Monthly Archives: January 2010

Berkshire Stock Surges After Joining S&P 500

BERKSHIRE HATHAWAY’S CLASS B SHARES have gotten a boost, rising 5 points, or 7%, this morning to 73 after Standard & Poor’s announced late yesterday that it will be finally adding the stock to the S&P 500 index.

Since the news, Wall Street firms have been trying to estimate the amount of Berkshire stock that will need to be purchased by index funds that seek to track the index. There appears to be some debate about the matter, with estimates ranging from 110 to 160 million of Berkshire’s class B shares (ticker: BRKB), which are the ones that will be added to the S&P index. Berkshire’s better-known class A shares (ticker: BRKA), now trading at $109,575, up $7,824, are also up 7% today.

Whatever the total amount of index buying, it’s a lot relative to the recent volume in Berkshire’s class B shares. That accounts for the sharp rise in Berkshire stock this morning. Ultimately, the big question is whether Berkshire shares hold gains following the closing of its purchase of railroad operator Burlington Northern, expected around Feb. 11.

Since the 50-for-one split last week, Berkshire’s class B shares have traded more than five million shares a day. That’s up from the equivalent of one to two million shares prior to the split. S&P had long kept out Berkshire from the S&P because of its low liquidity and concerns that index buying would drive up the share price if Berkshire were added to the index. S&P’s index committee chairman, David Blitzer, said yesterday that with the stock split and higher Berkshire trading volume, liquidity isn’t an issue.

Still, indexers will have to buy a lot of Berkshire stock relative to its recent, elevated trading volume in the next two weeks. S&P didn’t set a specific date for the addition of Berkshire to the index, but it’s likely to occur around the time that the $34 billion Burlington deal closes.

S&P weights companies in the S&P 500 by their public float. That means that Berkshire’s weight will be about 67% of its total outstanding shares, or about 1.05 million class A shares, or 1.6 billion class B shares. That will be about 1.1% of the S&P index. Berkshire has about 1.55 million class A shares outstanding (when the class B stock is converted on an equivalent basis). Each class A share equates to 1,500 B shares. Public float is less than the total Berkshire shares outstanding largely because of CEO Warren Buffett’s sizable holdings.

If indexers own about 10% of the S&P 500, they would need to buy an estimated 160 million Berkshire B shares, which is about $11.6 billion of stock. However, that buying may be offset by Berkshire stock that indexers will receive for their Burlington shares. Indexers may receive 15 million to 20 million Berkshire shares as consideration in the merger.

Berkshire is using a 60%/40 mix of cash and stock. Burlington has about 340 million outstanding shares. Any Berkshire stock received for Burlington would reduce the amount that indexers need to buy. Burlington will leave the S&P when Berkshire is added.

A mild offset to the index buying in the coming days could be selling by arbitragers who hold Burlington stock. The pricing period for the Berkshire stock is due to start today and continue for the next 10 trading days.

The index addition is good news for Berkshire holders because it likely will mean that the company will issue less stock to Burlington holders than it appeared when the deal was announced in late October. Berkshire’s class A shares then traded around $100,000.

Buffett suggested recently in an interview with Bloomberg that Berkshire shares were undervalued and that he wasn’t crazy about using stock in the Burlington deal but had little choice in order to get the deal done.

Berkshire’s fans also think the stock is attractive, now trading for about 1.3 times our estimate of Berkshire’s year-end book value of $84,000 a share.

Berkshire stock could continue to trade higher in the next two weeks ahead of the Burlington closing. The big issue is whether the gains stick after the index buying ends. Berkshire might stay strong because active money managers, who own little Berkshire, will have greater incentive to own it or risk trailing the S&P 500 if Berkshire stock does well. Active managers may decide that Berkshire’s attractive business mix, substantial earnings power and strong balance sheet are too good to ignore. There is little analyst coverage of Berkshire, whose ownership is dominated by individuals.

The index buying of Berkshire could depress the S&P 500 index around the time it is officially added to the index because indexers will have to sell the other 499 stocks in the index to make room for Berkshire. The index selling could total $8 billion or so.

