Fourth Quarter Summary
Our composite Equity account was up roughly 8.0% in the fourth quarter and 16.9% for the full year. Our composite Balanced account was up 6.6% in the fourth quarter and 14.1% for the full year. Our composite Equity account return was between comparable indices and our composite Balanced account return outperformed its index. Of note, our returns have been accomplished with about 15-20% cash balances throughout the year. We continue to seek compelling deep value investment opportunities to add to our portfolios.
Under-followed Companies Shine
Ben Graham, Warren Buffett's mentor, told a story over 40 years ago that illustrates why investment professionals behave as they do: "An oil prospector, moving to his heavenly reward, was met by St. Peter with bad news. 'You're qualified for residence,' said St. Peter, 'but, as you can see, the compound reserved for oil men is packed. There's no way to squeeze you in.' After thinking a moment, the prospector asked if he might say just four words to the present occupants. That seemed harmless to St. Peter, so the prospector cupped his hands and yelled, 'Oil discovered in hell.' Immediately the gate to the compound opened and all of the men marched out to head for the nether regions. Impressed, St. Peter invited the prospector to move in and make himself comfortable. The prospector paused. 'No,' he said, 'I think I'll go along with the rest of the boys. There might be some truth to that rumor after all.'"
For years, a common retort from our clients has been, "How come I've never heard of so many of the companies in my portfolio?" In other words, why don't you "go along with the rest of the boys?" We've always tried to convey that this lack of familiarity can be a good thing. Certainly when you compare our performance to the S&P 500 over the past several years - where household names are common - thank goodness we've always focused on companies rarely known by name. A recent study analyzing the equity returns in 2006 seems to underscore this theme in a particularly noteworthy manner.
Rich Bernstein, Merrill Lynch's chief investment strategist, recently sought out what the best performing investment strategy (among the 40 or so tracked by the firm's quantitative analysts) was in 2006. Here's what his study found: an investor who focused on the 50 stocks in the S&P 500 followed by the fewest Wall Street analysts beat all the other strategies (24.6% return versus the 13.6% S&P 500 return excluding dividends). There's a simple strategy - go where no one else is looking. This has always been an intuitive, if not totally obvious, notion to us for years.
Recently, we mailed out news articles on what have been our two top holdings for sometime: Capital Southwest Corporation and Tejon Ranch Company. We noted that neither company - to our knowledge - has ever generated a Wall Street analyst's attention and/or research report. And of course, for years, clients have asked, "What's this Tejon Ranch thing?" Or, "Who's Capital Southwest?" We decided to look deeper into our holdings and the extent to which they are followed by traditional "Street" analysts. Here's what we found: on a dollar-weighted basis, 54% of our equity positions are covered by four or fewer analysts, 36% are covered by two or fewer analysts, and 21% are not covered by "the Street" at all. To put this in perspective, currently 46 analysts report coverage of Intel to Bloomberg. What's our chance of outsmarting 46 smart people? In instances where we have purchased such a security (and we have), it is typically because the security has been "crushed" by the market, providing a possible investment opportunity, in our view, because of market overreaction. The odds of us outsmarting the collective judgment of analysts who follow popular securities are low.
Surely investors have made good money on known companies (purchased at the right prices), but the bigger point is the value of ignoring crowds and group think while exercising discipline, restraint and conviction in our own process. Our ideas tend to come to us through two distinct avenues: undiscovered/under-followed companies like Tejon and Capital noted above, or shares of beaten-down companies, at times with well recognized names, that have sold off significantly because of industry-wide or company specific problems. In each instance, however, we view ourselves as going against consensus thinking. One set of companies is ignored (undiscovered), and the other set, while possibly known, is in the dog house (out of favor). The three companies discussed below are more of the dog house variety, but also two of the companies have scant coverage as well. Each company is trading somewhere between 40% to 55% of its share price high reached within the past two years. John Maynard Keynes once said, "The central principle of investment is to go contrary to the general opinion, on the grounds that if everyone agreed about its merit, the investment is inevitably too dear and therefore unattractive." Our three top purchases in the fourth quarter of 2006 were certainly not held "too dear" by the investment community when we purchased them. Rest assured, if you do find a familiar name in your portfolio, it will not be because it recently won a popularity contest. Similarly, if you don't recognize one of the companies on your statement, take heart and recall Rich Bernstein's study.
