January's Results

Your intrepid blogger finished his first month of DEA’s Value Investing, and quite a first month it was: For yours truly and even moreso for Mr. Market. Due in large part to the difficulties with the mortgage industry, markets remain in a quandary, trying to assess the fallout. The uncertainty of confusing news is such that recently it has seemed to take Mr. Market a day or more to fully digest the latest developments. Just yesterday he was trying to understand the resilience of a troubled bond insurer when surprise employment and consumer confidence data, both negative, were reported. Mr. Market was in a good mood at the end of the day, having brushed aside these key indicators.

For the month of January, our benchmark, the S&P 500 index, was down 6.3%. It was a good month to take your time squeezing the tomatoes at the vegetable aisle.

I like machine shops--they remind me of my GE days. WSI Industries was a pleasant surprise. They’re very solid and are growing the right parts of their business nicely. So far, J.M. Smucker is proving to be a fine defensive play. The most positive surprise was Arkansas Best. This well-run trucking company is poised to benefit from lower fuel costs, and the market is beginning to see their value.

As a foil to the favorites, and probably somewhat fortuitously, all three of the “unfavorables” turned negative after they appeared in the blog. I love their products, but Apple is going to have a tough time reconciling expectations in today’s challenging market conditions.

Below is a summary of the month’s results:



Back in my Air Force days, pilot friends would say it is better to be lucky than to be good. With that in mind, all six favorites were in the black at the end of the month—I’ll leave it to our readers to opine which of the two applies. Given the short timeframe, the month’s results are nearly inconsequential and come perilously close to quantifying the market’s daily gyrations.

We will be in a better position next month to evaluate results. Yours truly will also continue to watch our favorites closely to ensure Mr. Market stays in check. Like an overripe fruit, the idea is to avoid his exuberance getting the best of him vis-à-vis the favorites, less their intrinsic value is forgotten and we become like the analyst who, with dame fortune, plays a duet on the speculative piano, allowing the fickle goddess to call all the tunes.

Disclosure: The author is long on PG, WSCI, and the Vanguard S&P 500 Index Fund

Which is Sweeter: J.M. Smucker ot Tootsie Roll?

There are quite a few well-known brands in the U.S. food industry yet few have managed to survive for over 100 years. One example is J.M. Smucker’s (NYSE: SJM). Another well-known centenarian is Tootsie Roll (NYSE: TR). In some ways the similarities are remarkable: (1) TR was started in 1896 and SJM began making jams/jellies in 1897; (2) both have their roots in the heartland: J.M. Smucker in Orrville, Ohio and Tootsie Roll in Chicago; and (3) the two companies are incredibly stable.

First Pass
Given their ability to endure the test of time, let’s look at these two companies through our 5-criteria filter:

(1) Straightforward business, preferably with a repeat purchase model: Both companies manufacture branded food products. J.M. Smucker’s goods are typically sold in the center aisles of supermarkets. Their brands include Jif peanut butter, Crisco shortening/ cooking oil, J.M. Smucker jam and jelly, Pillsbury baking ingredients, and PET evaporated milk. Tootsie Roll’s products are also sold in the aisles and near checkout registers at supermarkets. They are also frequently used as promotional material. Besides their namesake candy, TR manufactures dozens of brands including Andes Mints, Cella’s Cherries, Charms Blow Pops, and Junior Mints. Their business is to manufacture the products and maintain their brand recognition.

(2) Stable business: Having been around for over 100 years, it’s safe to say that both businesses are stable. J.M. Smucker has paid a dividend continuously since 1949 and Tootsie Roll has done the same since 1943. Amazingly, one Tootsie Roll still costs a penny—the same price the candy it sold for in 1896.

(3) Decent balance sheet: Looks good (more on this later).

(4) Top notch management team: J.M. Smucker is still run by the descendants of the original J.M. Smucker. The founding family has operated the company since its inception. Tootsie Roll is run by Melvin and Ellen Gordon. Mr. Gordon has been CEO since 1962. If their ability to endure is any indication of their competence, both companies are in good hands.

(5) Industry leadership: Given their strong brand recognition, both companies are leaders in their respective markets.