Paul Sonkin Interview

When it comes to investing in the micro-cap and nano-cap world, Paul Sonkin is one of the art’s most succesful investors. In an interview with Value Investor Insight, the manager of Hummingbird Value Funds explains why he’s unlikely to ever move up the market-cap food chain, how he’s set up his own customized research service, why he doesn’t consider himself at all overtaxed in tracking 100 positions at a time. The interview is posted HERE.

 

 

InterOil Corporation (NYSE: IOC): Possible Fraud?

We are adding InterOil Corporation (IOC) as a short to our ValueHuntr Portfolio, with the certainty that the price IOC is currently traded in the market is nowhere near the company’s intrinsic value. We believe that the huge price increase the stock has experienced in recent months is due to over-hyped press releases, which have deceived investors into believing that the company is worth its market value. Notice we are not saying the company is a Ponzi scheme, as Barry Minkow seems to believe (we don’t have information to prove such claim). Simply,  the price is too high considering the company has not found any oil.

Overview

InterOil Corporation engages in the exploration and production of oil and gas properties in Papua New Guinea. The company owns four petroleum prospecting licenses covering approximately 8.7 million net acres, as well as two petroleum retention licenses located in Papua New Guinea. Though the company has produced hundreds of press releases related to their “explorations”, the company has not found a single pint of oil. Despite this, the company is trading at 9X book value, with a market capitalization of $3.5 billion, which is comparable to exploration companies in the region with proven reserves.

Hyped Press Releases

According to Barry Minkow, founder of the Fraud Discovery Institute, the recent 132% increase in IOC stock price is due to hyped/untruthful press releases. An analysis of the company’s recent press releases shows that a clever play on words has the company flying high on the stock market.

A December 1, 2009 press release touted:

“The Antelope field confirms Papua New Guinea as a world class gas resource base in close proximity to the largest and most developed LNG market in the world.”

 InterOil’s December 10, 2009 press release boasted about government approval to construct a liquefied natural gas plant in Papua New Guinea:

“This approval is another major milestone in advancing the monetization and commercialization of our resources we have established at the world class Elk/Antelope fields.”

The truth, however, is that InterOil has “undiscovered resources”, which cannot possibly be assumed to be company assets. Furthermore, calling a field “world class” isn’t the same thing as actually knowing how much of a natural resource exists there. InterOil is capitalizing on the confusion between undiscovered resources (which are unknown quantities) and discovered resources.

Apparently all it takes for management to trick investors into buying up IOC stock is pretending they have officially discovered and certified resources, which the company is not even close to having.

Not only has the company produced over 200 press releases updating investors about the “exploration progress”, but it has somehow managed to get away with extremely vague releases. For instance, the latest press release is 2 sentences long, and reads:

“InterOil Corporation today announced confirmation of indications of oil in the Antelope-2 well in Papua New Guinea.  The Company is continuing to test whether the zone contains commercial quantities of oil and will announce the results of these tests when the evaluation has been completed”.

So it would seem that the company is confirming a finding in their exploration. However, it seems that they are instead confirming that there are “indications” that there may be oil at their drilling site. But then again, if there are no “indications of oil”, why would the company start drilling in the first place?

Possible Earnings Manipulation

We use the Beneish model to evaluate the degree to which earnings of InterOil Corp. have been manipulated.

The Beneish M-Score is a statistical model that uses financial ratios and eight variables to identify whether a company has manipulated its earnings. The variables are constructed from the data in the company’s financial statements.

The eight variables are:

1. DSRI – Days’ sales in receivable index
2. GMI – Gross margin index
3. AQI – Asset quality index
4. SGI – Sales growth index
5. DEPI – Depreciation index
6. SGAI – Sales and general and administrative expenses index
7. LVGI – Leverage index
8. TATA – Total accruals to total assets

Once calculated, the eight variables are combined together to achieve an M-Score for the company. An M-Score of less than -2.22 suggests that the company will not be a manipulator. An M-Score of greater than -2.22 signals that the company is likely to be a manipulator.

