If you’ve ever perused the Cheap Stocks website (http://stocksbelowncav.blogspot.com), it’s obvious that we are enamored with one of Ben Graham’s most fascinating (to us, anyway) investment techniques, that being the pursuit of companies trading below their net current asset value.  Indeed, we’ve taken some liberties with Ben’s formula, a necessary evil in this day and age.  (Ben’s formula sought companies trading at less than 2/3 NCAV, while we typically look for less than one times NCAV).

We’ve researched and written about the concept for years (yours truly published a handful of pieces on the subject during my time at Bloomberg), but only recently took it a step further.  In February, we rolled out The Cheap Stocks 21 Net Net Index, the first index of companies trading below net current asset value (that we are aware of, anyway).

It’s been an interesting experiment to date, and since inception the index is up 7.54% percent versus
-.38% for the Russell Microcap Index, the closest benchmark to this combination of down and outs, ne’er do wells, and potential bankruptcy candidates.  Don’t get us wrong, there are probably some gems in the mix, but companies don’t typically trade so cheaply relative to assets unless there’s either a very good reason, or the market is just not paying attention.  Nonetheless, the concept of building a “passive” index of net/nets is at the very least intriguing.

Below is more about this index, its construction and constituents:

The Cheap Stocks 21 Net/Net Index is a market cap weighted index comprised of companies that met the following criteria at index inception on Tuesday, February 12th, 2008:

•Market Cap is below net current asset value, defined as:
Current Assets – Current Liabilities – all other long term liabilities (including preferred stock, and minority interest where applicable)

•Stock Price above $1.00 per share

•Companies have an operating business; acquisition companies were excluded

•Minimum average 100 day volume of at least 5000 shares (light we know, but welcome to the wonderful world of net/nets)

*Index constituents were selected by market cap. The index is comprised of the “largest” companies meeting the above criteria.

The Index is naïve in construction in that:

•It will be rebalanced annually, and companies no longer meeting the net/net criteria will remain in the index until annual rebalancing.

•Only bankruptcies, de-listings, or acquisitions may result in replacement

•Does not discriminate by industry weighting—some industries may have heavy weights.

Cheap Stocks 21 Net/Net Index Constituents and Weights (%, rounded):

Adaptec Inc(ADPT)18.72%
Computer Systems

Audiovox Corp(VOXX)12.20%
Electronics

Trans World Entertainment(TWMC)7.58%
Retail-Music and Video

Finish Line Inc(FINL)6.30%
Retail-Apparel

Nu Horizons Electronics(NUHC)5.76%
Electronics Wholesale

Richardson Electronics(RELL)5.09%
Electronics Wholesale

Pomeroy IT Solutions(PMRY)4.61%
IT

Ditech Networks(DITC)4.31%
Communication Equip

Parlux Fragrances(PARL)3.92%
Personal Products

InFocus Corp(INFS)3.81%
Computer Peripherals

*Renovis Inc(RNVS)3.80%
Biotech

Leadis Technology Inc(LDIS)3.47%
Semiconductor-Integrated Circuits

Replidyne Inc(RDYN)3.31%
Biotech

Tandy Brands Accessories Inc(TBAC)2.94%
Apparel, Footwear, Accessories

FSI International Inc(FSII)2.87%
Semiconductor Equip

Anadys Pharmaceuticals Inc(ANDS)2.49%
Biotech

MediciNova Inc(MNOV)2.33%
Biotech

Emerson Radio Corp(MSN)1.71%
Electronics

Handleman Co(HDLM)1.66%
Music- Wholesale

Chromcraft Revington Inc(CRC)1.62%
Furniture

Charles & Colvard Ltd(CTHR)1.50%
Jewel Wholesale

*Renovis was acquired on 5/5/08; the allocation to that company in our index model remains in cash

Jonathan M. Heller, CFA

*The author does not have positions in any of the companies mentioned. This is neither a recommendation to buy or sell any securities. All information provided believed to be reliable and presented for information purposes only. The author will not trade any of the securities mentioned (buy, sell, short) for at least two weeks following the date of this post.

Mohnish Pabrai- Pabrai Funds
Pabrai began by reiterating the notion that we as investors or entrepreneurs should look for opportunities with low risk but high uncertainty. If your risk is low, losses will be not break you. Since Wall Street hates uncertainty, it tends to misinterpret certain situations and companies, over-punishing them in the process. This gives patient, diligent value investors a potential advantage.

