Centre Street Cambridge Corporation

Private Investment Counsel

Commentary

January 1997

Like many people, we had been rather skeptical about the relentless rise in stock prices over the past couple of years and were fully expecting that the innocents who had entrusted their savings to the markets, confident of the continuation of recent returns, would get hurt by the collapse that inevitably follows these periods of unbounded enthusiasm. Now we are not so sure. Recently, while perusing an article about doomsayers gearing up for the millennium and the Last Judgment, it suddenly dawned on us that mutual fund buyers might be on to something after all. Perhaps the stock market, far from being “irrationally exuberant,” is, in fact, merely discounting the end of the world! Immersed as he is in statistical data, Chairman Greenspan seems incapable of seeing beyond the present to a time, just a few short years away, when layoffs will be universal and interest rates will collapse to nothing in the midst of calamity. Everyone knows that in such an economic environment, the upside for stock prices would be absolutely unlimited.

 

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The aforementioned rise in stock prices continued apace during 1996's final three months, but despite what mutual fund buyers may think, the problem of investing has not been solved for all time. On the contrary it has become more acute, for a long period of happy times, uninterrupted by a reality check of sufficient magnitude, has inflated valuations and increased risk even as investors have lowered their guards and chased after returns. The prudent investor still must deal with a world full of uncertainty and face the possibility that someday, incredible as it may seem, stock prices may actually decline.

With this in mind, we thought we would depart from our usual practice of not commenting on individual securities and present an actual case showing how investors can profit from a strategy that is highly risk-averse. Our example comes from our friends at the New York investment advisory firm of Kahn Brothers & Co., Inc. Founder Irving Kahn was a close associate of Benjamin Graham's for many years, and the firm adheres strictly to the “value approach” which Graham advocated in his classic work Security Analysis, first published in 1934. Graham and his followers sought to purchase stocks at prices representing significant discounts to the underlying worth of the businesses whose ownership they represent. Evidence of a stock's undervaluation would include a low ratio of market value to balance sheet items such as net working capital (current assets minus all liabilities) or book value (net worth, or total assets minus liabilities), or a low multiple of average or “normalized” earnings. What might be termed Wall Street chatter -- market commentary, earnings forecasts, technical analysis -- was of little interest to these investors.

Beginning in 1988 the Kahns bought shares in a Peabody, Massachusetts company called Analogic Corporation, which among other things makes CAT scanning equipment. Then selling for about $8 per share, Analogic's balance sheet showed almost $3.50 per share in cash and net working capital of around $6.00 per share. Book value was approximately $9.00. Debt stood at a modest $12 million and the company was buying back shares. As for earnings, the record was positive (averaging about $0.61 per share over the three previous years), but erratic, and the stock price, as high as $31 at one time, had been in the mid-teens in recent years. The Kahns were impressed by a strong management team. Given the assets backing the shares, the positive record, and good management, it could be argued that the risk to the investor in buying Analogic at $8.00 was very small.

For the next two years Analogic proved to be a mediocre investment for the Kahns' clients as the stock price fluctuated between $8 and $11 per share and ended 1990 at $8. (We add parenthetically that such a result is anathema to most institutional investors due to their preoccupation with short term “performance.”) Meanwhile, cash and net working capital rose and repurchases reduced shares outstanding from about 15.5 million to 14 million. The subsequent two-year period saw some improvement as the price reached almost $15 and settled at $13 at 1992 year-end; shares outstanding dropped to 12 million and net working capital approached $9 per share while book value rose to nearly $13. Momentum gathered steam over the next few years: share prices reached $22 in 1995 and ended the year at $18.50, at which time the company boasted $8 per share in cash, $12.50 in net working capital and a book value of over $16. Earnings had shown some improvement as well, averaging $1.07 during the 93-95 period.

In 1996 Analogic attracted interest with the successful launch of a new portable CAT scanning device. The company's association with efforts to develop new bomb-detection equipment for airports also brought attention following the mysterious TWA Flight 800 disaster in July. The stock price surged to about $30, giving the Kahn group an annualized return over the eight-year period of nearly 18% -- not bad for an investment which carried only nominal risk.

The lesson in this example is that patience, experience, and adherence to this proven investment approach produced good results with less risk when compared to other strategies that typically rely heavily on forecasting. Patience is needed because time is usually required for sound investments to work their magic. Since good investments can be exceedingly difficult to find, experience makes the process of spotting such gems much easier. Finally, the time-tested value methodology provides the tools for rigorous analysis and in this case it enabled the Kahns to determine whether and why Analogic was attractive at $8 per share.

 

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Investors should keep in mind another lesson which is that it is dangerous to let down one's guard and assume good times will continue without interruption. Or, as Graham said, one should always invest “with an eye to calamity.” Not an easy assignment at a time when competition among money managers is so intense that they are pressured to buy out of the fear that if they don't, others will. The Kahns' traditional value methodology, in contrast, keeps an eye on risk, relies on ascertainable facts (as opposed to notoriously inaccurate forecasts), and ignores short term results. Its focus on two key considerations -- price and value -- heightens the investor's awareness of risk and dampens dangerous enthusiasms.  For investors looking for a proven way to safeguard their wealth over the long term, the value approach can be highly rewarding.

 

Dennis Butler, MBA, CFA