With an M-Score of -1.69, our model indicates that InterOil is likely to be a manipulator. Variables with largest M-Score effect are the gross margin index (GMI) and the sales growth index (SGI).

Email Threats

Susuve Laumaea, Senior Manager for Media Relations at InterOil, has sent threatening emails to Barry Minkow, founder of the Fraud Discovery Institute. Among other things, she writes:

 “You are a scum of the earth, a creepy-crawlie who should have been locked away and the key thrown away too so that you rot away like the dung heap you are. You are a coward of the highest order….I can’t use you as crocodile feed because you are too poisonous … those alligators will die eating you, cooked or uncooked.”

The emails can be viewed HERE.

Undisclosed Press Releases

According to the Fraud Discovery Institute, several press releases were never disclosed publicly, which violates SEC regulations. For undisclosed press releases see HERE.

Conclusion

We believe the recent 132% increase in InterOil stock price is completely disconnected from the reality of the business, and without merit. Though nothing is certain, we believe that the probability of price manipulation through vague/untruthful press releases is high. Therefore, we are adding IOC to the ValueHuntr Portfolio as our first short in the portfolio.

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Guest Post: Buy Bowne & Co. (BNE)

By Daniel Kaskawits, CFA ()

Investment Thesis – Bowne’s stock has been beaten down because of the cloudiness around earnings related to recent acquisitions and exacerbated by the slump in capital markets transactions. However, Bowne will benefit from three factors coming out of the economic downturn: 1) a modest and gradual rebound to a normalized environment in capital markets activity (IPO’s and M&A), which is Bowne’s most profitable business; 2) an increase in regulatory disclosure requirements, including the roll-out of XBRL (electronic tagging of financial statements); and 3), inherent operating leverage that will result from Bowne’s substantive cost cutting measures over the past two years, totaling about $100 million annualized.

Founded in 1775, Bowne is the market leading shareholder services firm providing printing, communication and other document services for the transactional, compliance, and corporate and mutual fund reporting requirements of its mostly financial services industry customers. Bowne is generally thought of as a printer, but this is a misunderstanding. Bowne’s sustainable competitive advantage leverages its access to customers and proprietary technologies, via its document creation expertise and end-to-end shareholder services. This will allow the company to evolve with the transition towards electronic distribution and digital content. In fact, Bowne now derives 70% of overall revenue from technology related document management services and just 30% from print.

 Bowne’s shareholder services segment has a very sticky customer base and a significant recurring revenue stream. The business can be thought of in two parts: capital markets transactions, which are highly profitable (but cyclical) and consistent and predictable compliance and investment management products, which are less profitable (GM likely ~25%, though management does not break out). On the transactional side, Bowne maintains its competitive advantage through strong relationships, including law firms and investment banks, which are generally price-inelastic given the time-sensitivity of the work. Indeed, Bowne typically captures about 30-40% of IPO and M&A activity, with the remainder falling to RR Donnelly (RRD), Merrill (private), and other smaller players. Meanwhile, compliance and investment management revenue is steadier, consisting of mostly 10K/Q’s, proxies, and prospectuses. Given the likelihood of increased and more complex disclosure mandates (XBRL, MM Funds required to register with SEC in 2010, potential hedge fund regulation), this segment should grow in the mid-to-high single digits for the foreseeable future.

While an upturn in capital markets activity is important for Bowne, my thesis does not rest solely on this outcome. According to my down-case estimates, Bowne would be able to fill a possible capital markets sink-hole by 2011 with compliance/investment management fees. Attaching a below average EBITDA multiple to this pessimistic scenario would still give the stock near 10% upside by 2011.

Valuation and Free Cash Flow – Bowne is trading at 4.7x my 2010 EBITDA estimate (or just about 6.6x EBITDA-MCX). Over the past 15 years, the stock has traded at a normalized mid-cycle 6.25x multiple. Accordingly, I believe the stock is worth $9.70 and could double over the next 2-3 years. Additionally, my estimate carries a free cash flow yield of nearly 10% on 2010 figures and 13% on 2011 forecast. In my down-case scenario, capital markets revenue would languish over the next two years, with margins staying compressed. This would cause the timing of the story to lengthen as higher compliance fees kick in around 2011/2012. Still, based on a 5x multiple and 2011 pessimistic EBITDA, the stock is worth $7.70 (nearly 10% upside). Plus, capex requirements are minor going forward, given the push towards a digital landscape, which should help keep free cash flow healthy – a meaningful change from Bowne’s operations in the past.

