Empirical Finance just released a detailed research study that backtested a simple Ben Graham strategy for investing in stocks.

Backtesting Ben Graham

The backtest is based on a 1976 article in Medical Economics magazine, where Graham was interviewed and provided some tips on stock selection.

From the article,

“Graham believes that a doctor handling his own investments should be able to utilize those same principles to achieve an average return of 15 percent a year or better”

According to Graham, investors should look for two defining characteristics when picking stocks:

• P/E ratio of 7 or less
• Shareholder Equity ratio of > .50

Graham also goes on to recommend a portfolio of roughly 30 stocks and a holding period of two to three years.

Empirical Finance has done an amazing job of running the study based on these criteria. Here is the explanation:

“We decided to keep it simple and backtest the low P/E (<10), shareholder equity > .5 strategy from 1965–2010. We also backtested the results in accordance with the “trading rules” alluded to by Graham: stocks entering the portfolio are held for 2 years, or if they appreciate >50%. For robustness, we tested a variety of P/E and shareholder equity combinations–all results are very similar.”

It turns out that Graham was spot on with his return estimates:

Both the small and mid-cap backtests eclipsed the 15% CAGR metric for the study period.

It looks like the large-cap portfolio did not fare as well.

The study is great confirmation that Graham’s methods work, especially for the smaller stocks that are the focus of this blog.

And probably proof that many investors badly over-complicate their stock picking strategies – myself included!

International Baler Corp (IBAL.OB) is manufacturing company that has been in business since 1945 and currently qualifies as a net-net stock investment.

The company manufactures baling equipment, large complicated machinery that compresses a variety of materials (including scrap metal, boxes, cans, etc) into bales for easier shipping, storage, and recycling.

A leader in the field, especially for made-to-order and customized baling equipment, International Baler has over 40,000 units installed worldwide.

The stock suffered through a rough 2009 (along with many heavy equipment manufacturers) as customers put off cap-ex purchases – the company’s products cost between $4k and $500k.

A micro-cap stock with a market capitalization of only $3.5m, IBAL’s balance sheet remains rock solid, and the stock price has barely moved despite strong evidence that financials are strengthening in a big way.

Company Financials

After 6 years of steady growth in revenue from 2002-2008, IBAL saw a sharp sales decrease in 2009, with sales dropping 48.4%. The company suffered a small net loss, its first since 2003, as orders for every type of product were down across the board.

IBAL bounced back in 2010, with revenues up 16% and profits coming in at $254k.

Gross margins have remained steady over the past 5 years with a median just under 20%, while both operating and net margins hover around 5%.

For the year, these results translated into an EPS of $0.05 and owner earnings of $336k, for a CROIC and FCF Yield of 13.84% and 17.3% respectively.

2010 ROE was only 6.46%, as the company has consistently stockpiled cash to go along with an unused $1M credit line.

Overall, IBAL is a company that has gone about its business for over 50 years – although the recent recession affected the numbers in 2009, the company has proven it has the power to stay afloat during tough times.

Quarterly Analysis

Although it will probably take some time to match 2008 levels – a banner year – the latest quarterly reports show signs of improvement, not only in the actual numbers but in management’s language.

From the Q1 report last year:

“The decrease in revenue is the result of lower shipments in the first quarter of fiscal 2010, reflecting the deteriorated market conditions and lower commodity prices for recycled materials compared to the prior year first quarter”

And the latest quarter:

“This increase in revenue is the result of higher shipments in the first quarter of fiscal 2011 reflecting the improved market conditions and higher commodity prices for recycled materials compared to the first quarter 2010… The market for baling equipment has been moving toward larger, more productive and efficient equipment in recent years.”

This movement towards larger baler equipment is a good sign for the company, as there is much less competition on the high-end products (along with higher margins as well).

The recently released Q1 results show another sales increase, up 18% to $1.8m compared to the prior quarter last year.

Pre-tax income increased to $68k, compared to nearly zero last year, benefiting from higher product shipments and continuation of the company’s cost reduction efforts in 2009.

