Previous DUH Investing Case Study: TMPL  

TMPL – Template SoftwareI think this company had a lot more potential as a business and as an investment, but I still more than doubled my money in a little over a year on it. The company had a unique way of constructing software, with the use of Templates for various vertical market industries. As a software engineer I was impressed, and as an investor I was even more impressed with its growth rates. So I started buying this little Gem of a stock in late ’98, first a little at $12, a little more at $9, a lot more at $6, and later a large truck load around $3.5. With the bulk of my investment around $3.5, and a cost average around $6.

Many traders would think I was nuts for continuing to buy a falling stock, but I managed to more than double my money in a year on it, because it was bought out, at around $14. I must admit to having the last laugh, because I don’t even consider the money to be at risk during the whole time. A trader’s capital is always at risk. An inefficient market investor never really has capital at risk, because value is backing it.

Why?

When I first bought TMPL, it was growing quickly. I didn’t buy much because all though it was fairly “cheap” to its growth prospects, it wasn’t DUH priced yet. The company had a slight miss in sales, and it hit $9. No big deal, it was a one time deal, and if you understand this type of company it was fairly reasonable. Then the Asian crisis starting happening, and just about every small and micro cap in the US towards the end of ’98 was falling like a MIR space station out of the sky. They were all doing it. Overpriced, under priced, fall one, fall all. 

The silliest day I observed was when TMPL went down around 20%, and the company announced a deal that would add 25% more in sales next year. If you knew anything about the company, you could see it would add a lot to the bottom line too. I thought to myself, certainly it will fly soon. Nope it just kept falling. I was watching the stupidest herd movement of money in my life. Here is a company that was already growing and profitable and trading under its tangible assets and just announced a deal which should have telegraphed to anyone with a live pulse and a mild brain turned on, “Hey, I am going to make at least 25% more next year, on top of high growth that I am currently doing.” Now, if the stock had already been up and pulled back some that would just mean the news had leaked. Not in this case. It kept going straight down. I made jokes to my investing buddies, well good thing they didn’t announce only a 20% increase in sales!

On down it went to a low around $3.5 a share. Book value was $6, so I bought some as it went down. The company had $3.5/cash, so when it hit this price, I went crazy. I had found DUH. To this day, I wish I owned more, and I had some cash available, but I do limit myself to how much of any one stock I will buy, so I at least have some diversification.

Don’t let any trader style investor tell you can’t make money averaging down, or that it isn’t a winning strategy. If you are doing it for value reasons, and the stock is sitting at DUH, buy. Why does this work? First at $12 and $9, I was buying a growing company, at a reasonable price, then at $6 I was buying a company with great growth prospects for its breakup price, then at $3.5 I was buying a growth company for its cash in the till, and getting its buildings, Accounts Receivables, software code, goodwill, and other assets for free! As well, I was buying a growth company for free! DUH DUH DUH DUH I would keep going, but I believe I made my point. Oh what the heck how about another one. DUH There I got it out of my system. It doesn’t get any dumber than this.

Many trader style investors would say, sell at a loss along the way. Try to find the bottom and then buy when it turns around. Sounds good, but how do you find a bottom, when people are giving their assets away for free, and increasing the rate of giving it away for free? How do you know when they will stop throwing their money into your pockets? Demanding you make them poor? I am sure many an institution and individual investor was selling right all the way down to $3.5, because they were paying attention to price movements rather than value. Thanks. I now have added their retirement to mine. 

Remember this only works when the price of the stock is worth a lot less than its assets, and those assets have a useful and profitable use. This is not the same as buying Yahoo at some silly $200/share and watching it fall to a still over valued $30/share. When and if Yahoo gets down to $5/share, I will be buying. 

GAAP Error

  A stock picking theory, I have coined GAAP Error, is my favorite. It is however the hardest and most time consuming and rarest of finds. It is also had the profoundest of effects on my net worth.

GAAP – Generally Accepted Accounting Principles. These are huge volumes of rules that define how to account for a companies assets, liabilities, and earnings. Every time you see (EPS) Earnings Per Share, GAAP rules were used to calculate it. GAAP is generally accurate, fair, and allows you to take EPS mostly at face value, without thinking about it too much. Because all companies follow GAAP, IBM’s EPS number can be compared to Fords, and vice versa.

However, there are some times where a company and what it is doing in the course of business where GAAP doesn’t show the right investing picture. These businesses are usually not “normal” businesses. GAAP usually works smashingly well for manufacturing, distribution, and most cash orientated service businesses. It even usually does a good job on most other companies. 

The trick is to find a company that must report its earnings way lower than they really are because they must follow GAAP, and the market has reacted to this “bad” news, when in reality, the company is smoking.

