Knowing you don’t know what you don’t know, or, how I stopped worrying and learned to love the Margin of Safety.

December 11, 2010 § Leave a comment

From my limited experience in the market, what I’ve found is that it is less about going with what you know, but learning to avoid the things you don’t know. This may sound like a weird and incredibly unhelpful statement, so let’s put it into an example regarding an industry I am interested in. And the magic of avoiding the thing you don’t understand is by being a good friend with Mr. Margin of Safety.

We are still in a pretty serious market restructuring craziness–century old banks go belly up, new tech stocks going to 60 P/E ratios in under a year and unemployment being a huge problem. People are freaked out, is getting huge numbers and people are buying gold coins on the way home from picking up the blue-ray of The Road at Wal-Mart. So you value investors out there should be all skin-tingly and pumped about finding great opportunities in places that have been on the business-end of all the hysteria.

One section I am particularly looking at is dry bulk goods shipping. Woo. Super exciting eh? Putting stuff on a boat and floating it to other places. Turn down the awesome on that one.

But, obviously, this industry was rocked during 2008 and hasn’t shown near the type of recovery as other industries. Have people stopped needing things floated around? Not likely. But if Mr. Market is still stuck watching the dvd commentary about Viggo Mortensen’s angsty performance, the pitches coming down the pipe may seem less rosy. Which is good for me.

So what am I looking for?
1. Relatively stable performance in a pretty unpredictable industry. I’m not looking for a hero, just someone who can move stuff well in a time when people thing stuff shouldn’t be moved.
2. Low P/E, low P/Book (for the company AND for the industry)  stable ROE (preferable > 15% over 10 yrs), and a Debt to equity under 1
3. Nothing crazy on the cash flow side. I don’t want to see money borrowed and burned at a fast clip
4. Margin of safety using a DCF and Graham Intrinsic Value calculation. It’s not a science, but gives me a relatively good handle if it is cheap or not.
5. Is it undervalued for dumb or for good reasons.

So I start looking at the big dogs.

DryShips (DRYS). Market Cap: 2.1 bil
Diana Shipping (DSX) Market Cap: 1.1 bil
Navios Maritime (NM) Market Cap: 560 mil
Excel Maritime (EXM) Market Cap: 473 mil

Well, Navios Maritime is off the list because it has too much debt, bad cash flow (with a dividend! I know! How can you pay a dividend consistently, but have high debt and negative cash flow. It’s like me trying to give my future child an allowance, but with an underwater mortgage and credit card debt. Fail) wonky margins, wonky ROE…man, NM you’re out to sea.

DryShips is the big dog of the bunch, but they have bad FCF, wonky ROE, no good EPS growth and has the highest P/E out of my bunch of 4.
Diana Shipping looks a little better, but they’re pretty new. Negative cash flow, but looks like they have been investing in PPE and paying of debt, but is positive cash flow really too much to ask for? They are trading pretty close to book, and their P/E is roughly 8 in the middle of a crisis. So they may be pretty fairly valued for shipping.

Excel Maritime is the one that kinda excites me. No, not because it’s the only one left on my list. I mean, I don’t have a little Greek man with a gun to my head, forcing me to buy at least one dry bulk shipper. (But if one industry was going to do that, I’d go with dry bulk goods shipping. I’ve watched season 2 of The Wire.)

EXM: stable margins, pretty good FCF (um except 2008. More on that later), P/E of 1.7 (yeah, not a typo), P/B of 0.3, stable ROE (except 2008…) debt/equity under 1. Oh yeah, and they have more boats than DryShips. Turns out they are 20% bigger than the big dog. Starting to look real cheap at 5 bucks.

Man, that P/E ratio and P/B alone is getting my attention. And a stupidly high EPS for the stock price. There must be something up.

Turns out there is. When you look at the numbers in 2008 they are all wonky. In 2008 Excel Maritime bought (or merged with… Guess it depends who you ask. Kinda like when you get dumped it was, well, you know, something we talked about and decided was best.) Quntana Marine. And turns out that it was a really complicated deal that did strange things to the book price and EPS numbers of EXM due to what is called “time charter fair value amortization.” You can read more about it here to get a nice overview on how much you don’t understand it. So yeah, when something this complicated happens (ie: funny smells from the spreadsheet) I get a bit more nervous about putting my money to it. How can I run a good DCF or Graham Intrinsic Value calculation when there is potentially smelly EPS or even book value numbers? How can I figure out if something is cheap if they may be playing fast and loose with some accounting. Especially the book value one. That worries me.

Well, enter my good friend Margin of Safety (the three most important words in investing.) Mr Margin of safety says to me that I can admit I don’t know what the heck is going on with some of these numbers but still be confident that it may be a cheap buy. How? Well, lets give EXM a brutal future scenario and see what sort of valuation we get from it.

EXM’s brutal scenario:
1. Let’s use the pre-2008 acquisition book value….cut in half: $10 per share
2. Their reported (and contested) EPS after the acquisition was 4.85. The EPS before the acquisition was 4.26 in 2007 and 1.56 in 2006. Let’s be jerks and say that they can only muster EPS of 1.30 (remember, we are building a crappy situation and seeing if EXM still looks cheap.)
3. Let’s say their revenue growth (sitting at a most likely unsustainable 44% 10 yr) drops to a crummy 5%.
4. In a DCF model lets have a high discount rate…like 15%.

That’s a lot of sucky factors not in their favor. I don’t even think that kind of scenario is likely. But, hey, who is Lehman Brothers er…John Galt.
In my this-sucks-we-didn’t-anticipate-this scenario we get a DCF fair value calculation of $21. In a Graham Intrinsic Value we get a value of $14. EXM is trading at $5.85.

Mr. Margin of safety is beginning to say to me that even if I don’t fully understand the merger/acquisition and the havoc it may have caused on the balance sheet, it is still cheap. Maybe even stupid cheap. And as far as dry bulk good shipping goes EXM seems to be doing a good/stable job (with DSX being an interesting one to watch as they grow.)

So I’m seriously thinking of them for my portfolio. If there is a big dip in the next little bit due to people freaking out some more, I may buy. I look for them to rise as people begin to remember that stuff gets shipped or the numbers are too large to justify the cheap price. They are definitely going on my CAPS.

But seriously–margins of safety are the biggest things to look for. Search for them, cling to them and your portfolio should be fine.


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