A nice review of my book!

Courtesy of Alpha Architect

In their search for strong investment returns, many investors have increasingly looked abroad to international markets.

International diversification makes sense from several perspectives. For instance, we wrote here about a paper that argued that some decisions to allocate to U.S. equities are due to survivorship bias. Our friend Meb Faber had an interesting post earlier this year arguing that foreign developed and emerging markets have a lower CAPE ratios than the U.S., and thus have higher expected returns than the U.S. We also reviewed a book about emerging market investing. There are certainly reasonable arguments for why investors would want to consider international markets.

With international investing comes some additional complexity on the tax and compliance front. Not an exciting topic, but an important one. Fortunately, figuring out the myriad of rules and regulations associated with international investing is a bit easier thanks to a new reference book by Nick de Peyster.

Nick’s new book is called, “Investing in Foreign Stocks: a Tax and Compliance Guide for People Living in the United States.”

Read more here …

 

Cooper-Standard Holdings (CPS) – a growing company at a reasonable price!

  • Industrial company selling into the global automotive industry
  • Solid cash flow generator
  • The stock appears undervalued

Cooper-Standard Holdings (CPS) provides components for use in passenger vehicles and light trucks, including “sealing, fuel and brake delivery, fluid transfer and anti-vibration systems.”

The sealing systems business accounted for 53% of the company’s revenues in 2015. According to the company, Cooper-Standard Holdings is the leading global sealing systems company

The fuel and brake delivery systems business contributed 20% of revenues. The company believes that it has a #2 position in the fuel and brake delivery systems that it produces.

The fluid transfer business is 14% of revenues. The company believes that it is the #3 competitor in this business.

The anti-vibration systems business contributed 8% of revenues in 2015. The company believes it is one of the larger North American producers of anti-vibration systems.

The company was founded by acquiring the automotive segment of Cooper Tire & Rubber Company in 2004. Since then, the company has grown organically and through acquisitions.

The company’s top customer is Ford (26% of 2015 sales). Its second most important customer is General Motors (16%).

Going forward, the company has a few different options for growth. It could continue to acquire companies. Intriguingly, the company’s U.S. operations have a double-digit profit margin. In contrast, the international segment (48% of sales) has been losing money. It does not appear as if the difference in profitability is a function of management shifting profits to lower tax jurisdictions, because very little of the company’s revenues are transfers between regions.

The company is earning at a run rate of about $2.00 per share per quarter, implying a P/E of about 11.5x. The company has been buying back stock this year. Before this year, the last time the company bought back a significant amount of stock was in 2013 (when the stock was at a much lower price than now).

The company’s business performance should have above average sensitivity to economic growth. If the U.S. economy were to enter a recession, we would expect Cooper-Standard’s results to suffer. Under those conditions, it is difficult to imagine that the stock will perform well. However, in the near term we don’t think a recession is likely.

This article is information purposes only. It is not investment advice nor an offer of investment advice. The author does not currently have a position in the stock. Please do your own due diligence, as you bear the entire risk of your investment.

10 Strategies to Increase Your Investment Discipline

One definition of investment discipline is:  do you pull the trigger when your investment process tells you to buy or to sell a certain number of shares of stock? Do you transact the number of shares your process tells you to transact, or some other amount?  Discipline means consistently following your investment process.

I believe the key to discipline is managing willpower.  I learned a lot about managing willpower from the outstanding book, Willpower:  Rediscovering the Greatest Human Strength by Baumeister and Tierney.

According to Baumeister and Tierney, we have a certain reserve of willpower each day.  Our reserve depends in part on how much glucose we have in our blood stream.  Willpower is needed continuously to suppress emotions so that one can function effectively during the day.  Some activities and events consume vast amounts of willpower, in particular what you would otherwise not do (e.g., exercising, being polite to people you don’t like, not eating sweets, etc.).  When you run out of willpower it becomes very hard to remain disciplined.

