Portfolio Update

Bought a few more shares of Hawaiian Holdings at an average cost of 5.77. I'll post some commentary later.

Trust Deficit

Judges Scientific and Elektron Technologies are so similar that they could easily be confused for each other.

Well, except for this:

Got that? Owning 13.4 million shares makes one’s interests more aligned with that of all shareholders than does owning 9.7 million shares.

Who says that irony is dead?

Valuing Howden Joinery Group

My posts on Howdens Joinery tried to understand its business model: how and why does it make money? That must be the very first question that a prospective investor asks of any business that s/he invests in. The arithmetic of valuation is the second step, and I’ll turn to that now.

A Rough Cut:

Howdens was once twinned with a low quality furniture retail business. Howdens sold that business to a private equity firm in 2006 and, when that business went bust in 2008, the legacy store lease obligations of the bankrupt business were, for one reason or another, put to Howdens.  Since 2008, therefore, Howdens had been both paying rents on properties it doesn’t use and paying breakage costs in order to rid itself of these legacy properties. These extraordinary payments are now almost entirely in the past; annual payments of only £2 million remain.

Also, Howdens’ pension fund assets once enjoyed assumptions that perhaps would have seemed reasonable at the time: an 8.4% rate of return on equities and a 4.5% rate of return on government bonds. As these assumptions crumbled in the face of the downturn, the net pension liability ballooned, and the trustee insisted on large cash infusions to eliminate the deficit. As it stands today, the deficit amounts to 154 million, the weighted average expected return on pension assets has contracted from 7.39% to 5.07% (Equities: 6.25%; Bonds: 2.55%) and Howdens has agreed to inject a further 45 million a year for the next three years. By 2015, the net liability should be eliminated: I doubt that there’s a reasonable basis for suggesting that expected long term returns on equities or bonds ought to be lower than they are now  and the cash payments will therefore be enough to make the retirement plan whole.  

We’re ready, now, to make a rough estimate of the lower bound of Howdens’ ability to generate free cash. We add back the legacy rent payments, the lease breakage costs, the cash contributions to the pension fund, and we are left with 23p in free cash per share, or, at the current market capitalization, an 8% FCF yield.

This is a rough cut and it’s wrong: we know that Howdens is growing, so that free cash flow doesn’t represent earnings; and we know that the years 2008-212 are exceptional ones, such that earnings in these years understate the company’s long-term earnings capacity.

So what is Howdens’ true earning power?

Approximately Right, from the Bottom Up

Let’s start with sales. We know that Howdens’ sales per square foot is a function of cyclicality and store maturation. The combined effect of these two factors can be seen below:

Average sales per square foot between the top and bottom of the cycle, i.e. between 2005 and 2012, is £199.4.

We know also that the depots mature with time. We can isolate this effect by calculating the CAGR in sales per square foot between the two bottoms of the cycle, 2002 and 2012. It’s not a perfect approach – that would take more information that we have available to us – but it’s good enough. The maturation effect is 1.4% per year.

Put these two factors together and look out to 2016 and we can estimate that sales will amount to something like £1,475 million: 700 stores, 10,000 sq ft per store, £211 in sales per sq ft.

We know that adjusted operating margin is 17.45%, that depot rents approximate £5 per square foot, that the business needs 30 days of noncash working capital, and that it costs £170,000 to build out each new depot so, at this point, we can estimate earnings and cash flow:

The business will generate about £650 million in cash over the next four years. Of this, 180 million will be contributed to the pension plan, £46 million will be tied up in increased working capital, and £30 million will represent cash capex for 171 new depots.

This leaves £390 million in free cash which, for the sake of simplicity, I choose to keep on the balance sheet. In reality, some of it will be paid out in dividends but it makes little difference to the valuation whether it is or isn’t.

A 2016 equity valuation of £2,775 sees the shares being worth 655p each, representing a return of 29% a year.

