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PNE Industries (website) is a net-net listed in Singapore. The company has two segments:

• Contract manufacturing: the manufacturing of electronic controllers, transformers, and other electrical and electronic products
• Trading: the manufacturing and trading of emergency lighting equipment and lithographic plates, used for off set lithographic printing

The latest financial data are from March 31, 2013 and show cash and bank balances of S$15.7 million (S$ = Singapore dollar), receivables of S$24.9m and inventories of S$19.9m. Total liabilities were S$8.4 million, giving PNE Industries a NCAV of S$52.0 million.

With shares trading at S$0.086 and total outstanding shares of 335.67 million, PNE Industries’ market cap is S$28.9 million. Currently, PNE is trading at 0.56x NCAV and 0.42x book value.

The company has shown decent profits over the last six years. In the financial year ended September 30, 2012 the company showed comprehensive income of S$4.3 million. Also, the company has been able to generate cash consistently. The cash has been used to pay off the debt (PNE is currently debt-free) and to pay dividends. PNE has paid a dividend in every year since 2007, I can’t find financial reports for the years before 2007.

Of course no investment is perfect and one of the risks with PNE is that two groups of customers accounted for S$46.6 million of the total revenue of S$94.3 million. Also, 48% of the revenues come from customers located in Poland and the rest of Europe. Losing one or both of these customers could have a huge impact.

Perhaps this is one of the reasons why the stock is cheap. Also, the Singapore stock market as a whole looks relatively cheap. But I think the illiquidity of the stock is the most important reason for the low price. There are many days where no PNE shares change hands. The majority of investors simply want to be able to get out of a stock instantly and this keeps out many buyers.

It looks like PNE Industries is family controlled. The CEO, Tan Koon Chwee, owns 11.1% of the shares. His brother and the chairman of PNE, Tan Kong Heng, owns 10.5%. The list of major shareholders contains many other people named “Tan Kong” and between them they own more than 50% of the shares. Perhaps this is just a very common name in Singapore though, I’m not sure. Only 18% of the shares are held by the public.

Investing in Singapore and Hong-Kong

I have looked at a number of companies on the Singapore and Hong-Kong stock exchanges, but have never felt confident enough to invest. With US markets rising rapidly, I have looked harder. I find it difficult to trust the numbers of Hong-Kong listed companies, but there are some very cheap stocks there. I have more faith in Singapore in this regard. I think if a company official in Singapore defrauds investors he will be punished, I’m not so sure this would be the case in Hong-Kong or China.

What also helped is that PNE Industries owns 50% of an associate, PNE Benelux BV, which is located in my country, The Netherlands. I was able to find some old job openings for this company. On Facebook and Linkedin you can also find profiles of people working for some of the PNE subsidiaries. Perhaps this is all a little flimsy, but it does make me feel the company is real and it helps to get some sense of the people working for the company and their operations.

Finally, I have found a few funds that focus on Asian stocks and they have done very well over the years. For example: Yeoman Capital Management claims a CAGR of +13.12% for a period over 15 years. They seem to have a basic value approach and invest mainly in Hong-Kong, Singapore, Malaysia and South-Korea. (BTW: don’t spend too much time reading their newsletters, it’s all macro talk unfortunately).

I think that if I keep my positions small and take a basket approach, investing in a number of these cheap Asian stocks should work out well.

Links:

• PNE Industries company website
• Singapore Stock Exchange: Annual reports select “PNE Industries” in the drop-down menu next to the text “Company Name:” and press the “Go”-button
• Singapore Stock Exchange: Company announcements other announcements (including half-year reports)

Disclosure: long PNE Industries (P07)

Tom Russo looks for something he calls “the capacity to suffer” in the companies he invests in. This is the willingness of a company to suffer poor initial returns on an investment in order to gain a big competitive advantage at a later time. For example a company that invested heavily in China since the 1980′s might today be a well established brand in a huge, booming economy.

I think this capacity to suffer applies to individual investors as well, but in a different way. After reading this excellent topic on the Corner of Berkshire and Fairfax forums, I thought about why I mostly invest in small caps and why most investors seem to dislike them. A lot of arguments I hear against small caps don’t have anything to do with the fundamentals of the companies. These are things like the illiquidity of the stock, a lack of information (companies that have gone dark or that provide very limited updates during the year) and the fact that there is no catalyst in an investment. I think an investor can gain an edge by accepting these negatives. From what I have seen so far, I believe that the market especially discounts illiquidity. Almost all investors want to be able to quickly jump in and out of a stock. By simply being willing to suffer the illiquidity of a stock you can often buy in cheap.

Belgravium final results for 2012

Perhaps the capacity to suffer also applies to investors in Belgravium (click here for my initial post on Belgravium). The company reported the final results for 2012 and as expected revenues and after tax profits were down sharply from 2011 coming in at £8.67m and £336k respectively.

The share price declined significantly and is currently below 3.0 GBX, bringing the market cap slightly below £3m. I was a little surprised by the market reaction, since the company had already updated investors and told them customers were delaying orders and that Belgravium’s full year results would suffer. The decline might be caused by the fact that the company also said it does not expect that their markets will be much better in 2013:

“2012 was a challenging year and we do not expect our markets to change significantly in 2013. However, the Group has a strong balance sheet and has initiatives in place which should at least ensure improved profitability in the current year.”

There are also some positive signs though:

• Belgravium expects improved profitability in 2013
• Belgravium continues to generate free cash flow: £593k in 2012
• The balance sheet is very strong: Belgravium has £1.6m in cash and no debt

Balance sheet

One thing I did not mention in my initial post on Belgravium is the significant amount of deferred income on the liability side of the balance sheet. This liability is created by the sale of advance maintenance and software contracts:

“Income from the sale of advance maintenance and software contracts is shown as deferred income in the balance sheet and released to revenue over the length of the contract in line with the substance of the relevant agreement.”

Short-term deferred income is included in “Trade and other payables”. You can only see this by looking at the notes of the annual reports. At December 31 2011 the amount for deferred income was £1.44m on total payables of £3.3m. We will have to wait for the annual report for 2012 to find out how much deferred income was included in the total amount of payables of £2.64m on December 31 2012. There is also non-current deferred income of £970k relating to long-term contracts. MSN Money lists this as “deferred income tax” which is wrong.

It seems clear though that from the total liabilities of £3.71m on December 31 2012, around £2m consists of deferred income. I understand the company needs to account for this as a liability, but thinking about this from an economic perspective it seems to me that Belgravium has a stronger balance sheet than you would think at first glance.

Acquisitions?