Even better, IBAL’s sales backlog more than doubled to $3.2m compared to $1.59m in 2010.

For comparison purposes, the backlog on Jan 31, 2008 was $2.8m – a year in which the company had sales and EBIT of more than $12m and $1.2m respectively!

While the company likely won’t approach those results, it has definitely gotten off to a good start in 2011.

Yet, despite the positive outlook, the stock has barely moved. In fact, it now trades at a discount to its working capital – compare the market cap $3.5m to net working capital of $3.68m.

Cash now sits at $3.08m, or $0.62 per share, unencumbered by any debt.

So IBAL is currently trading for less than working capital despite being solidly profitable, earning decent returns on capital, and announcing a record backlog!

Risks

Insider Ownership

Company insiders hold 58.8% of outstanding stock – I like to see management have a stake in the business but am cautious when the stock is so closely-held, as management can set compensation and make decisions at the expense of minority shareholders.

Digging into the latest proxy statement, the husband and wife team of LaRita & Leland Boren collectively own 51%, giving them tight control over the future of the company.

Outside of the Boren’s, little stock is owned by other company insiders or directors.

Recessionary Pressure

The company’s short-term results are heavily dependent on the economy. As commodity prices rise, it becomes more attractive and economical to purchase recycling equipment such as balers.

While the economy is showing signs of growth, a double-dip recession could reapply pressure to IBAL’s customers, potentially delaying purchases into the future.

Employee Lawsuit

On August 26, 2010, IBAL was served with a wrongful death lawsuit from a former employee for events that had occurred back in 2008. The lawsuit is asking for $2.5m, a huge potential liability for a company this small.

Lawsuits can be fickle and the company has liability insurance that should help cover any losses, but these sorts of cases can take a great deal of time and resources away from day-to-day responsibilities.

Positives

High-end Custom Baling Equipment

These special order products can cost up to $500k and offer much higher profit margins than traditional equipment.

These special orders remain a key growth segment for the company going forward – with such a wide array of configurations and over five decades of experience, the company is well positioned in the marketplace to capture the trend towards higher-end and custom equipment.

Undervalued Assets

The company owns its manufacturing facility in Jacksonville, FL, situated in a prime location next to a railroad and near a major highway. The facility is 62,000 square feet and sits on 8 acres.

With no mortgage, the company has depreciated the land, building, and all its contents down to $795k.

The land and buildings should be worth substantially more than the current carrying cost. Here are a few comparables:

Assigning a rough estimate at $30/sq ft to IBAL’s facility would yield a comparable value of almost $1m more than the current carrying cost (just for the building and land) – that’s almost $0.20 per share of additional value.

While it is unlikely that the company would sell the facility anytime soon (in fact, they had plans to expand the operation at one point), it is still a significant consideration for a company with a market cap of only $3.5m.

Insider Buying

John Martorana, a newly elected director, purchased almost 20k shares in the fall of 2010 at prices ranging from $0.45 – $0.52.

While the dollar value isn’t significant, insider buying is nearly-always a good sign for future prospects.

The CFO recently exercised his options and now holds 250k shares – it will be interesting to see what he chooses to do with this newly acquired stake in the business.

Valuation

There is no doubt that the stock is cheap on an asset basis – book value sits at $0.927, so the stock is trading at a P/B ratio of 0.75x.

Using Graham’s definition, the stock is a net-net, trading below its NCAV of $0.74.

Typically, these figures provide a measure of protection by limiting risk on the downside in the case of a liquidation.

Using TTM figures and the recent $0.70 stock price, IBAL trades for .75x EV/EBIT and only 1x EV/FCF, making it one of the cheapest stocks I’ve ever seen.

Consider this:

If the current sales and cash flow trend continue, the company will generate more owner earnings in a single year than the entire enterprise value of the company.

Conclusion

I’ve been purchasing shares for the past several months under $0.60 – basically picking up a piece of a growing, profitable business for less than the cash on the balance sheet.

