Chartwell Technology Inc. (TSX:CWH)

Chartwell Technology "develops, markets, licenses, implements and supports gaming applications and entertainment content for the internet and remote platforms. Chartwell’s JAVA and Flash based software products and games are designed for deployment in gaming, entertainment and promotional applications."

Balance Sheet: Current assets after deducting ALL liabilities listed on the balance sheet are $1.19 per share. Most recent share price was $1.15. So the company trades at a slight discount to it's "net-net" value (net of current and non-current liabilities). The current assets are primarily cash. The company has $19.5 million in cash, or $1.06 per share. There is no debt (although there is $234K obligation under capital lease. Relative to the cash balance this is insignificant). Using Graham's liquidation value formula (as discussed here), the liquidating value for Chartwell is $1.13 per share. Liabilities per share are 7 cents. So our balance sheet multiple is (1.15 price per share + .07 liabilities per share)/(liquidating value of $1.13) = 1.22/1.13 = 1.08. There are certainly a lot of very liquid assets backing the current share price and this provides a significant level of safety to the share value. Cash burn is a potential concern, with the company cashflow negative the past 3 quarters. Longer term, operating cashflow has been postive, if somewhat volatile.

Cashflow: over the past 5 years (20 quarters), Chartwell has generated an average of $1.93 million in CFBIT (Cashflow before Interest and taxes) per year. The enterprise value is about $2 million (that's the market cap less net cash). So our cashflow multiple is 2/1.93 = 1.04. This is a very low multiple. Bear in mind that earnings have only been about breakeven during this time. The company has substantial non-cash charges in the form of amortization, depreciation and write-offs and this accounts for the majority of the difference.

Cash usage: The company generated $9.7 million in cash flow from operations before interest and taxes, plus $2.9 million in interest income and a net $7.6 million from share proceeds (primarily from an $11 million private placement back in December 2004, net of share re-purchases over the 5 years). This cash was used to pay taxes ($2.5 million), repay debt ($1.1 million) and make acquisitions ($4.6 million). The difference of around $11.8 million remains as cash on the balance sheet. No dividend has ever been paid and there has not been significant share buyback activity except to offset option activity. Overall the cash usage is neutral. Chartwell has not returned cash to shareholders as yet but at the same time they do not seem to be squandering it either. The 2005 Micropower acquisition resulted in an $870K impairment charge in fiscal 2007.

The industry is highly competitive and subject to substantial legal and regulatory risk. So be forewarned. Still, at the current price, Chartwell deserves a close look by the serious value investor.

Disclosure: I own shares in Chartwell Technology

Still More on Goodfellow Inc.

I found an article at Seeking Alpha on Goodfellow Inc. The author, Jonathon Goldberg, make some interesting points. But I have to dispute one thing he says. Mr. Goldberg writes "The fact that GDL can be bought for less than its current assets (after satisfying all liabilities) has no implications for an investor." At the time of writing of the article, Goodfellow was trading for $7.90 agains net current assets of $8.43 per share.

I believe this fact actually does have some implication to the investor, as would, I believe Benajamin Graham, who devotes an entire chapter of Security Analysis to the importance of net current assets and the implications when they exceed the stock price. In the case of Goodfellow, the net current assets have acted quite effectively as a floor to the stock price. The chart below shows the year-end net current assets per share (split adjusted) for Goodfellow back to 1996 (the blue line). The pink line represents the low price for the stock the following year (for the stock prices I used Nov - Oct -- Goodfellow's year end is August, so by the end of October we can safely assume that the market is fully aware of the net current assets per share). The graph clearly shows that the share price rarely falls below net current assets and when it does (only during the recent market meltdown), it has been a buying opportunity. Please note that the years along the x-axis run backward, from 2009 to 1996. Also note that the 2009 low share price is for the past month and a half only.



Obviously just because this has held in past is no guarantee it will hold in the future. During this period Goodfellow showed a very steady increase in its net current assets and this trend was likely also a contributor to keeping a floor on the share price. But still, the graph demonstrates that the net current assets clearly have some relevance to the investor.

Disclosure: I own shares in Goodfellow Inc.

More on Goodfellow from a Different Perspective

There's not a lot of analysis out there on some of these smaller stocks, but I was pleasantly surprised to come across Susan Brunner's blog, which offers an interesting and detailed analysis (complete with spreadsheets) of Goodfellow Inc: Part 1 and Part 2 and here's the spreadsheet.

