What kinds of stocks are good to own now?

by admin on March 12, 2013

What kinds of stocks are good to own now?

Now that we are in fully-fledged yen-burning mode, buying gold with our yen only stops the feeling of sand slipping through the fingers. And sooner or later we need to get capital committed to something expected to earn alpha.

The market is stretched based on valuations of dumb large caps. Is Toyota, which is not even one of the poster-child basket cases lying in the gutter, worth its current market cap? It made basically no free cash flow over the last five years and is now trading at some 17x net year’s eps.  High hopes indeed.  I still think we are headed for cold-water-in-the-face treatment, particularly with US stocks.

The Japanese market seems to be, thankfully, as inefficient as a Tokyo corporate headquarters, so there are still opportunities around. And, after dumping a load of names that started to go up quickly, I have been going back to basics – starting with stocks with earnings growth at very low valuations. These are what made the core of my portfolio from the beginning, after which I diversified into some more speculative issues, and now I am full circle.

I call these “growth net nets”, even though they are not actually net-nets, and are not usually secular growers. I call them that because I start out thinking about net-nets and then mentally trade off cheapness for a relatively better business, leading me to very cheap stocks with some potential to move.

Japanese stock market traffic signal Japanese stock market traffic signal

Some examples of these kinds of stocks:

日本M&Aセンター 2127 – very cheap given growth prospects; went apeshit, so I sold it (too early)

リコーリース 8566 – nice and stable model, low financing risk, I felt; but I remodeled it and changed my mind on the liabilities and sold in Jan (too early)

東部ネットワーク 9036 – efficiency improvement/ economies of scale story; it then went apeshit, so I sold it in Feb (too early)

中西製作所  5941 – bargain considering the growth, went apeshit, so I sold it in Feb (too early)

You can see a pattern here – I sell too early.

Warren Buffet would not be impressed.

What to do?

The only thing to do here, it seems to me, is to go for:

a. Stocks that have not factored in the yen depreciation, even though they are in directly or indirectly yen-sensitive industries, such as a bargain company providing catering to the travel industry

b. Look for turnaround stories, as well as stocks which will have depressed earnings yet next year due to investment in growth, such as a chain of clothes shops spending money on expansion

c. Look for underappreciated stocks with real intangible brand value, such as sports brands known overseas

d. Find stocks which are close to net nets and have some growth coming up but have been laggards for no particular reason – there are quite a few like this, particularly in industrial names

Now, as an aside, since I am generally lazy and overly philosophical, the best way for me to get the info out to you on so-called “growth net-net” stocks is to sit down and write a report. It won’t be free, but should be affordable unless your employment involves washing cars and/or waiting tables. It will be details on cheap/ underappreciated companies which have not participated significantly in the huge rally we have seen.

Meanwhile, here is a stock I sold but I am now rebuying: NES – 日信電子サービス (4713)

They provide maintenance services for railway and traffic signal systems (72% of FY12 op inc) and IT services (28%). IT services does maintenance and sells parts for things like big medical equipment, car park systems and office appliances. I was originally attracted to the stability of the railway and traffic signaling maintenance business. However, if there is a real turnaround in the capital spending climate in Japan, then IT maintenance contract signings and margins will increase – in fact, they get more revenues from IT contracts at present, but the margins are low.

They have been reducing headcount since 2008 as revenues have been declining, but now they are turning around.

The company is 50.8% owned by 日本信号 (6741; http://www.signal.co.jp/), the top manufacturer within a 3-company oligopoly of signaling equipment manufacturers in Japan. 日本信号 is saying that demand for more automation at railway stations is increasing, and Japan generally spends ridiculous amounts of money on automating and updating everything.  Further, there is an upcoming change to the cards you use to swipe the ticket machines (currently the system in Japan is very disorganized), and this will be a boost starting in the next few months of this year. IT is still not really turning around. They are selling more consumables for car-park systems, but other areas are weak, and in the last quarter they had softened margins in the segment. But, the improvement in the signaling part is more important, I think.

Essentially, NES is a stable capital-light business with an improving core business and a cyclically-sensitive kicker, trading with an unadjusted enterprise value of about -1 B Yen, a market cap of about 6.4 B Yen, and which produced an average free cash flow of about 0.56 B Yen over the last five years, with net assets growing about 12% during that time – this despite revenues falling from 15.2 to 13.57 B Yen over those five years.

FCF was 0.4 B Yen last year, and they also paid out 0.12 B Yen in dividends.

The main components of their current assets are receivables (c. 3.5 B Yen, 1 B Yen of which is with the parent, the rest is with credible organizations such as GE and local governments) and 3.2 B Yen in deposits with their parent’s “cash management system”, which pays a “market interest rate”.

If you want to throw in 1.7 B Yen of investment assets (major constituent: 0.94 B Yen of pension fund prepayments; NB: Pension liabilities net of unrecognized differences are c. 3.7 B Yen, and the 0.94 B Yen is the net amount of pension assets after that liability), then it is difficult to even adjust the enterprise value to make it positive.

Ultimately, I do not think this will explode on the upside – but it is rather unlikely to do so on the downside either. And, while there are armfuls of stocks with nothing particularly going on (not even export exposure) to justify a 20%+ share price move since Q4 last year, at least here we can reasonably anticipate a reasonable turnaround for the next year or perhaps longer.

Disclosure: Conflicts up the ying-yang

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