Saturday, November 29, 2008

A Floor Under the Price of Oil (and Gas)

This article demonstrates what we have always discussed regarding the floor on the price of oil. As compared to the early 80s when relatively high prices encouraged exploration around the world for easy to develop oil glutting the market, new discoveries are in hard to reach places, like 10,000 to 20,000 feet under the ocean. Even though the discoveries in deep water the past few years add to the known world oil supply, they will not get developed at lower (current) prices. This means we are stuck with the lower cost reserves that are dwindling around the world.

The Alberta oil fields are relatively inexpensive to develop and produce. They are generally profitable at $30-40 / barrel, depending on the formation and the oil quality (the amount of stimulation required to get it out of the ground). The really cheap oil that is profitable at $10 / barrel is just about gone in North America (light sweet crude near the surface, like West Texas crude, or "Jed Clampett" crude as I call it). So, when you hear people talk about oil going back to under $20 / barrel, they really don't know what they are talking about.

Some of the more adventerous or less proven drillers are not a good idea right now. But PWE, PVX and PGH have very good operations that don't have many questions.

Also, see www.mcdep.com for his educated opinions on the status of the oil market.

I have attached an article from Barrons Online titled "The Downturn's Impact on One Oil Driller, Callon Petroleum gets a downgrade after it blames economy for decision to terminate project."

"The Downturn\'s Impact on One Oil Driller";


CALLON PETROLEUM (Ticker: CPE) announced that it has decided to indefinitely suspend development of the Entrada field, located in the deepwater Gulf of Mexico. Management cited the recent collapse in oil and gas prices and higher-than-expected development costs as the reasons for terminating the project.


To date, Callon has successfully drilled two exploration wells at this field. The third well recently reached a total depth of 21,100 feet but needs to be sidetracked.


In March 2007, after owning 20% of Entrada, Callon acquired the remaining 80% interest from BP PLC (BP) for $150 million. Subsequently, in the first quarter of 2008, Callon sold 50% of the field to Japan's ITOCHU Corp. for $155 million, with Callon remaining the operator. At the time of the divestiture, Callon estimated Entrada's development costs to be approximately $300 million.


At year-end 2007, Entrada had an estimated 192 billions of cubic feet equivalent (Bcfe) of proved reserves (a total of 339.6 Bcfe of proved plus probable reserves). After adjusting for the divestiture, Callon's pro forma year-end proved reserves were 168 Bcfe. Therefore, approximately 57% (96 Bcfe) of the company's total proved reserves are now uneconomic in the current commodity price environment.


The field was expected to begin initial production in the first half of 2009. With the project now halted, we are lowering our earnings estimates, and our proved net asset value also decreases accordingly. Entrada was expected to double the company's production rate, and without this new source of cash flow, Callon will likely be forced to make major cuts in its capital budget for 2009.


After two years of planning, the suspension of the development of this large asset is a very negative event for the company. Ultimately, Callon may have the opportunity to divest its remaining interest to a company that has the balance sheet to see the project through to its conclusion, but in the near term, Entrada's economic value has diminished considerably. Based on the potential for a large reserve write-down, the minimal visibility on production growth, and the uncertainty about the company's post-Entrada operating strategy, we are downgrading Callon Petroleum shares from Market Perform to Underperform.

Tuesday, November 25, 2008

Paul McCullough Proclaims the Fed on the Right Track

Check out this morning's CNBC appearance by Paul McCullough. He is one of PIMCO's three leaders, that includes Bill Gross and Mohamed El-Erian (who left PIMCO to be Harvard Trust Fund's manager of $38B, but came back to PIMCO and is highly respected). The three of these guys don't get it wrong too often.

http://www.cnbc.com/id/15840232?video=938759900

So, if we are in for a period of stabilization due to the pouring on of liquidity into our financial system, and then due for some significant inflation to pay for all that stimulation needed to save the financial system and home values, we should be positioned accordingly with our portfolios. And because this has been our thesis for the past year or more, we are.