Glucose alone does not mean we will have the willpower to take on our most challenging tasks.  Sometimes we must think through the structure of our life.  Poorly structured tasks take more willpower.  One can revise such tasks so that one needs less willpower to complete them.

If we manage our willpower effectively, we may have enough to be disciplined when it comes to following through on investment decisions.

TRADE at times of peak willpower

I find that I am much more disciplined when I trade in the late morning.  I have more willpower then compared to other times of the day.

Every weekday I complete my morning exercise by 6:30AM. Afterwards, my glucose levels are low and thus my willpower is shot.  So I need to rebuild in time for trading.

I rebuild my glucose (and my willpower) by eating a decent breakfast at 7AM, typically about 500 calories in a well-balanced meal of fat, protein and carbohydrates.  The early breakfast gives my body some time to convert the food into glucose to recharge my system and my willpower.

I will start planning out my trading around 8:00 AM.  This will take up to 90 minutes.  This is not very difficult to execute, so it doesn’t require a lot of willpower.  Meanwhile, I feel all of my mental acuity coming back as my blood sugar level returns to normal.

By 9:30 AM to 10:00 AM I start trading.  I find that I can breeze through the trades without the minimum level of emotions until about 11:00 AM.  I try to have everything completed before lunch.

If trading starts to run for too long, the energy from my breakfast will start to deplete and I find it difficult to remain focused.  Without focus, discipline disappears.  I might have to take a break and eat a decent lunch.

In the afternoon, no matter how much I have eaten, I am fighting a downward slide in my willpower.  I just don’t have as much as the day wears on.  Thus, I try to avoid trading late in the day.

SPEND LESS TIME FOLLOWING THE MARKET

Like most people, watching the value of my brokerage account go up and down creates an emotional reaction.  Statistically speaking, the information likely has little or no value in the near term.  I just as well could look at the account once per week, once per month or even less frequently.

Merely watching the market reminds me that I have money in the market which is fluctuating, creating an emotional response and using up willpower.  For the kind of investing that I do, I need not look at the market more than once per week.  My investment process is not designed for a shorter time period.  Therefore, observation of the market over a shorter time frame creates an avoidable drain on my willpower.

FILTER THE MEDIA

A major goal of media organizations is to get people to read or to view the stories they create.  One way they do that is by running sensational stories that provoke strong emotional reactions.  The media are very good at this. Otherwise, they would not be in business.

I make a conscious effort to filter what I read.  If I suspect that my process will want me to buy more stocks in a few weeks, I try to avoid reading news media that bleats about the terrible state of the economy and the markets.  If I read such stuff, when it comes time for me to buy, I likely will have to fight through a particularly strong emotional response.  Why should I make discipline more difficult than it already is?

Filtering the media does not apply just to investment related news and opinion. Any media that creates a strong emotional response may be a problem because dealing with any emotional response draws down the willpower one needs when it is time to take actions with one’s investments.

For some people, politics creates a strong emotional response. The more one reads about politics, potentially the more one experiences the negative emotion of frustration. Dealing with that emotion takes willpower. Perhaps one could improve investment discipline by paying less attention to politics.

Trading less often

Simply taking action on an investment opportunity requires willpower. The more actions one must take, the more willpower one consumes. As the willpower runs down, the investor will find it increasingly difficult to follow through and take action.

Therefore, one may improve investment discipline by designing an investment process that requires less action. For example, trading once per quarter may require less willpower and discipline than trading every day. While the daily strategy may have higher theoretical performance, the performance will not happen if the investor cannot keep up with the demands of the strategy. A quarterly strategy may have a somewhat lower (but still attractive) theoretical performance, but the performance actually happens because the investor can follow through.

Make smaller investments

Position size can affect investment discipline.  The more money one puts at risk in an investment, the stronger the emotional reaction.  If one has difficulty following through on investment decisions, perhaps the size of the investments is too much in relation to one’s available willpower.

Reducing the amount at risk may pave the way for more consistency.  One could diversify one’s assets across more positions, so that buying or selling any one position does not take such an emotional toll.

