Value play or value trap? Start by looking at the customers

AVNER MANDELMAN - Saturday, February 24, 2007
Value investors can be compared to managers of a shelter for beaten-up stocks. For example, every four or five years cyclical stocks get thwacked by the economy and are then discarded by the roadside. Even a fine tech company may see its main product die while the new one is only beginning to flower, and it, too, is then flung out by respectable investors, who may beat it up within an inch of book value, or even cash per share.
But these are also the times when value investors, perhaps wearing informal jeans and a loose T-shirt saying "Patience & Prudence," can pick up the bruised orphan, feed it, and shelter it in their portfolio where it can heal in peace. Then, two or three years later, its face glowing with financial health, the mended orphan can step out into the Street, where investors in pinstripe will now bid its price skyward. That's when the orphanage manager (value investor) is paid for his patience and troubles.
That, at least, is the theory. Yet there's a problem: Every now and then a bruised orphaned stock does not recover, and either stays in the sick-bed forever, or even succumbs. For a value manager it is thus of critical importance to know what makes one bruised stock an opportunity, while another would stay forever a value trap.
What is the answer? In my experience, eight times out of 10 it is "the quality of the business." Some businesses are good, some businesses are not good, and some are downright lousy.
What of management, you ask? Well, as Warren Buffett put it, when a business with a bad reputation meets a manager with good reputation, the business's reputation stays intact. In other words, even a first-class jockey can't win the derby if he's riding a nag,
What is a good business, then? In the large majority of the cases, a good business is simply one serving good customers. What are such paragons made of? Good customers quickly decide to buy, don't mind paying more, keep coming back, have the money or the authority to buy, pay promptly, and stay loyal. Bad customers are just the opposite.
Now a trade secret: If there's one thing we do really differently at Giraffe, it is analyzing the customer first, before we analyze the company, the product, the technology or the finances.
First of all we ask: Are this company's customers really worth serving? The company, as we see it, is only a mechanism to transfer its customers' money into our clients' pockets. Thus if we deem its customers good, we proceed to analyze the rest. If not, we stop, because you can't make a silk purse out of a porker's rear.
To make it clear how different this mindset really is, here's an example: Years ago, Geac Computer invented one of the first virtual memory processors in the world. The doodad could process vast amounts of data, fast.
And what did Geac's executives do with this? They automated the registered retirement savings plan query process in a trust company's branches. In effect, they aimed to make 6,500 tellers more productive. Was this a worthwhile endeavour? Hah. A teller then made $15,000 a year. (This was a long time ago.)
If the doodad made each teller 10 per cent more productive, it would make the trust company about $1-million. The doodad cost $1-million. Payback was therefore one year.
Sounds good? Hah again. To tinker with the computer systems of a large financial institution, you must get the ear of the chief executive officer. But to make sure it's executed well, the wise CEO (and that one was very wise) must ensure everyone is onside, so the decision goes through seven committees, none of whose members has a bonus incentive.
So why should they decide fast? Indeed, they didn't. Geac sold very few machines, and their cash fast dwindled. They also sold a few others to libraries -- where other committees of bureaucrats took their sweet time making up their minds.
As a result, Geac went bankrupt, and had to be rescued by Ben Webster (at the time Canada's premier venture capitalist), who put in Steve Sadler, who fixed Geac by firing the bad clients and jacking up the prices for the good ones until only those who really appreciated the service remained. Geac's stock zoomed. Why? Because the new jockeys fired the nag customers, and got themselves decent fast horses instead.
As you can see, same product + better customers = richer stockholders. So, if like many beginning investors you try to find value only via the numbers, know that cheap stock price, good balance sheet, even good management, are of course necessary, but are definitely not sufficient.
What you should also check is that the company's customers are indeed worth serving. If they aren't, avoid the stock, no matter how cheap it is.
But if the customers are worthy, and you give the poor beaten stock shelter when it is black and blue because of a temporary problem, when it eventually mends -- probably with the help of its customers -- it would likely repay you for all your kind hospitality.
Avner Mandelman is president and chief investment officer of Giraffe Capital Corp., a Toronto-based money management firm.
amandelman@giraffecapital.com