Beating the Street (34 page)

The popular prescription “Buy at the sound of cannons, sell at the sound of trumpets” can be misguided advice. Buying on the bad news can be a very costly strategy, especially since bad news has a habit of getting worse. How many people lost substantial amounts of investment capital when they bought on the bad news coming out of the Bank of New England after the stock had already dropped from $40 to $20, or from $20 to $10, or from $10 to $5, or from $5 to $1, only
to see it sink to zero and wipe out 100 percent of their investment?

Buying on the good news is healthier in the long run, and you improve your odds considerably by waiting for the proof. Maybe you lose a dollar a share or so by waiting for the announcement of a signed contract between Sears and Green Acres, as opposed to buying the rumor, but if there's a real deal it will add many more dollars to the stock price in the future. And if there isn't a real deal, you've protected yourself by waiting. I deferred further commitments and made a note to watch for the expected announcement.

This was the second of the master limited partnerships I recommended back in 1991. Cedar Fair is the permanent county fair for Middle America. It owns and operates two amusement parks, one, Cedar Point, on the Ohio shore of Lake Erie, and the other, Valley Fair, in Minnesota. These are open from May to Labor Day, and on weekends in the fall.

Cedar Point has 10 different roller coasters, including the one with the highest drop in the world, Magnum, and the highest wooden roller coaster in the world, Mean Streak. There's a large framed poster of Mean Streak on the far wall facing my desk. That and the photograph of the Fannie Mae headquarters in Washington are the only corporate mementos that share space with my children's artwork and all the photographs of my family.

Cedar Point is in its 120th year, and it's had roller coasters for 100. Seven U.S. presidents have visited this park, and Knute Rockne had summer jobs at Cedar Point. During one of his summers here, Rockne apparently invented the forward pass. A historic plaque commemorates the fact.

Next week, somebody might come up with a new AIDS drug and the companies that make the competing AIDS drugs will lose half their value overnight, but nobody is going to sneak up and install $500 million worth of rides on the shores of Lake Erie.

One of the side benefits of owning shares in an amusement park, as opposed, say, to an oil company, is that an annual visit, complete with test rides on the Ferris wheel and fundamental analysis on the roller coaster, could be construed as research for investment purposes. This gives grown-ups who love amusement parks a great excuse to frequent them.

It also occurred to me that in a recession the 6 million or so people who live within a three hours' drive of Cedar Point might decide to forgo the summer trip to France in favor of staying at the Cedar Point Hotel and taking a few flings on the world's highest roller coaster. This was a company that could benefit from an economic downturn.

In 1991, Cedar Fair stock rose from $11.50 to $18, which together with the dividend gave shareholders a one-year return of more than 60 percent. At the outset of 1992, I asked myself, is this stock still a buy? The yield was 8.5 percent, still a nice return, but no matter how good the dividend, a company will not prosper in the long run unless its earnings continue to improve.

This is a useful year-end review for any stockpicker: go over your portfolio company by company and try to find a reason that the next year will be better than the last. If you can't find such a reason, the next question is: why do I own this stock?

With that in mind, I called the company directly and spoke to the president, Dick Kinzel. If Joe Oddlot can't always speak to the president, he can get the information from the investor relations department. Having the ear of management will not necessarily make you a better investor, any more than having the ear of the owner of a racehorse will make you a better handicapper. Owners can always give you a reason their horses will win, and they are wrong 90 percent of the time.

In keeping with my low-key technique, I didn't ask Kinzel “How are the earnings going to improve?” straightaway. I asked about the weather in Ohio. I asked about the condition of the Ohio golf courses, the economy in Cleveland and Detroit, and whether it had been hard getting summer help this year. Only after I'd warmed up my source did I pop the important questions.

When I'd called Cedar Fair in previous years, there was always some new attraction—a new roller coaster, a loop-de-loop, etc.—that would add to the earnings. In 1991, the opening of the highest wooden roller coaster was a definite plus for earnings, but in 1992, there were no major exciting developments at the amusement parks, beyond the expansion of a hotel. Attendance at Cedar Fair usually drops the year after a new ride has been introduced.

At the end of our conversation, I didn't see the potential for another big move in Cedar Fair's earnings in 1992. I liked Sun Distributors better.

Sun Distributors has nothing to do with solar energy. This company, spun out of Sun Oil in 1986, sells auto glass, sheet glass, insulated glass, cables, mirrors, windshield glass, fasteners, ball bearings, and hydraulic systems to builders and to auto repair shops. These are activities that put graduates of our business schools to sleep. Financial analysts would rather count the ceiling tiles than follow a company that sells auto parts.

In fact, a lone analyst, Karen Payne of Wheat First Securities, had been covering the company, but her April 1990 report apparently was her last. Even Sun's president, Don Marshall, whom I called on December 23, 1991, didn't seem to know what had become of her.

This was point one in Sun's favor: Wall Street was ignoring it.

I'd owned the stock in Magellan (of course), and its poor showing by the end of 1991 had once again brought it to my attention. Actually, there were two kinds of shares, the Class A shares, which got a big dividend, and the Class B shares, which didn't. Both were traded on the New York Stock Exchange. This was a further complication from the normal complication of a master limited partnership: two classes of stock, and extra paperwork to boot. “Sun Distributors is a simple, well-run business hiding in a complicated financial structure” is the way Ms. Payne put it in her final communication on the subject.

Except for the dividend, the Class A shares offered very little upside—eventually, the company will buy these shares back for $10 apiece, and they were selling for $10 already. All the action was going to be in the Class B shares. The price of these had fallen in half, from $4 to $2, in 1991.

