Investing War Stories From Santa Monica Partners: Part 2

Following is a continuation of an earlier article discussing a phone conversation I had with activist hedge-fund manager Larry Goldstein, who runs the highly regarded hedge fund Santa Monica Partners (SMP).

Emil Lee: I noticed your earlier investments were geared toward "special situation" type of investments. Can you give us any examples?

Larry Goldstein: We have a stock -- it owned real estate in the Cayman Islands ... office buildings and shopping centers [and the like]. We originally paid a single-digit price [for the stock]. Over the years, it's paid good dividends. For example, in 2001, it paid two dividends of $1.75 and $3.50, in 2002 it paid $1. In 2005, it paid a $31 liquidation distribution. This past January, it paid $3.50.

EL: How do you find investment opportunities?

LG: My wife will say, "All you do is work." I love what I do, and I do what I love. I hate Fridays and love Mondays. I read. I'm the dullest guy in the world. I read annual reports, 10-Ks by the ton. Basically, I rule out companies that are on everybody's lips. I'll never look at IBM or any stock CNBC is talking about.

When I first started SMP, there were 2,000 stocks on the NYSE, 1,000 on the AMEX, and 4,000 trading over the counter -- there was not yet a Nasdaq. There were about 7,000 public companies. Probably 80% of investors looked at 20% of the companies.

Back in the '70s, there were 16,000 Pink Sheets companies. The Wall Street Journal did an article on me; they actually counted 16,000 green file folders [of Pink Sheets companies] I had. I built those files with an army of eighth-graders, by calling and writing companies. We got sacks of mail. Eventually, I arranged all the reports alphabetically. In the early years of SMP, my portfolio was top-heavy with companies that had names that started with the letters A, B, or C.

EL: So what do you look for, when you are looking at companies?

LG: I used a no-brainer approach [when starting SMP] -- solid balance sheets, top-heavy on the top left side and bottom-heavy on the bottom left side. Profitable -- those that showed increases in sales and earnings. And I looked for low multiples of last year's earnings -- at the time, I could find two and three multiples of trailing earnings. Some of those companies are what I call jaw-droppers -- a company whose annual report I show to a sophisticated professional investor friend, and he'll look at me and say, "Wow, pretty good," and I'll say, "Take a guess how much the company trades for." And I'll quote a tiny fraction of what he guesses, and his jaw drops. He can't believe it. How do I determine what something's worth? When you see something like that, you'll know -- you don't need a formula.

EL: Are jaw-droppers are still out there?

LG: Yes, but not as frequently. One reason is the advent of the computer. Everyone and his brother has a screen; everyone's massaging data. However, there are a group of companies still public that nobody scans -- those that do not report to the SEC -- so they are public companies which are private but partly public.

EL: Can you talk about why you invested in a long-term holding, Balchem (Nasdaq: BCP  ) ?

LG: We owned the stock since 1989, bought up through 1998. Our first purchase price, split-adjusted, is pennies. Our overall cost is about a buck. They've got two businesses. One [is] a cash cow, which had a hidden asset aspect -- they package ethylene oxide, which kills bacteria. It's used for sterilization, primarily where heat or moisture cannot be used -- for example, in a pacemaker. This gas is sold in tank carloads. There are many, many users that can't use the gas by the tankload; they need it in smaller quantities in drums. [Balchem is] the only supplier of this gas in sealed drums. The drums themselves are a valuable and hidden asset. They also sell [ethylene oxide] to McCormick (NYSE: MKC  ) -- when spices come to the factory, mixed in are crawling creatures, so the gas is used as a fumigant to kill insects as well. Hospitals use the gas to sterilize. So that was a unique business, virtually a monopoly, very profitable, 2%-3% growth. They can regularly raise the prices.

The second business is micro-encapsulated food ingredients, sold to producers such as Kraft (NYSE: KFT  ) , Campbell (NYSE: CPB  ) , and Heinz (NYSE: HNZ  ) . In tomato sauce, they have ingredients they don't want to mix with the sauce until it's heated, so Balchem encapsulates the ingredients, so when the material is heated, it mixes in. There are other ingredients they don't want to mix in except under pressure.