But I never thought we would go through this severe a deflationary recession to get to the expansionary inflation; only talked about it as a remote possibility since I thought the Fed / Treasury knew enough history to avoid it. Bernanke undoubtedly does. But don't underestimate the ability of the Congress to get in the way of solving our national problems. They have no trouble getting us in (way too loose regulation on lending / banking and way too socialist in home lending policy), but want to find someone else to blame when the stuff hits the fan (I am thinking of a certain Sen. Barney (Fife) Frank).

Thinking about how to lever up at these depressed stock price levels leads me to two of the Proshares ETFs: DIG and UYM. Both use leverage to get 150% of the Dow Sector index. Here is a sampling of their holdings and performance (naturally, miserable the past few months):

UYM

http://profunds.com/ProFundsProfiles/FundID_402/Basic_Materials/Profile.fs

DIG

http://profunds.com/ProFundsProfiles/FundID_413/Oil_and_Gas/Profile.fs



Saturday, November 22, 2008

Off the Charts Bad

The past week has brought the stock market, actually all investing markets, to the worst place they have been, by many measures, in recorded history. This is actually encouraging. If it is this bad, how much worse can it get? And we are all still standing, so we should congratulate ourselves for that not-so-minor accomplishment.

How bad has it been? From today's Barrons, here are some quotes from Michael Santoli:

"The virtually unwitnessed level of damage in a short period almost defies hyperbole. After Thursday's drop to an 11-year low on the S&P 500, the index was farther below its all-time high than at any time since 1949. The year 2008, had it ended then, would rank as the worst since 1872 at least. The S&P hadn't been as far below its 200-day average since 1932. Nearly 40% of S&P 500 stocks were below $4 billion in market capitalization, the minimum new stocks must meet to be added to the index. More than 40% of the stocks in the Russell 3000 were trading below $10."

"Investment-grade corporate bonds have outperformed stocks since 1980. The S&P 500's indicated dividend yield rose above the 10-year Treasury yield for the first time since around the time the Giants and Colts faced off in their classic 1958 championship game."

Yesterday, I blogged the opinions of super-Bear Marc Faber who is finally calling for an end to the crash. Other long-time bears, even perma-bears like Jim Rogers, David Tice and Peter Schiff, are calling for more of the same. Technician Louise Yamada is calling for a low around 400 to 600 on the S&P500, which is another 50% drop from where we are today. All of these are forecasts are possible, but are they likely? It seems that even if market cycles are never the same, at least they rhyme. The two major historical references are the twin 1930s declines and the twin late 60s and early 70s declines. The path from here is likely to be similar to the aftermath of both periods.

And from another article, an interview with Robert Fetch, are similar sentiments:

"...the market is clearly discounting a fairly severe recession. There's a good chance that before this is done, the S&P will make a new low. When the S&P went below 804 last week, the percentage decline off the highs marked the greatest bear market in history since the Great Depression." "You have the capacity right now, as a value manager, to find good, solid low-valued stocks of good companies without having to pay a premium for them for the first time, really, since the early 1980s".

What marked both the 1932 and the 1974 market bottoms and resulting economic declines, was a government led effort to restimulate the economy which eventually led to a dynamic market environment. The two periods had different political settings. 1932 marked a three year period under President Hoover where the government did nothing while the markets and economy declined. Hoover and the Congress were following "Laissez Faire" (hands off) economic policies under the theory that market economies would heal themselves without government assistance. It proved to be a painfully incorrect theory.

It wasn't until FDR took office in early 1933 (March back in that time), that the New Deal was born and the government poured money into the economy with the goal of re-employing people to alleviate the very high 25% unemployment of the period. In hindsight, economists, led by Milton Friedman, have shown that had the initial response to the 1929 market crash and resultant asset deflation been more aggressively reflationary (aka stimulation through low interest rates and work programs), the worst of the Great Depression might have been avoided. In any case, investing in the market in early 1933 would have proved very beneficial, even given the 1937 correction, severe in its own right.

