integrated circuits for Digital Television. While its products are used in all kinds of displays, LCD television is its most important growth market as LCD televisions take share from plasma in the market for larger screens as well as traditional CRT television sets of all sizes. Additionally, TRID designs, develops, and markets integrated circuits (ICs) and associated software for digital media applications, such as digital television (digital TV) and digital set-top boxes (STB). The company also designs cross-platform software that allows multimedia applications to run on devices in the digital living room, including digital STBs and digital TV sets.

 

Valuation

TRID is a net cash stock that always traded above its net asset value until this year. The company follows the typical case in Wall Street where analysts tend to emphasize earnings prospects and neglect the underlying value of assets. Once Wall Street realizes that positive earning prospects are no longer sustainable, the stock is sold off on the basis of poor earnings alone. This would never happen in the private market, where businesses tend to sale at a value equal to at least their net assets, plus a premium for earnings prospects for those which are profitable.

 trid_drop

 

 On its last earnings call, TRID reported net revenues of $19.2 million for the second quarter fiscal year 2009 representing a quarterly sequential decline of 45% compared with $34.8 million reported in the September 2008 quarter and a year-over-year decrease of 74% from the $75 million recorded in the same quarter of the prior year. Revenues from their top three customers represented 67% of total revenues in the second quarter. Revenues from the largest customer, headquartered in Japan, decreased by 63% from the prior quarter and represented 34% of total revenues. Amazingly, not a single analyst asked management about the company’s cash position and what their intentions are with this cash.

For the sake of conservatism, we value TRID based its cash at hand alone, assuming all other assets such as PPE and intangibles are worthless. Our analysis indicates TRID is currently trading at 60% below its net cash value, even all long-term assets are assumed to hold no value.

 trid_balance

Catalyst

Spencer Capital Management LLC, a New York-based investment partnership, announced on March 2, 2009 its intention to put forth a slate of candidates for election to the company’s board. We believe Spencer Capital will be able to realize some shareholder value in the near future. Spencer Capital is a New York-based fund advisor that specializes in deep value investing and is headed by Kenneth H. Shubin Stein, whose ascent to value investing has been nothing but ordinary.

In 2000 he founded Kenshu, LLC, the predecessor to the Spencer Capital Opportunity Fund, LP, which was formed in 2003. From 2001 to 2003 Dr. Shubin Stein managed Kenshu, LLC while also working as a portfolio manager for Promethean Investment Group, LLC. He joined Promethean after completing his internship in orthopedic medicine at Mount Sinai Medical Center in New York. Before his internship, he cofounded and managed Compo Asset Management, LLC, a U.S. based value investment partnership which was merged into Promethean. Prior to founding Compo, Dr. Shubin Stein was a medical technology analyst for The Abernathy Group in New York, an investment management firm specializing in the medical and technology sectors. Dr. Shubin Stein is a graduate of the Albert Einstein College of Medicine where he completed a 5-year medical and research program with a focus on molecular genetics. He graduated with a B.A. degree from Columbia College in 1991 with dual concentrations in Premedical Studies and Political Science. Dr. Shubin Stein holds the CFA designation and teaches an advanced investment research course to second year students at Columbia Business School.

In connection with their intended proxy solicitation, Spencer Capital Management, LLC and certain of its affiliates intend to file a proxy statement with the SEC to solicit TRID’s stockholders.

 

Conclusion

We have added TRID to the ValueHuntr Portfolio because it is trading significantly below its net-cash value, and we believe Spencer Capital, a fund that focuses on deep value investing, will be a catalyst to close this gap and thus increase shareholder value. With an estimated cash burn of $6-7 million per quarter, TRID’s net cash would stand at nearly $2.1/share at the end of 2009. We estimate the company is worth at least $2.54/share based on its cash alone compared to a current market price of $1.53/share.

 

Disclosure:  We do not have an actual holding in TRID. This is neither a recommendation to buy nor sell any securities]

Whitney Tilson Event

Whitney Tilson, noted value investor and manager of T2 Partners gave a presentation at the Harvard Club of New York today at 7:00 pm. In the presentation, Tilson presented his latest research on the state of the credit crisis. We attended the event, and have posted the presentation for our readers.

The full presentation can be found here.