A year ago, [Balchem] bought a company with an FDA-approved facility. They should be doing more and more in encapsulating pharmaceuticals. Their encapsulation process is proprietary. One of their processes is to feed cows additional nutrients. Cows are rumen animals, so when a cow digests its food, it stores that food in something akin to a fermentation process in the cow's stomach. If you want to feed the cow amino acids, which enables the cow to obtain additional nutrition, you have to feed a ton of it to get an ounce of it in the stomach, or, for example, if you want to feed vitamin C to fish in farm ponds, you also have to give them a ton to enable them to ingest a potent amount, because the vitamin C dissipates in the water. Balchem can encapsulate [these substances] so that [they] can get into the bloodstream. That is an enormously important thing to do. The company doesn't have much direct competition, which enables them to have the ability to fight cost inflation by raising prices.

EL: What metrics do you look for?

LG: I like low-enterprise-value multiples of cash flow and free cash flow. When it comes to cash flow, for example, I want to see free cash flow [multiple] below 5. Another thing I like is to find a very low price-to-sales ratio. For example, we own a stock which has a 25% ratio of price to sales. I like that kind of multiple. In many businesses, companies sell at a multiple of sales -- when you find something at a very low multiple of sales, that's something to check out.

The beauty of this investing business and our style is that we don't have to swing unless the pitch is fat and over the plate, meaning we don't need to buy something unless we plan on owning the company ... for the long haul.

EL: Do you use comparable multiples, such as relative multiples and acquisition multiples, to ascertain the value of a company?

LG: I know what a dollar's worth; I don't care what somebody else pays. So I don't typically buy on the basis of relative value. I'm more concerned with absolute value.

If, in the industry, the typical company sells for X, Y, or Z -- that's comforting, if the idea is to see the company sold. Typically, we're not interested in seeing the company sold; we're interested in seeing it grow and in seeing it trade in the marketplace for what it's worth. But if its management is tired, asleep, or doesn't care -- basically on vacation -- then we do not sell, but instead we believe it is proper time to speak up. We do not do as most other investors do -- vote with our feet. We're not looking for sales; we're looking for investments to hold for life.

So, yes, if we're gong to have no other recourse or choice but to say "sell," it is a last resort. Then if the industry average is X, sure, we'll make the case that the company could bring considerable value.

EL: At what point do you decide it's time to tell management to sell a company?

LG: It is as I just stated.

I'll give you an example. We bought Warwick Valley Telephone (Nasdaq: WWVY  ) five years ago, not because it had a plain old telephone system [POTS] business, which was OK, but because it had an investment in a limited partnership with Verizon (NYSE: VZ  ) . This partnership was, at the time, in our opinion, the world's fastest-growing, most profitable business. Growing at 60% a year back then, their pre-tax profit margins reached a peak a year ago of 87% pre-tax, and they had a ROE of about 400% on an overcapitalized equity to asset ratio of 99%.

I said, "What is that business worth?" If I wanted a yield of 5%, it'd be worth 20 times [its $10 million free cash flow], or $200 million. If I wanted a yield of 7%, it should sell at 14 times, or $140 million. At 10%, it'd be $100 million. So I made a case for [valuing this partnership investment] between $100 [million] and $200 million, and the POTS was then worth $60 [million] to $70 million by itself.

Very poor management was running the company. As a result, the regular phone business' profitability began to decline. What was criminal was, the board was putting the good cash from the limited partnership into capital expenditures to try to improve the POTS, and they were failing miserably -- they were allocating capital at negative returns, and as we speak, this stock has made a low at $16. It was $34 in November of 2003.

All of management has resigned ... and it has an interim CEO and CFO. We have filed many 13-Ds with letters to the board. Over the last five years, we've made the same suggestion numerous times -- the board has never given consideration; they refused to meet with us. We did explain to a former CEO, who was fired.

I don't think the board is moving with any urgency. They are far more concerned with finding a new board member than with where their company is going to be in a year or two or five, or how they might even get there. Who knows if we'll ever make any money or if this thing will go down into the toilet. But we're trying, because we don't give up. As shareholders, we're still there.

Related Foolishness:

H.J. Heinz and Kraft Foods are Motley Fool Income Investor recommendations. Try out Income Investor any one of our investing services free for 30 days.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.


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