I’ll pause here to re-emphasize a couple of points:

·      This estimate of Howdens’ intrinsic value would be impossible without confidence in the robustness of Howdens’ business model.  One can’t do this for some teen fashion retailer or low-grade home supplies distributor and reasonably expect to be close: tastes change, and anything that can be disintermediated will be, sooner or later; forecasting revenues and profits for these kinds of businesses is, in my view, a fantasy.

·       The above valuation is dependent on two assumptions only, neither of which is fanciful: (a) things stay as they have been; and (b) management’s 700 depot target is proved reasonable.     

      If you'd like to take a stab at breaking my valuation, I’d welcome it in the comments below.

Portfolio Update

I've picked up some of the Cybergun 8% October 2016 bonds.

Orientation

"In the year in which the first edition of this book appeared an opportunity was offered to the partners’ fund to purchase a half interest in a growing enterprise. For some reason the industry did not have Wall Street appeal at the time and the deal had been turned down by quite a few important houses. But the pair was impressed by the company’s possibilities; what was decisive for them was that the price was moderate in relation to current earnings and asset value. The partners went ahead with the acquisition, amounting in dollars to about one-fifth of their fund. They became closely identified with the new business interest, which prospered.  

In fact it did so well that the price of its shares advanced to two hundred times or more the price paid for the half-interest. The advance far outstripped the actual growth in profits, and almost from the start the quotation appeared much too high in terms of the partners’ own investment standards. But since they regarded the company as a sort of “family business”, they continued to maintain a substantial ownership of the shares despite the spectacular price rise. A large number of participants in their funds did the same, and they became millionaires through their holding in this one enterprise, plus later-organized affiliates.

Ironically enough, the aggregate of profits accruing from this single investment decision far exceeded the sum of all the others realized through 20 years of wide-ranging operations in the partners’ specialized fields, involving much investigation, endless pondering, and countless individual decisions.

Are there morals to this story of value to the intelligent investor? An obvious one is that there are several different ways to make and keep money in Wall Street. Another, not so obvious, is that one lucky break, or one supremely shrewd decision—can we tell them apart?—may count for more than a lifetime of journeyman efforts. But behind the luck, or the crucial decision, there must usually exist a background of preparation and disciplined capacity.

One needs to be sufficiently established and recognized so that these opportunities will knock at his particular door. One must have the means, the judgment, and the courage to take advantage of them."

Postscript to the revised edition of The Intelligent Investor.

Portfolio Update

I have taken a half position in Conrad Industries. I'll add the other half if the price comes down some. 

Secrets & Lies: Solutions Profit Model (Part 2)

Few companies, of course, lay out their business model as forthrightly as Howdens does and, in the wake of Who Says Elephants Can't Dance?, every company tries to pass itself off as a solutions provider.

The reward for successful implementation of the solutions profit model is loyalty and pricing power.

And loyalty and pricing power ought to show up in its financial statements in the form of 

(i) high and stable (or, in the growth phase, high and rising) gross margins,

(ii) high and stable (or high and rising) operating margins, and

(iii) fixed asset turns that remain steady, even during severe recessions.

And, in context:

There are several different profit models at play in the business of distributing building supplies and each has its own fingerprint, as one can see.

The solutions model is the most profitable and the most difficult to compete against.

Portfolio Update

I'm out of XPO Logistics at an average price of $17.07.

I am eyeing Conrad Industries and May Gurney as replacements. I feel a bit silly not owning at least one of the two.

Customer Solutions Profit Model

“So I set out to find the answer. I interviewed dozens of customers to get a sense of how Factset operated. Piecing together fragments of information from all these conversations, I eventually put together a clear picture of how Factset had designed their business. Here’s what I learned.

“The business information marketplace in which both Factset and my client, Data House, were operating involved close to a thousand major customers. But within that arena, to maintain a strong growth curve, Factset needed to capture only twenty new customers per year. Knowing this, they developed a powerful approach to make that happen.

“Once Factset identified a company as a potential customer for their information services, they’d send a team of two or three people to work there. They would spend two or three months, sometimes longer, learning everything they could about the customer—how they ran their business, how their systems worked (and didn’t work), and what they really cared about. Based on this genuine knowledge of the customer, Factset then developed customized information products and services tailored to the specific characteristics and economics of the account. Once they landed the account, they spent a ton of time integrating their product into the customer’s systems. During this process, Factset’s revenues were tiny and their costs were huge. If you looked at a monthly P&L for a particular account, you’d see they were losing a ton of money. Costs of $10,000 might be charged against revenues of $3,000.”