On Risk Management and a Flawed Investment Theory

 According to modern investment theory, diversification is a central feature to proper investment strategy. The theory holds that it is possible to diversify away the risks of holding securities by spreading this risk among many uncorrelated holdings. It’s a theory that has been widely followed, but one that has been tested by the recent financial meltdown in which stocks, bonds, commodities and real estate have all dropped in unison.

 

For most investors, the risk they take when they buy a stock is that the return will be lower than expected. In other words, “risk” is theoretically the standard deviation from the average return. Hence, diversification is not necessarily a way to reduce risk, but rather to lower volatility. We explore the flaws in this theory through two thought experiments.

 

Our first thought experiment consists of two investors with widely different portfolios. Investor A is aware of modern investment theory and is sure he can lower his investment risk by holding 3 uncorrelated investments: a real estate property, a stock, and a bond certificate. On the other side, investor B has decided to invest only in 3 real estate properties. Which investor has the riskier portfolio?

 

According to modern investment theory, investor A is more diversified, and therefore holds the less risky portfolio because his deviation from average return would ultimately be lower than the more correlated portfolio of investor B. This may be true, but let’s now imagine the portfolios look as follows:

 

Investor A

 

1. A stock whose company has no competitive advantage

2. A real estate property currently under water

3. Bonds of a company which cannot meet its future obligations

 

Investor B

 

1. Three real estate properties below fair value

 

Now that the content of each portfolio is known, I would argue, as most sane investors would, that the probability of permanent loss are higher in investor A’s portfolio. Thus, investor B’s portfolio is less risky.

 

This is the obvious flaw that haunts the diversification strategy most funds employ today, where holding hundreds (and sometimes thousands) of positions is considered less risky than concentration regardless of the fundamentals of each individual investment.

 

Unfortunately, these misguided definitions of diversification and risk are also employed in hedging strategies. For example, funds employing the so called “market-neutral” strategy aim to decrease risk by maintaining a balance between long and short positions. Though these funds may be better immunized from wild market volatility, this does not mean that the probability of capital loss is lower than any other strategies. In fact, the “a market neutral” strategy is used not to decrease investment risk, but rather to minimize redemptions, since investors are more likely to pull their money out of these funds when volatility is greater.

 

This takes us to our second thought experiment. Consider a portfolio that holds two stocks: one that pays off when it rains and another that pays off when it doesn’t rain. A portfolio that contains both assets will always pay off, regardless of whether it rains or shines. But the payoff in either case will always be 50% lower than the return we would realize on rainy days by concentrating on stocks that pay off only when it rains, and so on for shiny days. This thought experiment indicates that volatility is reduced, but above-average returns are more difficult to obtain. Many investors fall into this trap.

 

Since value investors tend to reject modern investment theory, it is not surprising that many also refuse to diversify. So how should value investors manage risk?

 

1.                 Forget about volatility

 

Volatility is not risk. In fact, volatility is what allows value investors to purchase companies at bargain prices. Unless you are a hedge fund trying to keep investors by making the market rides easier on their stomachs, volatility is not where your focus should be.

 

2.                 Don’t swing at every pitch

 

The standard response of value investors regarding diversification has been best expressed by Warren Buffett in his frequently cited baseball analogy. Buffett argues that great hitters such as Ted Williams were able to achieve high batting averages because they swung only to the pitches they were sure they could hit. Ted Williams stated:

 

My first rule of hitting was to get a good ball to hit. I learned down to percentage points where those good balls were. The box shows my particular preferences, from what I considered my “happy zone” – where I could hit .400 or better – to the low outside corner – where the most I could hope to bat was .230. Only when the situation demands it should a hitter go for the low-percentage pitch.

 

williams-zone

 

 

Similarly, investors are more likely to invest successfully only in situations where the probability of return is high. This may mean investing only within a circle of competence (investing in understandable companies), staying on the sidelines during bullish times, and purchasing heavily during periods of uncertainty.

Those who invest in hundreds of opportunities at a time, as most funds do, are bound to be obtain returns almost identical to the general market. In this case, investors may be better served by simply buying the S&P500 index.

 

3.                 Place bets according to odds

 

It has been mathematically proven that the best gamblers are those who bet heavily when the odds are in their favor, and who stay on the sidelines when the odds are against them. Similarly, value investors tend to bet according to the likelihood of a positive outcome. In probability theory, the Kelly criterion is used to obtain the optimize size of a series of bets.  In the simplest cases, it can be shown that the size of each bet or investment is proportional to the difference between the probability of winning and that of losing. For example, if an investment has a 60% chance of success – or 40% chance of failure – the size of the optimum bet should be 60%-40%, or 20% of the total portfolio.