Previous Investment Case study: GAAP Error - CANI

CANI is a consulting and systems company that specializes in the banking industry. CANI had been growing quite quickly, but their management realized they could make even more money if they changed the way they did their pricing. In the past they charged bank clients by the hour or for their software as they sold it. This made their sales cycle longer, and it was harder to convince the banks to buy their products, because they had to pay for it upfront. Instead, the management of CANI decided to switch over to providing the banks their products for a percentage of the money their products would save the banks, and a percentage of the revenue the banks would make off of using CANI’s products. The deals CANI were able to negotiate with the banks were a lot more profitable in general, and way more profitable in the future. As well, they could secure even more work, because the banks looked at the deals as if CANI were doing “free” work for them.

However, because CANI’s software and systems took investment up front from CANI, as CANI rolled into banks they had to expense all of their consultant’s time, while at the same time they didn’t get any pay back until up to a year later.

What this did for the company’s financials is put a giant lag on earnings for a while. Where CANI used to sell a software system and get the revenue immediately they now had to wait. As well they were growing and installing more and more systems, so expenses increased. Well, with lower revenue and higher expenses, this means a lot less profit according to GAAP. Only problem is they were really making a lot more money, but GAAP has no way to account for it! CANI was taking Cash from its accounts and “investing” into a “guaranteed” annuity like contract with the bank. With a huge rate of return on it!

CANI has a GAAP Error! 

Because they were doing more and more of this type of work their GAAP EPS number became a joke. But in reality over time, their EPS began to accelerate as more and more systems were installed in their client banks and began to hit their “sweet spot” The “sweet spot” for CANI is where they have more installed systems with royalties, and less money needed to be expensed to their consulting staff, to get it. This means more GAAP profit.

My average cost basis was 10.5, and I sold it for around 26. All during the NASDAQ Tech Bear market of 2000. I had about 40% of my portfolio in it, and to get a 2.5 bagger in a bear market aint too bad. If that bear hadn’t been running I shudder when I think of how much that stock might have run. Actually while I held it, it was the number 1 performer in the Business and Software sector. I am rather proud of finding this one.  

Out of Favor Sector Rotations

  Stocks will often go up and down together in the same sector. Essentially if GM has a problem, Ford will probably have a problem, and their stock will go down too. Often stocks tend to go up and down the same amount in the same sector. So if one company in the sector announces bad earnings, and its stock crashes in price, usually they all will go right after.

Usually, most novice investors who hear this don’t get why? (Particularly if they own the non-announcing company, and are upset their company went down too.) At first glance many novice investors might think this is totally insane. It was GM that had the problem, not Ford, why should Ford’s stocks go down too? Well, there is a good economic reason for it. If Ford is having problems, the other companies will also probably have the same problem. They are selling into the same customer set, with the same products, using the same labor market, etc. It is very likely that they will have the same problem. If GM is having trouble selling cars, and they discount them heavily, it will effect Ford's pricing. So it makes some sense that stocks in the sector will go up and down together.

Normal efficient markets will do this, and there will be broad “sector rotations” going on all the time in the stock market. But let us assume for a second that even though a company may be in a sector, it really is slightly different than the rest. Let us say that all of its competitors are having problems, because of some sort of problem. What if this company is slightly unique and has absolutely nothing to do with the sector’s problem, and it can’t be influenced by what the others are experiencing?

This isn’t going to happen very often, but it will happen. And guess what, the stock market will pummel this undeserving company along with the rest. A lot of large-scale money is rotated around in sectors. Even some individual investors play this game, by using specialized sector mutual funds, and they will rotate their money around based on what they think each sector will be doing.

But what about the company that got pummeled that absolutely shouldn’t have? Yep. Buy it. When the sector rotates back in favor the stock will fly. The ideal situation is a company that is not affected by the bad news and is growing fast or improving in some way. This way you are able to buy a great company at a low price. 

Previous Investment Case Study: Out of Favor Sector Rotations - BEBE 

During 2000 a lot of specialty retailers got crushed. Interest rates were rising. It makes sense that companies with sensitivities to interest rates should be harmed in this type of environment. Retailing in general is one of these sectors.

Why?

1. Obviously a retailer needs customers and when consumers have to pay higher interest rates on their credit cards, they wont be as likely to shop the mall as hard.

2. Probably even more importantly most retailers are highly leveraged. A lot of them borrow money for inventory, and they lease the space they are in. A lot of them use Other People’s Money, and are fairly thinly capitalized. A lot of them are just thin air. In reality, they don’t own much. They are often highly leveraged, with a lot of interest expense.

3. If you lose revenue from reason #1, and have to spend more money from higher interest payments in #2. As a retailer your profit can’t be looking good.

Or can it? What happens if you have a retailer whose stock price has been crushed to death, but has so much cash, it doesn’t borrow money? Matter of fact, it has so much cash EPS would rise, if everything were equal, because its cash was getting higher interest rates. What happens if the strength of its brand is still increasing sales? 

BEBE – fit this bill. It is a specialty retailer of women’s clothes. It has more cash then it needs, and was continuing to grow.

How did I find this Out of Favor Sector Rotations?

I had read that specialty retailers had gotten crushed. I ran a screen looking for debt free retailers with growing sales. BEBE stood out with its high growth, high ROE, high margins, and low P.E. I bought some. Made some nice money on it too.