Our Three Top Purchases in the 4th Quarter
Apollo Group, Inc., APOL. Apollo is best known for its University of Phoenix campus and online schools. Under the leadership of Apollo's founder, Dr. John Sperling, the company has steadily grown its University of Phoenix campus business and online offering into a nationally recognized brand. Apollo's national expansion coupled with a difficult job market paid off during the first half of the decade as revenue and earnings grew annually at roughly 30% and 50% respectively from 2000-2003. The company's stock price during this period of hyper-growth could be characterized as nothing short of meteoric rising from roughly $9 at the beginning of 2000 to $98 in June 2004. At some point, however, hyper-growth becomes unattainable as market saturation, competition or simply succumbing to the law of large numbers become obstacles of a maturing company. Apollo is covered by 19 research analysts and thus falls squarely into the beaten-down, albeit well-known, category of ideas.
By late 2004, Apollo's growth and momentum oriented shareholder base had concluded that the company's hyper-growth period was over. APOL's stock price moved accordingly retreating to $60 by the end of 2005. Still, at $60, Apollo maintained a valuation befitting of a growth company with multiples well above what we would consider cheap. Revenue and earnings growth continued to decelerate for Apollo in 2006 (revenue, however, still grew a healthy 10% over 2005). In October, APOL reported quarterly results that were not up to analysts' expectations. In addition to APOL's recent financial missteps, the company has not filed quarterly/annual reports with the SEC since the end of its fiscal 2006 second quarter in February 2006 due to potential back-dating of stock options. The market's reaction was severe. The stock was thrown out with the proverbial "bath water" selling off from just under $50 to around $35.
So, why did we invest in Apollo? First, at our average purchase price, we are receiving roughly a 7% free cash flow yield based on 2007 free cash flow estimates that, of note, are about 15% lower than the trailing three-year average. Second, our investment was made at approximately 2.2x enterprise value/TTM (trailing twelve months) sales, the lowest multiple to sales in over ten years. This depressed multiple is even more impressive when coupled with the company's historical 15-20% net margins; fiscal 2007 forecasts are at the lower end of that range. Our going concern analysis is buttressed by the existence of a private market transaction. In March 2006, Education Management Corp. (EDMC), a direct competitor to Apollo, was acquired by private equity firms Providence Equity Partners and Goldman Sachs Capital Partners for 11.3x TTM EBITDA (Earnings Before Income Taxes Depreciation & Amortization). We purchased Apollo, regarded as the industry leader, at slightly below 8.0x forecasted '07 EBITDA, a discount of roughly 30% to assets that arguably are not as valuable. In addition to its attractive valuation, we are reasonably assured that Dr. Sperling, who controls APOL via full ownership of the tightly held private Class B voting shares and maintains an 18% economic interest based on total shares outstanding, will surround himself with a management team that operates in shareholders' long-term interests.
Encore Wire Corp., WIRE. Carpe Diem. Seize the Day. Perhaps few companies have seized their day as Encore Wire has. Founded in 1989, it has grown to be the number two manufacturer and distributor of electrical copper wire and cable. Encore's revenues have grown at an annual compound rate of about 35% through the end of 2006. Even if one removes the past four years of growth due to the escalation of copper prices, compound annual growth is still over 30% through the end of 2002. In 1990, Encore's first year revenue equaled $11 million; last year's sales were $1.3 billion. Here's the real stunning piece of news: they've made zero acquisitions, the growth is 100% organic. For Encore, its mantra seems more akin to, "Conquer the Day." Encore is covered by two analysts.
We asked Encore's Chief Financial Officer, Frank Bilban, "How did you do this?" He answered, "We are tremendously focused on customer service, and the ugly truth is that though many companies give lip service to customer service, they don't deliver." The numbers suggest that Encore's clients agree (perhaps because their order fill rate is, by far, an industry leading 99%). Encore's management seems to always be pushing the envelope. During the downturn in copper prices from 1997-2002 they took the initiative to build mills and a new distribution facility while competitors downsized and, in some instances, went bankrupt.
In purchasing Encore, we paid about 0.6x Enterprise Value (EV) to 2006 Sales, about 5.0x 2006 earnings and less than 4.0x EV to TTM EBITDA. Based on Encore's historical valuation over the past ten years, we purchased our shares cheaply. Why the sell-off? The company's own financial statements tell the story: "The company is subject to significant volatility in earnings due to the unpredictability of swings in pricing for wire and copper." To underscore this point, Encore's 2006 earnings should be above $5/share, but are estimated to be around $2/share in 2007. Encore has managed its variable costs extremely well, but its main fixed cost - copper - heavily influences earnings because the company essentially receives cost plus from its customers, i.e., 10% of $4/lb copper generates twice the absolute dollars as 10% of $2/lb copper.
