ROUGH DRAFT

Finding Deep Value:

An Introduction to Outperforming the Stock Market

Christopher Moon

Copyright © 2015 by Christopher Moon

All rights reserved, including in whole or in part in any form.

CONTENTS

Preface

Introduction

Part I

Chapter 1: Small-caps

Chapter 2: Spin-offs

Chapter 3: Post-Reorganization Equities

Chapter 4: Bank Thrift Conversions

Part II

Chapter 5: Case Studies

Chapter 6: Mistakes Investors Make

Chapter 7: Buying and Selling

Appendix

Recommended Reading List

DISCLAIMER

This publication contains the opinions and ideas of the author. It is not a recommendation to purchase or sell the securities of any of the companies or investments herein discussed. It is sold with the understanding that the author is not engaged in rendering legal, accounting, investment, or other professional services. Laws vary from state to state and federal laws may apply to a particular transaction, and if the reader requires expert financial or other assistance or legal advice, a competent professional should be consulted. The author cannot guarantee the accuracy of the information contained herein. The author specifically disclaims any responsibility for any liability, loss, or risk, professional or otherwise, which is incurred as a consequence, directly or indirectly, of the use and application of any contents of this book.

PREFACE Before beginning a Hunt, it is wise to ask someone what you are looking for before you begin looking for it.

Pooh’s Little Instruction Book by Joan Powers, inspired by A. A. Milne

The efficient-market hypothesis (EMH) posits that it is impossible to “beat the market” because the efficiency of the market causes existing share prices to immediately incorporate all new relevant information. According to adherents of the EMH, stocks will always trade at their fair value, making it impossible for investors to buy undervalued stocks or sell them when they are overvalued. These adherents believe it is impossible to outperform the overall market through expert stock selection and the only way possible for investors to increase their returns is to increase the risk. I completely reject this convenient but naïve definition of the risk-return relationship. In this book I will explain how using a deep value investing approach will enable an investor to find opportunities that are both low in risk and high in return.

Before we go much further, it is important to define what I mean by “deep value investing”, as my definition is likely to be different from other value investors. I define deep value as being a situation in which a security is trading at less than half of its estimated intrinsic value and where there is a high probability the security price will increase by 50% or more within a 1-2 year period. This can include garden variety value stocks, special situations (such as spin-offs, mergers, and post-reorganizations), and distressed securities. In this book I will cover deep value and special situations – two areas that have the potential to generate the biggest returns. Distressed securities are not appropriate for individual investors (unless you are willing to quit your day job) and will not be covered here. Deep value investing is as simple as it is sophisticated. More importantly, it is about a willingness to stand apart from the crowd and look in areas other investors ignore.

This book is meant for serious investors who have a basic understanding of the stock market, enjoy the investment process, and wish to earn returns higher than the overall market while employing less risk. While the case studies only cover companies listed in the United States, the principles covered work equally well across the globe. It is important to remember that the strategies covered here rely only on information that is available to the public. All that is required is for the investor to have an interest in finding opportunities that are off the beaten path, but have a high probability of market beating returns. This means a willingness to look at many different prospective investments and choosing only the best prospects. Patience plays the most important role in this process. The best deep value investors understand the need to allow an investment thesis time to unfold.

I have included a dozen investment case studies in order to make the content practical and to illustrate the possibility of market beating returns. Among the successful case studies I have included a couple that have been disappointments. There is just as much to learn from these disappointments as there are from those that have been successful.

In each case study I explain how and when I found the company. I then give an overview of the thesis and discuss which factors influenced my final decision. At the end of each case study I provide a link to the

public filings I analyzed in order to come to my conclusion. I want to avoid burying the thesis under endless details, but allow readers to take a closer look at the information that was available at the time.

Readers will not master these strategies in just a few hours of reading. Learning them will require time and attention. Success is not guaranteed and these strategies require proper application and judgement. With the right frame of mind and patience, these strategies can shift the odds in their favor.

This book is not meant to provide a robotic investment approach that can be copied mindlessly. Rather, I hope to educate the reader on an entire way of thinking that can be adapted by any thoughtful investor who is willing to understand why it works and apply those fundamental principles to a wide range of investment opportunities. It is important to remember that each individual investment has its own unique characteristics, but the principles remain the same. My goal is for readers to analyze the strategies, understand the logic behind them, examine the evidence of their actual use, and come to the conclusion that consistent superior performance in the market is a realizable goal.

