The Argument for Value (Tilson)
tilsonfunds.com
Succeeding With Small Caps
November 1, 2001
Over the past few lessons, you've learned about what to look for (and what to look out for) when investing in small-cap growth stocks. I have to admit it's exciting to try to find the next Microsoft or Wal-Mart -- and no doubt one could have paid just about any price for the stocks of these companies in their early days and done exceptionally well -- but, as a general rule, buying richly valued stocks of any sort, especially small ones, is a perilous strategy.
Before I make the argument for value, I'd like to debunk some of the myths about value investing. Many people think that it means buying crummy companies at single-digit P/E ratios, never taking risks, avoiding technology stocks, and so forth. It is none of these things. Very simply, value investing means attempting to buy a stock (or other financial asset) for less than it's worth. In this case, "worth" is not what you hope someone else might pay for your stock tomorrow or next week or next month -- that's "greater fool investing." Instead, the value of a company (and therefore a fractional ownership stake in that company, which is, of course, a share of its stock) is worth no more and no less than the future cash that can be taken out of the business, discounted back to the present.
Buying something for less than it's worth: What a simple and obvious concept. Charlie Munger said it best at the 2000 Berkshire Hathaway annual meeting: "All intelligent investing is value investing."
This being said, investors are typically faced with buying high-quality, rapidly growing businesses -- but at high prices -- vs. buying inferior businesses that may be struggling -- but at low prices. Which is better? As I will argue below, my answer is neither, but forced to choose, the answer is the latter, according to numerous studies. Value investing (typically defined in studies as stocks trading at low price-to-book or price-to-earnings ratios) has trumped growth investing over time, and this is especially true in the small cap arena. According to the book Stocks for the Long Run (which I highly recommend), over a 33-year period from July 1963 - June 1996, companies in the lowest 20% of market capitalization earned the following compound annual returns (broken down by value vs. growth quintile):
-Book to Market Quintiles Annual Return
Annual Return
Value:.....19.5%
2:.........19.1%
3:.........16.4%
4:.........12.7%
Growth:.....6.7%
Interestingly, value trumps growth for larger stocks as well, but the gap is the widest for the smallest ones. It's not certain why, but I would guess there are two reasons: 1) small value companies are more likely to be ignored and underpriced than large ones; and 2) small growth companies are riskier than large ones.
So why do I say that neither growth nor value investing (as typically defined) is best? Because the most successful investors have the patience and discipline to only buy high-quality companies with strong growth prospects when the market makes a mistake and prices their stocks at low levels. Wouldn't you rather pay 8x earnings rather than 40x for a good business? If you're patient and turn over a lot of stones, such opportunities occasionally present themselves.
Real World Examples
Let me tell you briefly about four small-cap stocks I own, all of which I have been buying recently at prices near today's levels (in other words, I think they're all outstanding buys right now). I list them in rough order of how much I like them.
Imperial Parking
Imperial Parking (AMEX: IPK) is the fourth-largest parking lot operator in North America. Based in Vancouver, the company operates more than 1,500 parking locations, containing more than 270,000 parking spaces. The company dominates the Canadian market, in which it has operated since 1962, with approximately 50% market share. Imperial was spun off by a REIT in early 2000 and now trades on the American Stock Exchange under the ticker IPK.
While one might think that the parking lot business is a terrible one, think again. There's no technology risk, little real estate risk, and the business actually requires very little capital to grow, as almost all lots are operated under a management contract or lease, rather than being owned. This is NOT a real estate play.
The company is growing like gangbusters (revenue and operating income grew 25% and 112% year-over-year in the second quarter) and is trading at about 5x enterprise value to estimated free cash flow for this year.
AAON
AAON (Nasdaq: AAON) is a manufacturer of commercial rooftop heating, ventilation, and air conditioning (HVAC) units. It's a mundane business, but AAON's economic characteristics are anything but. Revenue growth has averaged 18% annually over the past five years, while earnings per share have grown at a remarkable 45% rate over the same period, due to rapidly expanding margins. Return on equity was 36.2% last year and AAON's 8.3% after-tax margin was, according to the company's annual report, "a record achievement for any major equipment manufacturer in the HVAC industry during the last four decades." Results this year have been weaker due to the slowing economy, but the company is still growing and is releasing many new products that should drive future growth. The stock currently trades for a modest 11x trailing earnings.
Huttig Building Products
Huttig Building Products (NYSE: HBP), with over $1 billion in revenues, is the largest and most geographically diverse domestic distributor of building materials used principally in new residential construction and home improvement. Despite low margins, Huttig is a surprisingly good business because of its industry-leading high asset turns. The company has been continuously profitable since its founding in 1885.
Huttig has been hurt by the slowing economy, so the stock doesn't appear as cheap as it really is, but consider this: Management estimates that it could liquidate the company for $8.50/share, about 70% above the current share price.
Ambassadors International
The core business of Ambassadors International (Nasdaq: AMIE) is organizing educational and sports trips overseas for high school and college students. It sounds like a commodity business, but the company has a unique franchise due to its exclusive right to the People-To-People program set up by the U.S. government in the Eisenhower Administration. The company has grown its top line at a compound rate of 33% over the last five years, and it earns exceptionally high margins and returns on capital.
The business has been hit very hard in the aftermath of the September 11th tragedy, but the company has cut costs and is committed to remaining profitable until travel picks up again. The company has $111 million in net cash, and only has a market cap of $137 million, so you're buying the business for $36 million, or only 2x-3x pre-September 11th earnings.
There are good write-ups on all four of these stocks on the ValueInvestorsClub.com website (which is now open to guests).
Conclusion
These are the types of small-cap companies that I believe offer the best opportunities to investors. All of the companies I've mentioned not only have cheap stocks, but are also good businesses, with strong balance sheets and capable management. They will certainly weather the storms they are facing right now, and when the storms pass, they will likely rebound strongly.
Homework
For your homework tonight, we'd like to introduce you to a valuable (when available) resource for small-cap value investment ideas. It's www.valueinvestorsclub.com, an online investment club where pre-screened investors (many of whom are professional money managers or analysts) post their best investment ideas for review and feedback. To access the idea board (unless you are a member, in which case you know how it works), simply click on the "Guest Access" button on the main page.
For your homework, follow the format of the ideas presented at Value Investors Club, and post your own 500-word essay on your best small-cap investing idea to the SC Work discussion board. If you don't have an idea or don't feel like you are ready to present your own, choose one idea posted on the board to review. Use the techniques presented in Lesson 5 to check for warning signs, and present your own thoughts on whether the idea offers a good chance for 2X/3Y or 3X/5Y at the current stock price.
Today's guest instructor is Whitney Tilson, a Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. To read some of his previous guest columns on The Motley Fool site, click here. |