…“After three or four months, Factset’s products would be woven into the daily flow of the customer’s operations. Their software would be debugged and working fine. Now Factset didn’t need three people working fulltime on the account. One person could maintain the service, probably part-time. And as the word spread among the client’s employees about how powerful Factset’s data was and how effectively Factset’s service had been customized to their specific needs, they began taking more and more advantage of it. Factset’s monthly costs fell from $10K to $8K, while monthly revenues started to grow, from $3K to $5K to $12K.

. ..“What were Factset’s margins?”

“How much do you think?”

…Steve grabbed a pencil and began jotting down numbers. Let’s see, he considered. Twenty-four million dollars in revenue generated by a staff of about forty people. How much would payroll costs be? These folks would probably be well paid. Some might make just sixty or seventy thousand, but a bunch would be in six figures. Steve seemed to recall hearing that benefits usually amounted to about fifty percent of salaries. So even well rewarded, the people would cost no more than, say, $200,000 apiece, counting salary, benefits, the whole nine yards. He multiplied. That makes eight million in payroll.

“How much would overhead be?” Steve wondered aloud.

“Use ten percent,” Zhao suggested.

Okay, figure ten percent of revenue for overhead—$2.4 million. Then there would be licensing fees for the rights to the information being sold.

Those might amount to another ten percent. Throw in a few more points for other costs . . . “I’ll guess forty percent operating margin—about ten million bucks, all told.”

Zhao smiled. “Very, very close.”

“So Data House came nowhere near what Factset accomplished.”

“That’s true.”

“I don’t get it. You laid out the whole plan for them, didn’t you? Are you saying that Data House didn’t choose to follow the winning strategy, even after they knew it would work?”

“About right.”

Steve shook his head. “Wow. I guess that must have been one of the worst organizations you’ve ever encountered. Did you ever work with any other company that simply refused to be successful?”

“Actually, it happens all the time. I can give you the complete recipe for the secret sauce, and the chances are good that you still won’t use it.”

“That’s strange. Why visit the doctor, then ignore his advice?”

“It’s a bit of a mystery. There’s probably no one reason why people seem to prefer failure to success. We know that change can be psychologically threatening—that’s part of the answer. In the case of Data House, they may have realized that following the Factset model would have taken a lot of hard work—much more than they were accustomed to. That’s part of the answer, too. But I think the ultimate explanation is a simple one. To succeed in business, you have to have a genuine, honest-to-goodness interest in profitability. And most people don’t.”

Zhao leaned back and spread his hands wide. “That’s all there is to it.”

Steve frowned. Can that really be true? he wondered. It’s hard to believe.

“That’s all for now. Today’s profit model was a simple one. But what is it, Steve? What’s the idea?”

Steve thought for a moment. Then he said, “Invest time and energy in learning all there is to know about your customers. Then use that knowledge to create specific solutions for them. Lose money for a short time. Make money for a long time.”

From The Art of Profitability by Adrian Slywotzky

What are the distinguishing characteristics of this business model, of this profit model?

(1) Intimate knowledge of the customer; and (2) customization of products and services into (3) integrated solutions that address (4) the customer’s mission-critical problems (5) in such a way that these solutions are woven into the daily fabric of the customer’s business operations.

Once all five components of the model have been locked in, it is very hard to compete against the incumbent, especially in a slow-growing, smallish market. 

It can command very high margins with impunity and earn returns far above its cost of capital. It is a moated enterprise, a franchise. It would take a revolutionary leap of some kind, or sustained bout of self-abuse, to threaten it. You can count on its earnings and you can calculate its earnings power value. 