This book is a preview of an expanded print version expected to be completed by the end of 2016. It will cover deep value, risk arbitrage, options, hedging, and risk management. I invite you to join the conversation by contacting me at christopher@deepvalueinsight.com with any questions or comments.

Christopher Moon July 2015

Introduction:

Knowing How to Find Deep Value

Where should investors look to find deep value stocks? In the age of the internet the possibilities seem overwhelming. There is everything from reading the Wall Street Journal or watching CNBC, to running stock screens, or even checking out the gossip on Twitter and Stocktwits, but really the most important question investors should be asking is how to look. Once the how to look has been established, the where to look is easier to determine.

The reality is that with the superabundance of investment content available to investors, there are numerous great places to look for potential opportunities. The more difficult challenge is filtering out the wheat from the chaff and focusing on the small fraction of stocks that are worthy of further analysis. The top value investors know that their time is a valuable asset. They have learned how to quickly identify the most promising deep value opportunities and devote their time accordingly.

How do I do that? I decided to write this book after having been asked that very question countless times. I can sum that up in a few sentences. I start by asking why a company or security is likely to be undervalued by the market. That theory can be based on a number of factors: if it is a spin-off, if it is emerging from bankruptcy, if it was recently removed from an index, etc. Once I have established my theory, I then analyze the company to see if the particular security is, in fact, undervalued. In order to invest, I need to understand why the opportunity exists.

To put it in other words, I do not start digging into the financial statements and analyzing every company that I come across. Instead, I start with a theory on why there could be a deep value opportunity and only then do I investigate further.

The top value investors are successful because they have identified their “edge”. The goal of this book is to be an introduction for investors searching for their own edge. The best way for investors to develop their edge is by identifying and categorizing different strategies or situations that are most likely to offer mispriced opportunities. I have attempted to provide an overview of some of my favorite opportunities and the key points to analyze when readers are conducting their own research. Establishing a mental database of categories and special situations will assist the reader in quickly determining which companies and situations are worthy of further analysis and which are a waste of time. My goal is for readers to focus on developing their own edge which is paramount to investment success.

I am certain that by internalizing some of the concepts I present in this book, investors will be on their way to identifying deep value opportunities. After reading it, please feel free to use it as a refresher on the need to focus on those areas of the market that offer the highest possibility of a deep value opportunity.

PART I ROUGH DRAFT

Finding Deep Value Opportunities Deep value investors want to buy stocks that are trading at a significant discount to their estimated intrinsic value. The philosophy is buying a dollar for 50 cents. Given the overall competitiveness of the market, which is not the same as the market being efficient, it would be an overwhelming and time-intensive task to look for deep value stocks if the investor does not know where to find them.

The best investors know that deep value opportunities are more likely occur in some areas of the market than in others. In order to avoid misusing their time on opportunities that do not warrant further analysis, they often look for deep value in areas of the market where they understand the reason for the stock to be undervalued. On the flip-side, they avoid areas of the market that are unlikely to offer a deep value opportunity.

Part I provides an analysis of favored areas in the market that I have identified as offering the highest probability for deep value opportunities. In some cases I will provide examples of past opportunities that proved to be lucrative investments.

Chapter 1

Small-Caps

One way of dealing with information being more available is to stop playing the game and seek out securities of asset classes where there’s less information or competition.

-Seth Klarman, The Baupost Group

The first area of the market that we will explore are companies with a small market capitalization, also known as small-caps. These are companies with a market value between $250 million and $2 billion. Companies falling below $250 million are known as micro-caps and companies with a market cap below $50 million are known as nano-caps. For the sake of simplicity I am going to lump small-caps, micro-caps, and nano-caps under the same umbrella. None of these should be confused with penny stocks, which, quite frankly, are not worth the time or trouble. As a group, small-caps have outperformed the market over long periods of time. This has not prevented small-caps from having a bad reputation. The bad rap is due to the perception that small-caps are prone to financial fraud or manipulation from “pump and dump” schemes. I would say that this is hardly a problem that affects only small-cap companies. Look no further than Enron or Worldcom, two of the biggest corporate bankruptcies in history that were mired in fraud.

Reasons small caps may be undervalued

Before discussing why investors should consider investing small-caps, it is important to understand why a small-cap is likely to be undervalued.

Small-caps are largely ignored by the larger market players including hedge funds and mutual funds

Many fund managers do not bother with small-caps because they may be illiquid and difficult to buy and sell in large increments. Or it could be that their charter prevents them from investing in small-caps; this more so in the case of funds that are only permitted to invest in stocks that are part of an index. Multi-billion dollar funds may not even consider a small-cap because it would be hard to justify the effort and time required to analyze them. Mutual funds are prevented from owning more than 10% of a company. If a mutual fund manager that oversaw $10 billion in assets wanted to invest in a company with a $100 million market cap, he would only be able to buy $10 million in stock. Even if the company’s stock outperformed the market, it would barely move the needle on the fund’s overall performance.