Since both companies are successful, operate in good, stable businesses and have strong management, let’s try to understand if this translates to a reasonable financial margin of safety by looking at 7 valuation-oriented parameters.

Margin of Safety
Margin of safety affords the business owner room for error if things go wrong. Companies with a good margin of safety are on stable ground and can be expected to withstand unforeseen difficulties. In practical terms, this means the company can continue to pay its bills while it works through issues. The following 7 data are provided for TR, with SJM’s values in parentheses:

• Price to book: 2.11 (SJM is 1.34)
• Cash on hand: $55 million or $1.55/share (SJM has $200 million or $3.60/share)
• Annual cash flow: $1.31/share (SJM has $4.04/share)
• %LTD/capitalization: TR has no long-term debt (SJM’s is 17.9%)
• Price to earnings: 25.2 (SJM’s P/E is 14.6)
• Common stock dividend yield: 1.27% (SJM’s dividend yield is 2.65%)
• Revenue growth (since 2004): 18.1% (SJM: 56.8%)

Margin of safety appears to be decent for both companies. Despite their age, both companies continue to grow revenue. For the most part, they have expanded their footprint by acquiring new brands. TR purchased Concord Confections, a Canadian candy maker, in 2004. SJM expanded its business by purchasing White Lily (flour and cornmeal) in 2006 and Eagle Family Foods (condensed milk) in 2007 while divesting Brazilian operations in 2004 and Canadian operations in 2005 (to Cargill). To summarize their businesses at a very high level:

Tootsie Roll:
• Very narrowly focused product base (confectionery products)
• US, Canada and Mexico exposure; negligible exposure outside North America
• Sensitive to raw materials and supply chain costs

J.M. Smucker:
• Focused products, primarily dealing with food preparation; some ready to eat foods
• US and Canada exposure; limited exposure outside North America
• Sensitive to raw materials and supply chain costs

Given that margin of safety is acceptable, which company is better? It appears to be a mixed bag. Even though they carry no debt, Tootsie Roll’s P/E is quite a bit higher than SJM’s. Still, both companies have steady, positive cash flow. Perhaps the hallmark of value investing, intrinsic value, can help us find out.

Intrinsic Value
Intrinsic value has been defined as how much cash can be taken out of each company during its remaining life—a powerful way to measure the value of owning a company. For simplicity, let’s use an equation borrowed from Warren Buffett’s mentor, Ben Graham:

Intrinsic Value = EPS * (2r + 8.5) * 4.4/γ

Where:

EPS = Trailing 12 months earnings per share
r = Expected earnings growth rate
γ = Yield on AAA-rated corporate bonds

Based on this, I estimate Tootsie Roll’s intrinsic value at about $6/share (recent stock price is $25.25). Similarly, J.M. Smucker’s estimated intrinsic value is about $46.80/share (recent price is $45.72). This is a significant point of differentiation. Tootsie Roll is priced significantly above its intrinsic value while J.M. Smucker is priced at very close to its intrinsic value. How can this be? The two key variables used to calculate intrinsic value are: (1) trailing 12 months EPS, and (2) expected earnings per share (EPS) growth rate. The former is straightforward enough: Current (TTM) EPS is $1.01/share and $3.04/share, for TR and SJM, respectively. The latter (expected earnings growth) is an entirely different story.

Profitability is Key
Expected earnings growth hinges on a company’s ability to either increase top line (sales), reduce costs, or a combination of the two. Looking at the last five years, TR has had flat earnings, so my expected earnings growth rate is 0%. In fact, indications are that earnings growth will be negative in the near future due to exchange rate-related cost pressures arising from production at their Canadian facilities. On the other hand, J.M. Smucker’s earnings have been growing more steadily. Their 2003 EPS was $2.02/share and current (TTM) EPS is $3.04, which means that EPS, up 50% in four years, is growing at about 11% per year. To be conservative, I’ve estimated earnings growth at 8% to arrive at the intrinsic value figure above.