Alternatively, one could have fewer positions but spread the trading of any one position over several days of weeks.  Of course, the viability of stretching the trading out over a period of time depends on the strategy. A rapid-fire strategy might not lend itself to this approach; for a longer-term approach, slowly trading in and out of positions might not affect performance too much.

CONFIDENCE IN PROCESS

Uncertainty triggers emotions, especially when the stakes are high as is the case with investing money.  If one becomes uncertain as to the future return potential of one’s investment process, one must use substantial willpower reserves to deal with the emotions and to follow through with discipline.

One can reduce the emotional toll of uncertainty by building confidence in the investment process that one uses to invest in stocks.  How does one do this?

  • Use an investment process that is well-supported by evidence.  In our opinion, the evidence strongly supports value and momentum as stock selection methodologies.  When in doubt, one can reduce uncertainty and reestablish confidence by consulting the historical evidence.
  • Read at least 10 books or papers that explain why your investment process should achieve the desired result.  The cumulative weight of the evidence should reduce uncertainty.  If you cannot find at least 10 books or papers and you don’t have the tools and resources to establish beyond a reasonable doubt the efficacy of your investment process, perhaps you should consider a different investment process.
  • Write a five to 20-page essay explaining why the investment process should work.  Writing forces clear thinking and increases one’s commitment to the investment process.  A long essay requires a thorough assessment of the investment literature.
  • When feeling doubtful, reread the literature.

HAVE MORE THAN ONE INVESTMENT PROCESS

As they say, there is more than one way to skin a cat.  Similarly, there’s more than one way to succeed at investing.

No investment process produces attractive returns all the time.  During the inevitable periods of poor performance, those who follow the investment process will suffer an increasing emotional burden.  Those bad emotions rapidly drain willpower.  The investment process becomes increasingly difficult to follow.

Having more than one investment process can help.  If one has two investment processes that operate on distinctly different principles, there may be a good chance that one will perform well when the other performs poorly.  Overall returns may not look as bad and the emotional toll may be easier to bear.

OUTSOURCING

If taking action requires too much willpower, having someone else take action on behalf of the investor requires less willpower.  The investor designs the investment process and turns it over to someone else to manage on a day-to-day basis.

Because it is not his money, the person actually taking the action will have no “skin in the game.”  He is a mere order taker and will not have the emotional attachment to the outcome. If anything, the order taker will have to push through the fear of making an error in the actual entry of the order.  However, a diligent trader can avoid such mistakes without too much difficulty.

At the same time, the investor himself will not have to deal with the emotions caused by trading – it has become someone else’s problem. Consequently, there is a diminished likelihood that failures of willpower will cause abandonment of the investment plan.

Exercise

I started Crossfit in February, 2015, after doing essentially no consistent exercise for about 30 years.  My oldest son had been doing Crossfit for a while and it appealed to me.  But the intensity left me thinking that I ought to get in shape before joining a Crossfit gym.

The catalyst for not waiting was a party at which I became winded after dancing with my wife for only two songs, and not particularly fast songs at that.  At that point, I decided that the situation was grave and that I would start Crossfit immediately.  I have been going six days per week for the past 20 months.

Crossfit is very hard work, but it requires less willpower than one might think.  I sleep in my gym clothes, thereby making it easy to get ready in the morning.  Once the alarm goes off, all I have to do is get into my car and drive three miles to the gym.  The rest is on autopilot:  the coach has the workout planned and all I need to do is follow instructions.  Because I am in a class, peer pressure makes it inevitable that I will work hard. The motivation is external rather than internal and requires less willpower. At Crossfit, there’s no sitting on the rowing machine reading a magazine.

For me, Crossfit initially consumed vast amounts of willpower.  It was very intimidating.  Over time, it became a routine.  At this point, I don’t feel like I need to use much willpower to get myself to go.

Crossfit has helped my investing. Specifically, the arduous exercise has led to a steadier emotional state.  Things that used to bother me don’t bother me as much since I started Crossfit.  Consequently, I find that unwanted emotions are not draining my willpower as much as they used to.  I now have more willpower to deal with other challenges (like pulling the trigger on investments).