Small caps are largely ignored by Wall Street analysts and the media

Small-caps are typically not known outside of their geographical area. Very few, if any, Wall Street analysts will analyze and therefore promote a small-cap company due to the low trading volume. Low trading volume means very little commission income. Furthermore, the media tends to only cover companies that have extensive analyst coverage.

A good example of an undervalued small cap-that was largely unnoticed and unfollowed by the Wall Street community was Cepheid, a molecular diagnostics company. In July 2010, with virtually no Wall Street analyst coverage and barely a mention in any mainstream media, the stock was trading at $16. That was when a small deep-value oriented hedge fund took notice of the company and its undervalued stock. Before too long the hedge fund began drawing the attention of other analysts and the media to this

interesting and dynamic company. By the summer of 2015 the stock was up to $60, for a return of 275% - a situation where patient investors were amply rewarded!

Very little public information is available

When compared to large cap stocks, there is very little public information on small-caps, save for filings with the Securities and Exchange Commission. Furthermore, what information that is available is likely to be only positive since companies are more likely to emphasize positive news and keep out of sight the negative news. Subsequently, investors that rely heavily on public information will be circumspect when it comes to investing in small-caps.

Small-caps are inherently carry more risk

Large firms with well-established histories have a lower risk profile when compared to small-caps. Small- caps appear to be less safe due to more volatility and less information. During periods of market disruption many investors will flee small caps for the familiarity of established large caps. Small-caps do not benefit from the same access to capital that larger companies tend to enjoy, putting them in a more precarious position during market downturns.

Reasons for investing in small-caps

Now that we have covered why small-caps are likely to be undervalued, we can look at why they make good investments, something the best value investors have known for a long time.

Easier to analyze and understand

Small-caps are easier to analyze than big companies and their business models tend to be simpler. They operate in only one or a few lines of business. It is easier for investors to approach management with questions about the company or financial results.

Growth potential can be significant

Most large cap companies were at one time small-cap companies. Small companies grow from a smaller arithmetic base. It is easier to double the revenue of a $50 million company than the revenue of a $5 billion company. At some point all companies stop growing at a fast rate, otherwise they would eventually outgrow the entire economy.

Small companies are often in growth industries and find it easier to change their strategy in the face of changing market conditions. Smaller companies are often run by their founders or a small group of managers that own a large share of the company and are therefore incentivized to increase shareholder value. Investors often lament over missing the opportunity to have invested at the start of Wal-Mart or Microsoft. Today’s small-cap could be tomorrow’s mega-cap.

Greater universe of opportunities

There are over 7,000 companies listed on the NYSE and the NASDAQ. There are an estimated 250,000 analysts worldwide. Approximately 80% of all analyst focus their attention on just 20% of all publicly traded companies, typically those with market caps of $2.5 billion or more. This leaves a large number of companies with negligible analyst coverage. With very few fund managers performing in-depth research on small-cap companies and the rest relying on conventional sell-side research, a staggering amount of

small-cap companies are overlooked. By focusing on this large number of unrecognized companies, investors can increase their chances of finding hidden value.

An inefficient market

Since few, if any, brokerage firms cover small-cap companies, there is a higher probability of market inefficiency. Because small-caps have a smaller float and fewer available shares trading, a liquidity problem can exist. This liquidity issue prevents many large institutional investors from investing in these companies. This reduces the number of potential buyers for the stock and can lead the stock price to be unjustifiably low. Conversely, when a large institution tries to buy an illiquid stock, the price can shoot up dramatically. This inefficient market works to the advantage of the individual investor who is willing to accumulate undervalued shares and hold on to them for the long-term. A small-cap company that grows and performs well will draw the attention of the bigger market players and the increased trading volume will drive up the market valuation.

A favorite target of activist investors

Small-cap companies have historically been ripe targets for activist investors. An activist investor is a hedge fund, or an individual in some cases, that buys a large stake in a public company with the goal of effecting major change in the company. Oftentimes the goal will be to have the company sold to a larger competitor at a premium to the market price, thereby unlocking value for shareholders. Investors would do well by paying attention to activist investors and the moves they make. One of the key questions I always ask about a small-cap, or any company for that matter, is would an activist investor have an interest in this company? Activist investors will target small caps if they believe it has the potential to become a bigger company or it will make an attractive acquisition for a larger player.

