Investors behave in very human ways. They look in the rear-view mirror and continue to believe that if a sector did well in the past that is way it will in the immediate future. In bull markets investors pile into the popular stocks as the trend gains steam and they disregard the unpopular stocks that didn’t perform well in the past regardless of how the companies are fundamentally performing. As bear markets develop it’s not unusual to see investors continue to focus on the leaders of the last bull market and miss the new leaders. But this is one of the greatest opportunities for savvy investors, this is the chance to find the new leaders when they are still cheap.
What may have once been boring will likely soon become beautiful in the new bull market.
Other Stuff
Earning season is upon us and most of the earnings surprises seem to be coming from those boring companies I talked about earlier. By the end of November many of the stocks we follow will have announced their financial results. We will report as we can and hopefully along the way find some new stocks based on strong financials. We’ll also be putting together another list similar to the Cheapies with a Chance lists, once we have all the quarterly reports reviewed.
Inventronics’ (IVX.V) shareholders should have received their dividends by now. I’ll be looking to put my dividend to good work back into the market. I love to reinvest cash.
Ceapro (CZO.V) released an important bit of news yesterday. We are busy trying to schedule a call with management to fully understand the impact of this news. We believe it is materially positive for the company and view the stock as a strong buy on any dips below the year high of $0.82.
I added a few more shares of Bri-Chem (BRY.T) last week at $0.70. The strong results from the energy drillers leads me to expect that suppliers of fluids and chemicals such as Bri-Chem will show strong results in support of these drillers. I continue to prefer playing the energy bull market by owning shares of small energy service companies over producers although it looks like the whole sector should continue to perform well over the next few years. I believe there is significant leverage among the small energy service companies.
On this past week’s Free-For-All we got into discussing one of the processes I use to build conviction in my major holdings. It’s a method of finding and ultimately determining how strong an opportunity a company could be from a purely fundamental value basis. It’s a method that is used in private equity purchases, usually how private equity groups buy companies. It’s an exercise to see if it makes sense to buy the whole company. Sometimes companies are so cheap that, under the right circumstances, you could buy the company with “no money down”. I hope you can watch this Free-For-All.
The basics revolve around how cheap the company is trading relative to the net assets of the business and the free cash flow from the company. What if your friendly neighborhood banker was willing to give you a loan. Does it make sense to buy the business? This is done everyday in the real world. Private transaction, where business are bought and sold use a somewhat, albeit more complex, formula.
Does the company generate enough free cash flow to pay for the interest (and principle) of the loan needed to buy 100% of the company? If the answer is yes then you likely have an extremely compelling opportunity. And while it’s unlikely you may ever buy a whole company using this approach to buy a few shares may make just as much financial sense.
When markets get as unsettled as they are right now many stocks become mispriced to their long-term underlying value. Some companies share prices are determined by a small number of shareholders who are actively selling their shares. They may be selling for a number of reasons completely unrelated to the company, whether it’s for personal financial reasons, a margin call somewhere else, a better investment opportunity or simply out of fear. It makes for opportunities that the savvy investor can take advantage of.
I’ve discussed many times how the current market turmoil has driven investors away from microcaps. It’s times like these that bring about the kind of opportunities where real deep pocketed investors start salivating because of the valuations that not only increase the potential upside of some of these stocks, but they also provide significantly larger margins of safety when buying.
The company we decided to look at is one of our past “Cheapies with a Chance” companies, IBEX Technology Inc (IBT.V). For disclosure purposes I own 40,000 shares of IBT.V.
IBEX manufactures and markets proteins for biomedical use through its wholly owned subsidiary IBEX Pharmaceuticals Inc. IBEX Pharmaceuticals also manufactures and markets a series of arthritis assays, which are widely used in osteoarthritis research.
IBT.V closed on Friday at $0.56. It has 24,823,244 million shares outstanding and 26,438,244 on a fully diluted basis, for simplicity’s sake I will not bother using the fully diluted number of shares. Let’s round the number outstanding up to 25 million. This gives us a market cap of $14 million. Keep in mind we are doing this as a simple exercise, so I want to keep the math as simple as possible.
Now let’s look at the balance sheet to see what assets and liabilities we get with the business. Looking at their 3rd quarter report we see that the company has $12,113,273 in total assets. The company reported $7,957,732 in current assets, $6,959,626 of which is cash. Total liabilities are $2,404,703. Subtracting total liabilities from total assets we get a book value of $9,708,570.
Two things stand out immediately when I look at the balance sheet. One is the large amount of cash relative to the liabilities and second is the large shareholder deficit of $43,945,685. This deficit likely means the company will not be taxable for quite some time or at the least will be able to shelter a good deal of income tax over time. This can be a big bonus.
Ok, so now that we have established a few things from the balance sheet let’s now look at the income statement to determine how profitable the company is and more importantly how much cash will be available to pay the interest payments we would have if we bought the whole company or what the rate of return would be if we had all the cash we needed for the purchase. Remember the market cap is $14 million. This is in essence the current asking price for the business.
Looking at the income statement we see that the company generated approximately $7,183,000 in revenue over the past 12 months ending April 30. It generated earnings of $1,669,000 and ebitda of $2,289,000. At the current market cap of $14 million we get a PE of 8.4 and a price to ebitda of 6.1. The company generated net cash of $2,748,916.
If we had spare cash of $14 million laying around and used it to purchase this business, we would have a pre-tax cash return of 19.6%. But what if we were able to borrow the $14 million? With rising interest rates, the cost of debt is getting more expensive and the interest rate would be higher than it was 6 months ago but let’s assume we could get financing at 10%, our annual interest cost would be $1.4 million (which would be tax deductible). We would still end up with net cash of approximately $1.35 million. But what if we used the existing cash that is in the business, remember the $6,959,626 in cash? Theoretically once we own the whole business that cash is ours to do with as we please. If we use all the cash, then it brings the purchase price down from $14 million to almost $7 million. This changes the cash return on our purchase price from 19.6% to 39.3%. In the scenario where we borrowed the purchase price (net purchase price is $7 million after using the existing cash to pay down the purchase) it would cut our interest in half resulting in net cash before tax of just over $2 million.
You could buy the business for $14 million, use the $7 million in cash to pay for part of the purchase and end up with a net $7 million out of pocket cost. Borrowing $7 million at even 10% would cost $700,000 per year resulting in a yearly pre tax profit of roughly $1.6 million (ebitda – interest payments).
The result is that IBT.V looks very cheap almost no matter how you purchase it. After going through this exercise, I’ve moved the stock up my buy list and will look to reach out to management for an update to see if I need to consider any items before adding to my position. There are a number of stocks that pass this test. If they can maintain similar revenues and earnings these stocks look remarkably cheap. Of course, a recession and slowing of business would have an impact but so many of these companies are trading with a significant margin of safety that it may still make sense to own them even if we do see an economic slowdown. We are sharpening our pencils and will be doing a lot more of these little buy out exercises. Stay tuned.
Before I go, I thought I would point out this chart. This is a chart of Hostess Brands, makers of the infamous Twinkie. While everyone seemed to be trying to figure out what direction the markets were heading, where interest rates would go or maybe the price of oil, shareholders of the Twinkie maker just sat back and enjoyed a heck of a nice ride. I don’t recall any financial commentators pounding the table on TWNK. Goes to show that boring (and fattening) can be beautiful.