Basically, we are agreeing to live with the uncertainty in copper prices (at the price we paid) because of management excellence, a strong balance sheet, operating efficiencies, market share gains and the general positive trend for sophisticated color coded electrical wiring. We make no attempt to predict the direction of copper prices, but would simply note that copper demand should increase as the world's appetite for electricity rises. Inside ownership is meaningful. Encore's co-founder, Vincent Rego remains Chairman Emeritus, and our own top holding, Capital Southwest Corporation, owns roughly 17% of outstanding shares. Finally, Encore recently announced a major share repurchase program and initiated a dividend for the first time in its history.
Glenayre Technologies Inc., GEMS. Glenayre is comprised of two businesses: Glenayre Messaging and Entertainment Distribution Company (EDC). The Messaging business is a supplier of next-generation messaging solutions and enhanced services for wireless and wireline carriers and cable companies. It provides solutions for voice, fax and email messaging. EDC manufactures and distributes pre-recorded entertainment products, including CDs and DVDs, for music labels, movie studios and other entertainment providers. Glenayre is covered by one analyst.
Glenayre was purchased using a sum-of-the-parts analysis. First, we looked at the Messaging business, Glenayre's legacy business. Due to heavy competition, Messaging business revenue has been declining and has generated operating losses of late. An activist shareholder was demanding that this business be sold because of its drag on the overall business. Glenayre decided to hire an investment bank to explore a possible sale of the Messaging business. We valued the Messaging business at about 0.4x sales, or $25m. In fact, in late 2006, Glenayre announced that it sold its Messaging business for $25m in cash.
The more intriguing part of the investment in our view was EDC. EDC was acquired by Glenayre in May 2005. The deal was brought to management by James Caparro, who has over 30 years experience in the entertainment industry, including four years as Chairman and CEO of Universal Music Group's The Island Def Jam Music Group, a company he founded through the integration of 14 record labels. Universal Music, the world leader in music sales, decided to outsource its EDC business and sold it to Glenayre for about 3.6x EBITDA. Mr. Caparro became President and CEO of EDC. At the time of the acquisition, Universal Music and EDC agreed to an exclusive 10-year contract. With EDC's independence and the stability of the Universal Music contract, Mr. Caparro can pursue his vision to grow the business by capturing manufacturing and distribution business from other music labels and expand capabilities beyond music. Mr. Caparro's personal financial success is heavily tied to his equity in the EDC deal, strongly aligning our interests with top management. When the sale of Messaging was announced, he became the President and CEO of Glenayre.
Placing a modest multiple on EDC and adding net cash (including the proceeds from the sale of Messaging) plus the value of net operating losses (which would shelter future operating income from taxes with certain constraints) results in an estimate of intrinsic value significantly greater than our purchase price.
Once again, we want to thank you for the trust and confidence you have placed in us. As always, please feel free to contact us directly about your account.
Investment Strategy: Roumell Asset Management, LLC ("Roumell") is an independent registered investment adviser and employs a value investment strategy in managing client portfolios. Roumell Equity accounts can have up to 100% of assets invested in stocks; Roumell Balanced accounts typically have 65% of their assets allocated to stocks (though the figure can range from 50% to 80% depending upon the needs of the client).
Calculation of Rates of Return: First and foremost, readers of this letter should recognize past performance is no guarantee of future results. Returns are reported net of all management fees and applicable trading costs; annualized returns are the result of linking quarterly returns (only accounts present for the entire quarter are included in a given quarter's performance composite); returns are time-weighted; returns reflect reinvestment of dividends and other earnings. Returns include an insignificant number of accounts that utilize margin. These returns are based on a composite of Roumell's accounts and therefore were not necessarily duplicated in any specific account. These consolidated performance numbers include all of Roumell's fully discretionary accounts within each category. Discretion is defined as the ability of the firm to implement its intended investment strategy without restriction.
Inclusion of Accounts: As of 12/31/06, in the performance calculations for Roumell Equity, there are 458 equity portfolios totaling $170.5 million. This represents 67.5% of total portfolios and 60.8% of total dollars under management. The standard deviation for Roumell Equity in this quarter is 1.0%. Currently, in the performance calculations for Roumell Balanced, there are 159 balanced portfolios totaling $87.1 million. This represents 23.4% of total portfolios and 31.1% of total dollars under management. The standard deviation for Roumell Balanced in this quarter is 1.4%. A complete list and description of the firm's composites is available upon request. Additional information regarding policies for calculating and reporting returns is available upon request.
Comparative Indices: Because Roumell utilizes an all-cap (large, medium and small companies) investment strategy, there is no perfect index for comparison purposes. We have included two equity indices and one balanced index to allow readers to judge our performance against benchmarks that collectively offer good comparative illustrations.
The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.