Despite the everyone-is-special-in-their-own-special-way heterogeneity of business, profit models, like plot lines in fiction or film, recur with surprising regularity. Understanding the elements and structure of a profit model well gives one the opportunity to recognize it where others may not.  If one understands this Customer Solutions Profit model, any company employing it is in one's circle of competence. Isn’t that why Buffett bought IBM? 

Classifying companies by profit model is an effective way of gaining insight into the strengths and weaknesses of an investment case. It is far more useful, in my view, than the headline categorizations of industrial organization popularized by Michael Porter and reformulated somewhat by Bruce Greenwald: “economies of scale”, “brand power”, “switching costs”, and so forth, very easily deteriorate into hollow, vacuous bumper sticker slogans. 

Consider now a business like Howdens Joinery, listed in the UK.  I will quote from the Chairman’s essay at the front of its 2011 Annual Report:

“250,000 local builders hold credit accounts with Howdens because we provide the products and services they require in order to run a successful business of their own. Through our national network of 509 depots we offer the builder a range of well-designed, well-made kitchens and associated joinery and hardware, all of which is available all the time in every depot. We sell to the builder on a trade-only basis, with a confidential discount that allows him to determine his margin and a net monthly account that gives him the ability to manage his cash flow requirements.

Howdens has acquired national scale, but it remains a local business, serving local builders who do not want to waste time travelling long distances or dealing with impersonal, centralised operations. Each depot runs its own customer accounts; employees are engaged locally; and profit-sharing is calculated locally, not centrally. Howdens’ customers expect to see familiar faces in their depot and rely on people they know to offer them sound advice.

A typical Howdens’ depot occupies around 10,000 square feet and employs about a dozen people. The depot is a low-cost operation, located on a trading estate rather than a high street, with convenient access and parking for the builder. Rent averages £5 per square foot and the typical depot fit-out cost is around £170,000.

The depot is able to keep everything in stock, and Howdens is able to refine stock levels, because each depot manager can use local knowledge to tailor re-order requirements to suit the needs of his or her customers...

The results we are reporting for 2011 reflect the inherent profitability of the business, and its capacity to generate cash, which has allowed us to grow and develop as well as meet our legacy obligations…

I’ll start at the beginning, with the Howdens’ model, which is based on a number of well-defined elements.

First, and principally, it is trade only, which means a constant focus on serving one customer – the small builder. We must not forget that we supply builders, who in turn supply people like us. Only Howdens can offer: a well-designed range of rigid cabinets, frontals and joinery that are easy to install, saving the builder time and therefore money; a quality of construction that means our kitchens do not break, look good and work well, saving more time and money (we call it “fitability”); a confidential discount that allows builders to determine their own margin and make a living; and a net monthly account that   allows them to manage their cash flow.

Second, we promise small builders everywhere that all our ranges are available locally, all the time, so they can pick up a complete kitchen when they need it, and they can finish their job and get paid by their customers, which means they can pay us.

Third, Howdens is a local business.  We have 509 local depots, because builders do not want to waste time driving to and fro – they want to get on with the job. Their account is with their local depot. The depot staff know what each account customer needs. And so there are no misunderstandings, and no call centres, which saves everybody a lot of time, as well as money.  “Local” also means that each Howdens’ depot is fully accountable for its own performance. Depot managers hire their own staff, refine their own stock to suit local needs, market it themselves to their own customers, and adjust their own pricing to suit local conditions.  They are wholly responsible for their own sales and their own margin.  Depot managers and staff are all incentivised to drive more sales and more margin, as efficiently as possible. Their bonus is based on a share of their locally generated profit less any stock loss – there is virtually no stock loss.  It is therefore not surprising that depot managers and staff are keen, willing and able to open new accounts and make sure that they trade.

Last year they opened 76,000 new accounts, which equated to 38,000 net new accounts in just one year. The total number of credit accounts now stands at almost 250,000.  On any given day, you can observe  the combination of around  £80 million of stock, spread across  509 depots, with 1,000 kitchen  planners capable of planning up  to 3,000 kitchens per day, 600  depot-based telesales people, 700  sales reps out on the road looking  for new customers, and 250,000  existing customers also out on  the road looking for their next job  to be getting on with – all of which  makes Howdens a business to be  reckoned with. 