It’s a Jungle Out There
Business is tough: without adequate growth in revenue, costs eventually eat away at profitability, diminishing value for owners (shareholders). Failure to sufficiently grow revenue, in light of cost increases due to energy, raw materials and foreign exchange fluctuations, can take a hefty toll. J.M. Smucker has been able to negotiate these troubled waters by investing carefully in the growth of their business, avoiding excess debt, and paring non-value adding operations. In contrast, it appears Tootsie Roll is struggling to grow their business enough to also increase earnings. The good news is that they have available cash and no debt to help grow the business. If they fail to do this, someone else may seize on the opportunity.

Disclosure: The author has no positions in TR or SJM.

Microcaps that Warren Buffett Would Love?

Below the Radar
Early on, Warren Buffett took control of a small New England textile mill that became the namesake for his new company. Since then the company bearing the mill’s name, Berkshire Hathaway, has witnessed incredible growth because of its ability to invest effectively. With a market capitalization in excess of $220 billion, Berkshire Hathaway no longer buys small companies. What if they did? Perhaps they would invest in microcaps, but which ones?

Tough Hurdle
Chances are they would focus on intrinsic value, which Buffett says, “is an all-important concept that offers the only logical approach to evaluating the relative attractiveness of investments and businesses” and has been equated to the discounted cash that can be taken out of a business during its remaining life. Even though he is famous for buying stocks that were “cigar butts” with a few puffs left, Buffett has also invested in companies with strong growth prospects (e.g., Coca Cola moving into overseas markets) provided there was a nice margin of safety. With that in mind, consider these guidelines:

• Price/book: Less than 3 and preferably below 2
• % LTD/capitalization: Less than 30%
• 4-year revenue growth: Greater than 20%
• Quick ratio: Greater than 1.0
• P/E: Below 25 and preferably below 13
• Positive cash flow for at least the previous 12 months

Then There Were Four
In keeping with Buffett’s famous aversion, technology stocks were omitted from our search. Although the criteria initially identified numerous microcaps, those with poor earnings (defined as having had one more years of negative revenue in the past four years) or with complicated business models, were removed. The search resulted in the following four microcaps. Given that Buffett sees himself as buying the business as opposed to buying a stock, let’s take a look at what each company does:

• Electro-Sensors (NASDAQ: ELSE): Designs and builds speed sensing equipment for manufacturers. Anyone who has seen high-speed manufacturing has probably looked with amazement at how everything flows smoothly. ELSE helps its customers manufacture more efficiently, optimizing production rates. Customers include many Fortune 500 companies such as ADM, 3M, Anheuser-Busch, GM, GE, Ford, and Exxon-Mobil.

• WSI Industries (NASDAQ: WSCI): Manufactures very low tolerance (high precision) machined parts. They serve various industries that require highly precise parts: defense, aerospace, medical, etc. In business since 1950, WSI has recently entered new markets that offer tremendous growth opportunities. Current customers include: Polaris Industries and General Dynamics.

• Dryclean USA (Amex: DCU): Founded in 1963, DCU is all about dry cleaning. They have subsidiaries that: (1) franchise/ license over 400 dry cleaners, (2) design and build equipment for laundry/dry cleaning facilities, and (3) broker the purchase and sale of dry cleaning businesses. Headquartered in Miami, they serve markets in the U.S., the Caribbean and Latin America.

• Air T (NASDAQ: AIRT): Has two business segments, both dealing with aviation services: (1) contracted express air cargo delivery, and (2) manufacturing aircraft support equipment such as scissor-lifts and deicing equipment. The contracted air cargo express air cargo service operates 95 aircraft that provide overnight delivery for companies such as Federal Express.

In Closing
As always, each investor needs to perform their own due diligence, especially when dealing with microcaps. With that being said, all four of these companies have strong financials and a demonstrated ability to focus on growth while limiting debt. Based on a quick analysis, each company appears to be trading below its intrinsic value and provides a nice margin of safety due to a straightforward business model and solid management, resulting in reasonable debt levels, positive cash flow, and consistent earnings. Hopefully Warren Buffett would agree there is opportunity here.

Disclosure: The author has a long position in WSCI. The author has no position in any of the other three stocks and will not trade (buy, sell, short) any stocks in this post for a minimum of two weeks.