One of the first small-caps I paid close attention to was Cinar Corporation, an entertainment company based in Canada. It attracted the attention of noted activist hedge fund manager Robert Chapman, who specializes in small-cap activism, and soon after he became involved he pushed for a sale of the company. After much back and forth between Chapman and the management, which included Chapman taking out a “help wanted” ad for the CEO’s job, the company was sold to a private equity firm at a high premium to its market value and in the process benefitting all shareholders.

In-depth research can be a game changer

Because small-caps receive little attention from Wall Street analysts, they offer an opportunity for the individual investor willing to do the in-depth research necessary to understand a small company, its economic cycle, its management, and its future prospects. By going beyond the information readily available on the internet or in public financial filings, opportunities that were previous hiding in plain sight become available for investment. The management and investor relations of small companies are not typically flooded with calls from Wall Street analysts, making them far more accessible to individual investors that have questions or comments.

Risks associated with small-caps

• Small-caps have less trading liquidity, meaning there may not be enough shares available at acceptable buying prices. When selling it may be difficult to quickly sell the shares at an acceptable price.

• Small-caps have less access to capital and limited financial resources compared to larger companies. This can make it difficult for the company to obtain financing necessary for continued growth or to endure economic and industry downturns.

• Small-caps may lack the long operating histories or the proven business models of larger companies. This leaves them vulnerable to sudden shifts in customer demand or the aggressive tactics of larger competitors. Not to mention, regulators tend to give more scrutiny to companies without long track records or proven business models.

• Less information is publicly available and financial filings may only meet the minimum requirements imposed by the Securities and Exchange Commission. This requires the investor to either be extremely competent in the analysis of financial statements or to be willing to rely on the integrity of company management, auditors, and the oversight of regulators.

A few words on time, volatility, and patience

Time

Finding undervalued small-caps worthy of investment is hard work and time consuming. Many investors are intimidated by the serious research that is required to be successful at investing in small-caps. While financial ratios and growth rates are widely publicized for larger companies, this is rarely the case for small-caps. All successful small-cap investors accept that the tedious number crunching will be left up to them, knowing that the neglect and lack of coverage by analysts is what provides the opportunity.

Volatility

Historically, small-caps have outperformed large caps, but this outperformance is coupled with greater volatility. According to data from Morningstar, from 1926 through 2012, small-caps averaged an annual return of 12.28 percent, compared to 10.08 percent for large-cap stocks. With that reward comes higher risk. Over a 10-year period that ended in 2013, the standard deviation for small-caps was 19.28, compared to 15.54 for large caps. What this means is the returns for small-caps fluctuated by as much as 19.28 percent in either direction. This queasy-inducing volatility chases many investors out of small-caps and in turn, unwittingly deprives them of long-term market-beating returns.

Patience

Patience is one of the most important character traits a deep value investor can possess and this is a point I will repeatedly make. In light of the volatility displayed by small-caps, it is important for investors to remain patient and allow their investment thesis time to play out. It is not uncommon for a deep value investor to buy the stock of a small-cap only to have the stock drop 40 percent in the first six months. An

impatient investor that lacks discipline may sell out in a panic and lock in a 40 percent loss. That same stock could go on to return 200 percent over the next 3 years, rewarding the patient deep value investor.

Rule of Thumb on Patience: When investing in a small-caps or in any other deep value opportunity – be prepared to wait at least 1-3 years for the investment thesis to play out.

My Research Process

My research process for small-caps is extensive and thorough (and this goes for every strategy I employ). I continually search for good candidates throughout the small-cap universe. Once I have identified a candidate, I begin due diligence that goes beyond just crunching the numbers. I consider it important to act like an investigative journalist. I investigate company management, take a tour of the company’s headquarters (or talk to someone that has), and interview knowledgeable people about the industry and the company, including consultants and competitors.

Visiting the company is important – it provides an opportunity to discover promising areas that are hidden in weak numbers. On the flip-side, it provides an opportunity to find problems that have yet to show up in the numbers. While I find reading reports from other analysts to be helpful, talking to management and viewing the facilities is much more important. Only a small number of companies will meet my exact criteria. Once a company’s stock has been purchased or added to my watch list, I stay in close contact with the company and continue to analyze all new financial data to monitor whether or not my original investment thesis remains valid.