SUPPORT STRUCTURES

A well-designed support structure can help one follow an investment program.  The support structure consists of one or more trusted people who hold the investor accountable for following an agreed-upon program.

Facing a challenging task alone requires more willpower than acting as part of a group.  When one is part of a group, one does not want to disappoint.  The fear of being a disappointment can help one overcome the emotional barriers to taking action on one’s investments.  The fear provides an external motivator such that one needs less internal willpower.

The group should meet regularly, perhaps once per month.  In the near term, investment results can be unpredictable. It does not help to focus on what lies beyond the control of the investor.  Instead, the group should focus on the consistent implementation of the plan.  For example, the plan called for buy 1,000 shares of XYZ Company on Thursday.  Did the investor do it or not?  Why or why not?

Inflation and taxes strip the investor of capital

Investors subject to the U.S. capital gains tax ought to be fearful – very fearful – of high rates of inflation.

The reason for this is simple: on the one hand, over the long term inflation tends to flow through and to increase investor returns. On the other hand, the inflation contribution to the investor’s return does not actually help the investor, because the inflation also increases the investor’s costs.

At the same time, the tax code of the United States taxes all of the investor’s return including the part of the return caused by inflation.

Inflation and returns

Over the long-term, inflation flows through and contributes to the investor’s return.

Consider the following example:

Scenario A: The investor owns a phosphate mine that produces a yield of 8%. The investor spent $100,000 developing the mine. Production does not grow or shrink, and is expected to continue for hundreds of years. Because there is no inflation, the price of phosphate and cost of mining each ton of phosphate remain the same. In this case, the expected return is equal to the yield (8%, or $8,000 based on a $100,000 investment). The government taxes half of that return; so the investor receives 4% after taxes ($4,000). The investor spends that money on groceries, which do not change in price from year to year because inflation is zero.

Scenario B: Now let’s imagine all of the same information, but inflation is now 10% per year. The company is producing exactly the same amount of phosphate. But inflation causes prices, costs and profits to increase by 10% per year, every year indefinitely.

In the first year, the return is the same as in Scenario A: $4,000. Each year, the return increases by 10%, but so does the cost of groceries. So the investor appears to be in good shape: returns and costs are advancing at the same rate, and the investor can buy the same amount of groceries each year.

The problem happens when the investor decides to invest in something other than a phosphate mine. Let’s imagine that after 25 years, the investor decides to put his money into gravel pits. The economics of gravel pits are the same as for phosphate mines.

In Scenario A, the investor sells the phosphate mine for $100,000 and buys a gravel pit for $100,000. Because the investor sells the phosphate mine for the same amount of money that he originally invested in the mine, he has no capital gain, nor tax on capital gain. He can fully redeploy the $100,000 into the gravel pit. His investment income remains the same and he can still buy his groceries.

In Scenario B, after 25 years the after-tax investment income from the phosphate mine and the cost of groceries will have increased from $4,000 to $43,339 due to inflation. The cost of a phosphate mine (or a gravel pit) will have increased from $100,000 to $1,083,471, again due to inflation. When the investor sells the phosphate mine at the inflated cost, he will have a capital gain of $983,471. The government will tax that gain, let’s assume at a 50% rate ($491,736). Net of capital gains taxes, the investor has only $591,736 left after he sells the phosphate mine.

Now the investor is stuck. The gravel pit costs $1,083,471 but the investor only has $591,736 after the government has taken its taxes.

So the investor goes from owning 100% of a phosphate mine to owning 54.6% of a gravel pit. His income is now only 54.6% of what it used to be, and the gravel pit buys only 54.6% of the groceries that the investor was able to buy when he owned the phosphate mine.

Inflation monitor as of 11/23/2016

This post reviews a wide range of market-based and statistically derived measures of inflation.

Our takeaway:  inflation is probably in the 1.5%-2.5% range with an upward bias.