Pabrai’s favorite idea was Wellcare (WCG, $46.49), whose shares slid from 128 to 21 in a very short time frame, following a raid and seizure of documents and materials by 200 federal agents related to potential excess Medicare billings.
• Pabrai became interested when it was disclosed in a 13G filing that Fairholme Funds took a 16% stake in Wellcare, following the raid
• Believes that ultimate damage to the company from allegations/penalties will be minimal
• Wellcare has loads of cash, and a solid, growing business
• Currently trading around $46, Pabrai believes it may be worth in the $93-$108 range

Steven Romick- First Pacific Advisors
Romick is nervous and somewhat wary of current market conditions. He believes the global credit crisis is still early, is not finding many compelling ideas, and currently has a relatively large cash position.
Among Romick’s concerns are:
• Negative US savings rate
• Too much foreign investment in the US
• Government debt growing
• Inflation
• Higher interest rates on the horizon
• Potential for bank failures
While Romick is avoiding financials, his largest position is in energy (17-25% in the portfolios he manages)

One idea Romick is bullish on is automotive retailer Group 1 Automotive (GPI, $27.27). Romick sees many positives in the company and sector:
• Not as cyclical as many believe
• Parts and service are growth businesses
• Used cars will become even more lucrative
• Valuations in this sector are currently attractive
• Strong management is a plus
Romick believes Group One could earn $3.23 in 2008, $4.00 in 2009 and $5.00 in 2010, putting its forward P/E in single digits.

Jonathan M. Heller, CFA
*Author does not own any securities mentioned

The Mortgage Crisis
Whitney Tilson and Glenn Tongue of T2 Partners kicked off day 2 with a sobering look at the mortgage crisis. For his part, Tilson believes that we have not yet seen the worst. His extremely detailed presentation (“The Latest on the Mortgage Crisis and Implications for Certain Financial Stocks”) paints a very bleak picture, suggesting that all things housing and mortgage related will get much worse before improving. Tongue and Tilson put their money where their mouth is with short positions in monoline insurers AMBAC and MBIA, Washington Mutual, and a long position in Fairfax Holdings (which has gained and may gain further in the mortgage crisis due to its credit default swap holdings).

Glenn Tongue gave an excellent overview on Berkshire Hathaway, making the bullish case based on:
• Over –capitalization
• In a great position to take advantage of opportunities this market presents
• Remains the premier capital allocator
Tongue Valued Berkshire on:
• Investments/share ($90,342)
• Plus PV of future pre-tax eps (excluding investments)
• Intrinsic Value of $156,000- $159,000, a 20% premium to current price
We can only hope that Whitney and Glenn are wrong on the depth of the mortgage crisis (wishful thinking) and right on Berkshire’s valuation.

Aaron Edelheit- Sabre Value Management
One of the very pleasant surprises this year was newcomer Aaron Edelheit, whose passion for value investing was very apparent in his presentation. Edelheit pointed out the outstanding returns from the small cap value area of the market since 1970 (16.2% annualized), but noted the disinterest here from many investors. He cited the following reasons for this situation:
• Small Cap Value can be very boring to investors
• There may be long periods with no news
• Illiquidity associated with SCV companies scares investors
• Too much volatility
• Little or no analyst coverage
One of Edelheit’s favorite ideas is Hemisphere GPS (HEM CN), formerly CSI Wireless. This misunderstood company is his largest holding.
• Hemisphere operates in the agricultural GPS arena, offering “auto steering” technology to farmers, which allows for more efficient use of tractors and thus their acreage, seed and fertilizer
• Pricing of HEM’s products are very favorable
• He forecasts rapid sales and earnings growth on the horizon

Jonathan M. Heller, CFA
*Author does not own any securities mentioned

Ken Shubin Stein, of Spencer Capital, laid out his philosophy, which includes:
• Looking for asymmetric payoffs (limited downside, with much upside)
• Bottom-up fundamental analysis
• A “scientific” research process
• Belief that volatility is the key to successful long term investing

Shubin Stein made an extremely interesting, and often forgotten observation that value investors need the emotional stability to invest and take on more risk during a crisis.