The 1968 and 1974 twin crashes were a little different, politically. 1968 was brought on by the uncertainty around civil upheaval caused primarily by the Vietnam war and two major political assinations (Martin Luther King, Jr. and Robert Kennedy) coinciding with a blowoff top of the 60s tech bubble. Thereafter were several years of economic gyrations and failed government policy as indicated by the collapse of the gold standard and the 1972 wage-price freeze to contain inflation. Then in 1973 came the OPEC oil crisis and gasoline rationing accompanied by a 400% spike in oil and gas prices. The proverbial straw came with the Nixon Watergate scandal and his subsequent impeachment.

But unlike 1932-33, the market collapse in 1973-74 did not coincide with a Presidential election. Instead, we had Gerald Ford serving essentially two years of a lame duck Presidency, during which nothing significant could be accomplished in Congress or the Administration to repair the economy. Under Jimmy Carter, there were efforts to stimulate the economy which worked to some degree. But the stimulation in the vicinity of high oil prices, caused massive inflation by 1978. Then came round two of OPEC's assault on the Western world's economies. High oil and gas prices in 1978-79 caused another significant recession and 20% market decline which was eventually resolved by Paul Volcker's attack on inflation and then the Great Bull Market of 1982-2000.

It is clear to me that we can rely on one of these two precedents to forecast the next 5-10 years in the markets. As pointed out before, even if history does not repeat, it rhymes. Here is a chart comparing the three periods in question that makes that point:




If we are at the end of 1932, just prior to the inauguration of a new Democratic President with a mandate to fix the economy and get people back to work, we can look at a market run 0f over 400% between February 1933 and February 1937. If instead, we are at May 1938, we can look at a 50% run over the next 16 months. After the market peaked in October 1939, the fear over WW2 stopped the market ascent and it went sideways until February 1945, near the end of the war.

If, as I think we are, at the market bottom of September 1974, on the heals of Nixon's impeachment in August, we can have at least a 70% run over the next two years as we did until the uncertainty over the 1976 election stopped the run up that summer. But because the market crash has coincided with the Presidential election, we may have a much more robust recovery in the market and economy than in 1974-76. Barak Obama has already promised to rebuild the national infrastructure to put people to work. This will be his New New Deal. The resulting spending will pump a lot of money into the economy, will lower unemployment and eventually improve the consumer spending outlook.

If the last scenario is correct, what will benefit? Infrastructure, materials and energy companies. The improving consumer will also benefit the developing export-driven economies in Asia and restart the Chinese economy (further increasing demand for infrastructure materials and services). Some names that look interesting, all down 60-80% from their peaks, are engineering companies: JEC, FLR and URS; Materials stocks: CX, BHP, FCX, NUE; Energy stocks: PWE, MRO, PVX, SU; and Asia stocks: FXI, IFN and TDF.

I already own most of the above, and have held them through this decline for better or worse (mostly worse as of late). But the case for infrastructure is better than ever. Now the above stocks are dirt cheap by every fundamental metric. Even if the timing of the recovery of the market is off by 6 months or a year and there is more decline to come in the immediate future, held over a 5 to 10 year time frame, the above will reward.

Good investing!

Friday, November 21, 2008

"Dr. Doom" Marc Faber calls for a Huge Market Rally

There is a certain Marc Faber, who is an anti-American Swiss national, living in Hong Kong, who has long called for the demise of the American stock market and the US dollar. He is interviewed in Barrons's regularly, and is a member of that journal's elite "Investor Roundtable".

Last night (Friday morning Europe time), he gave an interview where he is calling for a huge rebound in the stock market, and a collapse of the US Treasury bond market and US dollar, in response to the current market decline and the monetary expansion to prop up the economy. This is the scenario that I am positioned for, with big holdings in Canadian energy (non-US denominated) and material stocks and funds.

He did end his interview with an ominous warning that if the monetary expansion / reflation does not work, then we will experience a tremendous depression, worse than the 1930s. But this is how he got his title: "Dr. Doom"

Here are some of his quotes. You can see his interview on the right hand bar of this webpage.

"The sheer amount of money governments are pumping into the financial system will eventually lead to a very strong rally in beaten-down assets (aka energy), investor Marc Faber said on CNBC Friday.