Belgravium mentioned in the report that their financial situation is very different from 2010:

“This year’s downturn in Belgravium’s performance is very different from 2010 when we had a demanding bank debt. Our cash generative policies have allowed that debt to be repaid in full and left a healthy surplus for future corporate development. Whilst we aim to increase sales organically, now that we have the resources, it is right that we also seek further growth by acquisition.

We are examining two areas:

Increased territorial coverage. We have long felt that our products and services could be sold into more countries, particularly in Europe. So far, sales have been restrained by the perceived need to have local representation, installation and maintenance arrangements. Certainly where we have such facilities, as in France, good business has resulted. We are therefore pursuing the development of relationships where we can extend territorial coverage.

New market sector. Belgravium will continue to be focused on digital data capture but there are other markets to which this can apply outside of logistics and where our hardware and software expertise would provide immediate benefits. In 2013, we shall attempt to find such a company and to use some of our cash reserves to build a growth relationship.”

(Emphasis mine)

I am not a big fan of acquisitions when a company is trading at such a depressed price. This is why I sent an e-mail to the IR address listed on the Belgravium site. I just asked them to also consider repurchases. It seems that management is fairly confident that Belgravium can stay profitable: they expect “improved profitability” in 2013, they have paid a small dividend in 2012 (for the first time since 2008), have announced a 0.1 pence dividend for June 2013 and they are looking at acquisitions. These are not things that management tends to do when it is expecting losses. Cash conservation is key in those times.

Since management believes the company will stay profitable, in my view repurchasing shares at these depressed prices is a very good use of the excess cash. Belgravium’s Board should consider this possibility and weigh it against the uncertain returns from acquisitions. In my first post I said I thought acquisitions were a “big mistake” at current prices. I have changed my mind somewhat, because the latest report made me realize that Belgravium is probably losing some business, because it has not been able to provide local support throughout Europe. This is something their customers seem to value very highly, so it makes sense to invest in this. It would help increase revenues and the company probably already has a good idea in which countries it is most likely to achieve success. But perhaps the company can do both an acquisition and a share repurchase.

I hope Belgravium will repurchase some shares, but it is difficult because the stock is illiquid. Perhaps the company can buy shares from a large shareholder looking for an exit. Another possibility is a tender offer. One problem there is that the costs of the tender process itself might be significant. I saw an AIM-listed small cap that incurred about £100k in costs in their tender offer. For a company of Belgravium’s size this is a big number. Perhaps for a nano-cap like Belgravium these costs can be reduced.

Conclusion

I still like Belgravium and at the current price I like it even better than in my initial post. This is why I bought some more shares recently. Belgravium will stay a small position for me and I don’t want to give the impression that I think it is a wonderful company I would like to own forever (a Buffett-type investment). I just like the fact that sentiment is very negative and that the share price has collapsed. If the company can stay profitable and keep generating cash, I believe the investment should work out well when business improves a little.

Disclosure: long Belgravium

It has been a while since I last posted. I don’t really have a regular posting schedule for the site at this point. The best way to keep up with new posts is to subscribe to the RSS feed or follow me on Twitter.

One interesting stock I recently found on the AIM market in London is Leeds Group (company website). Leeds is an investment holding company and has one subsidiary called Hemmers-Itex. Hemmers-Itex is engaged in the import, warehousing and wholesaling of fabrics. Leeds used to be involved with textile processing (fabric printing and yarn dyeing), but the ever increasing competition from Asia made them cease all manufacturing operations. Today Hemmers-Itex is only involved with the trading of fabrics.

The investment case for Leeds Group is fairly simple: on November 30th 2012, the company had current assets of £15.4m (cash: £2.0m , receivables: £7.2m , inventories: £6.2m) and total liabilities of £5.6m. Net current asset value was £9.8m. The market cap of the company is currently £6.5m. So, the company is trading right around the 2/3 of NCAV level that Graham net-net investors are looking for.

Leeds Group has been profitable in 4 of the last 5 years, only showing a small loss in 2009.

Peter Gyllenhammar

There is one more interesting thing about Leeds. Swedish activist investor Peter Gyllenhammar owns 21% of the shares. Anothere Swede, Johan Claesson, owns 25% of the shares. I don’t know what the relationship between these two is exactly, but I read an old article that shows these two have been involved with some other companies as well.

I recognized Gyllenhammar’s name from a book I read called Free Capital. The author of the book has interviewed a number of successful investors in the UK markets and has written profiles of these people. It is fun to read. I have reread the chapter about Gyllenhammar. He is mostly an activist. He often takes a stake of about 25% in a company to take “negative control” of the company. It means that with a stake like that it becomes possible to block certain management actions, especially if he can find a few other large holders that agree with his agenda. He then tries to unlock the value in the company.

Leeds appears to fit this profile. Gyllenhammar and Claesson effectively control the company. Gyllenhammar is certainly more of a Graham style investor than a Buffett style investor. He looks for companies that have seen their shares come crashing down and buys in to them heavily. Usually these are not quality businesses, but they are trading at big discounts to their book values. He does not avoid ugly situations and risk. Gyllenhammar went bust twice, earlier in his career.

Gyllenhammar has been a shareholder in Leeds since 1999. Gyllenhammar and Claesson have invested some of the cash of Leeds and unfortunately they made a bad investment when they bought a 29% stake in Dawson International PLC. That company had a big problem with its defined benefit pension scheme and eventually went into administration in August 2012, wiping out the value of that stake.

One positive thing about the capital allocation is that Leeds has been a consistent buyer of its own shares.

Receivables quality

There is one issue that looks worrisome to me and that is the quality of the receivables. In note 16 of the latest annual report, Leeds shows £1.05m in trade receivables past due and impaired (up from £0.88m in 2011). Leeds has a further £1.0m in trade receivables past due but not impaired (down from £1.12m in 2011). The company does report about this last category that: “In many cases these debts are covered by trade insurance”. The provision for impairment that Leeds has taken is £762k.

I worry that when the industry has a further string of bad years that this situation could get much worse. Since Europe is in and out of recession for some time now, this risk should be taken into account.

Considering the receivables quality and the marginal business Leeds is involved in, this company doesn’t look like a net-net I would like to invest in. It will still be interesting to follow this company and see where Gyllenhammar and Claesson take this. Excess cash can be invested in other businesses and this could also create value for Leeds shareholders.

For those interested, here are three articles about Leeds Group by Richard Beddard from 2011:

• Leeds: Money for old thread
• Leeds by lines and numbers
• The Peter Gyllenhammar story

Belgravium Technologies (company website) builds rugged mobile computing devices and also develops software that runs on these devices. Belgravium is listed on the AIM in London (ticker: BVM).