He laid out a very detailed case for his favorite idea, American Express (AXP, $50.96):

• Trading at 14X earnings
• Best credit quality of anyone in the business, with premium customers
• Have successfully shed unrelated business to focus credit card ops
• High ROE (37% in 2007)
• Superior management
• Competitive advantage and long-term growth prospects
• Best service, and reward programs
• #1 in customer satisfaction
• Wide acceptance in US, and internationally
• Should be relatively unscathed by credit crisis
• Should trade at 18-21 times earnings
• Earnings target of $4.50 share in 2011 implies an $89 target price

Robert Hagstrom, portfolio manager of Legg Mason Growth Trust laid out his case that worst of the credit crisis is probably over, and that the markets are functioning much better since the Fed, (and other leaders) acknowledged the seriousness of the credit crunch, and became engaged in trying to address it. (Two rate cuts in 8 days in January, the first of which was between Fed meetings, first time that’s happened since 2001).

Hagstrom labeled the current environment as “Large Cap Growth Heaven”, with declining interest rates, slowing growth, and attractive valuations.

When it came to his favorite idea, Hagstrom was very self effacing: Last year’s best idea was Amazon, and he hit a home run with that pick. This year, it was Yahoo; whose acquisition by Microsoft fell apart in recent days. Hagstrom made light of the misfortune of his timing, but proceeded with his case for Yahoo (YHOO, $25.72):

• YHOO is still growing faster than many believe
• Company now emphasizing innovation over marketing, which bodes well
• Contrary to conventional wisdom, Microsoft needs Yahoo, more than Yahoo needs Microsoft
• Ultimately, this deal will get done

The Value Investing Congress would not be complete without the interesting perspective and style of Carlo Cannell, of Cannell Capital LLC. Cannell presented the relatively unknown (at least in the US) company Hunter Douglas NA (HDG.AS), distributor of high-end shades and blinds:

• Main business throws off a great deal of cash, which feeds a $1billion portfolio of securities
• Business itself is worth close to market cap, essentially buyers get the investment portfolio for free
• Portfolio experiences little to no taxation
• Meanwhile, company pays a 5% dividend

Cannell also broached another interesting topic, that being the proliferation of Chinese companies listing on US exchanges, through reverse mergers. In Cannell’s view, there may be shorting opportunities in some of these names due to corruption, fraud, accounting issues, weak corporate governance.

Jonathan Heller, CFA
*The author does not have positions in any of the securities mentioned.

Zeke Ashton, of Centaur Capital, opened with some observations of some of the things that we, as value investors, think we should not do. Among them:
• Don’t sell short
• Run concentrated portfolios
• No leverage
• Buy and hold
• No technology companies
• No stocks with commodity price risk
• Must accept high volatility
• Don’t use derivatives
• If Warren wouldn’t do it neither should you
Zeke’s point was well taken: we often become so beholden to the concept and textbook notion of value, that we tie our hands in the process, leaving opportunity on the table. Ashton also made the case for utilizing covered call strategies in our portfolios, in an intelligent way.

His favorite idea was American Oriental Bio (AOB,$9.50):
• $733 million market cap, $130 million cash, $603 million EV
• Fast growing manufacturer/distributor of pharma/nutritional products in China
• Continues to acquire small, undercapitalized Chinese companies at bargain prices
• Despite recent bad press, China risk, high short interest, Ashton believes fair value is in the $15 range

Randall Abramson of Trapeze Capital presented a more technically oriented proprietary method his firm uses to time buys and sells. This unique strategy is based on historical trends and levels of price to adjusted book value, and can be applied to stocks and indices.

Abramson revealed this analysis on a number of stocks, and indices, suggesting that:
• Office Depot (ODP, $13.51) Ruby Tuesday (RT, $8.52) and Walgreen (WAG, $35.45) are significantly undervalued.
• Berkshire Hathaway (BRK/A, $130,200; BRK/B, $4,345) now appears overpriced. (Abramson deserves credit for making such an assertion in a roomful of Berkshire devotees, many of whom were in Omaha last week).
• As for the major indices, the Dow Jones Industrial Average, S&P 500, NASDAQ Composite , and Russell 2000 are all undervalued at current levels

Jonathan Heller, CFA
*The author does not have positions in any of the securities mentioned