This has been a fascinating quarter for the Contra portfolio. Of the 31 stocks with which we began the period, four received takeover bids: Cambridge, Noma, Royal LePage and UniHost. Three of these were at substantial premiums to their prices in the past 52 weeks, and far above our purchase price. Two other Contra positions, Navistar and Spar are also being affected by takeover vibes and have moved up smartly. During each of the past eight years, Contra stocks have received takeover bids. One of the questions weire often asked is: How do we spot these takeover candidates before they come into play?
The explanation is certainly not magic. It is simply a confirmation of our investing style, ie buying undervalued, underappreciated assets, which other shareholders have decided to part with at fire sale prices. A large proportion of these purchases are consummated during the tax loss selling season when a couple extra percentage points can be picked up as people do their very late, year-end tax planning.
What are some of the specific things my partner, Ben Stadelmann, and I look for? Book value is a key indicator. Within this parameter we try to diagnose if the book value is “real” or not. Since most companies we purchase are out of favour, with many of them experiencing financial difficulties, often write-offs are pending. These might be because of layoffs, a re-evaluation of assets, an overabundance of goodwill on the balance sheet, or for sundry other reasons. We know though, after calculating a book value, which we perceive is fair, and if this value is higher or near the price the stock sells at, then our purchase will likely have good value. That means that other companies within the industry, who are assessing the competition, or related firms for a good fit, might also eventually “discover” this enterprise.
Of course, many other considerations are taken into account. Positive cash flow is an important sign. Some companies operating at a loss, even during the lean times, still have more money coming in than is being dispensed. Often investors ignore this fact, concentrating their sights simply on the fact that the business is losing money. This tunnel vision obscures a complete look at the operation.
Another key indicator is debt. As I outlined in my last piece for MoneySaver, we attempt to buy firms that are debt-light or debt-free. Many times, these companies also have substantial cash on hand. The combination of these two makes the firm an attractive takeover proposition.
Many companies we purchase, while not mega-giants in the way of a Microsoft or GM, are nonetheless large players in their fields. Noma, Royal LePage and UniHost all fall into this category. For firms striving for fast growth, cherry picking a large player in the industry not only lessens competition but allows for economies of scale to be achieved in a short period of time.
Last, we watch to see if insiders are accumulating positions. This was the situation both with Cambridge and Spar, and in the former case, we highlighted this to our readers a couple of months before the Cambridge bid.
When a takeover is announced, it is rare that we sell before the acquisition is completed. There are three reasons for this. Often, the bidding firm will either up its offer, or another suitor will join the fray. Second, normally the best price one can receive in the open market is less than the acquisition price. In cases where the stock price is higher than this, it is usually an excellent indicator that an increase in the bid price is expected. By tendering rather than selling into the market, no commissions are paid.
One caveat of particular importance: we never invest expecting a takeover to occur. Sometimes, a company has put itself into play in the past with no takers, or there are rumours that a suitor is considering a purchase. While these can be factors when a Contra purchase is made, it is only a small weighting within our decision parameters. Our investment strategy is never based on making a short-term killingnalthough sometimes we do get surprised, for example when Royal LePage was swallowed within three months of our purchase at a 75 percent premium.
Eventually, even if the firms we buy do not become takeover candidates, following these conditions, usually sees the enterprise return to rosier days. The fact is that normally, investors do eventually re-discover value. Therefore, if a person has the temerity to invest when others fear to tread, and the patience and financial ability to wait for the herd to catch up, higher long-term returns will be achieved.
Published April 1999, Canadian MoneySaver