Buying Cheap Retailing Companies and Selling On Blips

Today I feel like writing with more of a stream of coincidence because I don’t have a very narrow topic to talk about but rather a few ideas that I have been thinking a lot about and I want to make one post discussing all the topics so I apologize in advance if it seems as if I am jumping around. 

The first of which that I have meant to make a post earlier about was ARCI or Appliance Recycling Centers of America. This is a stock that I had purchased when it was trading at about 60 cents a share. This is a company that has 16 retail locations where they sell appliances from the large suppliers that are off cycle, essentially they sell the iPhone 5, and 4’s of appliances. They also had two other segments that includes contracts with real estate management companies where they would come in and take all they old appliances that were in the various complexes. ARCI would subsequently sell these appliances to companies hoping to make money off of the scrap metal within these machines. Somewhere around 2011 ARCI thought it was a good idea to get in the scrap metal business themselves and ended up taking a 50% interest in a partnership with another company and opened their own scrap metal business. This turned out to be a horrible mistake as it was a highly capital intensive business as well as it exposed them to commodity prices they previously weren’t exposed to when they were simply just selling the appliances to the scrap metal companies to break down themselves. The company was of interest to me because of the deep discount to its book value as well as the fact that the capital intensive business was hiding its OK retail business. When I first took a look price to book was 0.30x. This sort of ties into one of my other point of topics I wanted to touch on which is the retail sector. Before making this investment I stubbled upon HHGregg when I was writing my Amazon post, I had looked at HHGregg before but never really gave it a good look as it didn’t seem like something I was going to end up investing in. But after the Amazon article I was able to take a real good look at the company about a month after I filed for bankruptcy. I took some of what I learned look at the financial ratios and metrics that would have pointed an investor toward knowing that HHGregg was completely on its way out and applied that when I was looking at ARCI. I’d like to pass along some of the takeaways that I had that I feel helped me when making my decision.

1. Quick Ratio – this is highly important when it comes to retail companies as this can be a great indicator and you happen to get a rather large runway to realize your mistake because this number slowly starts to erode as the company gets closer to bankruptcy. After looking at HHGregg and observing this I went back to other retail bankruptcies and found it over and over, and it seems as though investors had between 2-3 quarters of reports to realize the quick ratio had fallen from its norm. In the case of HHGregg you had 4 different balance sheet to look at to realize the company was worthless. This metric should really only be held to a gold standard when it comes to retail companies as I have no looked at other bankruptcies in other sectors or industries to see if it applies elsewhere. On top of that I would like to point out this is something to keep in mind but you cannot put an exact number on what a quick ratio should be but you can see over and over that once this number takes a nose dive bankruptcies is imminent unless a miracle is to take place. This might best be explained with examples, RadioShack had a rather consistent 1.0 – 1.2 quick ratio over the last 3 quarters this number feel to .66 and its last quarter to .50 showing they were unable to pay current liabilities for 9 month before having to go to court. The same can be said about HHGregg The last 3 years had a quick ratio of about .39 to about .30 this number slipped in the next 3 quarters to a level HHGregg only achieved during the financial crisis which was .18.

2. Another – That is rather self explanatory is cash, this should really be obvious but should be reinforced. When the quick ratio starts to slip the velocity at which these companies burn through cash gave me some real pause. RadioShack had around $500 million in cash a year and half before bankruptcy and in its last 10Q they reported $60 million. The same can be said about HHGregg again a year and half before filing they reported $30 million in cash and the last 10Q before bankruptcy they had $1 million a 2 10Qs before that they reported only $7 million in cash which should give investors some pause and again enough of a runway to see the writing on the wall.

When I first looked at ARCI I ended up passing because of these two takeaways I thought that because of the capital intensiveness as well as exposure to commodity prices in their scrap metal selling business I felt as though it ARCI was on the same path as HHGregg and RadioShack. This was until ARCI announced that they were going to sell their 50% interest in the scrap metal company to the other partner in the business. In effect they removed the risk of bankruptcy, the price of the stock reacted accordingly as it went up to 85 cents a share. At this price I still didn’t want to purchase a piece of this company. Buffett has talked about this before, its hard to purchase shares in a company after you’ve seen a large increase in price but I still felt as though I made the right choice in not purchasing shares in the first place. Even though it was priced at .30x book I still didn’t think the margin of safety was enough given the uncertainty and in effect the company was completely worthless when the scrap metal company was attached with the other two businesses that I mentioned before that one would consider slightly below average. Somehow though the same day this sale was announced and the price went to 85 cents in a about an hour the company was trading for less than it was before the announcement. I mention in the beginning that I purchased shares for an ownership stake at about 60 cents a share, before the announcement you could purchase shares for 68 cents. I really couldn’t believe it and I still can’t believe it that I was able to purchase the two remaining businesses for .27x book value just even a quick look at the balance sheet would have told investors that.

