"An Asset-Focused Investor Finds 'Deep Value' Stocks" - December 30, 2001
James K. Glassman, Syndicated Columnist
In the next few days, the Wall Street Journal will announce the results of its Investment Dartboard contest for the second half of 2001. In the competition, Journal editors ask four market professionals each to choose a single stock for the six months ahead. Their results are compared with the choices of four readers and stocks "chosen at random by flinging darts at the stock tables."
The winner this time will be Jim Roumell, who heads Roumell Asset Management, an advisory firm based in Chevy Chase. Patterson-UTI Energy Inc., Roumell's selection, has risen 40 percent since the contest began. When I made the calculations last week, his closest competitor picked a stock (Ensco International) that was up just 17 percent. Seven of the 10 other stocks in the race lost money, and the three others rose by only a few percentage points. (By the way, it's reassuring to know that, since the series of monthly contests began in 1990, the pros have beaten the darts and the readers.)
Of course, winning any six-month, single-stock contest may be simply a matter of luck, but when I interviewed Roumell and looked at his long-term record closely, I found that he had an important story to tell. Investors should not necessarily emulate him, but they can certainly learn from him.
Roumell calls himself a "deep value" investor -- that is, he looks for significant bargains among unloved stocks. There's nothing new in that, but Roumell has a specific strategy that is both unusual and logical. Most value mavens concentrate on the price-to-earnings (P/E) ratio, the number of dollars that investors are paying for a dollar of a company's profits. The P/E last week for the Dow Jones industrial average, for example, was 27, but many stocks had P/Es far lower. Ameron International, a maker of building materials, had a P/E of 10; Goodrich Corp., an aerospace firm, a P/E of 6.
But earnings do not obsess Roumell. "To be perfectly honest," he told me, "I look at earnings only out of the corner of my eye." Instead, he focuses on assets -- what a company owns. For most investors that can be tricky, since the assets of different businesses tend to be valued differently by investors and those valuations often rise and fall with economic conditions. But Roumell has a solution: He looks at actual transactions to determine what a company's assets are worth.
It's a simple process that nearly every home buyer understands. "If you want to find out how much you should pay for a house," says Roumell, "you just ask what other houses on the block have been going for. I do the same. I look at comparables."
Last year, for example, he bought shares in a modest company called J&J Snack Foods Corp., which, he wrote at the time, "dominates the market for giant pretzels," the kind sold in football stadiums. J&J also contributes to America's nutritional needs by selling slushy soft drinks. Roumell's comparable in this case was Ben & Jerry's Ice Cream, which had recently been purchased by Unilever PLC, the British-Dutch packaged-goods giant, for $ 265 million. At the time, Ben & Jerry's had annual revenue of $ 240 million, so the price was 110 percent of the ice cream maker's sales.
J&J had about $ 300 million in sales, so a comparable price would be 110 percent of $ 300 million, or $ 330 million. J&J has 8.8 million shares of stock outstanding. Divide $ 330 million by 8.8 million and you get a price of $ 37.50 per share -- again, assuming J&J is valued the same as Ben & Jerry's. Actually, J&J should probably be worth more: It has a much larger share of its own market, and its pretax profit is 7 percent of sales, compared with 3 percent for the ice cream company.
But $ 37.50 was the target price that Roumell used in August 2000. At the time, J&J was trading at $ 14.50. No wonder Roumell told clients that the stock was "significantly undervalued" and, at a discount of more than 50 percent, it seemed "to be a safe investment." He was right. On Christmas Eve, J&J was trading at $ 24 a share -- still less than 70 percent of sales.
Another example is Datastream Systems Inc., which sells software that helps businesses schedule maintenance and manage their inventories of parts. Roumell bought shares for his clients' accounts at between $ 3 and $ 3.50, down from a 52-week high of $ 13. But was $ 3.50 cheap or expensive?
With 20 million shares outstanding, the market capitalization of Datastream was $ 70 million (20 million times $ 3.50). Revenue for 2001 is estimated at about $ 100 million, so the stock was being valued by investors for considerably less than its yearly sales. Roumell found that similar business-to-business software companies, also breaking even and also without debt, were being bought out at prices of 1 1/2 to two times annual revenue. Sure enough, on the very day I interviewed Roumell, Dec. 20, MRO Software made a hostile bid of $ 6 a share for all of Datastream's stock. That sounds cheap, but it still provides Roumell with a profit of nearly 100 percent.