How I find new ideas:

Experience

As deep value investors continue to grow and learn by analyzing more and more companies, they compound knowledge and gain experience. This experience will enable a deep value investor to quickly recognize what is a potential opportunity and what is not. After two decades in this business I have analyzed thousands of companies and special situations. Often, when a deep value opportunity presents itself it is possible that I have already been watching the company for years, either having previously analyzed the company or a close competitor and understood it very well. This allows me to quickly interpret new developments or changes in the stock price. Other times I may have analyzed a company and made a decision to not buy due to overvaluation, but kept it on my watch list. A sudden drop in the stock price or a favorable industry development can renew my interest. Due to my previous analysis and familiarity with the company and management, I am able to move quickly and reach an investment conclusion.

Screening

I am constantly searching for new investment opportunities that meet my exact criteria. This includes reading through the Wall Street Journal or Financial Times and other financial publications or browsing through investment surveys such as Valueline. I use my own customized screens or screens provided by third party vendors. When I use a screen, I am able to narrow down the universe of potential opportunities that meet my stringent criteria such as low price-to-earnings or low price-to-book ratios, attractive debt-to-equity characteristics or other preferred metrics. This leaves me with smaller and easier to manage basket of companies that I can add to my watch list for further in-depth analysis and investigation.

Industry analysis (along with a little macro and regional trends)

I consider myself, first and foremost, to be a bottom-up analyst, focusing on individual companies and opportunities rather than going after what is trendy. Although some of my ideas will come from noticing industry or macro trends, I have never relied on economic forecasts or interest rate movements in making a buy or sell decision. But a market crash or recession will cause me to pay closer attention to debt levels and look for companies that display countercyclical characteristics. For example, a drop in oil prices could cause an overreaction in the stocks of oil services companies and thus interest me in taking a closer look at companies across the sector.

Occasionally, stocks in an entire region or country may become cheap when compared to historical averages, much like what appears to be happening in China at the time of this writing. The cause could be something as simple as a currency devaluation or more complicated such as a recovery from a recession. An opportunity is created when companies in affected regions or countries have opted to raise capital in the United States and list on American exchanges and is now undervalued due to trouble at home.

How I evaluate an idea:

Once I have a company in my sights, I analyze it with all of the skepticism and curiosity of an investigative journalist. I am looking for a “gotcha” that will cause me to discard the idea and look for the next one. Unfortunately, many investors feel obligated to buy a stock after they have invested a minimal amount of time analyzing it – an attitude that is not conducive to outperforming the market. I remind myself that stock picking is a messy business and that I would rather spend 20 hours figuring out what not to buy than convincing myself I am obligated to buy it. Analyzing companies is a multistep process. The following is a general outline of all the steps I take before I come to a decision to buy or not buy. Please note that, in addition to small-caps, I use this same process anytime I analyze a potential investment opportunity, whether it be a spin-off, a post-reorganization equity, or a bank thrift conversion.

Reading the public filings and other publicly available information

A company’s financial statements are the most important component to serious analysis. I use them to to discover what is behind the numbers, what is driving the growth (or lack of it), and come up with a prognosis for the company’s future prospects.

I begin my financial quest by pulling the last 3 years of Form 10-Ks (annual reports) filed with the Securities and Exchange Commission along with the last 6 Form 10-Qs (quarterly reports) and any Form 8-Ks (amendments to the 10-Ks and 10-Qs). This gives me all of the numbers from the annual reports from the last 5 years and the all of the quarterly reports from the last two years. This allows me to compare trends on cash flow, inventories, receivables, and margins.

I find it helpful to divide the financials into small parts and then put them back together and see if they fit. I consider the footnotes to the financial statements to be the most useful tool in determining if the numbers make sense. The footnotes are where any red flags to creative or fraudulent accounting will pop up. If the footnotes are complicated and difficult to comprehend I will assume it is deliberate. In addition to analyzing the numbers, I will review the last 3 years of proxy statements looking for corporate governance issues such as bloated executive compensation or management that is unfriendly to shareholders. I look for any kind of poison pill or change-of-control provision that would prevent an activist investor from coming in and pushing for a sale of the company.

Crunching the numbers

Many professional investors build elaborate financial models – I do not. Models are only as good as their inputs – which can often be nothing more than an educated guess. If you are looking through a telescope out at the night sky and tilt your telescope a few degrees, you could change your view by a million miles. Instead, I spend my time doing an extensive amount of numbers crunching. The primary questions I want to able to answer when I have finished going through the numbers is, are these numbers solid and believable or is management pandering to investor expectations with creative accounting?

