January completes a remarkable month for the Value Stock Guide portfolio, and this is a great time to update my readers with certain highlights. To recap, as of Jan 31, 2012, the Value Stock Guide portfolio performance compared to S&P 500 are as follows:

You can review the current portfolio in detail as well. If you are a premium member, you can sign in to view the restricted data fields. The performance table is always viewable on the sidebar from any page on the site.

Quick Highlights

• The best performing stock in the portfolio is up 97% in 5 months since purchase
• The next best performing stock in the portfolio is up 78% in 2.5 months since purchase
• The worst performing stock is down 7.24% since purchase a little less than 4 months ago
• I sold XRTX in January for a gain of 29.94%, which does not include dividends. The stock was initially purchased in Jun for a holding period of 7 months.
• I purchased 2 new stocks in January. Both these stocks are down marginally or almost flat. Together, they make up about 15% of the total portfolio

Expectations for February

While it is tough to forecast for the future, I do expect to harvest gains in at least 1 stock and reduce my exposure to another. This will generate additional capital to start positions in 2-3 new stocks that I am contemplating. I will be posting my recommendations for these stocks for the members shortly, so stay tuned.

The economic situation is improving at a rapid pace domestically in US and the solution to the Greece problem is within sight as well. This will mean that investors will return back to the stock market in large numbers due to increased confidence as well as increased investment capital as the job market continues to improve. Now is the time to invest and stay invested to maximize your gains in the coming months.

If you are not a member, you can quickly sign up to receive my premium stock picks and other benefits of the membership, either as a monthly member or with an annual membership that will give you 4 months of membership for free.

Vishay Intertechnology (VSH) designs, manufactures and sells passive electronic components and discrete semiconductors. The company has grown over the last 5 decades by pursuing a strategy of growth through acquisitions. The current valuation of the company shares may be attractive to a value investor looking to get an exposure in the semiconductor sector.

The Value Thesis for Vishay

The company shares trade at a Price to Book ratio of 1.21 (using the share price of $12.65 as of Feb 1, 2012 closing). This number may not seem too tempting at the first glance. A part of the reason is the $1.73 B in goodwill impairment the company took in 2008 which cut its equity down in half. This is a problem I see with companies that try to grow with acquisitions. When the times are good, they inflate their balance sheets with intangibles and goodwill, that buffers the earnings. When the industry cycles down, as was the case in 2008, the previous years of “great earnings” are neutralized with an asset write down (impairment of the goodwill asset is a charge on the income statement)

The positive side of this is that Vishay has already taken the impairment charge so its financials are relatively clean now. In the last 4 quarters, the company has grown its book value from $1.49 B to $1.65 B, or about 10% in a little over a year.

It makes sense to judge the valuation based on the earnings, rather than the book, and we will take note of the following:

As of Feb 1, 2012, the company had

• Stock Price: $12.65
• Market Value: $1.99 B
• Cash on hand: $1.035 B (mrq, Sep 2011 quarter)
• Debt: $423 million

After adjusting for the $59.5 million in one time tax benefit Vishay took in the Dec 2012 quarter (or $0.31/share), the company earned $1.7/share in the trailing 12 months giving it a trailing P/E of 7.44. However, most of the $1.035 B in cash on its books is non essential and can be distributed to the shareholders without any material impact on the company’s future operations (Vishay intends to use the cash for future acquisitions as part of its growth strategy). I adjusted the P/E calculation further by discounting the price by the distributable cash, which I estimate to be around $5.73/share. This leads us to a trailing P/E of 4.07. If the operations continue to generate 11% in net profit margin as they have averaged for the previous 5 quarters, than the stock can potentially find its true value to be around a (ex cash) P/E ratio of 9, which gives it a target price of $21/share. However, this is not a given as the historical profit margins are much closer to 5%-6% range, which reflects the competitive nature of the industry as well as the fact that the customers have greater buying power than the suppliers like Vishay due to their size and concentration.