Insider Ownership

A lot of value investors place great emphasis on insider ownership. They believe that if management and/or the board of directors are significant shareholders, then the decisions they make will be based on the best interests of all shareholders. They won't, for example, attempt to raise the share price in the short term by engaging in massive share repurchases at a high share price in order to increase the value of their options. They might also be more prudent with capital investments and acquisitions since it is literally their own money they're investing.

But it can also happen that insiders who own significant stakes in the company may not actually have long term share price appreciation as their primary goal. Instead their goal might be simply to fleece the other minority shareholders by taking a bigger piece of the profits for themselves. This could be hidden in various related-party transactions such as leases or consulting fees or exorbitant compensation. It's true that this sort of abuse could be practiced by insiders even if they were not large shareholders, but it's easier to get away with this sort of thing when you're the boss.

I think the best thing would be to judge the past record of a company that has significant insider ownership. If the same owners have been around a while and have done things in the past that have benefited all shareholders, not just themselves, then I would view that as a very positive sign. After all, as psychologists will tell you, the best predictor of future behaviour is past behaviour.

The academic studies looking at firm performance vs. insider ownership are ambiguous. This study from the Journal of Corporate Finance argues that the amount of insider ownership is actually a function of firm performance as well as vice-versa, which just demonstrates how difficult it is to judge whether insider ownership is a good thing or not. The article's appendix includes summaries of past studies done in this area.

Bottom line, insider ownership in and of itself is probably not a bullish indicator while insider ownership combined with a long history of shareholder-friendliness probably IS a bullish indicator.

Caldwell Partners (TSX:CWL.A)

Caldwell Partners (TSX:CWL.A) is an executive search consulting firm. Its shares last traded at 52 cents and with around 16.5 million shares outstanding, that's a market capitalization of just $8.5 million. The company carries $10 million in cash and marketable securities and has no debt. So it actually has a negative EV. That's cheap!

So what's the catch? Cash burn. The company had built up a pretty large stockpile of cash and investments over the years while it was cashflow positive. At the end of Q32008 there was over $20 million in cash and investments on the balance sheet but today that number has been cut in half due to a combination of investment and operating losses. Prior to the recent downturn in the company's fortunes they had been generating around $2 million a year in CFBIT (cashflow before interest and taxes).

The company claims the recent losses are due in part to the recession, which makes sense, and also to increased expenses relating to the investment "in the addition of new search partners" and "aggressive expansion into the U.S." They say these investments will "build a solid platform for sustainable and profitable growth." If those statements are actually true and the company returns to profitability quickly, then the shares will likely see a significant rise.

Besides significant operating losses over the past several quarters, another red flag is the possibility that management is not of the highest ethical calibre. Last year a lawsuit with 3 shareholders (JC Clark Ltd, Tailwind Capital Inc. and McElvaine Investment Management) was settled with part of the terms being that Caldwell will move to a single share class effective November 2011. The class B voting shares will be converted at a rate of 1.149 class A non-voting shares for each class B. Based on the most recent share counts, this would increase the shares outstanding to 18.3 million. The action alleged that "Mr. Caldwell and members of the Board of Directors...[engaged in] a series of related-party transactions that are alleged to have benefited certain members of management at the expense of Caldwell Partners and its minority shareholders." The statement of claim also asked that "the Company declare and pay a dividend from the Company's excess cash reserves."

I don't know the details behind all of this, other than what's noted above. I do know that there was no extra dividend paid out and instead the excess cash reserves have been "invested" in growing the business and another $2.6 million was lost on investments during the market crash.

Are the current woes simply a temporary setback caused by the recession? Will the new capacity built in the last year actually add to the bottom line in future? Unfortunately these are questions I'm not qualified to answer. We would definitely welcome input from anyone with more knowledge on the economics, opportunities and outlook in the executive search space. In the meantime, even with the uncertainty, the rock-bottom valuation is very compelling.

What Does the Company Do With Its Cash?

Free cashflow is a big part of the way we analyze stocks here. The more cash, the better. But just generating cash is not enough (although it is essential). We need to know what the company has done with its cash. Sure, some will go to pay taxes, and, if the company is capitalized with debt, some will go to make interest payments. But what about the rest? Was it used to pay down debt? As conservative investors, we see this as a positive action, although modern finance theory might debate that. Was it used for dividends? That's always good, we like to see cash returned to the owners. Was it used for share repurchases? That can be good if the shares were repurchased at reasonable valuations. But was the cash just used blindly to buy back shares, regardless of price? Were there acquisitions made? If so, how did those acquisitions turn out? Did revenues and profits increase as a result of the acquisition? If not, it could mean the acquisition hasn't had time to bear fruit, or it was simply a bad one, or it could mean the original business is on the decline and acquistions are required just to keep the business from shrinking. Is the cash building up on the balance sheet? If so, why? Is the company planning an acquisiton? Often with smaller companies, a significant build up of cash can be the precursor to the start of a regular (or special) dividend payment.