The Balance Sheet

I first look at the most recent balance sheet and compare it to previous years’ balance sheets. I then start investigating whether or not the assets are believable. Some of the questions I might ask right off the bat: Are the assets, such as real estate, listed at inflated values? Are the inventories packed with obsolete product? Are loss provisions too low? What is the policy for booking receivables?

I pay close attention to accounts receivable and inventories by comparing them to the growth in sales and the cost of goods sold – if they are out of alignment it is a red flag and should be explained. Then I look at deferred charges to see if the company is pushing expenses too far into the future; a bad habit that can lead to a sharp reversal if revenues slow. I then move on to intangible costs like goodwill and amortization and look for evidence the company could be capitalizing routine costs – a sure sign of earnings manipulation. Accumulated depreciation is another area I check, if the company has recently changed its average life assumptions I will want an explanation. This is why it is important to go over the footnotes with a fine-toothed comb.

I then move onto the liability side of the balance sheet. I want to know if there are any liabilities that are difficult to comprehend – a red flag that management could be using the company as a personal piggy bank. Next I want to know if short-term debt growing and when is long-term debt due. I check the footnotes to see if the company has any off-balance sheet liabilities.

The Income Statement

Much like with the balance sheet, I review several years of the income statement. I want to know if the company has a history of relying on nonrecurring income to bolster results. This could be the sale of land or securities, tax credits, and one-time credits from suppliers happening year after year. I look for a change in accounting policies and revenue recognition. Again, this information can be fleshed out in the footnotes. What I am looking for is a business that is stable and likely continue being stable for the foreseeable future. On the flip-side I look to see if one-time charges are strictly one time.

I always look carefully at earnings-per-share (EPS). Are earnings per share up only because there are fewer available shares? I compare the numbers using the previous year’s fully diluted shares outstanding, never relying on just the undiluted average shares. Another trick is to take the number of shares from the 10-K, add in convertible shares that are close to conversion, add in options that are close to being exercised, and add in warrants if there are any. Add up all of those numbers for fully diluted shares outstanding. Inexplicably, Wall Street often fails to make this calculation and gives EPS manipulation a wink and a nod.

The Cash Flow Statement

The cash flow statement is the toughest part of financial statements to understand and it is also my favorite. In a nutshell I am looking for sustainable operating cash flow. Let me rephrase that; I am looking for sustainable operating cash flow that is trading at a low valuation – if you are paying attention I have just given away my biggest secret.

Cash flow statements are broken up into three parts: operating, investing, and financing flows. I look at the cash flows from financing to see if the company needs to keep borrowing money in order to stay in business. I look to see if the company has to keep issuing new shares every year to raise much needed capital. Then I look at expenditures and what is necessary to keep the business going. One calculation I like is to take the net income and add in depreciation, amortization, and deferred taxes and then subtract nonrecurring items (adjusted for taxes) and then add or subtract changes in current assets. That calculation will give me a more accurate picture of what is truly operating cash flow – getting to know the company inside and out will tell me if that number has room for improvement or is sustainable.

I check cash flows from investing to see what exactly the company is investing in; I want to know if it is new real estate or plant and equipment. Then I want to know if it is a necessary expenditure for conducting business. I then check for free cash flow by deducting capital expenditures and dividends to find out if that number is negative or positive. If it is negative I will do a year-by-year check to see if it is a one-time anomaly or if the situation is deteriorating. If the company is a cyclical business with up and down cash flows I want to know if the company has a strong enough balance sheet to weather the downturn or if it will need to raise cash through more debt or an equity offering. I want to know that if the company will need to borrow money and if a cyclical downturn will make borrowing difficult due to impaired coverage ratios?

I like to think of the balance sheet, income statement, and cash flow statement as individual parts of a 3-D puzzle. The bottom line question is do all of the pieces fit smoothly?

My Checklist of Ratios

Keeping track of the various ratios is crucial to truly understanding the company and its numbers. While not an exhaustive list, the following are just a few of the ratios I rely on the most.

Return Ratios:

• Return on equity • Return on assets • Return on invested capital

I look at return ratios over a course of several years, it lets me see the trends and the volatility of the returns over a period of time. It also allows me to compare the numbers with other similar companies in the same sector or industry. More importantly I want to know if the company is earning more than its cost of capital. One of my favorite metrics is return on invested capital (I owe this one to famed short-seller James Chanos), it allows me to spot which companies are not what they say they are. My calculation: earnings before interest and taxes divided by average total capital. This is a hard number for companies to manipulate and it is a good indicator of a high quality business.