The company is active in three main markets:

• Warehouse and Logistics: mobile computers and bar code scanners make it easier for companies to keep track of inventory and reduce human mistakes.
• Fuel distribution: Belgravium hardware and software is used by most of the large fuel suppliers around the world. It helps drivers of fuel trucks with scheduling, communication, navigation and proof of delivery.
• On-Board retail: Belgravium offers mobile Point of Sale (POS) solutions to the travel retail industry (primarily to airlines).

To better understand some of the products and services Belgravium offers, I recommend watching a few “Case study” videos the company has uploaded to its Youtube channel.

Belgravium has been hit by the struggling UK economy. The company showed weak sales for the first 6 months of 2012. Customers were delaying orders. Management expected sales to improve in the second half of the year. The stock dropped from 7.28 GBX to 5.88 GBX on the day of that announcement, September 6, 2012. On December 7, 2012 the company posted a trading update. More bad news: the expected recovery in the second half of the year was “unlikely to materialise within this time frame”. The stock dropped to 4.38 GBX.

Since then the stock has slipped a little further and is currently trading at 3.80 GBX. At the time of writing Belgravium has a market cap of £3.84 million.

Cyclical companies

I avoid investing in cyclical companies, because generally I don’t think I can get the timing right. There is tremendous upside when you can figure out were the bottom is and buying when many investors are selling their shares in disgust, because of falling earnings and a poor outlook. But it also requires good insight into the industry and a lot of knowledge about the company involved. A company that has one or two bad years might still be acceptable as an investment, a company that has a poor decade can be a disaster. I am a novice investor and need to keep my picks very simple.

I decided to look closer at Belgravium anyway, because the company has remained profitable in 2008 and 2009, although sales and earnings were depressed. My main question was how were they able to stay profitable? When I read that Belgravium made mobile computer devices, my initial thought was that these products seemed like a commodity. Companies that produce products that can be viewed as commodities tend to do very badly in a recession and show losses.

Acquisitions

Belgravium made a large acquisition in 2005 when it acquired Touchstar Technologies for £10.75m. In 2006 a smaller acquisition was made: Novo IVC was bought for £1.3m. The company issued shares and took on some debt to make the acquisitions. It has over the years retired the debt and is currently debt free. These acquisitions have put Belgravium in a position where it can offer both the hardware and the software to a customer.

From the 2011 Annual report:

“Inhouse hardware manufacture combined with application software gives the business the opportunity to create bespoke solutions, a significant differentiating factor over much of the competition.”

Nature of the products / services and competitive position

After reading the most recent annual report and the reports from 2008-2010 I have changed my mind about the nature of the company’s products and services. Here are some quotes from those annual reports:

“As has been the case for some years, customers remain reluctant to commit to what are perceived as significant capital projects but appear more willing to agree projects of a profit and loss account nature. Our success has been largely down to our ability to develop sales opportunities where we have been able to demonstrate the economic benefits of using Belgravium’s complete services, which include hardware, software and increasingly support services as part of a ‘wrapped’ solution. Often, as a result we are able to provide a solution, which gives customers better value and added functionality, which we believe will be a continuing feature of our success.” (Annual report 2011)

“In the year, the Group actively worked alongside its strategic partners to capture a greater market share, particularly in the on-board retail sector where its system is now consistently being chosen over competing products. As a result several significant new contracts have been won in the period and there is a healthy pipeline of new prospects. Belgravium now provides a retail solution system to over 50 airlines in the world.” (Annual report 2011)

“A large French energy company and a customer that Belgravium has worked with for several years awarded the replacement contract to equip 1,200 vehicles with the ‘Raven’ mobile tablet device and associated software. This contract will continue during 2012 with a total contract value of approximately £3.3 million. This contract requires on-going sales and technical services to ensure that the customer’s changing needs are met.” (Annual report 2011)

“Historically, Belgravium has been thought of as a hardware supplier but increasingly the contracts we gain tend to centre around software and the other elements of a complete system. Licences, upgrades and maintenance are all essential in a system and all differentiate the overall product and provide repeat revenues. In addition the Group has been successful in offering web hosted services attracting healthy and recurring revenues. In particular, we have added vehicle tracking and telematics capability to our core fuel distribution system. The company also seeks to gain repeat revenue from GPRS data contracts and software licencing. We have successfully added accredited “chip and pin”, Wi-Fi on-board and GPRS data transfer technology to our portfolio providing wider recurring revenue, as well as being able to offer “virtual” on-board products to the airline passenger such as tickets to theme parks and other major city attractions.” (Annual report 2010)

“The contraction in our market and the operational gearing inherent within the Belgravium business model is very obvious when these results are compared with 2007 when the Group achieved revenues of £10,637,000 and made a profit before tax of over £2 million. A sustained improvement in market conditions would quickly enable us to return to better profits.” (Annual report 2009)

“Airlines, in particular, have been under serious pressure in the past two years and have sought ways of increasing their margins, which has brought more interest in in-flight retailing services. Whilst we have a long-established presence in this market, we have, until recently, been unable to supply all the functions that the operators now require. As a result of strenuous developments in hardware and software, some involving specialised partners, we now have the most complete product range in the business. This created a great deal of fresh interest as the year concluded, with excellent prospects for 2010.” (Annual report 2009)

“We rarely have to convince operating management of these advantages but it has proved increasingly difficult, in the current economic climate, to gain financial authorisation for what are usually seen as capital projects. This is currently the nature of our market; slow moving and frustrating. Margins are still healthy, and we believe that revenue growth will be restored once confidence returns.” (Annual report 2009)

“All of our markets have experienced slowdowns and delays. We believe that most will gradually show recovery, as product advantages overcome financial caution. It is important to note that Belgravium’s products currently in the field have a finite lifespan and, at some stage, the increasing cost of maintenance and repair will necessitate customers upgrading to the latest products and software. Our experience has shown that this represents an opportunity to the Company, as customers typically upgrade with Belgravium.” (Annual report 2008)

I think these quotes provide a reasonable answer to the question why Belgravium has remained profitable in 2008 and 2009. The company is certainly not immune to a recession, but it seems to be able to maintain the revenue levels required to keep it profitable. This has to do with the type of products and services Belgravium offers. When you think about it, Belgravium offers products and services that enable their customers to increase revenues (on-board retail) or to work more efficiently (fuel distribution, logistics). These types of products and services are not the things customers will cut back on the most in a recession. For example: airlines will probably try to sell more high-margin products to passengers during flights in times of recession to help them overcome their large fixed costs. Belgravium has seen customers delay expenditures and therefore revenues have declined again in the most recent recession (I believe we are currently in our triple-dip in Europe). Eventually customers will need to upgrade though and some maintenance and service revenue will still be required even for these customers.