Fourth, we run Howdens as a focused and therefore low-cost operation, with high volumes and predictable sales. We have invested in our own manufacturing capability to ensure better service, greater efficiency, and no waste – whether of money, people, process or space.  Our trade depots are typically 10,000 square feet in size, with rent of around £5 per square foot. They are located on trading estates – not retail parks. We do not have glossy showrooms. Our depots open early in the morning and are shut on Saturday afternoons and Sundays.  So altogether, they are not like High Street retailers at all, and their costs are very different too.

As I have remarked before, the Howdens’ model only works if it is implemented as a whole, which  means all of the elements are  non-negotiable [emphasis added].  Our model was designed when the business began in 1995. Its aim is to enable the business to find solutions to complexity efficiently and profitably, because we are engaged in a highly complex activity – that of getting kitchens into homes and making sure they work…

We are seeing an increased level of trust from builders keen to benefit from our knowledge, as well as from the other aspects of our offer, including the attractive terms I have described, and our planning facilities, which are second to none. As we have always said, builders follow the work and right now, proportionately, we are seeing more money spent by the private sector and less by the public sector.

I mentioned at the start of this review that continuing investment had been a critical factor in our ability to outperform the market and to continue to take market share in these challenging times. But what we have invested in? The short answer is that we have invested in serving one customer. That means making sure that we can offer our customer both service and efficiency, which together are the drivers of margin and market share. In order to improve service, we have invested in customer awareness. We provide each of our 250,000 account customers with catalogues, videos, samples and plans of kitchens, worktops, joinery and flooring to support their sales. We have also invested in focused advertising aimed at the end-user or consumer, rather than at our customer, the small builder, because we have observed that this helps the builder to market the whole range of Howdens’ products to an expanding population of aware consumers…

Furthermore, manufacturing supports our reputation with our customers. Builders do not like surprises with product.

They prefer to buy from manufacturers, and feel they know what they are getting, from people with credibility and a track record. By manufacturing product ourselves, we are also investing in supporting the margin of the business as a whole – and growing it, compared to others – because of the inherent efficiencies of not producing for anyone else. There is also the matter of security of supply. This is extremely important to a business that makes over 3.5 million cabinets and 860,000 worktops last year. We have also invested in the systems that control the manufacturing process, and by so doing have supported our ability to increase productivity and reduce waste. For example, we have invested in robots at the end of the production line, which have helped us gain more efficiency in the smooth transition from manufacturing to warehouse. Our investment in systems underpins our sales activity too. For example, we have invested in the latest CAD technology that means we can offer the builder an industry leading design service to support his sale, and he can fit a properly planned kitchen as quickly and efficiently as possible…

We know the importance of vigilance and we monitor everything, all the time – sales, margin, stock, cash, and the performance of every part of the business. In this market, we need to be quick on our feet. The way Howdens is organised means we are very close to where sales happen, and that is a source of competitive advantage. Vigilance also means responsiveness in every area. If a depot has an IT problem, we see it the moment it happens, and will set about fixing it immediately. If a customer account does not trade for 15 months, we close it, so that we keep a clean account base and know that we are tracking only active customers. We control credit by means of our nett monthly account, which is tightly managed, so that our total cost of credit, including debt recovery and bad debts, still remains less than 1.5% of sales.

What this all adds up to is that Howdens outperforms because we are clear about what we are doing. We design and build a professional product, with an up-to-the-minute design, that requires a professional fit, and we sell it to professional fitters who can go and pick it up from local stock day in, day out; and because we give them a truly reliable service, and a confidential discount, they can make a living out of it.

You might recognize the customer solution profit model in that opening essay. (1) Intimate knowledge of the customer; and (2) customization of products and services into (3) integrated solutions that address (4) the customer’s mission-critical problems (5) in such a way that these solutions are woven into the daily fabric of the customer’s business operations. 

It is a conscious, coherent, comprehensive, and sophisticated business model that should allow it to earn returns that are far above its cost of capital and well in excess of that earned by other home and construction supply companies operating in the UK market.