Backward Looking Measures

Consumer Price Index (CPI) – changes

The CPI is calculated by the government.  More than a few investors view the index with a degree of skepticism.

CPI:  +1.48%

Median CPI:  +2.53%

Core CPI:  +2.21%

Sticky CPI:  +2.61%

Core PCE:  +1.86%

Producer Price Index (PPI) – changes

The PPI is calculated by the government.  Some investors regard it with suspicion:

Finished Goods:  -0.05%

Wages

Wages are very important because they account for such a large portion of the cost of goods and services.

Average hourly earnings:  +2.82%

An increase in average hourly earnings does not translate into an equal amount of inflation.  Increases in productivity can offset (entirely or partially) the inflationary effect of higher wages.

Billion Prices Project

The billion prices project estimates the annual rate of inflation by using prices posted by online merchants.

As of 9/15/2016, BPP estimates the U.S. inflation rate at about 0.2% per month, which is about 2.5% annualized.

Purchasing Manager’s Index

The Institute for Supply Management publishes the results of a monthly survey of their members, including a price diffusion index.  A diffusion index doesn’t tell us the rate of inflation, but rather what percentage of the survey respondents are seeing prices go up or down.

The survey results suggest no significant inflationary pressures.

Manufacturing Prices:  54.5

Services Prices:  56.6

FED REGIONAL MANUFACTURING SURVEYS

Certain Regional Federal Reserve Banks survey businesses on a variety of trends, including prices.

Diffusion Indices – past month

The following are diffusion indices, a simple difference of the percent reporting price increases less the percent reporting price decreases.

New York Prices Paid:  22.6

New York Prices Received:  4.7

Philadelphia Prices Paid:  7.0

Philadelphia Prices Received:  -3.7

Kansas City Raw Materials:  0.0

Kansas City Finished Goods:  -5.0

Dallas Raw Materials:  13.7

Dallas Finished Goods:  1.2

Estimated inflation – past month

Richmond Raw Materials:  1.17

Richmond Finished Goods:  0.64

Forward Looking Measures

Treasury Inflation Protected Securities

In addition to ordinary bonds, the U.S. Treasury issues inflation-protected securities (TIPS).  By comparing the yields, one can infer the inflation forecast of the capital markets.

Ordinarily one should assign high credibility to this type of information. However, caution may be appropriate given extensive central bank manipulation of the credit markets.

Five Year Forecast:  1.57% per annum (5Y Treasury Yield5Y TIPS Yield)

Ten Year Forecast:  1.73% per annum (10Y Treasury Yield10Y TIPS Yield)

5-Year, 5-Year Forward Inflation Expectation Rate

Inflation expected from 5 years from now to 10 years from now:  +2.01%

Fed Regional Manufacturing Surveys

Certain Regional Federal Reserve Banks survey businesses on a variety of trends, including prices.

Diffusion indices – 6 month forward estimate

The following are diffusion indices, a simple difference of the percent reporting price increases less the percent reporting price decreases.

Kansas City Raw Materials:  19.0

Kansas City Finished Goods:  18.0

Dallas Raw Materials:  25.9

Dallas Finished Goods:  14.0

Estimated inflation – 6 month forward estimate

Richmond Raw Materials:  1.51

Richmond Finished Goods:  0.71

Michigan Consumer Sentiment

1-Year Expected Rate of Inflation:  +2.7

5-Year Expected Rate of Inflation:  +2.7

ECRI U.S. Future Inflation Gauge

ECRI November +0.6

Trend-based indicators

Crude Oil:  Uptrend = inflationary pressure

Copper:  Uptrend = inflationary pressure

U.S. Dollar:  Uptrend = deflationary pressure

Central bank money printing – 10/2016

Each month, we track the monetary base for the world’s major central banks. It gives us a sense of whether the central banks are increasing or decreasing the world’s supply of money.

Perhaps in response to the sell-off in stocks seen in January, 2016, central banks dramatically expanded the monetary base in the first half of 2016. The stock market did pretty well. Recent additions have been very low; the stock market has been sort of flat.