But Faber also warned that if the markets remain depressed as liquidity increases the result could be a depression worse than in 1929. (don't know how this could happen...they seem mutually exclusive...either you have an asset deflation-based depression, or inflation. If it turns to hyper-inflation and worthless currency, ala Germany in the 20s or Argentina in the 70s, it would destabilize the economy, but would not be called "a depression").

By and large asset markets are "terribly oversold" now, while investors are going overboard into the U.S. dollar and U.S. Treasurys, Faber, editor of the Gloom, Boom & Doom Report, told "Squawk Box Europe."

"What you could see in the next three months is a very strong rebound in asset markets, in equities, followed by a selloff in bonds and eventually a selloff in the dollar," he said.
Governments and central banks around the world are providing liquidity and that will eventually have an impact, Faber said.

And once the buying starts the rally is likely to be "stronger than people expect" given that financial institutions are sitting on so much cash, he added.

'Colossal Deflation'

"I think the intervention by the government in the past and at the present time has created more volatility, not less, and so right now we have deflation, we have colossal deflation in asset prices," he said, noting that equities alone have lost $30 trillion globally.

But "I assure you if you throw enough money at the system, eventually you can reflate, especially in the United States," Faber added.

Statistically a rebound should happen, but if it doesn't "the air is out" and the world faces an economy "worse than the depression of '29 to '32," he said.

Thursday, November 20, 2008

Is there a Rainbow somewhere?

All:

This has been a very tough few weeks. As bad as the market was at the beginning of the year through the middle of March, this is much worse. Now the economy has joined housing in the dumpster. And with a vaccuum in government between the Presidents, the timing could not be worse (I wonder if it is any coincidence that previous major market bottoms in 1932 and 1974 were during Presidential transitions, as well).

I still plan to review some of my small cap favorites and their Q3 reports. There is a lot of good news there that makes me more optimistic after reading the reports. I will try to get to it over the Thanksgiving Holiday, if not sooner. But for a quick overview: the Canroys and the high dividend closed end funds that have just been hammered by hedge fund redemptions and the changing currency situation, continue to have decent earnings and cash flows. None of my high dividend funds has had to cut its dividend yet. That time may come, but there is so much fear built into the prices now, that I am convinced they will weather the storm nicely.

As the high dividend funds / Canroys dip in price, but continue to yield high monthly income, I just reinvest it into the stocks to average down my cost. This way, when the eventual / inevitable rebound comes, my performance versus cost basis will be that much more fantastic. I will have a lower cost but also a lot more shares. And, if worse comes to worse, and they rebound no time soon because the economy goes nowhere, I may have those dividends to help pay my monthly expenses in the event of unemployment! Hope that last one doesn't come true, but we can never know the future....

I continue to think this economic and market situation is most like the mid 1970s. Then as now, we had an unpopular President (Nixon) forced out of office after an unpopular war (Vietnam), which put the country in a generally bad mood. Then as now, we had a massive oil shock that crunched the economy after many years of above average times, making the change in mood that much more dramatic. Then as now, there was a fundamental shift in the manufacturing / auto sector and the creation of new country markets that put pressure on global materials supplies (Japan, Germany, S. Korea, etc). It took us 8 years, till 1982 to recover from the 73/74 crisis. The best investment place to be during that period was in materials and energy stocks, which can withstand and even thrive during a period of weak economic performance, deficit spending and global inflation.

I am copying yesterday's edition of the Prudent Speculator that I receive. First, John Buckingham who runs the newsletter and fund is a common sense kind of guy who keeps his cool. Second, he references quotations from Steve Leuthold, who is a local (Mpls) market forecaster with a very good long term track record. So that is worth reading on its own. Good investing!!