 

4.                 Remain pessimistic: challenge own judgement

 

So how do value investors evaluate the probability of success for their investments? They tend to do so by continually focusing on what can go wrong with an investment rather than what can go right. Focusing on the negative prospects of each investment serves as a check in situations where the prevailing market sentiment is irrational (tech bubble, credit bubble, etc.)

 

 

Update on Alliance Semiconductor (OTC: ALSC.PK)

This morning we had a conversation with Mike Gullard, acting CEO of Alliance Semiconductor, in an effort to get some clarity regarding Alliance’s balance sheet, particularly the status of nearly $60M in short-term investments reported as of December 31, 2008. As we mentioned on our first post, ALSC, has halted all operations and the Board of Directors has decided to return all remaining cash and cash equivalents to shareholders.

 

Mr. Gullard indicated that all of $60M in short-term investments reported in the latest balance sheet are in the form of Ambac preferred shares which have no market at the moment. Although the investments are illiquid, they are paying interest every quarter. According to Mr. Gullard, these cash inflows from interest are the source of the $0.02 special dividends ALSC has been paying out every quarter, and he expects ALSC will periodically return these interest payments to shareholders as long as these are received. The dividends from Ambac preferred amount to nearly $2.5M a year. Moreover, he indicated that the directors have taken an 85% cut in fees, and that all cash accumulated from these reductions in management expenses will go directly to shareholders.

 

We also asked Mr. Gullard whether or not the company is following proper accounting practices in considering $60M in Ambac preferred as “short-term” investments when there is currently no market for it. His response was that the company’s practices are consistent with GAAP, because there is a possibility that the auction-rate securities could be monetized within a one year period, but that there is really no way of knowing that with certainty. He pointed out that if it becomes clear that these investments cannot be realized within a year, then they will be carried as “long-term” investments in the books (the company is no longer required to report to the SEC).

 

Regarding the fair value of these auction rate securities, Mr. Gullard said future impairments are likely, but that is impossible to know whether they are still worth $60M. So clearly, ALSC is not what it appears to be at first sight, as Sivaram pointed out. But based on the current market price of ALSC, even if these securities are worth only 13 cents on the dollar we would still be breaking even in our investment. In addition, we will be receiving nearly $600K in dividend payments every quarter (8% per quarter) so we believe that the probability of gain in our ALSC investment is higher than the probability of loss.

Value Investing Collection

Our electronic collection of rare value investing articles, lectures, videos, and books is now open to the public. All the scanning and copying was paid for by your small donations. Visit our resources section to access the collection, and help us grow it.
 

 

Ben Graham’s Lectures on Valuation Techniques

We were recently able to obtain copies of some of Ben Graham’s original lectures (dated 1932 to 1947) while he was teaching at Columbia University, and we thought we would share some common themes among them.

 

According to Graham, analysts who value companies based upon the capitalization of its earning power must make certain adjustments for the asset picture. However, asset valuation is more reliable than earnings-based valuation because the assets tend to move slower than earnings.

 

In general, Graham points out that if the earning power value exceeds the asset value, the value of the business should be marked upwards, but that some reduction should be made based on its assets. He suggests that to value these cases conservatively, analysts should take off a quarter of the difference between earning power value and asset value. The other case is that the asset value exceeds the earnings power value. For this case, companies should not be valued upwards because the assets have no earnings-generating potential, with the exception of cases where working capital exceeds earnings power. From experience, Graham points out that when this exception is validated, the analyst should add half the difference between earnings power value and working capital to correct for the eventual impact of this excess working capital on the business once it is put to work.

 

Additionally, Graham explains the two fundamental approaches that analysts may use to pursue the valuation of securities. These are:

 

1)     The conventional – that is based primarily on quality and prospects.

2)     The penetrating one – that is based on value.

 

 

graham_text

 

 

 

 

 

 

 

Lastly, Graham insists that analysts should stay away from the game of expectations – the idea that because the prospects of a company are good then the company should be bought. He is most skeptical of this frequent Wall St. activity because “it tends to be the most popular form of passing the time for security analysts”. Graham stresses throghout the lectures that this behavior is naïve, at best.

 

More of these documents can be found in our resources section. To support the collection and publication of our library of documents, go here.