I purchased the shares on a Thursday and didn’t really think much about them for the rest of the day as I was mostly just elated at the fact I got to purchase them as cheap as I did. Then late on Friday I headed over to the company website to check when the next quarterly report was so I could put it in my calendar and I found out that they were actually suppose to put out the report the day I purchased the shares but didn’t as they needed to make adjustments as a result of the sale. Because of this failure it seemed to have scared investors off which is why, (i’m assuming at least) I got the purchase price that I did which I’m perfectly fine with because it was obvious why the report was late.

When the report came out on Monday I really wasn’t expecting much but much to my surprise the company reported earnings of around 30 cents a share, or about half the price in one quarter and this was operating earnings not including the sale of the scrap metal business and as a result the stock when to $1.10 and I sold at $1.12 for an 85% gain. This is the shortest time in which I have held a stock, and I have been thinking about it an immense amount over the last 2 weeks.

As an investor I consider myself a mix of Ben Graham and very early Buffett, I try to look at everything I possibly can and pick and choose the cheapest securities that I come across, and when value is realized and the market becomes rational I sell said securities that I deem fairly valued and start the process over again. Even with the jump in price this company is still trading at the same book value as it did when I first purchased it because they were able to increase book value by about 50% during the quarter. The reason I sold the stock was that when they released the quarterly report the CEO also put out a news release saying that they were going to move from their retailing business into buying high margin businesses and he specifically mentioned tech. This is something I don’t want to be apart and to me I felt as though I have a better ability to invest my dollars then having an appliance retailing CEO try to invest in an area he has no idea about for me. Charlie Munger once said that when your a cigar bud investors you have to sell on blips, this applies whether you purchased said cigar bud 8 months or 8 minutes before the blip because these aren’t great nor are they good businesses. This is best shown in the ARCI example, the CEO of the company is able to cut expenses by 15%, post one of the best profits in its company’s history and just as the company seems to have figured it out the CEO wants to move on. Always sell on the blips.

This leads me to the second point I want to touch on after selling ARCI I went hunting again for a cheap stock and I figured the first exchanges I would look through was the exchanges in the United States. Just from going through the major exchanges its simple the United States equity market is overpriced, I don’t think there is really any other word that could describe it. I went through 5400 equities and wrote down 77 that I thought were worth further research. 12 of which were net-nets and of those 12 six where Chinese based companies. Only six or .001% of the market trade as net nets that I would deem real investable companies, around the same number as was in 2007. These names include JCS, RBCN, RELL, AEY, and THST, another 14 of the 77 where companies buying back shares with a P/E ratio that was cheap relative to the last 5 years EPS % growth. Davita, Hanes Brand, and Lear Corporation made the list to name a few. Next I had 16 companies I considered cheap relative to P/E and 5 year % growth in EPS that weren’t buying back share but had high ROE and ROIC. Some names include Sinclair Broadcast Group, Gray Television, Thor Industries, and LCI Industries. Lastly I had growth companies or what I call high flying companies. These are companies i consider with high EPS growth at a fair price. These include LGIH, NTES, and OCLR. Of all 77 only about 22 were truly interesting, less then 30% of my original list or .004% of the total market.

While the list I gathered has definitely been longer during former time periods this still hammers home the point Michael Burry made during the Tech Bubble, don’t focus on market valuation, focus on bargains. If there was ever a better time to value invest (its always best to value invest) its when the market looks like it does today. Value investing is about risk aversion and higher prices means more risk while lower prices means less. Regardless of when you see stocks trading at 50x earnings going up 500% in a year in a half like Nvidia or Amazon trading at a 250 times earning multiple that is when investors dismiss value investing the most.

Corporate profits peeked in 2014 yet during that time the Dow Jones is up 33%, NASDAQ 55%, and the S&P 35%. This reminds me of something that Buffett said when he was asked during the 1999 Berkshire Hathaway meeting it went something like where is a good place for new investors to invest right now. His reply was that corporate profits are going up, but stocks are going up faster. How can that continue indefinitely? Investors can only earn what companies themselves can earn was his reply. That statement rings true today besides one part, during 1999 corporate profits where going up where as in 2017 corporate profits peaked in 2014 and have remained flat while the market continues to create new all-time highs. Either corporate profits must increase or in the words of Chuck Price “As Long As The Music is Playing” at some point the music will stop if corporate profits don’t increase.

Luckily I don’t have to know when the music stops and I feel bad for whatever analyst job it is to do just that. Keep buying undervalued securities and selling them when the market realizes its value and rinse and repeat. My last point was that I’m trying to set up a page so that I can show my performance, I currently have 3 different brokerage accounts that I have sent and took capital from depending on the security I am purchasing. So I’m still trying to figure out if their is some software or if I’m just going to have to brute force it in excel with some maths. During 2016 I had a return on 49%. So far this year in my eTrade account which holds about 68% of my capital has a YTD return of 38% with a 1 year return of 72% but in my Fidelity account which I created for the sole purpose of purchasing Greek stocks has 20% of my capital is up 85% YTD so my exact number is not known but if I had to guess it would be between 45-49% YTD.