The Prudent Speculator - Wednesday Evening Hotline: November 19, 2008

*** Executive Summary 11/19/08 ***
Near-Term Woes - Retesting the Lows
Long-Term Opportunities - What Does History Say?
Sales - Closed Out ASYT, PLAB & THC
Partial Sale - Sold 50% of ASEI at $71.20 for Certain Accounts
Hotline Special - Buy DAR up to $5.46

Another horrendous day in the equity markets, with the 'modest' 5% decline in the Dow Jones Industrial Average masking the damage done to the overall market as evidenced by a 7.9% plunge in the Russell 2000 small-cap index and the 7.4% drubbing suffered by the S&P MidCap 400. The advance/decline line was ugly as well with preliminary readings showing only 192 winners on the New York Stock Exchange compared to 3,001 losers. The numbers were not quite as bad on the Nasdaq, but a 326/2,524 ratio was dismal as well.

While the catalysts for the giant selloff included renewed concerns about the viability of Citigroup (C - $6.40) and the U.S. auto industry as well as the Commerce Department's report that housing starts fell 4.5% on a sequential basis to a seasonally adjusted 791,000 annual level that is now 38% below the reading a year ago, the Federal Reserve received a lot of the blame as the minutes of the Federal Open Market Committee (FOMC) meeting on October 28-29 were released this morning.

It shouldn't have been a big surprise that the FOMC "generally expected the economy to contract moderately in the second half of 2008 and the first half of 2009, and agreed that the downside risks to growth have increased." This is consistent with the view of many economists, though the participants did lower their collective forecast for growth in 2009 to between negative 0.2% and positive 1.1%. Of course, we would argue that the massive decline seen in equities over the past year might suggest a far worse economic environment than what the FOMC is projecting. Clearly, unemployment will continue to rise into the new year, and the FOMC now predicts that the jobless rate will average 7.1% to 7.5% in 2009, but, again, we believe that the stock markets have priced in a substantial higher number.

Despite our continued optimism for the long-term, we realize that with fear running rampant these days and it unlikely that economic or corporate news will be uplifting in the near term, we have to brace ourselves for more volatility and the likelihood for additional weakness in the short run. Having said that, the technical indicators we look at are about as oversold as they have ever been, suggesting that we are overdue for a significant bounce. For example, the S&P 500 is now 35.5% below its 200-day moving average while the Russell 2000 is 39.0% below its 200-day moving average. Those figures stood at 34.1% and 35.4%, respectively, when stocks began a six-day rally on October 27 which took the S&P 500 up more than 18% from 849 to 1006. During that same time-span, the Russell 2000 rebounded from 448 to 546, or more than 21%. In addition, the Volatility Index (VIX) hit 74 today, not far from the record close of 80 seen on October 27.

We always operate with a long-term, three-to-five year investment time horizon and we continue to think that this period of time will be looked back upon in subsequent years as one of the best buying opportunities in stock market history. As 71-year-old money manager Steve Leuthold said in his latest investor letter, dated October 28:

"If the current U.S. recession (which got underway about a year ago) is about 20 months in duration (our estimate), it would be the longest recession since WWII (average being 11 months). As a leading economic indicator, the stock market would begin to rebound in November 2008, per our historical economic time clock.

"Today's stock market, per our valuation benchmarks (P/E ratios, Price to Sales ratio, Price to Cash Flow ratio, et. al.), is quite undervalued, in the low 15% of our 60 year valuation history. From current valuation levels, the stock market has returned an average of 40% over the subsequent two years and 66% over the subsequent three years, historically.

Obviously, there can never be any guarantee that history will repeat, and we realize that many folks think that this time is different, but we've survived 1987, 1990, 1998 and 2002 by continuing to adhere to the Al Frank strategy of buying and holding broadly diversified portfolio of undervalued stocks. And the market as a whole has persevered through numerous crises with equities seeing long-term returns on the order of 10% to 12%, dating back to the 1920s.

Of course, despite our long-term optimism, we do realize that the companies we own must make it through the near term in order to participate in the eventual recovery. Though we know from experience that the biggest losers going into a bear market are often the biggest winners coming out, we have become more critical of some of the names we hold, opting to sell these stocks a bit quicker than we might have in a more 'normal' market and economic environment. With so many other undervalued stocks available for purchase, we prefer to slowly redeploy these proceeds into other bargains that might offer a little better reward/risk profile.