It has much more in common with IBM and Factset Research Systems than it does with Home Retail Group, Kingfisher, or even Travis Perkins.  It would take something special, something other than the hum-drum of daily competition, to knock Howdens down.

And if you recognize Howdens as an effective, successful example of the customer solutions profit model, you will have an insight into the investment case if its shares fall. 

In May of 2012, for example, Howdens’ shares were priced at 109p, or at half its current earnings power, even though it boasts 60% gross margins, 22% after-tax operating margins, and 20% returns on invested capital. Investors looking only at its financial statements would worry that such performance was unsustainable. An intelligent, prepared investor, on the other hand, would be thinking of the quality of the underlying business, as though a businessman considering a private purchase of the whole company. And that investor would have an advantage over the market.

This post is the first of twenty or so in a series. 

If you find this approach interesting and know of any small, listed companies that employ this profit model, go ahead and name them in the comments section below.

Disclosure: No position in FDS, HWDN, or IBM.

The Forest for the Trees

Note 1:

Note 2:
Technology & content expense = 2/3 maintenance, 1/3 growth

So:

6.6% normal margin x Revenue of $61,093 Revenue = $4,032 normalized profit

Amazon's grown at 33% over the last ten years and 40% over the last five years. If Amazon grows at 10% for next ten years, the stock is worth $375.

Tell me this isn't a Buffett stock.

School Specialty 3.75% Convertible Subordinated Debentures

This is my take on an idea suggested by Tbone Sam in the comments section of a previous post.

School Specialty sells classroom, janitorial and office supplies to schools. It’s a cyclical business that took on far too much debt to fund acquisitions of businesses that were worth far less than the price it paid for them. As a result, with large debt maturities due in 2014, it’s in a bit of a pickle, perhaps presenting us with an opportunity.

The capital structure:

I.                Secured debt:

SCHS has drawn on $54.8 million of a total $200 million LIBOR + 250bps, Wells Fargo-led asset based loan facility (“ABLF”) that is secured by a first priority interest in substantially all of SCHS’ current  assets and a second priority interest in all other assets.

It owes a further $67 million under a Term Loan facility (“TLCF”) that has first claim on all non-current assets of the company and has a second priority claim on the current assets. This loan is held by Bayside Capital Partners, costs 12.75%.

It owes $12 million under capital leases and a further $65 million under its operating leases (or only $10 million under a liquidation scenario).

II.             Unsecured debt:

The company has issued convertible subordinated debentures (“the convertibles”) with a book value of $157.5 million and a 3.75% coupon payable semiannually in May & November.

The Opportunity:

Scenario #1: Refinancing of the convertibles

What’s important for our purposes is that the holders of the convertibles have the right to require the company to repurchase them on November 30, 2014 for $115.9  (including accreted principal) – a hard put that values them at 2.4x their current market value.

The company says that it plans “to refinance the debentures prior to September 30, 2014 and to obtain the money to refinance the debentures from the issuance of new debt and/or additional equity.” And it may be able to do just that, in which case for the convertibles is a simple and clean one.

Scenario #2 Involuntary Chapter 11 Reorganization

If the company is unable to refinance the convertibles before that date – the credit markets stink; the company’s cash flow profile deteriorates – then the company will be in default on the terms of the secured loans, the ABL and TLCF creditors will call in their loans, and SCHS will enter the Chapter 11 process.

One can see from the above that the business is worth something like $455 million. After accounting for the $134 million in secured liabilities, the residual value is ~$320 million, meaning that the convertibles will receive at least what they are owed, i.e. $183 million, either in cash or stock.

Of course, the restructuring process being what it is, and creditors being what they are, it seems quite probable that a  valuation professional engaged by the court could slap a 5x multiple on current (or on average trailing 2 year) EBITDA which, if approved , would value the enterprise at $400 million and the leave the convertibles owning 85% of the business (183/(400-134).  In that eventuality, the convertibles will be worth $270 million (85% of the real value of $320 million).