Additionally some of Belgravium’s products seem to be the preferred choice for customers. Belgravium noted in 2011 that their on-board retail product is chosen above competing products and that in fuel distribution their products are used by many of the large fuel suppliers worldwide.

The downside is that Belgravium will need to keep a certain number of people employed to provide customer service, to further develop existing products and to develop new products. They can not easily cut back on this and it is the main reason why you see a big hit to earnings when revenues decline. If revenues decline significantly below the levels seen in 2008 and 2009 the company will show losses and start burning cash.

Insider ownership

The Executive Chairman, J.P. Kembery, owns 9.1% of the outstanding shares. Other board members don’t own a significant amount. I prefer companies where the management and board members own a larger percentage of the outstanding shares.

There was a director, R.D. McDougall, who owns 5.8% of the shares. In January 2013 the company announced that McDougall had resigned as part of a cost reduction program. In general it is bad news to see a significant owner resign from the Board of Directors, but in this case I can understand it. The company wants to reduce costs and the Board of this very small company had five members. McDougall is 69 years old and might have stepped back at some point in the coming few years anyway.

Capital allocation

The company paid dividends in 2007 and 2008, but then decided to eliminate the dividend as sales remained depressed. Management focused on paying down the debt incurred in the acquisitions of 2005 and 2006. Looking at the balance sheets of 2007-2010, the situation actually looked a little worrisome: the company carried some debt, had no cash and sales and profits were depressed. The cash flows stayed healthy though and this helped Belgravium to slowly clean up the balance sheet. The debt is now gone.

If the company maintains the depressed earnings of 2008-2009 in the current recessionary period, it should still have more cash available to distribute to shareholders in the form of dividends and share repurchases, since cash will not be needed for debt retirement anymore. Financially, the company is in much better shape now than it was in 2008.

The current stock price could be an excellent opportunity for management to repurchase shares. The balance sheet shows £1.6m in cash and the company has generated a substantial amount of cash in the last five years. I read in the annual report that the company is looking at possible acquisitions to grow the company. At the current price I think that would be a big mistake. If management is confident about maintaining solid free cash flows in the coming years, the best use for the cash at this price is surely a share repurchase. Perhaps a few larger shareholders are looking to get out of the stock and the company can buy back their shares. It should be noted that Belgravium is an illiquid stock and that repurchasing a substantial amount of stock in the open market looks difficult.

Conclusion

Belgravium is not a typical Ben Graham stock. The balance sheet does look solid with a cash balance of £1.6m and no debt (but keep in mind £0.9m in operating lease commitments). A large part of book value consists of goodwill though (£9.1m). For me this is not a reason to dismiss the company. A margin of safety can also be found in the nature of the business and its position in the industry. I believe Belgravium will see reduced revenues in times of recession, like today, but I also think the company will catch up when the economy recovers a little. This happened in 2011 when sales jumped to £11.2m from £8.2m in 2010 and the company earned £876k vs £282k the year before. Because of the company’s structural costs (personnel), a recovery in sales results in a dramatic improvement in profitability. The share price tends to follow.

In a “normal” year I think Belgravium should be able to make around £1m. Of course, when the company actually posts these improved revenues and profits, the company is probably not selling below £4m like it is today. With a company like Belgravium you need to figure out if the price is attractive in times of recession. I believe it is and have bought a small position. If the company continues to post depressed earnings, the share price is likely to decline further. I would not be surprised to see a share price below 3.00 GBX, a level that was also reached in 2010. If the company is still reasonably profitable at that point I will probably increase my position a little.

Disclosure: long Belgravium Technologies

Riken Keiki (company website) is a Japanese company that manufactures and sells gas monitors. Their monitors are used to detect toxic gases, to prevent oxygen deficiencies and to prevent gas explosions. Users are oil refineries, petrochemical and chemical facilities and various other industrial users. Examples of the gas detectors it sells can be found here: Riken Keiki products.

The company is currently trading at ¥558 and 23.2 million shares are outstanding (446k shares are held in treasury), giving Riken Keiki a market cap of ¥12.95 billion.

Shareholders’ equity on 09-30-2012 was ¥25.7 billion. The company has a strong balance sheet. Cash & cash equivalents were ¥9.1 billion, but the company also holds another ¥2.2 billion in non-current investment securities. Total liabilities were ¥7.3 billion of which total debt was around ¥1.7 billion. Riken Keiki is trading at a discount to NCAV. NCAV on 09-30-2012 was ¥13.9 billion, this is excluding the non-current investment securities.

The company has shown continued profitability over the past 10 years and the current P/E ratio is about 8. Sales have been fairly stable, growing slightly until 2008 and dropping a little since the financial crisis hit. More importantly, the company has also been cash generative. Even though there has been some lumpiness because of swings in working capital needs from year to year and higher capex last year, the company’s free cash flow looks good. I think Riken Keiki should be able to generate at least ¥1 billion in FCF on average going forward.

I don’t know much about the quality of Riken Keiki’s products or their position in the industry. The company has an American partner in RKI Instruments which sells Riken Keiki products in North America. Riken Keiki also has a European sales and service office in Germany: RKI Analytical Instruments GmbH.

As so often with Japanese companies an investor looking at Riken Keiki will ask himself what the company is going to do with the cash. In my previous post on Japanese stock Maruzen I wrote that my strategy is to buy companies where I have some hope capital allocation will be more rational than at some of the biggest cash boxes out there. In short my theory is that a company with a very long history of hoarding cash is less likely to change its ways then a company that has been building up cash for a shorter time. Since poor capital allocation is probably one of the most important reasons for the low valuations of many Japanese companies, I prefer to choose companies that offer a better chance of improving their capital allocation. Perhaps this strategy will prove to be nonsense, but the fact is that an investor in Japanese stocks needs to use some criteria to make a choice between all the bargains that are still out there in Japan. Buffett’s comment about feeling like an oversexed man in a harem comes to mind.

Riken Keiki pays a reasonable dividend and currently yields about 3%. Unfortunately the company has not repurchased a meaningful amount of shares. In this regard I like Maruzen a little better, because they did do a small buyback. Offsetting this factor is that Riken Keiki trades at a very low multiple of book value (0.50).

All in all I like the company and I have made Riken Keiki my second stock in my basket of perhaps 3 or 4 Japanese stocks.

Disclosure: long Riken Keiki (JP:7734)

I recently found out I can buy Singapore stocks at IB, so I have been looking at some stocks over there. I used the FT.com stock screener to find some interesting stocks. This post will be about Casa Holdings Ltd (C04.SI).

Casa Holdings’ (company website) activities in Singapore consist of the distribution of electrical and electronic home appliances. It also has a manufacturing subsidiary in China which makes air-conditioning units and dryers machines.