These are some of the questions we ask as part of our analysis, and if we don't like the answers, we'll think twice before investing our money and/or demand a larger margin of safety.

Liquidation Value

The second part of my valuation system is to look at the liquidation value. To calculate liquidation value, I simply use the model described by Graham in Security Analysis: 1 x cash + 0.8 x accounts receivable + 0.67 x inventories + 0.25 x tangible fixed assets. Graham actually offers up .15 as the "rough average" for fixed assets, but I upped it to 0.25. He offers a range of from 1 to 50%, and I thought I'd use something in the middle of that.

Obviously, this is a very crude estimation, but should be effective for screening large quantities of stocks. An example of a more intricate methodology, practiced by Marty Whitman's team over at Third Avenue Management, is outlined in this article.

Once we have the liquidation value, we can compare that to the market price of the shares plus all outstanding liabilities. Let's call this Full Enterprise Value (FEV), as opposed to Enterprise Value (EV) which normally includes only debt from the liabilities and deducts any cash balances. In other words, if we bought up all the shares and then paid off all the outstanding liabilities, we should own all the companies assets, at which point we could realize the liquidation value. I generally divide the FEV by the liquidation value to come up with a "balance sheet multiple." (I guess I need to work on some catchier names for these metrics) which would be analogous to the commonly used price-to-book ratio, but hopefully a little more meaningful.

Putting It All Together
Once I've derived the cashflow multiple and the balance sheet multiple, my next step is to multiply the two together to come up with an "overall value" (OV) rating. The lower this number, the better value the stock represents. Overall value ratings below 20 often represent very good bargains and are the primary vein I use to mine for good stocks. However, certain characteristics, such as company size, stability of cashflows, the competitive advantages of the business, etc., can justify higher valuations and there may well be very attractive bargains found at higher levels. In any event, once you're down to a manageable list of possible value stocks, the next step is to look at each stock in more detail, examining the financials and the news reports closely, to verify that the numbers are correct (again I use MSN data and it occasionally has errors) and to get a better feel for what the future might hold. Is the company teetering on bankruptcy? Were the significant cashflows of the past 5 years generated from a now-spent mine or oilfield? Has the company sold off significant divisions or made a recent acquisition? Has there been a significant change to the balance sheet since the last financials were reported? Etc., etc.

Goodfellow Inc.

Goodfellow (TSX:GDL) bills itself as "The Wood Specialists" and claims to be "one of Eastern Canada's largest independent remanufacturers and distributors of lumber products and hardwood flooring products." The company is based in Delson, QC,with regional offices and distribution centres across Canada.

When we calculate CFBIT (Cashflow Before Interest and Taxes) for Goodfellow over the past 5 years, we first look at the average cashflow from operations, which has been $16.8 million. To this we add the taxes reported on the income statement, which averaged $7.5 million, as well as the net interest reported on the income statement. Unfortunately the income statement for Goodfellow does not report interest expense directly, but rather has a line item labeled "financial" which we'll use as a proxy, and it has averaged $2.3 million per year. Cashflow adjustments relating to income taxes add back another $0.7 million. From this we now deduct the capital expenditures, which averaged $2.5 million. So, over the past 5 years, Goodfellow Inc. generated an average of $24.8 million each year in free cash, before interest or taxes.

The shares last traded at $9.85 and there are 8.6 million shares outstanding, so market cap is $84.4 million. Debt on the most recent balance sheet (August 31, 2009) stands at $5.4 million, offset by $0.6 million in cash and short-term investments. So that gives us an enterprise value (EV) of $89.3 mllion. Dividing our EV by our average CFBIT gives us an earnings multiple of just 4.0. In other words, a historical return at current prices of a whopping 25% before taxes and interest. How many investments do you know that have that kind of yield?

Of course there are caveats. Revenue has fallen dramatically the past two years, from $518 million in fiscal 2007 to just $438 million in fiscal 2009. The outlook for the housing industry is cloudy. But it's these very uncertainties that create such an intriguing investment opportunity.

5-Year Cash Flow

Ben Graham spends a good portion of the common-stock section of Security Analysis outlining proper analysis of the income statement. He warns of companies charging costs directly to equity accounts, completely bypassing the income statement and thereby inflating reported earnings; of companies taking huge reserves in one year with the intent of using the reserves to inflate earnings in subsequent years; of deferred charges that should really be expensed; and so on.