Scenario #3 Prepackaged Chapter 11 Reorganization

This seems to me the most likely scenario: covenants have been breached, forbearances granted, and reorganization lawyers and bankers engaged by both the secured and unsecured creditors.

One imagines that Bayside Capital Partners’ TLCF credit line to SCHS was strategic, and that they will pay off the ABL creditors and come to an arrangement with both the holders of the convertibles and with the equity owners whereby the equity survives (but only just), and Bayside and the holders of the convertibles take ownership of the lions’ share of the remainder.

It is hard to pin down the exact value of the convertibles under this scenario, but we can, I think, be confident that is somewhere between the minimum value envisaged under Scenario #1 and the maximum value envisaged under Scenario #2 – i.e., somewhere north of $115.9, though much closer, I would have thought, to the lower end of that range: Bayside Capital Partners’ hand seems to me much stronger in a prepack than it would be under an involuntary Chapter 11 process.

I haven’t discussed Chapter 7 scenarios because I don’t think there’s even a small chance of a liquidation process: all parties would lose under that scenario.

The bonds haven’t traded for a month. I think they are attractively priced: a likely 130% recovery in 21 months. If and when they trade at under $55, I’ll try to establish a position.

Portfolio Update

I am out of GEA at 71.80, and have used the proceeds to establish a fresh position in Lamprell. 

Portfolio Review

Time for a half-year review of my holdings and, while I’m at it, a discussion of what I have and haven’t (yet) learned from 2012.

I.  Current Holdings

Hawaiian is still good value. I estimate its worth at about $25 and, in so valuing Hawaiian, I have on my side arithmetic and, I think, some modest insight: Most market participants, even those who like HA, no doubt perceive it to be “an airline” with all that implies; I see it as a toll road to a favored destination. Hawaiian has a lot more in common with Mattel than it does with United Continental: an effective low-cost firewall behind which is a premium offering for a branded product for which demand will rise in the future. 

Dunkerley and the board seem to see it my way and every strategic move that they’ve made since 2008 – a second hub in Maui, adding Asian destinations, etc. – can be understood in the light of this perspective, as can the structure of the executive compensation plan.

Hawaiian is yielding 40% on trailing earnings. It more than earns its cost of capital, and growth, therefore, will add value – whether fuel prices rise or fall. And grow it will, meaning that one doesn’t have to fret about how long it will take for the gap between price and value to close.

Relative price appreciation has promoted it from a 20% share of my portfolio when I bought in, in August 2011, to a 33% position as of January 10th. In the three months since my last portfolio review, the stock price has moved from $5.30 to $7.30 to now $6.60 –sizeable moves but nevertheless just noise. 

It reports 4^th Quarter, and therefore full year, results at the end of the month. I expect headline EPS of $2.55 and true earnings, excluding the after-tax cost of intangible amortization, of $2.82.

Northgate is a new addition premised on arithmetic rather than any particular insight. “Return on Invested Capital” is, at bottom, nothing more than the cash that is generated in return for the cash invested in the business. The fastest way to calculate that relationship also happens to be the literal and best way of doing so:

[EBITDA *(1-Operating Tax Rate)]/[Operating Working Capital + Gross PP&E + Capitalized Leases + Gross Value of Operating Intangibles]

Northgate returns 16.4%, on average. Apply that figure to the net value of its operating assets, subtract the net non-operating liabilities, and one arrives at a value of 732p per share for the equity, almost 3x its price at the time that I took a position in it. I wish I’d seen it when it was selling at 160p in June. Woulda coulda. I bought it with the proceeds from the sale of my stake in Cegid – a fair exchange. What I particularly like about it is that the valuation is indifferent to the macroeconomic environment: its vehicle fleet is, for all intents and purposes, working capital and an economic downturn sees it converted into cash. And there’s nowhere for that cash to go but to debt repayment and buybacks. 

Cybergun is this quarter’s winner of the William Ewart Gladstone Award. A "stern and unbending" follower of High Church traditions takes in a lowly, reviled stock, gives it a cuppa and sees it on its way, after which he self-flagellates for being tempted by such a wretched creature, draws little whips in his journal, and vows not to do it again – until the next time. Except that the wretched stock still here, skulking, stinking up the joint.