The company currently has a market cap of 39m SGD and Casa has shown solid profitability over the last few years, making 9.47m SGD in 2012 (6.7m excluding a reversal of impairment loss), 6.8m in 2011 and 5.9m in 2010. Annual reports for Casa and other stocks in Singapore can be found on the Singapore Exchange website.

What caught my eye initially were not the earnings or cash flows of Casa, but its balance sheet. Looking at the FT.com data, Casa showed shareholders’ equity of 53m SGD on 09-30-2012, so Casa is trading at about 0.75 times book value. The most striking thing on the balance sheet are the ‘long-term investments’ of 26m SGD. What are those investments? We find the answer in the annual report.

The balance sheet in the annual report shows about 1.4 million SGD consists of an investment in a joint venture. The far more important item however is an investment in an associated company of 24.9m SGD. To find out more about this investment in this company we have to look at the notes to the financial statements.

Note 16 shows that Casa Holdings has a 26.5% equity interest in a Malaysian company called Fiamma Holdings. I thought the story would end right there, but Fiamma Holdings turns out to be a publicly listed company in Malaysia and it files financial reports in English. So this post continues.

Fiamma Holdings

Since a significant part of the assets and earnings of Casa Holdings come from its interest in Fiamma an investor in Casa needs to dig into Fiamma’s financials. Financial reports for Fiamma Holdings (company website) can be found on this page on the Bursa Malaysia website.

Like Casa, Fiamma also distributes products like kitchen appliances and bathroom furnishings, but their activities are located in Malaysia. Unlike Casa, Fiamma has a property development segment. Fiamma has a market cap of 171m Malaysian Ringgit, which should be about 69m SGD if I calculated correctly. Revenues and net income have been steadily increasing. This all looks very good. The cash flow statement show a less positive picture, because working capital requirements have gone up as inventory needs and receivables balances have increased. Some of this is to be expected with a business like this. Sales have grown from around 160m Ringgit in 2008 to 260m Ringgit in 2012. Still, on balance the company has generated a reasonable amount of cash and has distributed some of it to shareholders as dividends.

What I don’t like about Fiamma’s is that it has spent a lot of cash on acquiring land and developing real estate over the years. The 2012 cash flow statement shows property development costs of 8.5m Ringgit and 5.4m in 2011. The balance sheet now shows 52m in property development costs and 74m in land held for property development. Total shareholders’ equity was 261m on 09-30-2012.

The property development activities of Fiamma are much bigger than I am comfortable with in an investment. In 2008 the company issued rights and warrants and the proceeds seem to have been used for acquiring two property development companies. I know very little about real estate and nothing about Malaysian property development. In general I am willing to take real estate for free in an investment, but here it is a significant part of Fiamma’s business. It looks certain that a significant amount of future cash flows will be used to acquire land and develop property.

Also, I saw a big revaluation of real estate in the annual report that I am uncomfortable with. Another thing that is a red flag for me is note 7 of the latest annual report. This shows a list of Fiamma subsidiaries. Three active subsidiaries of Fiamma (of which two are involved with property development: the two companies that were acquired after the rights & warrants issue in 2008) have not been audited by Fiamma’s auditor, KPMG. In my view it should not be that difficult to change the structure of the company to ensure that all activities of the company are covered by one auditor.

Additionally there have been a number of related party transactions. Here is one from July 2012 that includes the sale of property to directors of a subsidiary: http://www.bursamalaysia.com/market/listed-companies/company-announcements/1015389#13594758475751&3161. I can’t judge how questionable a deal like that is, but I don’t like to see these types of deals. In my view even the appearance of a conflict of interest should be avoided and selling real estate to related parties is something I don’t want to see in companies I invest in.

One other thing to mention is that the CEO of Casa – Mr Lim Soo Kong – is on the Board of Directors of Fiamma.

Conclusion

Nate from Oddballstocks.com has talked about killing an investment in some of his posts and it is a way of thinking that I found very useful. Instead of getting excited initially and thinking that a stock looks incredibly cheap, it is far better to start with a negative mindset and think to yourself: ‘this is probably not a good investment for some reason I don’t see yet’. Then go out and try to find that reason. This helps avoid feeling disappointed and feeling committed to your first impressions.

Since a big part of the value of an investment in Casa Holdings comes from Fiamma Holdings an investor needs to make an assessment of Fiamma’s business to determine whether Casa could be a good investment. Personally I am not able to judge the property development side of Fiamma’s business and that kills the investment for me. I have seen enough things in the annual reports of Fiamma that make me want to avoid this stock.

Disclosure: no position in Casa Holdings, no position in Fiamma Holdings

There has been a lot of coverage of Japanese stocks on a number of value blogs the past two years. Guys like Nate from Oddball Stocks and Geoff Gannon have been investing in Japan and posting their thoughts and some of their picks.

The Japanese market has rallied quite a bit since the end of 2012. So, an investor might ask, are there still bargains left in Japan? After running some screens and checking out a number of companies I believe the answer is yes. There are still a great number of bargains to be found in Japan. I ended up buying my first Japanese stock about a week ago. I will discuss the stock later on in this post, but first I wanted to post some of my thoughts on investing in Japan and about my timing.

Why did I invest in Japan and why now?

I am late to the party when it comes to investing in Japan. I have been reading Geoff’s and Nate’s posts about Japanese stocks and only now did I decide to buy, so why now? I don’t have a very good answer. The best answer I can give you is that I gradually got comfortable about the idea of owning a few Japanese companies in my portfolio and that the rising US stock market also helped.

Initially I just couldn’t understand how stocks could get so cheap and stay so cheap for such a long time. I had read about the bursting of Japan’s bubble and the deflation that has been plaguing them, but it was only after reading Richard Koo’s book The Holy Grail of Macroeconomics: Lessons from Japan’s Great Recession that I realized the full impact of the bursting of the bubble on Japanese citizens and corporations. Koo’s book is mostly about macroeconomics and the concept of balance sheet recessions, but it also discusses the psychological aspects of these types of recessions. Some of the balance sheets of Japanese companies can only be understood with these psychological effects of the long recession in mind. A lot of companies have become allergic to debt and are paying down debt balances that were very modest to begin with. Some companies are hoarding cash to levels that just seem absurd. Reading Koo helped me understand why this is happening and also convinced me that this is not a permanent situation. I believe eventually Japanese companies will become a little more rational about debt and cash levels. It probably won’t change drastically, but a minor improvement in capital allocation or investor sentiment can do wonders for a net-net or a cheap stock.