Capital Structure:

• Long-term debt-to-equity • Total debt-to-total capital • Total debt-to-equity

It is important to understand how a business is capitalized. I compare several years of balance sheets to look for trends in the ratios. I am wary of companies that are trending towards over-leveraged.

Valuation Ratios:

• Price-to-earnings • Price-to-book • Price-to-cash flow

I always keep a close eye on the valuation ratios of the companies I keep on my watch list. It allows me to check in minutes if the stock is running up or if it is tanking. I also use them for a quick-and-dirty comparable with other companies, which comes in quite handy if a competitor is taken over. Keep in mind that valuation ratios are relative to the industry – lower in financial services and higher in retail companies. A high price-to-earnings (P/E) is an indication Wall Street believes there is growth potential. A high price-to-cash flow (P/CF) is an indication Wall Street believes there will be a buyout.

Other Useful Filings

Form 13-D

A big part of my overall investment philosophy is to look for companies that could become targets of activist investors. Studies have shown that companies that undergo a campaign by an activist investor tend to outperform the market. Through experience I have found that most market outperformance is the result of a catalyst that unlocked shareholder value. The most efficient catalyst is some type of one-time event such as a spin-off or a merger and this why it is handy to have an activist investor waiting in the wings. An activist investor’s reason for being is to push for a catalyst that unlocks value.

The best way to find out if an activist investor is pushing management to take action is to check the 13-D filings. These are required by the Securities and Exchange any time an institutional investor buys 5% or more of the outstanding stock and intends to communicate with management. Aside from the boilerplate language, 13-Ds are fascinating to read because it offers the activist investor an opportunity to communicate its ideas about the company to the market. If you want to know what a top investor thinks the future potential of a company could be, read the 13-D. Many times I have read a 13-D and then contacted the activist investor to gain more insights into their thoughts on the company. Paying attention to the top activist investors is not only a good way to learn how to think about investing, but it can lead to market beating opportunities.

Proxy Statements

All publicly traded companies must file a proxy statement before the annual shareholders meeting. The proxy serves as an announcement to shareholders on what they will be voting on at that annual meeting. It is packed with information that gives investors insight in the company’s philosophy. In it can be found management salary – including bonuses, option awards, and perks. It also details employment contracts with key executives – always good to know if management has golden parachutes. One game I like to play is to count how many times it says “certain transactions”. It is also a good place to look for pending litigation.

Many institutional investors farm out the analysis of proxy statements to institutional proxy services such as Glass, Lewis & Co. or Institutional Shareholder Services, who then recommend to the institution how they should vote. The reason for this is beyond the subject of this work, but I have always felt it was an abdication of an institution’s fiduciary duties. I prefer to read them myself and come up with my own conclusions and questions.

A short list of some of the questions I want answered by the time I have finished reading the proxy:

• What is the percentage of executive compensation to earnings? • Does the company pay large bonuses? • How is the bonus determined? Performance, return on equity, or some other measure? • Are bonuses tied to EPS growth? (If so, there is motivation to fudge the numbers) • Does the company pay for stock options? • Does the company pay a bonus to cover the taxes on options? • How many shares do top executives own? • Does the company have a severance payout in the event of a merger or buy-out? • What are the terms of the retirement contracts? • Are there perks such as apartments, planes, cars, etc.? • Are there any “arm’s length” transactions? • Are any of the officers related? • Does the company do any deals with companies controlled by relatives of key executives? • Does the company loan money to executives? If so, what is the interest rate? • Are there any joint-ventures in which executives are limited or general partners? • Are there any lawsuits? What is the potential liability? • How independent is the board of directors?

Once I have done my homework with the financial and other filings, I will move onto the next step, contacting investor relations and management as well as listening to earnings calls.

Contacting the company

One of the advantages of investing in small caps is that the company’s investor relations and upper management is unlikely to be flooded with requests and questions from other analysts. Listening to earnings calls and talking to management is a powerful tool for filling in the gaps left from simply reading the financial statements. By getting to know the management, an investor can discern if management is trustworthy and competent. Investors should want to work only with management that is candid when

things are not going according to plan and when mistakes are made. The question all investors should ask is, do I trust this management with my money?

Following small caps within a particular industry or region for many years and developing rapport with top level management can pay off in other ways. There have been occasions I have been able to call an executive with a company I previously covered and ask them for their thoughts on a competitor that I am looking at. Some of the best analytical intelligence will come from a competitor.