Regardless of what has happened in the past, one cannot assume that positive changes in the monetary base result in positive changes in stock prices. The monetary base tells us about the supply of money. If demand for money is low, then we think an increase in the monetary base is more likely to result in higher stock prices. If the demand for money rises as the monetary base rises, the two may offset with no effect on stock prices.

Here is the data through the end of the last month:

mbase-20161101

 

Murakami Corp (TSE:7292) – looks undervalued to us!

Murakami (Tokyo; symbol “7292”) looks undervalued to us.

Murakami is an industrial company with more than a century of business operations. According to the company’s website, it has three business segments:

  1. Automotive mirror systems appears to be the most important business.
  2. Opt-Electronics is a new business and represents an effort to leverage the company’s automotive mirror systems expertise to enter into other, related markets.
  3. Other Businesses are a variety of endeavors including glass construction materials, sale of raw materials for resin, logistics, transport and temporary staffing.

The company’s businesses appear mature. Growth has been moderate in recent years.

The balance sheet appears very strong. As of the most recent quarter, the company had 47 billion Yen of equity supporting 67 billion Yen assets. Liquidity was excellent with a current ratio of 2.9.

The company has 13.1 million shares outstanding. Cash per share is 1,601 Yen as of the most recent quarter. This compares very favorably to a stock price of 1,910 on November 14th, 2016.

The company’s businesses produce solid cash flow over time. Cash from operations is about six billion Yen per year. Capital spending on property, plant and equipment averages about four billion per year, leaving free cash flow of about two billion per year (approximately 150 per share).

The valuation appears compelling. The Price-to-Free-Cash-Flow ratio (P/FCF) is about 13 if one uses the results for the past five years. If one deducts the value of cash from the stock price, the P/FCF ratio falls to just 2x – very compelling in our opinion.

The stock has no obvious catalyst to trigger a significant revaluation in the near term. In addition, Japan’s sub-par economic performance over the past decade or two is well known. However, change is afoot in Japan. The Stewardship Code of 2014 and the Corporate Governance Code of 2015 are encouraging Japanese companies to become more focused on improving shareholder returns. Management teams are increasingly accountable for taking proactive steps to improve returns. Major institutional shareholders are also increasingly accountable for exercising more vigorous oversight over the companies in which they invest.

With a strong balance sheet and a deeply undervalued stock, Murakami has some obvious opportunities to increase shareholder value:

  • A stock repurchase program
  • Recapitalizing the company
  • Selling the company to a strategic buyer

In increasing value for the shareholders, we would like to see management take advantage of the undervalued stock price. They could also simply increase the dividend – there is more than enough free cash flow to increase the payout by a significant amount.

By our calculations, pretax returns on net invested capital seem reasonable in the low double digits. Based on these returns, we believe there is a reasonable case for the company to reinvest in its core businesses. However, we think buying back stock at these levels is a better use of the shareholders’ money. The company appears to be doing so, but at a very slow pace. Perhaps they will step up the repurchases in the future.

One can buy Murakami through a broker like Interactive Brokers.

This article is information purposes only. It is not investment advice nor an offer of investment advice.

A simple model of inflation and printing money

I am going to review three simple models of the economy that provide a lot of insight into inflation and central bank money printing.

Model #1

Let’s start with a simple model of the economy; specifically, total economic activity (Y) is the product of two variables:

  1. the total quantity of units of economic activity (Q; as in “quantity”)
  2. the average price per unit of economic activity (P; as in “price”)

Thus:                   Y = Q * P

The economy produces more stuff when “Q” increases.  Inflation happens when “P” increases in price.

As an example, let’s imagine that there are Q = 100 and P = $10.  In that case Y = $1,000.

Model #2

A second way to look at the economy is view economic activity (Y) as the product of two other variables:

  1. the total quantity of money in circulation (M)
  2. the number of times the money changes hands over the course of a year (V; as in “velocity”)

Thus:                   Y = M * V

The economy can grow because “M” increases, or because “V” increases (meaning that “M” is changing hands more frequently).