As for Patterson, Roumell's Wall Street Journal pick: The company owns 302 drilling rigs that are used to get oil and natural gas out of the ground. Patterson works on a contract basis for big producers, and the rate it charges each day is determined mainly by energy prices, which fluctuate wildly. Oil and gas have been cheap lately, and in July, when Roumell entered the contest, Patterson stock was trading at $ 15 a share, down from $ 41 in March.
To find a reasonable price for Patterson's stock, Roumell looked to the rigs. In a recent letter to clients, he noted that Patterson had merged with UTI in a deal that valued UTI's 150 rigs at about $ 10 million each. Patterson's current stock price is about $ 22, so, with 71 million shares outstanding, its market capitalization is about $ 1.5 billion. With 302 rigs, that comes to about $ 5 million per rig -- quite a discount. In addition, a check of Patterson's balance sheet shows little debt and a lot of cash.
Judging from the UTI deal and other transactions, Roumell figures that, conservatively, the rigs are worth at least $ 7 million each. So, "independent of commodity prices, we value the assets themselves in a way an industry insider might to determine if we are in fact buying a value." Most analysts, on the other hand, try to predict earnings for a few years ahead -- a process that "is always impossible," Roumell says.
His system has its drawbacks. It works only when there are adequate comparables, and it requires investors to sell when a stock reaches its target. Roumell bought shares of LandAmerica Financial Group, a real estate title insurance company, at $ 28 a share earlier this year, then sold them in August when the price hit $ 36 -- a target he set by examining other title companies and looking at a secondary stock offering that Lehman Brothers negotiated. When the stock dropped to $ 26.50, Roumell was buying once more, again with an eye to selling at $ 36.
For most small investors, a better strategy is to find excellent businesses at good prices, then to buy and hold them for many years. But it is hard to argue with Roumell's success. The stock accounts that he manages for clients returned 30 percent this year (through Dec. 19) and 8 percent last year, while the market as a whole was averaging a loss of about 10 percent.
Roumell himself manages only the money of private clients, but in the past he has worked with Marty Whitman, a legend of deep-value investing and manager of the Third Avenue Value Fund, which has long been one of my favorites. Over the past three years, Third Avenue has returned an annual average of 13 percent while the Standard & Poor's 500 benchmark has just broken even. The fund has also whipped the S&P over the past decade, with far lower risk than the average fund. Morningstar gives the fund its highest rating -- five stars.
Whitman's largest holdings include AVX Corp., a maker of electronic components; MBIA Inc., a large insurer of municipal bonds; and Tejon Ranch Co., which owns California real estate. Like Roumell, he prefers small and medium-size companies. Since they are less scrutinized than large-caps, beneficial anomalies are more likely. Whitman also has an admirably long horizon. Over the past five years, turnover at the fund has averaged just 17 percent; in other words, he holds the typical stock for six years, compared with one year for the average fund. Third Avenue even has a relatively low expense ratio: 1.1 percent.
Research shows that the approach of stock pickers such as Roumell and Whitman works well over time. Ibbotson Associates examined the Fama-French database, which divides the stocks of the New York Stock Exchange each year into two equal groups: value, for those with low ratios of price-to-book value (or net worth on the balance sheet), and growth, for those with high ratios. From 1928 to 2000, large-cap value stocks returned an annual average of 12.4 percent while large-cap growth returned 10.0 percent. But value stocks were more risky.
My advice is to own both value (defined as low P/B or low P/E) and growth and to use Roumell's brand of analysis as a way to find great companies that are temporarily underpriced. It's surprising how many there are. Yes, the market makes mistakes, and smart investors can capitalize on them.
Warren Buffett made this point with typical pith in a 1988 letter to the shareholders of his company, Berkshire Hathaway Inc.: "Observing that the market was frequently efficient, [financial scholars] went on to conclude incorrectly that the market was always efficient. The difference between the propositions is night and day."
That's lucky for those of us who like ferreting out companies like J&J Snack Foods.