Never underestimate a company’s need for an active and vigorous investor relations team. Their job is to increase awareness and demand for the stock. How else will the stock ever go up if no one knows the company even exists? I look for an investor relations team that is honest in discussing the company’s opportunities and challenges. One that is willing to give presentations at investor conferences, and arrange conference calls between investors and management. I avoid companies where investor relations is insincere and unwilling to engage in an all-out effort to attract investors and promote the company. When I speak with investor relations one of the first questions I ask is what is their strategy going forward.

Listening to earnings calls

Listening to earnings calls is one of the most overlooked sources of information about the company, its most recent performance, and the management. During an earnings call, investors and analysts can call in over the phone to hear management discuss the financial results of the most recent quarter. Most companies hold four calls a year, shortly after the quarterly results are announced. Usually the call is available online as an audio or a transcript of the call is available from investor relations. No matter how boring a call may be, I find them a valuable tool to gain insight into management’s mindset.

Most calls follow the same format: an introduction by the operator, then the general counsel or CFO will give the usual legal disclaimers; the following discussion will involve forward-looking projections, which are only expectations and are not factual. Next up the CEO or CFO will give a recap of the earnings announced in the most recent press release, covering what happened in the past. Management will move on to discuss what is happening currently and what management expects performance to be in the future. It is always a good idea to go back and see how optimistic or pessimistic management was in previous earnings calls and how those results mesh with the current results. Is management prone to overstating or understating future performance expectations?

After management completes that part, the call is opened up to questions from analysts or significant shareholders. I believe this is the most important part of the call as analysts and investors are able to pose questions about any area of the company that requires elaboration from management. An investor can learn a lot about the quality of management when they are in the hot seat. This can provide insight into concerns other investors have about the company and how well management handles them. It is a chance to see whether management can answer the questions candidly and confidently or whether they fumble the questions when pressured. More than anything, earnings calls can be used to gain a gut feeling for the company’s management. The key is to differentiate what is boilerplate conference call speak and what is useful information.

After taking in all of this information – the financials, future prospects, management, etc. – I decide whether or not I am a buyer. A lot of that depends on how the company scores on my checklist. If I do not

buy, the company could stay on my watch list in the event something occurs that later makes me change my mind.

My Final Checklist

I look for investments that have all (or at the very least many) of the following:

Low valuation: I am looking for a cheap price in relation to earnings, cash flow, or book value. Without this there really is no need for me to even consider the investment.

Financial Strength: Strong balance sheets with low-debt levels in relation to assets and sufficient working capital to help the company survive downturns.

Profitable: I look for companies with a history of profitability. This is one reason why I generally avoid start-ups because they are usually losing money, but, like with turnarounds, I will make exceptions if the near-term projections are compelling.

Cash Flow: Cash is king and reported earnings mean little if there is no cash flow. I look for companies with strong cash flows after accounting for capital expenditures. I steer clear of companies that are capital intensive as they may need to raise cash through equity or debt to finance their needs.

Overlooked: I prefer companies with little to no coverage, any company being scrutinized by an army of analysts is not likely to be undervalued.

Growth: I look for companies that have consistent growth rates of 15% or more. How else will a small-cap become a large cap? If it is selling for super cheap, I will consider a small-cap with a slower growth rate.

Industry: I look for industries that are growing. The probabilities are against my finding a good undervalued company in a declining industry.

Competitive Strength: Companies with a market niche or that dominate their industry can grow revenues and margins even in downturns.

Solid Management: Taking a page from Warren Buffett, I only want to be in business with management I can trust and respect. I look for management that is competent and knowledgeable. It is important to have management that is candid and upfront when things go bad and that is capable of fixing the problem. On the flip-side, I want management that does not get overly optimistic when things are good.

Significant Ownership: I look for management that has skin in the game, their interests are more likely to be aligned with shareholders. At the same time, I do not want management that has majority ownership and running the company like their own private fiefdom.

Active Investor Relations: I look for investor relations that is actively promoting the company. Whether that be conference presentations or setting up conference calls with analysts and investors. Investor relations need to be in the trenches drawing the attention of other investors to the stock’s value.

Lawsuits and Regulatory Scrutiny: I typically avoid small companies that are fighting a major drawn-out lawsuit or facing extensive regulatory scrutiny. Not only is it a distraction for management, it can have a negative impact on valuation. Not to mention, an adverse ruling could have dire consequences for the company’s survival.

Key takeaways:

• Investing in small-caps requires hard work, discipline, and patience. • Extensive due diligence and fundamental analysis is required. • Short-term volatility is to be expected. • Expect to wait several years for the thesis to play out.