Currency risk was not much of a concern for me. I will make the Japanese stocks a fairly small portion of my portfolio and I am willing to bear the currency risk. As a European I have been investing primarily in the US for the last few years and I saw some currency swings in my own portfolio. I don’t have an opinion on the relative values of currencies. The main thing I try to do is to diversify my holdings so I don’t get ‘unlucky’ owning too much of a currency that manages to depreciate the most.

The main thing that has made me look harder at other markets is the rising US market. It has become more difficult to find cheap stocks in the US. This past year I have sold some positions that appreciated and recently I also abandoned a position. I have reinvested some of the proceeds in French small caps, but have found few cheap stocks in other European markets. The Japanese market however still has plenty of bargains.

Ok, now to the stock I bought. I want to mention in advance that the information I have been able to retrieve on most Japanese stocks is very limited. With the Japanese stocks I’m betting mainly on the statistical cheapness of the stocks. I have used Google Translate to piece together some info in the Japanese financial statements, but this is far from ideal. Still, as a group (I plan to buy perhaps 2-3 more stocks) I think they will do well.

Maruzen Co Ltd (JP:5982)

Maruzen Co Ltd manufactures and sells commercial kitchen equipment. This is professional equipment that is used by restaurants and other places in the home-meal replacement market like nursing homes. The company owns three plants where it manufactures the equipment. Maruzen has around 90 sales offices covering Japan.

Their main product lines are:

• Noodle Boilers
• Meat Dumpling Cookers
• Gas Ranges
• Fryers
• Rice Cookers
• and Grillers

The company also manufactures bakery equipment. I believe this segment is still relatively new and therefore small. Maruzen wants to grow its market share to 10%. The final segment is the Building Leasing segment. The company manages a few properties. From what I understand this segment is basically utilizing real estate the company currently owns and the company does not seem to be actively purchasing properties for the development of this segment at this time.

The restaurant market has been pretty weak in Japan since the recession in 2008. Maruzen’s sales have remained stable from 2008 to 2011. It seems like business has picked up a little in recent quarters.

These are the main things that attract me to Maruzen:

- At the current price of ¥676 Maruzen has a market cap of ¥12.62 billion (based on outstanding shares of 18.67 million, thus excluding treasury stock, the websites of MSN Money, FT and Bloomberg seem to use issued shares (19.78 million) for their calculations). Book value on 11/30/2012 was ¥21.16 billion, for a price-to-book ratio of 0.60. Cash & Short Term Investments were ¥10.57 billion and have grown from ¥3.28 billion in 2008. PP&E is a substantial part of book value though at ¥14.58 billion.

- The current P/E ratio is a little below 7. ROE has been in the 7-9% range over the last five years, which is good for a firm with excess cash and very low debt.

- The company is generating a lot of cash. In 2008 the company built a new distribution center and plant, this explains the large capital expenditures for that year. Recent years show capital expenditures that have been well below depreciation. It is probably a good idea to assume that capex will be substantially higher than in recent years, perhaps ¥800-900 million is a better estimate for future years. Even then we should get a decent FCF yield that lies comfortably above 10%. Maruzen’s cash flows have been very consistent.

- Maruzen still has a little bit of debt on the balance sheet (around ¥ 2.2 billion), but this is less than half of what it was in 2008. Like many other Japanese companies, Maruzen has continued to reduce its debt.

A negative point about this stock is that the minimum lot size for Maruzen is 1000 shares.

One other thing I noticed is that the Fidelity Low-Priced Stock Fund owns roughly 10% of the outstanding shares of Maruzen. Since this investment is a minuscule part of their portfolio this fact is probably meaningless, but it is nice to know that this stock belongs to their group of Japanese investments.

Why Maruzen?

I chose Maruzen above other, perhaps even cheaper looking cash-box type stocks like Tsutsumi Jewelry. What I hope is that Maruzen will be better at allocating capital than some of the true net-nets out there. A company like Tsutsumi just seems to be piling up the cash year after year and paying a very small dividend. I’m not confident that a company like Tsutsumi will change their ways soon.

The management of Maruzen offers more hope in this regard, I think. In 2011 the company repurchased about 1 million shares, although these shares have not been cancelled. The company also pays a small dividend, the stock currently yields about 2.5%. If the cash keeps streaming in and the little debt that remains is further reduced, they will have to make a decision whether to keep piling up the cash, make acquisitions (or real estate investments) or to return more of the cash to the shareholders in the form of a larger dividend or the repurchasing of shares. My hope is they will choose to increase the cash spent on the latter option. To be clear: I don’t think investing strictly in Japanese net-nets is a bad idea. I think that will do very well. I just prefer companies that in my view have a better chance of redirecting their cash flows to dividends and repurchases.

Disclosure: long Maruzen (5982)

I have recently finished James Dyson’s autobiography Against the Odds (published in 1997). Even though 2013 has only just begun, I am sure this book will make my list of favorite books for this year.

I’ll try not to put any major spoilers in this post.

James Dyson is the man behind the Dual Cyclone bagless vacuum cleaner. A vacuum cleaner that uses centrifugal force to collect dirt.

Dyson’s net worth is estimated at £1.45 billion. The autobiography is his story about how he built his company, Dyson Inc., to what it is today. Dyson Inc. is a private company and has reported sales of £1.05 billion and earnings of £306 million in 2011.

Dyson describes himself in the book as “a creator of products, a builder of things”. In the book we read how he stumbled on inconveniences in the use of everyday products, things like the wheelbarrow and the vacuum cleaner.

Dyson visited the Royal College of Art. He took classes in subjects like interior design and structural engineering. He was inspired by some of his teachers and by engineers of earlier times, he mentions Buckminster Fuller and Isambard Kingdom Brunel. This autobiography contains a fair amount of criticism about the lack of investment by the British government in science education. Dyson sees this as a major problem and is worried about the future state of manufacturing in Britain. Judging from a recent article (linked at the bottom of this post), these concerns have not gone away.

After noticing flaws in existing products he began to think about possible improvements. And more importantly, he tore apart the machines to see why they worked the way they did and how they could be improved. Dyson made countless prototypes of his products and did lots of tinkering, making one small change at a time and seeing what happens.

Dyson did not profit much from his earliest work, others made most of the money. It was the Dual Cyclone vacuum cleaner that ultimately became his major success. Reading Dyson’s story, you will see there were many times where things could have fallen apart or where he might just have given up. One of the major takeaways from Dyson’s history for other entrepreneurs is the danger of debt. Dyson in the early years of the development of the Dual Cyclone struggled immensely, because he simply did not have the money to do things. He was married, had a child and had recently bought a house. He had to take care of his family, make the mortgage payments and develop his newly established company. He could only do it by taking on debt and finding investors.