Capital Markets Rebound – For Bowne, there is a range of deals from small boilerplate transactions to large, intricate, and hostile takeovers. The latter are the most lucrative as they often require last minute edits by clients who are insensitive to price, as filing fees represent a tiny fraction of the deal bill. Bowne’s capital markets revenue tracks closely to overall trends in M&A activity and IPO Issuance. While it is difficult to project exactly what the trajectory will be coming out of this financial crisis, it seems safe to say that 2009 should represent the trough. A few factors should benefit the near-term recovery, including ample liquidity fueled by Fed-driven restrained interest rates, a pick-up in IPO issuance as part of the overall deleveraging process and exits from the abundance of private equity deals that occurred in 2006/2007, and a corporate appetite for accretive acquisitions as exploitations from cost-cutting measures become more difficult. In my base-case, I assume that Bowne can book capital markets revenue of $150, $170, and $190 million in 2009-2011, while the down-case accords just $160 and $170 million in 2010 and 2011, respectively. This seems reasonable given a typical mid-cycle run-rate of about $250 million. In addition, near-term estimates may be conservative as IPO issuance has accelerated with 33 deals in 4Q.

XBRL – By 2011, it will be an SEC mandate that all companies electronically tag their filings (via XBRL) – in part, so that investors can export data to excel or click on an item for its definition (similar to Cap IQ or FactSet, albeit with less detail), http://www.sec.gov/spotlight/xbrl.shtml. During the 2Q09 filing period, Bowne completed 126 XBRL filings at a 29% market share, which was ahead of their 25% target. Additionally, XBRL Cloud, an independent organization that runs technical audits of XBRL documents, recognized that Bowne completed the highest number of error-free filings during the period, more than 90% as compared to other providers, with the next being in the low 80’s, followed by a big drop-off. This speaks to Bowne’s competitive edge, which should conservatively drive at least a 25% market share in this space. While filers only need to tag their financial statements in their first year of reporting, in the second year they will also need to complete detailed tagging for all of their notes which is far more complex and not easily automated. Bowne currently charges about $25,000/year for XBRL tagging, but that is likely to increase sharply as the tagging requirements become more exhaustive. Bowne estimates this should create an annual market opportunity of about $200 million by 2012. I estimate that Bowne should be able to capture about $5 million, $20 million, and $40 million in 2009-2011, respectively.

Marketing Communications (MC) – Shareholder services represents about a $2-$3 billion market, while MC is about $15 billion, which offers a nice opportunity for Bowne. Since 2007, Bowne has made three acquisitions to gain share. However, these acquisitions have resulted in hairy earnings reports as integration and restructuring charges have been necessary. As of 2008, MC accounted for 22% ($169 million) of Bowne’s revenues, yet management has commented that margins are currently thin as they have been developing this segment. In fact, gross margins from recent acquisitions were just 14% in 2008, versus over 30% for the rest of the company. Bowne should be able to leverage its infrastructure, spread its utilization of resources more efficiently, and pull from its existing client relationships and competency as an end-to-end service provider. However, this is an extremely competitive and fragmented space and I would like to see more evidence of profitability before suggesting that Bowne can realize significant value from this business. The segment suffered during the recession, losing about 10%-15% (half volume/half discontinued contracts with low-margin customers).