At that price, the company actually has a negative enterprise value, meaning the market thinks that the baling business is worth more dead than alive – and yet it is very much alive.

Book value has compounded at 22% per year since the Boren’s took over in 2005, and the large jump in backlog should forecast good things in the coming months.

With a solid balance sheet, competitive products, and undervalued assets, the company is ripe for an acquisition or merger.

Tragically, LaRita Boren passed away in February 2011, meaning her ownership stake passes to an Estate controlled by her husband, Leland Boren.

Leland Boren, now 87, not only controls IBAL, but is also in charge of Avis Industrial Corporation, a conglomerate of industrial companies including one of IBAL’s competitors, American Baler Corporation.

With the recent passing of Mrs. Boren, and the advancing age of Mr. Boren, estate planning is surely a consideration – I think the company is now poised to unlock shareholder value via a number of different catalysts – whether it is a merger with Avis Industrial or an outright sale.

Long term, the increase in fuel prices and other commodities, along with greater awareness and acceptance towards recycling, will only increase the need for the International Baler’s products.

At current prices, IBAL represents one of the most undervalued stocks I’ve ever seen.

Disclosure

Long IBAL

Other Articles on IBAL

Bailing out of the bailed out market and into International Baler (Ragnar)

Servotronics, Inc (SVT) is a small aerospace stock that has maintained profitability through the recession and in 9 out of the last 10 years.

The company’s financial metrics are decent but not extraordinary, and should benefit from strong tailwinds in the global aircraft industry.

While the economics of airlines have been dismal, many aircraft suppliers have benefited from strong growth in the aerospace market.

If SVT can capture some of this momentum – and be recognized by the broader market – the stock could appreciate to 2007 levels.

Company Breakdown

Servotronics is split into two operating segments:

Advanced Technology Products

ATG designs and manufactures servo-control components such as torque motors, hydraulic valves, and electronmagnetic actuators.

These are high-tech components with stringent safety standards, as they are primarily sold to aerospace, missile, and governmental industries.

This division is the prime asset at SVT, producing the vast majority of operating profits over the years, and has the most potential for future growth.

Consumer Products Group

CPG designs and manufactures cutlery products – knives for household use and hunting/fishing expeditions, along with products like machetes and bayonets for the U.S. government.

Unlike the ATG segment, the CPG division is moderately seasonal, and operates at much lower margins. Despite bringing in almost 40% of revenues, it contributes almost zero profit.

As an outside investor looking in, the combination of the two segments doesn’t make much sense – aircraft components + knives? – and could result in making less-than-ideal capital investment decisions.

Financial Results

2010 revenues fell 4.09% to $31.7m from $33.0m in 2009, with a $2.6m decrease in the CPG segment offset by a $1.3m gain the ATG division.

Both segments saw margin improvement, with ATG increasing its operating margin by 103 basis points, while CPG saw a leap of 121 basis points.

Despite the improvement, Consumer Products is still running at extremely low margins, just 1.47% in 2010.

In comparison, ATG’s margins came in at 14.61%, an increase over 2009, but still below the company’s long-term average, leaving room for additional margin improvement.

In total, operating income increased 9.6% to $3.0m compared to $2.5m for the prior year. This is the 3rd highest operating income in the company’s history, trailing only 2007-2008.

Net income increased 11.8% to $2.1m or $1.08 EPS.

SVT maintains a cash balance of $4.4m offset by $3.4m in debt. The majority of this debt is for Industrial Development bonds issued by a governmental agency to build the company’s headquarters and advanced technology facility.

This property has 82,000 square feet of building space and sits on 38.4 acres.

As the bonds are paid back in full (a lump sum payment is due in 2014), the company will own the property outright after paying a nominal final fee.

Until that time, this debt is a very attractive form of leverage, with current interest rates at only 0.54%.

Management

Servotronics is a family-run business that has been around since 1959. The company’s founder and CEO, Dr. Nicholas D. Trbovich, has been at the helm for the past five decades.

His son has also been on the board of directors since 1990.