Let’s imagine that there are M = $500.  This means that there is a total of $500 of currency floating in the economy.  That money changes hands on average twice per year, so V = 2.  Therefore, Y = $1,000.

Model #3

Let’s combine the two models through the common term “Y”

Y     =     Q     *     P      =      M     *     V     =    Y

$1,000 = 100  *  $10    =   $500   *     2      =  $1,000

Thus:                   Q * P = M * V

Implications

As a practical matter, “Q” – meaning quantity of goods and services produced – does not vary all that much from year to year.  So let’s assume for our purposes that Q is basically a constant.

In recent years, the major central banks have taken it upon themselves to increase the amount of “M” dramatically by creating money out of thin air.

The model looks like this:

Q P = M V
0 ??? = +++++ ???

“Q” remains unchanged, as indicated by the “0” value.  “M” has increased significantly, as indicated by the “+++++” value.  “P” and “V” remain unknown, as indicated by the “???” values.

As it turns out, “P” has not changed all that much because “V” has been falling, like this:

Q P = M V
0 + = +++++ – – – –

Note that the number of “+” signs is exactly equal to the number of “-” signs.  The enormous increase in “M” has resulted in only a little increase in “P” because “V” has fallen dramatically.

In essence, the economy’s participants have mostly sat on the money created by the Federal Reserve Bank, rather than spending it on goods and services.

Going forward, the key concern we should have is whether “V” will change.  In general, people may be willing to sit on the money if they are reasonably confident that the money will continue to have value.  If they become fearful that it will lose value, then they may want to spend it before the value of the money declines.  The act of spending will cause “V” to increase, and with it “P:”

Q P = M V
0 +++++ = +++++ 0

If “V” were to return to where it used to be before the Federal Reserve Bank created all this money, “P” would be much higher – in other words, inflation would increase dramatically.

Of course, if inflation were to increase that much, people sitting on money would become apoplectic that they were losing the opportunity to convert their money into goods and services.  This fear could cause “V” to accelerate even more:

Q P = M V
0 ++++++++++ = +++++ +++++

To conclude, the aggressive creation of money has not resulted in much inflation, but the potential for inflation is dramatic.  What is holding inflation back is the confidence (or complacency) that inflation will not happen anytime soon.

The velocity of money (“V”) can increase dramatically in periods of high inflation.  In periods of very high inflation, people have been known to spend cash receipts in a matter of hours:  On receiving their wages, they run to the grocery store to buy food lest the value of the wages decline too much.

Fukuvi Chemical Industry – too cheap to ignore!

Fukuvi Chemical Industry Co. Ltd. (TSE:7871) is one of those stocks that is just too undervalued to ignore.

Fukuvi is a diversified industrial company. Founded in 1953, it has stood the test of time. According to the company’s website, it has three business segments:

  • Interior residence materials, exterior decorative materials and apartment building flooring systems.
  • Resin parts used in a wide range of application such as residential equipment, office equipment, consumer appliances, etc.
  • Manufacture and sale of precision chemical products, including artificial marble, precision resin products, etc.

The company’s businesses appear mature. Growth has been minimal in recent years.

The balance sheet appears strong. Here are the highlights as of June 30:

  1. Current assets: 32.108 billion yen ($311.23 million).
  2. Noncurrent assets: 12.337 billion yen.
  3. Total assets: 44.446 billion yen [ = (1) + (2) ].
  4. Total liabilities: 17.464 billion yen.
  5. Net current asset value: 26.982 billion yen [ = (1) – (4) ].

The company has 20.7 million shares outstanding. Thus net current asset value per share is 707 yen. The stock traded at just 486 yen on Monday. That’s a 31% discount to net current asset value.

The company has 10.726 billion yen in cash, or 518 yen per share. Cash per share exceeds the stock price.