Cost Cutting – Bowne has restructured over the past few years, which should allow the company to realize meaningful operating leverage as capital markets activity rebounds and compliance requirements are extended. Indeed, Bowne states that it has removed about $100 million of annualized expenses since 2007. This includes a 30% headcount reduction, a consolidated real estate footprint from 21 print facilities to 9, increased outsourcing to India, a reengineered work flow, and process automation that will allow the company to take on more work without adding much more on the resource side. Since 4Q07, Bowne has cut its LTM SG&A to $177 million from $242 million. On the 3Q09 conference call, Bowne suggested that about 70% of this relates to the fixed cost base versus more impermanent declines such as salary cuts, overtime, or demand-driven outsourcing. In my base-case, I assume that SG&A cuts will bottom in 2009, then pick up modestly as financial transactions rebound. Specifically, I estimate that for each incremental $1 million in revenue, Bowne will assume an increase of $100,000 in SG&A. COGS savings also were realized, which should help gross margins and Bowne’s revised operating structure should allow it to unlock significant operating leverage as transaction activity moves forward through the cycle.

Balance Sheet Restructured – In August, Bowne completed a secondary equity offering of 12 million common shares, which raised about $72 million. This capital was used to pay down term loans in full and reduce the amount outstanding on the revolver. Bowne reduced total debt to about $35 million from $114 million and from 3.5x LTM EBITDA to 1x. Although the offering was dilutive to existing shareholders, who were understandably displeased, this removes liquidity concerns and financial risk that was an overhang on the stock.

Opportunities – Beyond the near-term horizon, there are future regulatory initiatives, which I have not included in my assumptions, but do provide a margin of safety around revenue and earnings estimates. These include more clarity on XBRL requirements for investment management firms, and disclosure mandates for hedge funds and municipal securities. All of this is difficult to quantify, but would allow Bowne to further leverage its infrastructure.

Risks – 1) I will keep an eye on the trend in restructuring charges (a result of severance and integration costs). Given the evolution of Bowne’s business and the recession, I am willing to give a pass for recent marks, but I would like to witness a pattern towards a more clean report going forward. Bowne has indicated that restructuring will drop to single-digits (millions) by next year, which would be welcomed. 2) A prolonged slump in capital markets activity would suppress the operating leverage that Bowne has built over the past few years. 3) If companies believe that they can tag financial statements in-house (XBRL), the revenue opportunity outlined above may be unattainable.

Ben Graham on Liquidations

Continuing with our discussion of investments in voluntary liquidations, we now review Ben Graham’s writings regarding voluntary liquidations. It is my personal view that to be the best you have to learn from the best (our entire resources section is dedicated to compiling the knowledge of the best investors). To that end, we now post a brief excerpt stemming from a Forbes article by Benjamin Graham during the Great Depression.

Should Rich But Losing Corporations Be Liquidated? (1932)

The stockholders do not have it in their power to make a business profitable, but they do have it in their power to liquidate it. At bottom is not a theoretical questions at all; the issue is both very practical and very pressing.

It is also a highly controversial one. It includes an undoubted conflict of judgment between corporate managements and the stock market, and a probable conflict of interest between corporate managements and their stockholders.

In its simplest terms the question comes down to this: Are these managements wrong or is the market wrong? Are these low prices merely the product of unreasoning fear, or do they convey a stern warning to liquidate while there is yet time?

Directors and stockholders both would recognize that the true value of their stock should under no circumstances be less than the realizable value of the business, which amount in turn would ordinarily be not less than the net quick assets.

They would recognize further that if the business is not worth its realizable value as a going concern it should be wound up. Finally, directors would acknowledge their responsibility to conserve the realizable value of the business against shrinkage and to prevent, as far as is reasonably possible, the establishment of a price level continuously and substantially below the reasonable value.

Hence, instead of viewing with philosophic indifference the collapse of their stock to abysmally low levels, directors would take these declines as a challenge to constructive action. In the first place, they would make every effort to maintain a dividend at least commensurate with the minimum real value of the stock.

For this purpose they would draw freely on accumulated surplus, provided the company’s financial position remained unimpaired. Secondly, they would not hesitate to direct the stockholders’ attention to the existence of minimum liquidating values in excess of the market price, and to assert their confidence in the reality of these values. In the third place, wherever possible, they would aid the stock-holders by returning to them surplus cash capital through retirement of shares pro rata at a fair price.

Finally, they would study carefully the company’s situation and outlook, to make sure that the realizable value of the shares is not likely to suffer a substantial shrinkage. If they find there is danger of serious future loss, they would give earnest and fair-minded consideration to the question whether the stockholders’ interest might not best be served by sale or liquidation.