Together, the Trbovichs own 28.5% of the outstanding stock through direct ownership and options. They also vote unallocated shares of the Employee Stock Ownership Trust (ESOP), another 8.6%.

Effectively, they control the company, making it hard for outsiders to affect change.

Executive compensation is high – maybe excessively so – with a large portion made up of base salary.

In 2009, SVT earned total net profits of $1.9m yet paid $1.3m in total compensation to its top 3 executives.

Corporate Governance

In addition to the high annual pay, the two family members also have employment agreements which trigger on any change in control, requiring a payment of 2.99x of average annual compensation over the past 5 years.

This would trigger a severance payment of over $3m, a significant hurdle for a potential acquirer when they are buying a company with a market cap of $17.8m.

Making it even harder, SVT has a shareholder rights plan in price that triggers if someone acquirers more than 25% of the company. It effectively dilutes the stake by offering new preferred stock and an option to purchase additional common.

While management often frames shareholder rights plans as a benefit, they often hinder sources for unlocking shareholder value such as selling the company or replacing management.

Positives

Share Repurchases

The board has authorized a share repurchase plan and the company has purchased a total of 238,088 shares – but only 943 of those shares were bought during the past two years.

Buybacks can be effective when management repurchases stock when it’s trading at a discount to its intrinsic value.

Looking at SVT’s buyback history, a significant number of shares were purchased at much higher multiples of earnings and book value compared to current prices.

I’d much rather see management repurchase additional shares now, when the stock is trading at a ~20% discount to book value.

Special Dividends

Instead of repurchasing shares, management has returned cash to shareholders via a special dividend. This past year marked the third consecutive year that a dividend has been paid, at $0.15 per year.

This payment represents a 3.3% dividend yield.

Industry Tailwinds

Finally, the company should benefit from strong industry tailwinds in the aerospace market (and I try to avoid industry headwinds whenever possible).

Air traffic, especially in Asia, is expected to continue growing at a rapid pace, and aircraft manufactures are churning out new planes to meet this demand.

As the company mentioned in its press release,

“certain major manufacturers of commercial aircraft have publicly announced that they have initiated plans to ramp-up production to support their customers’ forecasted increases in aircraft deliveries in 2011 and 2012. Aircraft component suppliers are being advised to increase their manufacturing capabilities to support this forecasted accelerated aircraft production.”

Suppliers such as SVT should benefit from this boost going forward.

Stock Valuation

No matter which way you look at the company, SVT appears to be an undervalued stock.

At current prices, the stock is selling at a discount to book value (P/B is 0.8x) despite earning respectable if not unspectacular ROE and CROIC of 10% and 10.9% respectively.

A DCF calculation using extremely conservative inputs ($2.1m in FCF, 3% growth, 9% discount rate) yields an intrinsic value estimate around $14, almost 40% upside based upon current prices.

On a multiple basis, SVT trades at 5.2x EV/EBIT and 6.9x EV/FCF.

The company is small, float is tiny, and it operates in two completely unrelated business segments, so finding comparables is difficult.

However, even assigning a conservative multiple of 8x EBIT and 10x FCF would see the stock trading around $12-13.

Conclusion

Servotronics has a solid and extremely profitable business segment that is being held back by the low-margin barely profitable consumer division.

Consider this: The CPG segment has done $73m in sales over the past six years but only earned $811,000 in total profit!

Despite this inefficient capital allocation, the Trbovichs pay themselves a considerable compensation package.

The harsh truth at many public companies is that the larger the company (based on revenue), the more executive pay packages can be justified – reducing the likelihood of a divesture even if it’s in the best interest of minority shareholders.

I have all of the respect in the world for company founders and entrepreneurs in general, and Dr. Trbovich should be properly applauded for his work in building up the company over the past five decades.

Shareholders would be better served by spinning off or divesting the low-performing unit, which is currently taking away capital investment and management focus that could be better served by the company’s core competency.

Maybe then the market will realize the mispricing – and everyone will benefit.

Disclosure

Long SVT