One of the people who he worked for before starting his own company was Jeremy Fry. Fry decided to invest in Dyson’s company later on after Dyson decided that he needed capital, but had to pull out of his investment eventually because the legal problems Dyson faced just seemed never ending. There was no bad blood between Dyson and Fry though. You get the sense that Dyson is very grateful for the things he learned from Fry and the support he received after he stopped working for Fry’s company.

One other thing that complicated matters for Dyson’s young company was that competitors were not really interested in doing licensing deals. They were making good money selling vacuum cleaner bags. Dyson’s disruptive new technology would turn their business model upside-down. In the book the negotiations with different parties are described in detail. There were also numerous lawsuits along the way, some lasting many years. This forced Dyson to spend money he couldn’t really miss in this early stage of his company. A successful licensing deal eventually came from an unlikely place and after that, his business started to take off.

All in all it is a wonderful story of a successful inventor, designer and entrepreneur. We tend to label people and it is easy to view James Dyson strictly as an inventor, but he is much more than that. He is also very much an entrepreneur and he can run a business. I think it is quite rare to find all these qualities in one person. Investors sometimes discuss how you could find the next Microsoft or the next Apple. I don’t think you can do that with any confidence. I do think that you might be able to recognize a person that has a combination of all these qualities that ultimately led to Dyson’s success, things like: perseverance, ingenuity, good business sense, focus, intelligence, the constant search for improvement and the willingness to take tough, unpopular decisions. Perhaps Charlie Munger sees some of these things in Wang Chuanfu, the CEO of BYD. Still, I think even Dyson recognizes that luck also played a role in his success. Sometimes you just need that lucky break for things to take off.

By the way, to me the company Dyson does not seem like a bad fit for a company like Berkshire Hathaway or perhaps Markel, but Berkshire might be too big now to even be interested. James Dyson is currently 65, but has revealed in 2006 that his children will inherit the company. From that article it seems likely that the company will carry on as an independent private company in the future when James Dyson’s time as the CEO of the company has passed. A time might come where the company would be better off as a subsidiary of another company. Berkshire is a company that gives a lot of autonomy to its subsidiaries, which is essential for a company like Dyson.

The book was published in 1997 and Dyson has not stood still since then. I will close with a few links with more recent information about the company, a few articles and an interview with James Dyson.

• More recent products: Airblade, Air Multiplier, Hot + Cool fan heater
• December 2004, BBC: Engineering the difference, excerpts from a James Dyson lecture: most interesting for his comments on why he decided to move the assembly side of the business to Malaysia, a move that cost British jobs and caused a lot of criticism in Britain at the time.
• December 2011, Guardian: Dyson seeks to block copycat manufacturers in China: Dyson explains how China plays the patent game.
• January 2013, Sky News: Dyson Warns Government Over UK Manufacturing
• Video August 2011, Youtube: long interview with James Dyson: perhaps not a good idea to watch this if you want to read the book.

Today I noticed a former holding of mine Alpha Pro Tech (APT) gained about 30% in just two days on very strong volumes. So, what happened that caused the stock to spike like this?

It’s dangerous to talk about “the reasons” for a stock (or the stock market) going up or down. I find it funny to see the market headlines on Google Finance or Yahoo change during a trading day. For example: a story might first explain a rising market by claiming that something Bernanke said at Jackson Hole caused the market to rise, but at the end of the day they might explain a decline of the S&P by saying investors lost confidence because he did not say something. The earlier headline and story are forgotten and the fitting headline is remembered and recorded as ‘fact’. Some poker players call this type of reasoning ‘results oriented thinking’ and it is one reason why newspapers and online news can be dangerous. It is often better to know nothing at all than to be misinformed.

Back to APT though, sorry for the digression. So, while we can’t know for sure what caused the stock to go up suddenly, we can speculate. As long as we recognize and label it as speculating, all is fine.

As far as I can see, APT has not released any news or filings these last days (even weeks). The answer, I believe, may lie in what the company sells. From the business description in the latest 10-K (emphasis mine):

Alpha Pro Tech is in the business of protecting people, products and environments. We accomplish this by developing, manufacturing and marketing a line of high-value, disposable protective apparel and infection control products for the cleanroom, industrial, pharmaceutical, medical and dental markets through our wholly owned subsidiary, Alpha Pro Tech, Inc. We also manufacture a line of building supply construction weatherization products through our wholly owned subsidiary, Alpha ProTech Engineered Products, Inc.

Is it the flu?

The ‘infection control’ products are things like face masks and face shields. Examples can be found on the Alpha Pro Tech website.

This year the flu season is pretty bad, I have heard and read. This might be what is causing the sudden rise in APT’s stock price. Investors could be speculating that APT will sell many more face masks because of this flu epidemic.

History repeats?

Look at a long term graph of APT: Yahoo Finance: APT chart. You will notice a large spike in late 2009. What happened there?

This excerpt is from the 10-K for the fiscal year ended December 31, 2009 (emphasis mine):

Infection Control segment sales for the twelve months ended December 31, 2009 increased by $14,343,000, or 194.7%, to an annual record of $21,710,000, compared to $7,367,000 for the same period of 2008. Mask sales were up by 283.3%, or $12,827,000, to $17,354,000, shield sales were up by 86.8%, or $1,767,000, to $3,803,000 and medical bed pad and pet beds were down 31.2%, or $251,000, to $553,000, compared to the twelve months ended December 31, 2008.

The overall increase in mask sales for 2009 was primarily attributable to the surge in N-95 respirator mask sales, which began in the second quarter of 2009 due to concerns relating to the H1N1 Influenza A pandemic. Our N-95 respirator mask sales started to slow down in the latter part of the fourth quarter and are expected to return to pre-H1N1 levels in 2010 unless concerns relating to the global H1N1 Influenza A pandemic resume. Shield sales were up primarily due to a $1.7 million non-recurring shield order received in the fourth quarter of 2008 and due to the H1N1 Influenza A pandemic.

If I remember correctly, APT had a mask that was approved by the authorities for use during that particular H1N1 epidemic. This caused a huge surge in sales and net income. The stock price followed, maybe helped by the $2.1m the company spent on share repurchases that year.

Optionality

After reading Antifragile by Nassim Taleb I have been thinking about his ideas about optionality. The idea is that you pay a small price for something that has huge, somewhat hidden upside that is not recognized or valued by others. Usually the upside does not materialize and you end up losing your “bet” and the price you paid for it. Once in a while though, your bet does pay off and you get the benefits.