However forcibly the stock market may be asserting the desirability of liquidation, there are no signs that managements are giving serious consideration to the issue. In fact, the infrequency of voluntary dissolution by companies with diversified ownership may well be a subject of wonder, or of cynicism. In the case of privately owned enterprises, withdrawing from business is an everyday occurrence. But with companies whose stock is widely held, it is the rarest of corporate developments.

Liquidation after insolvency is, of course, more frequent, but the idea of shutting up shop before the sheriff steps in seems repugnant to the canons of Wall Street. One thing can be said for our corporate managements–they are not quitters. Like Josh Billings, who in patriotic zeal stood ready to sacrifice all his wife’s relations on the altar of his county, officials are willing to sacrifice their stockholders’ last dollar to kept he business going.

The conclusion stands out that liquidation is peculiarly an issue for the stockholders. Not only must it be decided by their independent judgment and preference, but in most cases the initiative and pressure to effect liquidation must emanate from stockholders not on the board of directors. In this connection we believe that the recognition of the following principle would be exceedingly helpful:

 The fact that a company’s shares sell persistently below their liquidating value should fairly raise the question whether liquidation is advisable.

 Please note we do not suggest that the low price proves the desirability of liquidation. It merely justifies any stockholder in raising the issue, and entitles his views to respectful attention.”

 Ben Graham’s entire article can be found HERE.

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Seth Klarman on Voluntary Liquidations

Continuing with our discussion of investments in voluntary liquidations, we now highlight Seth Klarman’s methodology for investing in liquidating businesses. The following paragraphs are taken from Margin of Safety, written by Seth Klarman himself.

Market Inefficiencies: Investing in Corporate Liquidations (Chapter 10)

Some troubled companies, lacking viable alternatives, voluntarily liquidate in order to preempt a total wipeout of shareholders’ investments. Other, more interesting corporate liquidations are motivated by tax considerations, persistent stock market undervaluation, or the desire to escape the grasp of a corporate raider. A company involved in only profitable line of business would typically prefer selling out to liquidating because possible double taxation (at the corporate and shareholder level) would be avoided. A company operating in a diverse line of business, however, might find a liquidation or breakup to be the value maximizing alternative, particularly if the liquidation triggers a loss that results in a tax refund. Some of the most attractive corporate liquidations in the past decade have involved the breakup of conglomerates and investment companies.

Most equity investors prefer (or are effectively required) to hold shares in ongoing businesses. Companies in liquidation are the antithesis of the type of investment they want to make. Even some risk arbitrageurs (who have been known to buy just about anything) avoid investing in liquidations, believing the process to be too uncertain or too protracted. Indeed, investing in liquidations is sometimes despairingly referred to as cigar-butt investing, whereby an investor picks up someone else’s discard with a few puffs left on it and smokes it. Needless to say, because other investors disparage and avoid them, corporate liquidations may be particularly attractive opportunities for value investors.

Case Study: City Investing Liquidating Trust

In 1984 shareholders of City Investing Company voted to liquidate. The assets of this conglomerate were diverse, and the most valuable subsidiary, Home Insurance Company, was particularly difficult for investors to appraise. Efforts to sell Home Insurance failed, and it was instead spun off to City Investing shareholders. The remaining assets were put into a newly formed entity called City Investing Liquidating Trust, which became a wonderful investment opportunity.

As shown in Table 2, City Investing Liquidating Trust was a hodgepodge of assets. Few investors had the inclination or stamina to evaluate these assets or the willingness to own them for the duration of liquidation likely to take several years. Thus, while the units were ignored by most potential buyers, they sold in high volume at approximately $3, or substantially below underlying value.

The shares of City Investing Liquidating Trust traded initially at depressed levels for a number of additional reasons. Many disgruntled investors quickly dumped the liquidating trust units to move on to other opportunities. Finally, after the Home Insurance spinoff, City Investing Liquidating Trust was delisted from NYSE. Trading initially only in the over-the-counter pink-sheet market, the units had no ticker symbol. Quotes were unobtainable either online or in most newspapers. This prompted further selling while simultaneously discouraging potential buyers.