For example, yesterday we decided to part ways with Asyst Technologies (ASYT - $0.24) and Photronics (PLAB - $0.47), two struggling semiconductor capital equipment companies. With the odds of bankruptcy having risen dramatically, we sold ASYT at $0.23 and PLAB for $0.54. Both companies are presently spilling red ink and with conditions in the tech sector having deteriorated in recent weeks, we are worried that high debt levels may be very problematic.

With the prognosis for hospital owner Tenet Healthcare (THC - $1.46) looking increasingly dire, we decided to finally lay our position to rest this week. In its most recently reported quarter, the company reported that it ailments were becoming more malignant. Bad debt from patients is hovering at 8% of sales, and services are steadily becoming less profitable as a higher percentage of them are to Medicare, Medicade or uninsured patients. Because Tenet depends on more commercially insured patients (admissions of which fell more than 3%), layoffs and the economic downturn have pressured occupancy down to one of the lowest in the industry. With negative tangible book value and debt of $10 per share, we decided to let our THC shares go yesterday at $1.72.

Given the low share prices for the three sales, the value of the holdings at this stage of the game were not enough to move the proverbial needle in terms of performance going forward. Such was not the case for our final sale as Mark Mowrey explains…

In an environment such as this, it's vastly more difficult to justify holding sizable positions in winning stocks with rich valuations, especially when one considers the multitude of inexpensive alternatives into which one can funnel the gains. 'Course it's also tough to move money out of a stock that's been bucking the general trend downward. A smart value investor will put prudence above cupidity, nonetheless, as we did with our holdings of American Science & Engineering (ASEI - $68.04), half of our stake in which we sold yesterday for no less than $71.20 per share for those portfolios where the position was more than 1.3 times the 'normal' size. For Mowrey Portfolio Compiler and Buckingham Portfolio we received $71.25 for the shares sold, while Al received a penny more for TPS Portfolio.

The generally lumpy revenue series took a turn up for American Science in the latest quarter, as the traveler, parcel and cargo inspection systems seller gained further traction in sales of its z-backscatter systems, which produce photo-realistic images of items baddies are carrying or shipping but should not be. Service revenues were higher, too, on account of a higher total number of systems in operation. Margins were on the rise as well.

Meantime, the sales pipeline has continued to grow - backlog is at a record high - as the company targets new markets for products like the z-backscatter vans, intended for use in force protection, counter-drug and anti-terrorism applications. And with intentions here and abroad to further border protection efforts, the long-term outlook is pretty grand.

And, yet, given current market valuation metrics, this stock seems already to have priced in a good portion of that eventual growth, trading at 36 times trailing earnings and more than three times revenue. A price-to-book value measure of 3.6 times is similarly rich, most comparisons considered.

Tempting as it was to hold fast to the shares and hope for greater gains on the whole position, we found it better to sell a chunk of our holdings in ASEI to reduce some of the risk that the rosy picture will fade. The remaining shares we'll hold for a revised-higher target FG price of $78 as the balance sheet is pristine with over $10 per share in cash, net of debt, and fiscal 2009 (ends 3/09) earnings are expected to jump to more than $3.00 per share from the current trailing-12-month tally of $1.87.

Eric Hare pens this evening's Hotline Special on Darling International (DAR - $3.60)…
Darling currently operates in two segments and has been at it since its founding in 1882. Its first segment is the rendering services business, where Darling collects and processes animal by-products, converting them into useable oils and proteins that are needed in the agricultural leather and oleo-chemical industries. Darling collects these by-products from grocery stores, butcher shops and meat/poultry processors. The finished products that Darling delivers via animal parts are pretty impressive. Using meat and bone they can make anything from pet food to fertilizer, using grease they can deliver animal feed and bio-fuels and using tallow Darling can assist in the making of numerous consumer goods.

The second segment, restaurant services, involves the collection of used cooking oils from restaurants and recycling them into high-energy animal feed ingredients and industrial oils. The need for this service is high, as it allows for restaurants to be more productive as it helps streamline the kitchen cleaning process.

