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winner of the Wall Street Journal's Investment Dartboard
contest for the second half of 2001 is Jim Roumell, who heads Roumell
Asset Management, an advisory firm based in Chevy Chase, Maryland.
In the competition, Journal editors ask four market professionals
each to choose a single stock for the six months ahead. Their results
are compared with the choices of four readers and stocks "chosen
at random by flinging darts at the stock tables." Patterson-UTI
Energy Inc., Roumell's selection, has risen 40% since the contest
began.
When I made
the calculations, his closest competitor picked a stock (Ensco International)
that was up just 17%. Seven of the 10 other stocks in the race lost
money, and the three others rose by only a few percentage points.
(By the way, it's reassuring to know that, since the series of monthly
contests began in 1990, the pros have beaten the darts and the readers.)
Of course,
winning any six-month, single-stock contest may be simply a matter
of luck, but when I interviewed Roumell and looked at his long-term
record closely, I found that he had an important story to tell.
Investors should not necessarily emulate him, but they can certainly
learn from him.
Roumell calls
himself a "deep value" investor — that is, he looks for significant
bargains among unloved stocks. There's nothing new in that, but
Roumell has a specific strategy that is both unusual and logical.
Most value mavens concentrate on the price-to-earnings (P/E) ratio,
the number of dollars that investors are paying for a dollar of
a company's profits. The P/E last week for the Dow Jones industrial
average, for example, was 27, but many stocks had P/Es far lower.
Ameron International, a maker of building materials, had a P/E of
10; Goodrich Corp., an aerospace firm, a P/E of 6.
But earnings
do not obsess Roumell. "To be perfectly honest," he told me, "I
look at earnings only out of the corner of my eye." Instead, he
focuses on assets -- what a company owns. For most investors that
can be tricky, since the assets of different businesses tend to
be valued differently by investors and those valuations often rise
and fall with economic conditions. But Roumell has a solution: He
looks at actual transactions to determine what a company's assets
are worth.
It's a simple
process that nearly every home buyer understands. "If you want to
find out how much you should pay for a house," says Roumell, "you
just ask what other houses on the block have been going for. I do
the same. I look at comparables."
Last year,
for example, he bought shares in a modest company called J&J Snack
Foods Corp., which, he wrote at the time, "dominates the market
for giant pretzels," the kind sold in football stadiums. J&J also
contributes to America's nutritional needs by selling slushy soft
drinks. Roumell's comparable in this case was Ben & Jerry's Ice
Cream, which had recently been purchased by Unilever PLC, the British-Dutch
packaged-goods giant, for $265 million. At the time, Ben & Jerry's
had annual revenue of $240 million, so the price was 110% of the
ice cream maker's sales.
J&J had about
$300 million in sales, so a comparable price would be 110% of $300
million, or $330 million. J&J has 8.8 million shares of stock outstanding.
Divide $330 million by 8.8 million and you get a price of $37.50
per share — again, assuming J&J is valued the same as Ben &
Jerry's. Actually, J&J should probably be worth more: It has a much
larger share of its own market, and its pretax profit is 7% of sales,
compared with 3% for the ice cream company.
But $37.50
was the target price that Roumell used in August 2000. At the time,
J&J was trading at $14.50. No wonder Roumell told clients that the
stock was "significantly undervalued" and, at a discount of more
than 50%, it seemed "to be a safe investment." He was right. On
Christmas Eve, J&J was trading at $24 a share — still less
than 70% of sales.
Another example
is Datastream Systems Inc., which sells software that helps businesses
schedule maintenance and manage their inventories of parts. Roumell
bought shares for his clients' accounts at between $3 and $3.50,
down from a 52-week high of $13. But was $3.50 cheap or expensive?
With 20 million
shares outstanding, the market capitalization of Datastream was
$70 million (20 million times $3.50). Revenue for 2001 is estimated
at about $100 million, so the stock was being valued by investors
for considerably less than its yearly sales. Roumell found that
similar business-to-business software companies, also breaking even
and also without debt, were being bought out at prices of 1 1/2
to two times annual revenue. Sure enough, on the very day I interviewed
Roumell, Dec. 20, MRO Software made a hostile bid of $6 a share
for all of Datastream's stock. That sounds cheap, but it still provides
Roumell with a profit of nearly 100%.