The underlying value calculation on Table 2 is deliberately conservative. An important component of the eventual liquidating proceeds, and something investors mostly overlooked (a hidden value), was that City’s investment in the stock of Pace Industries Inc. was at the time almost certainly worth more than the historical cost. The apparent value of City Investing Liquidating Trust units was therefore well above the estimated $5.02 in Table 2, making them an attractive bargain.  Moreover, approximately half of City’s value was comprised of liquid assets and marketable securities, further reducing the risk of a decline in value.

By 1991 investors who purchased City Investing Liquidating Trust at inception had received several liquidating distributions with a comprised value of approximately $9 per unit, or three times the 1985 market price, with much of the value received in the early years of the liquidation process.

Tomorrow, we highlight Benjamin Graham’s opinions on voluntary liquidations.

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Preserving Value: The Case for Voluntary Liquidation

This week we discuss investments in companies undergoing voluntary liquidation.

One of our favorite topics at Valuehuntr, these have typically been among the best performing of the ValueHuntr Portfolio. Opportunities we have highlighted in the past such as SOAP (88% return),  FACT (100% return), and VNDA (1150% return….got lucky on this one), have all been sub-liquidation investments.

A voluntary liquidation is one conducted at shareholder or management discretion, not one forced by creditors or bankruptcy courts. Managers may choose to liquidate make it value-increasing for shareholders. When engaging in such investment strategy we tend to only look at the value of the company’s balance sheet. Our rationale is that if the level of cash that could be extracted from a business through the liquidation of its inventory, property, equipment, etc. is greater than the market value of the company plus its liabilities, then liquidation may create value for shareholders. Because uncertainty of liquidation timing is a major risk, we proceed with liquidation investments only if there is a significant margin of safety between the cash that could be extracted and the company’s commitments, as mentioned above.

However, a 1995 statistical study conducted by Michael Fleming (Federal Reserve Bank of New York) and John Moon (Goldman Sachs), points out that the likelihood of a company’s voluntary liquidation may in fact be a function of several variables not accounted for on a company’s balance sheet. Interestingly, several hypotheses are laid out:

Financial Performance: This hypothesis argues that firms with poor financial performance are more likely to liquidate. Supporting evidence from this hypothesis comes from literature on takeover targets, which have generally been found to have low sales growth and low asset productivity. Therefore, both are predicted to be negatively associated with the probability of liquidation.

Asset Liquidity: This hypothesis argues that firms with more liquid assets are more likely to liquidate. This makes sense, as liquid assets can be sold more easily to other buyers at higher and more competitive prices than illiquid assets. Therefore, liquidity is predicted to be positively correlated with the likelihood of liquidation.

Market-to-Book: Firms with low market-to-book ratios due to high tangibility are generally good liquidation candidates. This is because tangible assets always remain on the books after a purchase, while intangibles may not.

Capital Structure:

Costs of Equity: Several studies conducted by Jensen and Meckling (1976) have shown that as the percentage of insider ownership decreases, management has greater incentive to consume the cash available for shareholder distribution.

Costs of Debt: For firms with no debt, maximizing the value of a firm is equivalent to maximizing the value of a firm’s equity. For firms with debt, however, firm value maximization is no longer equivalent to shareholder value maximization.  If shareholders face a choice between a fixed payoff under liquidation and an uncertain payoff if the firm continues as a going concern, shareholder interests may be served by not liquidating.

Executive Age: Several studies have found that friendly bids are more common when firms are run by founding families, and at these firms, the top executive tends to be older than the average firm. Therefore, the age of a chief executive may be a factor in the likelihood of voluntary liquidation.

Surprisingly, the study concludes that out of all possible variables that could have an effect on voluntary liquidation, only three ratios are significant: cash/assets, debt/assets, and market-to-book. Notice that all variables are balance sheet items. This validates our general strategy of focusing on the company’s balance sheet when looking for opportunities in liquidating businesses.