The company’s businesses produce solid cash flow over time. Cash from operations has averaged more than 2 billion yen per year. Capital expenditures have been in the 800 million to 900 million yen range. Thus free cash flow is typically about 1.100 billion to 1.200 billion yen per year, or roughly 55 yen per share. The stock trades at just 8.8x free cash flow per share.

The stock has no obvious catalyst to trigger a significant revaluation in the near term. In addition, Japan’s subpar economic performance over the past decade or two is well known. However, change is afoot in Japan. The Stewardship Code of 2014 and the Corporate Governance Code of 2015 are encouraging Japanese companies to become more focused on improving shareholder returns.

Management teams are increasingly accountable for taking proactive steps to improve returns. Major institutional shareholders are also increasingly accountable for exercising more vigorous oversight over the companies in which they invest.

With a strong balance sheet and a deeply undervalued stock, Fukuvi has some obvious opportunities to increase shareholder value:

  • A stock repurchase program.
  • Recapitalizing the company.
  • Selling the company to a strategic buyer.

In increasing value for the shareholders, we would like to see management take advantage of the undervalued stock price. It could also simply increase the dividend – there is more than enough free cash flow to increase the payout by a significant amount.

By our calculations, pretax returns on net invested capital appear modest in the high single digits. Therefore, we don’t think the reinvesting in the business is the best use of the shareholder’s money – not while the stock is trading at such a low valuation. Therefore, absent a significant improvement in returns, we would view an aggressive increase in capital spending or a large acquisition skeptically.

A Classic Graham & Dodd Net Current Asset Value Opportunity

Years ago, Benjamin Graham made a case for investing in stocks that trade below net current asset value. According to Graham, assuming that a company has a reasonable earnings track record and future prospects, paying no more than two-thirds of net current asset value per share ought to be a good deal for the investor. In the past, Warren Buffett and Joel Greenblatt have used this investment strategy or variants thereof.

How does one calculate net current asset value? One subtracts from current assets a company’s total liabilities. Such a calculation likely is very conservative, as it assigns no value to a company’s non-current assets such as property, plant and equipment.

A criticism of this strategy is that such opportunities are few and far between. They may have been commonplace many decades ago but one may see them only in the depths of a nasty bear market. If one appears under normal market conditions, then the company more often than not suffers from deep fundamental problems that make an investment too risky.

If one looks overseas, however, one can find quite a few stocks trading at substantial discounts to net current asset value. Companies with real businesses and profitable track records.

Consider Nippon Antenna Co., Ltd (OTC:NPNZF). Founded in 1953, it makes a range of products used in broadcasting and in reception, such as cable television equipment, satellite receivers, television signal receivers, antennae, marine antennae, portable phones, etc.

The company’s businesses perform reasonably well. The company has produced a recurring profit in each of the past five years. Over the same period, cash flow from operations average 789 million Yen. Capital spending has averaged 557 million Yen, leaving free cash flow of 232 million Yen.

The balance sheet appears very strong. Here are the highlights in millions of Yen as of June 30, 2016:

The company has 14.3 million shares outstanding. Thus net current asset value per share is 1,075 Yen. The stock trades at just 543 Yen on November 1st, 2016. That’s a 50% discount to net current asset value.

What are the catalysts to make the stock move higher? Nothing dramatic appears in the cards. However, the company has repurchased its shares in the past and appears to be doing so recently in a modest way. In our opinion, any repurchase of stock at this level tells us two things about management:

  • they probably think the stock is a good investment, and
  • they are willing to use at least some of their cash in a way that seems highly likely to benefit the shareholders.

Nippon Antenna appears deeply undervalued at a time when the winds of reform are blowing through Japan’s system of corporate governance. The Stewardship Code of 2014 and the Corporate Governance Code of 2015 are encouraging Japanese companies to become more focused on improving shareholder returns. In this environment, perhaps Nippon Antenna will become more aggressive about repurchasing its stock.

The stock trades in the U.S. under the symbol NPNZF. Alternatively, it trades on the Tokyo Stock Exchange under the symbol “6930.” A U.S.-based investor can buy the stock in Tokyo through a firm like Interactive Brokers.