Since the small investor today must filter through thousands of stocks with the tools he or she has on hand, often with limited time since for most this is a part-time endeavour, I decided that in order to circumvent any tomfoolery going on in the income statement, I would use cashflow as my earnings proxy.

I start my cashflow with the total Cashflow from Operations as reported on the cashflow statement. From this I deduct any capital expenditures. Now because I want to compare the ability of companies to generate cash irrespective of their capital structure, I next add back the net interest expense. By net interest I mean the interest expense less any interest earned from cash balances. I also want to ignore differences in cashflow caused by different tax rates, so I remove any cashflows relating to income tax. This would be income taxes charged on the income statement adjusted for changes in deferred taxes and/or taxes payable/receivable. While it is important to recognize and consider permanent differences in tax rates and the value of tax assets, for the initial filter I feel it's better to remove these effects and consider them afterward.

Once I've made these adjustments (or come as close as I can since I don't have the resources to pull this information exactly; instead I use MSN's on-line financial data, which I can access for free. It often pays to be stingy in the investment game, particularly if you're a small investor) I have what I call CashFlow Before Interest and Taxes, or CFBIT. I look at the average value over the past 5 years, since that's how far back MSN data goes. As mentioned previously, Graham was adamant that several years' earnings be considered, not just the most recent year. He writes "The [earnings power] record must cover a number of years, first because a continued or repeated performance is always more impressive than a single occurrence, and secondly because the average of a fairly long period will tend to absorb and equalize the distorting influences of the business cycle." Good advice that's rarely followed by small investors.

So once I have my average CFBIT, I compare it to the firm's Enterprise Value (EV) to derive an Earnings Multiple. The EV is calculated as the total value of the outstanding shares at the current market price plus the book value of debt plus the value of any outstanding preferred shares, less any cash and short term investments. The idea of EV is to estimate what it would cost to purchase the entire firm so that all the CFBIT returns to you. Some analysts use the market value of debt in the EV calculation but since we're looking at this from the position of an equity investor, it makes more sense to me to use the book value. After all, the bondholders and other creditors would have first claims on the company and if you really did plan to buy the entire firm, you'd likely have to pay out the book value. Obviously there are exceptions but we want to keep this simple.

So with the Earnings Multiple we are halfway to coming up with a "cheapness rating". Next we turn our attention to the balance sheet.

An Updated Model

Well, I've been away for a while. But the time away was not completely wasted. After poring over the 6th edition of Security Analysis (which is really the 2nd edition with some additional editiorials by current Graham-esque investment professionals) I have developed a model for judging whether a stock is cheap or not based on Graham's ideas. This post gives a high level outline of how the model works.

First, let me summarize what I believe are the main points made by Graham in Security Analysis with respect to judging equity investments. First, Graham emphasizes that a company's valuation should never be based on just a single year's earnings, particularly when those earnings are record-high. He states several times that 5 to 10 years' worth of history must be considered when coming to a proper valuation. Secondly, Graham says that although it's true there is little correlation between book value and market value, there must still be some consideration given to a company's tangible book value when considering a fair price for its stock. Finally, Graham warns against accounting deception and spends a good deal of time instructing the analyst on how to derive a realistic, more-standardized earnings number from the financial statements.

With those 3 points in mind, I devised a model that attempts to incorporate these ideas into a single valuation metric. While it's still in development, the early results seem promising. I use 5 years of earnings data instead of just a single year (a single year's earnings is the standard practice when determining price-earnings ratios nowadays). I also use adjusted cashflow instead of earnings in an effort to filter out any accounting gimmickry (or even legitimate differences in accounting methods used between companies) that Graham warns against. I will expand on what I mean by 'adjsuted cashflow' in future. I also calculate a liquidation value for the company, based on formulas Graham provides. The 5-year cash flow and the liquidation values are then compared to the enterprise value of the firm (basically the enterprise value is the value of all outstanding shares plus all outstanding debt) and we can then tell if the firm is trading at a good price.

I will go into more specifics of the model in future posts and advise readers which stocks the model says represent good value and why. For a taste, here are three small cap Canadian stocks that Graham may have liked: Chartwell Technologies (CWH), Goodfellow Inc (GDL) and Caldwell Partners (CDL.A). All have generated ample cash in the past and all have strong balance sheets. It's true that these companies may be suffering hard times right now (some, such as Caldwll Partners, more than others, such as Goodfellow), but what makes them compelling is that these hard times are already priced into the shares. If things can turn around for these companies, their stock prices could improve dramatically.

And for the record, I own shares in all three of these companies.