Initially I thought this idea of optionality was mainly applicable to derivatives. Michael Burry making his CDS bets came to my mind. Prem Watsa of Fairfax Financial buying cheap insurance against deflation a while ago might be a current example. Fairfax also profited handsomely during the credit crisis. So I thought this idea was something strictly for professionals who had access to all these exotic instruments and who had the brilliant minds to realize things that others totally miss. Reading on in his book, Taleb showed me I was wrong and that this idea can be applied in many areas of life, also outside of investing.

After finishing the book I was thinking about current and past positions in my portfolio and I thought that APT was a stock that did have this optionality. I bought the stock for $1.07 in August 2011. The market cap was $24.0m. Book value stood at $35.7m (intangibles were negligible). Cash was $6.4m and total liabilities were $1.7m. The company was profitable (although marginally) and had shown a long string of profitable years.

Buying at a big discount to book was a good bet, I believe. I think buying at that price gave an investor good downside protection, while maintaining the big upside in the case of an outbreak of influenza or some other airborne disease. The beauty is that you don’t have to know if it hits, which disease it is or when it hits. You get the option for free if you are right that the business is worth more than the current market price.

By the way, I did not recognize this free option in APT at the time I bought the stock. I mainly bought it for the discount to tangible book, the profitable history of the company and the earlier willingness of management to buy back stock. It was only after finishing Taleb’s book that I started thinking about all this. I ended up selling the stock at around $1.50, well before the run-up of the last few days. I also didn’t think APT was a wonderful business that I would like to own for the long term or anything like that. There are plenty of negative things to say about APT as well, this post focuses on the optionality that I believe was in this stock.

The perception can be enough

Also, the event doesn’t even have to materialize. It could be that APT doesn’t profit significantly from this current outbreak of the flu, I have no idea. Even investors becoming more aware of the possibility of APT profiting from an outbreak could cause the stock price to rise. The perception of the possible upside by others can be enough for you to benefit from the optionality you recognized.

I have to credit Whopper Investments for recognizing this in APT in his post on Alpha Pro Tech from May, 2011: An interesting but volatile value investment (APT). Here is a quote from his post (emphasis mine):

The main question going forward is if the company can return to their previous level of earnings. First, the company’s products (protective gear) are in much higher demand during times of panic or crisis (similar to ABIX, another protective product company mentioned as a potential value investment that subsequently doubled). In a way, this can make the company’s stock act as disaster insurance, as earnings will spike (and thus, the share price could rise) in the event of a disaster, but earnings will remain flattish in normal times.

It was probably his post that made me remember APT after reading Antifragile and thinking about this idea. His post probably contributed to me buying the stock in the first place. It is one example of a blog I have benefited greatly from, some others can be found on the right side of this page.

Conclusion

Let me close by saying again that these ideas about the suddenly rising APT stock price are speculative. APT also has a rapidly growing segment that sells housewrap and synthetic roof underlayment. Perhaps investors are becoming enthusiastic about these products, because they think housing is recovering. I don’t know. There is no proof and there are no answers to the question of what makes stocks and markets go up or down. This post was mainly to discuss this idea that optionality is hiding in stocks and other areas and that small investors can profit from them as well.

If you have some examples of your own or you can think up one, I would love to hear them in the comments.

ADDvantage Technologies (AEY) is a well known stock among value investors in micro cap stocks. Whopperinvestments.com has covered the stock extensively and has a position. In a post today he poses the question Is it time to bail on ADDvantage Tech? For now Whopper continues to hold.

Another perspective was offered a few days ago by Booth Laird in this post: Management has the ADDvantage.

I have also owned the stock, but I have sold my shares recently (but before these posts). I struggled to make this decision. In this post I want to discuss what eventually made me decide to sell.

No buybacks

Capital allocation is an important factor for me. I thought AEY did a reasonable job until recently. They have made a good, fairly small acquisition in May 2011 (Adams Global) that fits in with their current business. After that they decided to drastically reduce their debt. I think these decisions made a lot of sense. Their business has slowed down significantly, because an agreement with Cisco was terminated and because cable industry spending as a whole was down. Making a small acquisition and reducing debt were good conservative decisions in these circumstances in my view.

I followed a number of conference calls to hear what management’s plan was on future capital allocation. As you would expect, in most calls questions were asked about buybacks and dividends.

Management always responded fairly negative towards this and pointed to the debt the company had and the low volumes of the stock that would be an obstacle for a buyback. At one point (I don’t remember which conference call this was) I heard management respond to a question about dividends and they appeared to have changed their tone somewhat and seemed to be more open about the idea of a dividend.

But management did not follow up on this idea in the quarters since that conference call. On the contrary: in the last conference call they said that at the current stock price they are not really interested in buying back shares and prefer to look for an acquisition.

Inventory

An investor in AEY needs to answer the question if the $22.7m in inventory on the books is realistic. I was disappointed to see a significant inventory write off this year. That was another factor that made me decide to sell.

The role of the new CEO

One thing I disagree with in the post on the Booth Laird site is the role of the CEO in all this. I believe the ownership situation in a stock, especially in micro caps, usually determines the strategy of a company. Here we have two brothers – Ken and David Chymiak – owning roughly half of the shares.

I just do not believe that they would let a CEO talk them into making an acquisition. I think the brothers perhaps even initiated the idea. So, I don’t see this situation as an agency problem. Major owners tend to make sure the CEO does what they feel is right. I don’t think the CEO would be there in the first place if the Chymiak brothers were not enthusiastic about the idea of an acquisition.

Conclusion

The question an AEY investor needs to answer is: why would a 50% owner of a stock prefer an acquisition over a buyback or dividend at the current stock price?

One possibility, besides the agency issue, might be that the decline in their business is worse than anticipated and that one or more acquisitions are necessary to stay profitable in the long run. Management has made a successful acquisition in Adams Global, but how would results have looked like this year without Adams?

Initially I bought AEY because I believed the share price would recover if results improved a little and / or the company would buy back shares or start paying a dividend. You could summarize it as mean regression and better capital allocation. Both have not happened. Worse: buybacks are very unlikely at this point, considering the comments from management and their controlling position. An activist will probably not be able to accomplish anything here.

I figured my reasons for investing are no longer present. Instead I would now be betting on management to make a successful acquisition. They might well do that, but I’m not willing to bet on it. I prefer situations where market sentiment about a depressed stock improves or good capital allocation causes the stock to rise. I fear AEY is more and more becoming a turnaround investment and I simply do not have the industry knowledge to be able to judge if management can make it happen.

It was difficult to sell this stock at such a depressed price and large discount to book value, but I have to make decisions looking forward and not backwards. Looking forward I see other stocks that have better capital allocation then AEY and similar discounts to book value. I prefer to own those. I hope to post later this week or early next week about a Japanese stock I’m currently looking at.

Disclosure: no position.