Moreover, there are other interesting conclusions we can infer from the data:

1)    The number of opportunities in voluntary liquidations increases inversely proportional to general market levels. That is, there liquidations are more likely in bear markets. Although this makes sense, the implications on investment strategy are less intuitive. Because liquidations are more likely in bear markets, investors may be able to insulate their portfolios from bear markets by allocating portions of their portfolio to opportunities in the liquidation space. This is exactly what we observed on March 2009, when the probability of excess market returns through liquidation investments was greatest when market fear was at a peak level.

2)     There is typically more money to be made before a liquidation announcement than after. On average, most candidates for voluntary liquidation returned more than 30% prior to the announcement. After the announcement, investors received roughly 6%. On announcement day, companies announcing voluntary liquidation increased their stock price by 12.5%.

We will continue to look for opportunities within the liquidation space. However, it is unlikely that we will find as many in 2010. It is very likely that no opportunities will be found in the near term, as the market has returned to its normal state relative to the distressed levels of March 2009. However, it is clear that liquidations should be a portion of every investor’s portfolio. These have a low correlation with general market returns, which may allow investors to make money even in bear markets.

Tomorrow, we will highlight Seth Klarman’s views on voluntary liquidations and how he is able to make money on them.

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In solidarity with those affected by the earthquake in Haiti, ValueHuntr.com will be providing a free premium membership, including a subscription to our monthly ValueFocus Newsletter, to readers who donate more than $30 to the ValueHuntr Haiti Relief Fund below. This offer expires Friday,  January 22nd.

If the link does not work,  feel free to donate through the “Donate” button HERE. It is our hope that this will provide an extra incentive for our readers to donate.  We guarantee you that all funds collected will be donated to the Haiti Relief and Development Fund of the Red Cross (we will send receipt to donors as proof). If you wish to skip Valuehuntr and donate directly, then we encourage you to do so HERE.

Tickets to Value Investing Congress for ValueHuntr Readers

Today we are excited to announce that readers of Valuehuntr will be able to receive a steep exclusive discount for the Value Investing Congress taking place on May 4 & 5, 2010 at the Langham Huntington Hotel & Spa in Pasadena, CA. If you want to hear from some of the best hedge fund managers in the game, then this is the conference to attend. Not to mention, it’s a fabulous networking event and place to acquire wisdom to profit in this irrational market. But over 50% of all seats are already reserved, so readers must act fast.

If you’re unfamiliar with the Value Investing Congress, then here’s what you need to know: One good investment idea could more than pay your cost of admission to this event and net you some great returns. The wisdom gained from listening to these great investors is truly priceless. For a slide show of last year’s event see HERE.

Speakers at the two day event include many of the prominent players we track here on the site on a daily basis. Here is the list of confirmed speakers (more to be announced later) include:

John Burbank, Passport Capital

Patrick Degorce, Thélème Partners

Bruce Berkowitz, Fairholme Capital Management

Eric Sprott, Sprott Asset Management

Paul Sonkin, Hummingbird Value Funds

Mohnish Pabrai, Pabrai Investment Funds

Thomas Russo, Gardner, Russo & Gardner

Lloyd Khaner, Khaner Capital

J. Carlo Cannell, Cannell Capital

Whitney Tilson & Glenn Tongue, T2

Click here to receive the over 30% discount to VIC

You must use discount code: P10VH1 to receive the full discount. Hurry and register because this discount expires on January 21st, 2010!

You’ve got exactly one week to get signed up with these savings. If you work for a firm, get approval to go and have your company foot the bill since this is one of the premier conferences out there. If you’re an individual, we can truly say that the cost of admission is worth every penny.

The regular price of the two day event is $4,295. However, Valuehuntr readers pay only $2,795. That’s over a 30% discount and savings of $1,500!  If you’re from out of town, the Congress has also negotiated lower room rates at the Langham Huntington for attendees.

It’s going to be an awesome and insightful event, to say the least. Make sure you get our exclusive discount for the Value Investing Congress here. Remember that you MUST use the discount code P10VH1 to receive the full discount!

Please let us know if you have any questions or problems when trying to register with the discount code.