As for Patterson,
Roumell's Wall Street Journal pick: The company owns 302
drilling rigs that are used to get oil and natural gas out of the
ground. Patterson works on a contract basis for big producers, and
the rate it charges each day is determined mainly by energy prices,
which fluctuate wildly. Oil and gas have been cheap lately, and
in July, when Roumell entered the contest, Patterson stock was trading
at $15 a share, down from $41 in March.
To find a
reasonable price for Patterson's stock, Roumell looked to the rigs.
In a recent letter to clients, he noted that Patterson had merged
with UTI in a deal that valued UTI's 150 rigs at about $10 million
each. Patterson's current stock price is about $22, so, with 71
million shares outstanding, its market capitalization is about $1.5
billion. With 302 rigs, that comes to about $5 million per rig —
quite a discount. In addition, a check of Patterson's balance sheet
shows little debt and a lot of cash.
Judging from
the UTI deal and other transactions, Roumell figures that, conservatively,
the rigs are worth at least $7 million each. So, "independent of
commodity prices, we value the assets themselves in a way an industry
insider might to determine if we are in fact buying a value." Most
analysts, on the other hand, try to predict earnings for a few years
ahead — a process that "is always impossible," Roumell says.
His system
has its drawbacks. It works only when there are adequate comparables,
and it requires investors to sell when a stock reaches its target.
Roumell bought shares of LandAmerica Financial Group, a real estate
title insurance company, at $28 a share earlier this year, then
sold them in August when the price hit $36 — a target he set
by examining other title companies and looking at a secondary stock
offering that Lehman Brothers negotiated. When the stock dropped
to $26.50, Roumell was buying once more, again with an eye to selling
at $36.
For most small
investors, a better strategy is to find excellent businesses at
good prices, then to buy and hold them for many years. But it is
hard to argue with Roumell's success. The stock accounts that he
manages for clients returned 30% this year (through Dec. 19) and
8% last year, while the market as a whole was averaging a loss of
about 10%.
Roumell himself
manages only the money of private clients, but in the past he has
worked with Marty Whitman, a legend of deep-value investing and
manager of the Third Avenue Value Fund, which has long been one
of my favorites. Over the past three years, Third Avenue has returned
an annual average of 13 percent while the Standard & Poor's 500
benchmark has just broken even. The fund has also whipped the S&P
over the past decade, with far lower risk than the average fund.
Morningstar gives the fund its highest rating — five stars.
Whitman's
largest holdings include AVX Corp., a maker of electronic components;
MBIA Inc., a large insurer of municipal bonds; and Tejon Ranch Co.,
which owns California real estate. Like Roumell, he prefers small
and medium-size companies. Since they are less scrutinized than
large-caps, beneficial anomalies are more likely. Whitman also has
an admirably long horizon. Over the past five years, turnover at
the fund has averaged just 17%; in other words, he holds the typical
stock for six years, compared with one year for the average fund.
Third Avenue even has a relatively low expense ratio: 1.1%.
Research shows
that the approach of stock pickers such as Roumell and Whitman works
well over time. Ibbotson Associates examined the Fama-French database,
which divides the stocks of the New York Stock Exchange each year
into two equal groups: value, for those with low ratios of price-to-book
value (or net worth on the balance sheet), and growth, for those
with high ratios. From 1928 to 2000, large-cap value stocks returned
an annual average of 12.4% while large-cap growth returned 10.0%.
But value stocks were more risky.
My advice
is to own both value (defined as low P/B or low P/E) and growth
and to use Roumell's brand of analysis as a way to find great companies
that are temporarily underpriced. It's surprising how many there
are. Yes, the market makes mistakes, and smart investors can capitalize
on them.
Warren Buffett
made this point with typical pith in a 1988 letter to the shareholders
of his company, Berkshire Hathaway Inc.: "Observing that the market
was frequently efficient, [financial scholars] went on to conclude
incorrectly that the market was always efficient. The difference
between the propositions is night and day."
That's lucky
for those of us who like ferreting out companies like J&J Snack
Foods.
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