A large portion of the by-products from rendering are high growth markets. Demand for new bio-fuels continues to grow and with the new administration starting in January, we’d expect it to at least stay the same. Furthermore, Darling does wonders for the environment. The recycling of fat and protein through the rendering process significantly lowers the amount of green house gas that would have been emitted.

Darling operates all over the world, with the United States providing the majority of its revenue. As a global provider with a proven aptitude in acquiring and synergizing other companies, Darling has an ability to scale the business and offer better prices to customers than any of its regional competitors. The revenue breakout is about 73% rendering and 27% restaurant services.

Operating margins favor the rendering segment as the most recent quarter saw a figure of 19.7% compared with 15.3% for the restaurant services. In addition, margins are improving as the prices at which the by-products can be sold have outpaced the increased manufacturing costs. In the most recent quarter, Darling earned $0.28 per share which compares favorably with the year prior where it earned $0.15. Revenue over the same period jumped to $236 million from $171 million.

A knock on Darling is that its business is capital intensive. The company has to constantly maintain/replace its large fleet of vehicles and heavy equipment for rendering and processing plants. That said, Darling is financially sound, sporting strong free cash flow, a good interest coverage ratio and a net cash position. Management has done a tremendous job of using the strong cash flow to pay down debt and accumulate cash as just last September Darling was showing a long-term debt number that was ten times its cash position.

The valuation for Darling is enticing as it trades for 4.5 times trailing-12-month earnings and for 35% of sales. We recognize that earnings will decline in 2009, but we think that that the nearly 80% decline in the share price since the end of July has been overdone. For those who share our long-term, three-to-five year investment time horizon, we are buyers of DAR up to $5.46 based on an LG/FG pair of $10/$11.

Saturday, November 15, 2008

Earnings Season: AMS reports results

Back from two weeks of hectic travel, I have some time to go over my investment portfolio. I like the way it is set up right now. I am out of most of the more dangerous plays I was in over the past 12-15 months, especially in the financial sector. Most of what I have now is energy, primarily Canroys, emerging market funds and small cap high tech and medical plays.

Because the small caps typically report 4-6 weeks after the end of a quarter, it is just now that we are able to review the 3rd quarter results for the small cap stocks, including the Canroys. I will go over my favorites the next few days, in separate reports. From what I have seen, I am very happy with the performance of my picks.

First, I would like to take a look at American Shared Hospital Systems (AMS). This "microcap" has a market cap of only around $8M. It has 5M shares outstanding, but $10M in cash. So, it has more cash than market cap, which would be great under any circumstances (some of this cash will be used to service loan payments). Today (Monday) you can buy a share for $1.50, give or take. Being this small, it takes very little buying or selling action to move the price. A buy of $5,000 for 3500 shares, will have a material impact on price. The price moves by 10-20% almost every day. It was as low as $1.01 on Oct. 10.

But there is a lot more to this company than cash on hand. It also owns many radiation therapy machines of different types, which it has leased to major cancer treatment hospitals for their tumor therapy centers. Currently, AMS has $45M of assets on its balance sheet for equipment at medical centers, this is net of depreciation. So, on the $8M market cap, there is a lot of financial leverage in the form of equipment owned and under lease. But there is almost no risk of default considering to whom that equipment is leased. The leases cover the depreciable life of the equipment. There is zero residual value at the end of the term.

Against the leases, securities and cash is $22M in long term debt and another $13M in short term or current debt that is completely covered by cash on hand. This all leaves a very healthy $20M of shareholder equity or book value (assets less liabilities) that is 1/2 in cash. With the current market cap of $8M, AMS is selling at less than 50% of tangible book value, which is cheap in any era, the 1930s or the 2000s. The Directors like their own stock and announced on the investor conference call they will buy back 500K shares, or 10% of stock outstanding, which will support the stock price.

Oh, one other thing, there are $1.5M in preferred shares listed under assets. These are the Still River Systems shares and account for about 20% of SRS's equity. SRS has a decent chance to become a major player in radiation therapy, alongside Siemens, Varian and Phillips Medical. That position alone could someday be worth more than 10X the current AMS stock price ($80M). This stock is a bargain by any standard. Check it out: http://www.ashs.com/investors.html