Increase your Value Investing Batting Average

First and foremost we are value investors, who strive to purchase discounted securities that are trading below their intrinsic values based upon our research and analysis. When searching for value investments, we begin by first focusing on some financial metrics that may help us identify a suitable list of underpriced candidates. There are so many stocks in the investment universe that we would probably die at our desks before we were able to go through them all one by one. In order to limit our downside risk and not lose money we want to focus on companies with sound financial strength. There are many ways to sort or screen through a universe of stocks such as Piotroski’s F-Score or Altman’s Z-score. Really what we try to do is decrease the pool of candidates to eliminate the weaker investment options. This allows us to focus our time and efforts on more attractive investments. 

It’s sort of like baseball great Ted William’s approach to hitting as described in his famous book “The Science of Hitting.” For those of you who might not be familiar, Ted Williams is considered one of the greatest hitters of all time and was the last player to have a batting average over 400. Anyway, Ted had a batting approach that is easily comparable to an approach one should take with value investing. He took detailed notes throughout his career and calculated his batting average based upon where each pitch was thrown by the pitcher (aka doing his bottom up research). This observation made him realize where his strengths and weaknesses were and helped him wait to swing at pitches that he had the highest probability of getting a hit.  He even created a real life chart with colored tennis balls outlining the exact batting average of each pitch within the strike zone. You can actually see this in person at the baseball hall of fame in Cooperstown, New York. 

You should think about Ted’s approach when looking for potential investments. Should you swing at every pitch? No, you want to wait for ones that provide you the best probability of success, and you can do this by investing in companies that are financially sound. Once you have narrowed your list of stocks down, then you need to begin a more in depth rigorous fundamental analysis, but it helps to focus your efforts in the right places. Do you have any questions? If so email us or comment, we want this to be an interactive blog.

For more on Piotroski’s F-Score, Altman’s Z-Score, The Science of Hitting

Sauer-Danfoss, Inc. (SHS) – Research Report

Strong Buy – Target $58.00

 Background: Sauer-Danfoss is a mobile hydraulics manufacturer operating in North America, Europe and Asia Pac.

- GARP Value Opportunity (Growth at a ridiculously [cheap] price)

- Piotroski Score = 9

- High Magic Formula rank using earnings yield and ROIC

- Low PEG

Catalysts

Potential Tender – Back in 2009 Danfoss A/S launched a tender offer to acquire the roughly 30% of outstanding shares they did not already own. The tender price reached $14 per share before expiring without meeting the minimum tender condition. Looks like the minority shareholders were right in not accepting the tender as prices have more than doubled since 2010. We believe Danfoss may again try to purchase the remaining outstanding shares but this time at a much more lucrative price.

Ownership Structure

Some might see the ownership structure as a negative aspect of SHS as minority shareholders will always play second fiddle to Danfoss. That being said there are a few positive aspects that we believe offers us an edge. SHS has somewhat of a thin float and low daily volume which makes sense when you think about that fact that 70% of the company’s shares are held by Danfoss. This however makes many large institutional money managers unable to establish big positions in SHS. SHS is also largely ignored by the sell side as the brokerage firms are unable to generate large commissions from selling this stock to their clients per the reasons mentioned above. Value investors should always search for companies that are not closely followed by the large buy and sell side firms as there are less eyeballs watching the tape. When few investors follow a company, there is often a greater chance for the stock to trade further from its intrinsic value. The ownership structure and float might partly explain why the stock trades at such a discount from its peers and we have factored this into our model but we still believe that SHS’s undervaluation is more caused by lack of attention than by its ownership.

Expansion in China

China seems to be the future growth catalyst for many companies including SHS. Even if there is a slowdown in China we still believe China will provide growth for SHS for years to come. Recently SHS announced plans to invest over $100 million in China and expects sales in Asia Pac to reach $900 Million by 2015.

Valuation

Current Price: 40.84    
Target Price: 58.00                      
Potential Returns:  42%                      
Alpha: 20%

SHS is trading at a historically low price to earnings ratio of 5.8 compared with a pre recession average of 27 (excluding a high outlier).  Present revenue CAGR (Compound Annual Growth Rate) is 32% vs. pre recession of 10% CAGR.  EPS is 6 times pre recession levels with a growth rate of 54% (YOY).   Operating margins continue to improve significantly despite a competitive business environment.  Our valuation is based on a conservative P/E valuation and confirmed with our DCF model. (below) 

P/E Valuation

DCF Inputs

Expected Case
WACC	18.00%
Base Sales Growth Rate	20.00%
Terminal Growth Rate	3.00%
Effective Tax Rate	0.00%
Depreciation % of Sales	4.00%
Operating Margin	20.00%
Cap Ex % of Sales	2.00%
Change in WC as a % of sales	10.00%
Market Price	$59.27

DCF Model

Disclaimer: Neither Will nor Tim currently owns SHS and will not be initiating a position within the next 48 hours.