From Ms. Payne's last report, I found out that Shearson Lehman owned 52 percent of these B shares, and that the management of Sun Distributors had an option to buy up to half of Shearson Lehman's half at a fixed price. This gave the managers a powerful incentive to boost the value of those shares by making the company succeed. That the president was in his office taking phone calls on December 23, two days before Christmas, I took as powerful evidence that management was serious about its mission.

Marshall is an unassuming sort whose life story has not been told in
Vanity Fair
magazine, but can be found in a book called
The Service Edge.
In his frugal regime, executives get no bonuses unless
the company does well in a particular year. Success and not status is the basis for rewards.

The gist of my investigation was the same as with every company whose shares have taken a beating in the market. Will Sun Distributors survive? Did it do anything to deserve this punishment, or was it simply the victim of the annual tax-loss selling that creates bargains year after year?

Obviously it was still making money, because it still had earnings. Sun Distributors had made money every year since 1986, when it got its independence. It even made money in 1991, in spite of the fact that the glass business was terrible in general and so was the electrical parts business, and they weren't whooping it up over at the fluid power division, either. But this was another case in which the low-cost operator was a survivor and bad times eventually worked to its benefit, as competitors faltered and disappeared.

How did I know this was a low-cost operator? I could figure it out with information I found on the income statement (see
Table 14-1
). By dividing the cost of sales by net sales, I arrive at Sun's gross margin, or its return on sales. This had held steady over two years, at roughly 60 percent. Meanwhile, Sun had increased its sales, and its overall profits were also increasing. A company with a 60 percent gross margin is making a $40 profit on every $100 worth of stuff that it sells. This was tops among all the distributors of glass, fasteners, etc.

This business requires very little capital spending, another plus on the checklist. Capital spending has been the undoing of many a major manufacturer, such as a steel company, that might make $1 billion a year but have to spend $950 million to do it. A regional grocery store for windshields and spare parts doesn't have this problem. I could see on page two of the annual report that Sun Distributors' outlay for capital expenses was only $3-$4 million a year. Compared to its revenues, this was peanuts.

As a tightfisted operation in a nongrowth industry, capturing a bigger and bigger share of the market as its free-spending competitors fell by the wayside, Sun Distributors deserved to be included in my “blossoms in the desert” category. If it hadn't been a master limited partnership, I would have put it there.

Table 14-1. SUN DISTRIBUTORS L.P. AND SUBSIDIARY—CONSOLIDATED STATEMENTS OF INCOME

(dollars in thousands, except for partnership interest amounts)

More important, even, than the earnings was the cash flow. I focus on the cash flow situation with any company that makes a lot of acquisitions. Since 1986, Sun had bought no less than 36 related enterprises and folded them into its operation, reducing their overhead and making them more profitable. That was Sun's growth strategy. It's goal, Marshall explained, was to become a super grocery store for wires, fasteners, glass, and other such parts.

When you buy a company, you usually have to pay more than book value. This premium becomes the goodwill, and it has to be accounted for on the balance sheet.

Prior to 1970, companies did not have to penalize earnings to make up for goodwill. Under the old accounting system, when Company X bought Company Y, Company X could carry the full purchase price of Company Y as an asset. One of the consequences was that if Company X paid too much for Company Y, the foolishness of the purchase was hidden from the shareholders, who had no way of knowing if the purchase price for Company Y would ever be recovered.

To solve this problem, the people who make the accounting rules changed the system. Now when Company X buys Company Y, the amount it pays over and above the value of the tangible assets, i.e., the goodwill premium, must be deducted from the earnings of Company X over several years.

This “penalizing” of earnings is a paper transaction, which results in a company's reported earnings being less than its actual earnings. Consequently, companies that make acquisitions appear to be less profitable than they really are, a situation that often results in their stocks being undervalued.

In this instance, Sun Distributors had $57 million in goodwill to write off, and this accounting exercise reduced its reported earnings for the two classes of stock to $1.25 a share—when in fact it earned nearly twice that amount. These phantom earnings that the company has but can't claim as earnings are called the free cash flow.

A healthy free cash flow gives a company the flexibility to change course in good and bad times. This was particularly important in the case of Sun Distributors because the company's debt load was very high—60 percent of total capitalization. The cash flow, I was relieved to discover, was sufficient to cover the interest on the debt four times over.

When the economy was strong, Sun Distributors used its cash flow to expand by buying $41 million worth of businesses. In 1991, Marshall said, the company had responded to the recession by curtailing its acquisitions and devoting its cash flow to reducing its debt. The $110 million it had borrowed at 9½ percent could be retired within
two years if Sun used all its excess cash flow for this purpose. Apparently, that is what it has decided to do.

If times get even tougher, Sun can sell some of its acquisitions, such as the auto parts division, to reduce its debt even further.

The temporary moratorium on acquisitions will likely result in Sun's earnings not growing as fast as they did before, but on the other hand, the balance sheet will be strengthened. The move to cut the debt reassured me that the management was facing up to reality, and that the company will survive to make more acquisitions in the future.

Sun Distributors will survive even in a bad economy, but if things pick up, it can become very prosperous. Eventually, when the master limited partnership arrangement expires, the entire enterprise may be sold off. The 11 million Class A shareholders will get their $10 a share, as promised, and the 22 million Class B shareholders will get the rest of the money, which could be as much as $5-$8 a share. If that happens, the Class B shareholders will more than double their investment.