 

 

 

XTNT position realized after 77% gain

On March 13, 2009 we wrote an article about XTENT Inc. where we explained our reasons for adding the $10M company to our ValueHunter Portfolio. At the time, we estimated the company’s intrinsic value to be nearly $15M at liquidation. However, two weeks later, XTNT is now trading at nearly $17M market cap, which is $2M above our estimate of intrinsic value. Because XTNT has no revenues and is now overpriced based on our estimates for liquidation value, we are terminating the XTNT position. As of today, XTNT is no longer in the ValueHuntr Portfolio.

 

We did not intend to hold the stock for such a short amount of time, but it is clear that we have now realized as much value as we intended. The company is now trading 12% above our estimate for liquidation value.

Alliance Semiconductor Corporation (OTC: ALSC.PK)

At a market value of $8.3M, the company is currently trading at an 86% discount to the net cash assets the company carried on its books as of December 31, 2008. The latest balance sheet indicates that the company is holds nearly $60M in cash equivalents and short-term investments. The company’s shares are traded over the counter, so its financial situation is not widely followed by Wall Street.

 

It is our view that the company’s intrinsic value is equal to at least its net cash value, or $1.82/share compared to its current market value of $0.25/share,  so ALSC.PK is being added to our ValueHuntr Portfolio.

 

About ALSC.PK

 

Alliance Semiconductor Corporation was originally in the business of designing and manufacturing memory and memory-intensive logic. Its product lines included Static Random Access Memory (SRAM), Pseudo SRAM (PSRAM), Dynamic Random Access Memory (DRAM), Flash Memory, and embedded memory and logic solutions. For a little while they also sold some video chipsets for PCs. However, since 2005 Alliance Semiconductor has made a significant transition from being an operating company focused on the semiconductor industry with synergistic investments in emerging companies into a holding company. In the wake of mounting losses, ALSC sold all its 3 business units (memory, mixed signal, and system).

 

In early 2006, as the result of a proxy contest, large Alliance shareholder Riley Investment Management effectively took control of the then money-losing and mismanaged company and installed Melvin Keating as CEO. Under Keating, ALSC has spent the past few years divesting assets and reducing expenses. After accumulating a sizeable cash hoard through a series of asset sales, Alliance has returned value to shareholders over the past year through a series of special cash dividends. Since July of 2007, ALSC has returned a total of $4.37 a share in cash dividends to shareholders.

 

 

Valuation

 

We estimate that ALSC’s intrinsic value at liquidation to be nearly 600% greater than the current market value, excluding costs associated with the dissolution and liquidation of the company’s assets. The company has no long-term liabilities, and minimum near-term commitments to fulfill. Additionally, nearly all of ALSC’s current assets are in the form of cash or short-term investments.  

 

 

alcs_balance

 

Catalyst

 

On September 3, 2008 Alliance Semiconductor Corporation issued a press release announcing that its Board of Directors has determined to begin proceedings to dissolve the corporation. Melvin Keating, President and CEO, noted that the company has for some time been considering whether to re-invest in another business or to liquidate and distribute its net assets to shareholders. Mr. Keating noted that the amount and timing of additional distributions to shareholders is uncertain, especially because the company’s holding of auction rate certificates will need to be monetized in an orderly manner. Bryant Riley, Alliance’s chairman, noted that since the new board took office, Alliance had sold its operating businesses and its venture capital portfolio, and had liquidated its holdings in two publicly traded semiconductor companies. To conserve cash and reduce costs, Alliance has substantially reduced its staff and the amount of office space it leases.

 

 

Conclusion

 

Alliance Semiconductors is a stock traded over the counter, so it has been widely neglected by Wall Street and the general market. Given that the company has already decided to pursue liquidation and has taken the right steps to preserve cash, we believe this is a rare opportunity where substantial returns and a high probability of realization are both present. We estimate that the company’s value at liquidation ($1.82/share) is at least 600% than the current market value of $0.25/share. ALCS has been added to our ValueHuntr Portfolio.

 

 

[Full Disclosure:  We do not have a holding in ALSC.PK. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. Do your own research before investing in any security.]

 

Martin J. Whitman: Profile of a Value Investor

Today we profile Martin J. Whitman, the legendary veteran value investor who founded and still manages Third Avenue Value Funds. The profile includes a summary of the value strategy Mr.Whitman has followed for nearly half a century.