I added to my position in Cybergun and lowered the cost basis from €2.29 to €1.97.  Minimum upside is, I think, €4.00.

More notable – and shameful – is what I didn’t do: Cybergun’s 2016 8% bonds fell to €32 implying a yield to maturity of 51% … and I didn’t buy them. A truly inexplicable mistake; I remember seeing it, I remember thinking “that’s good value”, but I don’t remember deciding not to buy it. (Similarly, at the start of 2012, I watched, slack-jawed, as Trident Microsystems fell to 6 cents, and only bought in when it had rallied to just above 15 cents. An unrepeatable mistake, I thought then.)

Precia. Nothing to report. Good stock, good price, profitable growth.

XPO Logistics. Nothing interesting to say about this one. I think it’s likely worth $75, although most of that perceived value is in the form of unmapped future growth. My aim is to lighten up on this stock as its price appreciates in 20% increments. It's the opportunity cost that I'm thinking about. The UK market, for example, is still stocked with some obvious bargains – notably Dewhurst, MS International, Lamprell, Instem, Northbridge, Finsbury Food Group, DRS Data & Research, Cambria Auto, Chemring, and Air Partner, to name only the ones that are selling at well below half their demonstrable value – and it would be a shame to completely miss out on these bird-in-the-hand opportunities for the somewhat more speculative opportunity that XPO’s unmapped growth represents.

GEA. I’ll be out of this one soon.

II. Full Year 2012 performance.

The first half of the year predates the blog and therefore predates the tracking portfolio that mimics my holdings. Nevertheless, for what it’s worth, here’s my 2012 performance:

Not quite as bad as throwing darts at the stocks page of the newspaper but, given the wealth of deep value opportunities available in 2012, it is a disappointing showing. I try to balance patience, action, and cash and I got that balance all wrong this year. I turned over 35% of the portfolio in 2012, which is about normal.

III. The blog

This blog is intended to be a real-time demonstration of a particular approach to value investing as well as a journal recording my mistakes.

I have fallen way short of describing my overall approach to value investing; that is something I’ll be focusing more on in the future.  I have written about French stocks in English only; I'll correct that going forward. I don't like 98.3% of the stocks that I look at. You'd never know it from reading the blog. So, I'll occasionally weigh in on why I don't like particular stocks that other value investors do like.

In order to minimize the chance that I’ll write utter nonsense just for the sake of something to say, I’ve set up an “inventory” page to track the performance of stocks that I have said I think are good value. In general, try to highlight those stocks (and, occasionally, bonds) that seem to me to priced at below half their value; the average performance of the stocks in the inventory page should therefore outperform the S&P by 2x or by 10% per year in any subsequent two year period. I can tell you now that the one post that I repudiate, am embarrassed by, and regret having written, is the one on Lojack, no matter how well it does in the future.

Ironically, aside from the mundane performance of my portfolio, 2012 was a productive year for me. I have managed to conclude a process that I started in 2010 of mapping out a large patch of the small cap equity space in the UK, France, Greece, Australia and NZ, sorting out good companies from bad, getting a sense of how their stock prices behave, and so on. It has been very interesting and helped greatly by bloggers in those countries – thank you! No doubt this preparatory work will come in handy at some point in the future. This year and next I hope to do the same for Germany, the Nordics, Switzerland, Austria and Spain.

IV “the 2013 Picks”

I have lately been experimenting with various approaches to automating a value investing approach that makes sense. I’d be happy enough to design an approach that I can rely on to earn good returns without regular attention to the markets.  In that context, the 2013 picks for the UK, the Eurozone, and the USA are attempts to accelerate this experimental process by running concurrent paper “portfolios” that use the same approach but in different markets. A paper portfolio that uses a slightly different approach that I started in April is doing okay, but probably not well enough for me to have full confidence in it. 

In any case, thanks for reading and Happy 2013 and, if you're new to the blog, please bear in mind that I'm an idiot.

Disclosure: I am long HA, XPO, NTG, PREC, and GEA