There are Other Risks

Vishay’s Class B shares control almost half the voting power (1 Class B share has 10 votes compared to 1 Class A shares with 1 vote). Since substantially all Class B shares are in private hands and not traded on the market, the possibility of Vishay being an acquisition target is remote. It is also difficult for an activist investor to get on the board and initiate changes to unlock the value. This can keep the share price depressed below its intrinsic value for a long period of time.

Vishay is also more susceptible to currency fluctuations and political events as over 70% of its production and revenues are overseas, with a significant presence in mid-east (Israel). It can work for or against the share price and introduces a level of uncertainty.

Bottom Line

While the value is there, whether you chose to buy the stock at the current prices will depend on your assessment of these external risks. If you do chose to initiate a position, it may be wise to keep it a small portion of your portfolio and increase your position if the gap between value and price increases.

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Investors are constantly reminded that the markets are efficient and there is no use trying to beat the market as it cannot be done on a consistent basis. In fact, we are told, that over 70% of the mutual funds fail to beat the market, presenting this as an evidence to somehow imply, in some convoluted logic, that we are better off handing over our money to the same mutual funds and invest passively, rather than take control of our own portfolio. I find this argument even more vacuous, considering that the best investors and stock pickers, who also happen to manage significant sums of money, do not usually run mutual funds.

But Is the Market Truly Efficient?

The Efficient Market Hypothesis states that the securities prices reflect all publicly available information. Trading based on insider knowledge is illegal, and even if it were possible, not enough investors would be privy to such non public information to make any significant impact on the overall returns of any stock. If Efficient Market Hypothesis were true, wouldn’t it imply that no investor has any particular advantage over any other when it comes to investing in stocks? If security prices immediately adjust to reflect any new public information than perhaps the only predictor to stock performance is the amount of risk an investor is willing to take.

Indeed, most financial products available to the investors today tacitly assume the sanctity of the Efficient Market Hypothesis. Passive investing, diversification and overall market index as a benchmark for performance are all a result of a blind faith in the EMH. Or to put it another way, if what you know about the past of the company doesn’t matter (since the stock price already reflects it), and there is no way of reliably knowing the future of the company, you might as well invest in a basket of stocks to cancel out individual stock risk and let your portfolio ride on the market risk alone.

No wonder index funds and passive investing are such easy sells. The financial industry has all the incentive to continue to promote the EMH and use it as an excuse for their own incompetence.

History Paints a Different Picture

Many studies on historical performance of stocks classified by asset classes have shown that over a reasonably long periods of time small cap stocks tend to out perform large cap stocks and value stocks out perform growth stocks. Traditionally, this has been brushed aside by asserting that small cap stocks and value stocks are riskier than the market so it is not surprising that the returns are higher. However, a study by Ibbotson Associates (now part of Morningstar) goes even further and shows that small cap value stocks outperform all other asset classes on risk-adjusted basis.

Professor Greenwald in his seminal book Value Investing: From Graham to Buffett and Beyond (Wiley Finance) shows that if investors had blindly bought a portfolio of the lowest Price to Book ratio stocks they would have done better than the market. Even a slight introduction of a value bias improves portfolio performance.

So if the Markets are Efficient, How can this be?

Markets are efficient in aggregate and they are also reasonably efficient for well understood companies with highly liquid stock. For a large company that has a good number of Wall Street analysts following it, it is understandable that almost everything that is known is reflected in the stock price. Liquidity in the stock ensures that complex computer generated trades continuously work to exploit any inefficiency that may occur from time to time and quickly erase it.

However, there are quite a few situations where the markets are not as efficient and one can find stocks that are truly undervalued if one is alert. Here are a few cases where this is true

• Small cap stocks that are not well followed – Large institutions such as mutual funds and pension funds tend to avoid these stocks. Typically these funds avoid buying meaningful stakes in any company as that comes with additional filing requirements and the responsibilities of being a large shareholder. A smaller stake may not make sense for a large fund as any performance advantage of these stocks will just be a blip on their overall portfolio. They are also not covered adequately by the Wall Street as some of these companies are too small to be a investment banking prospect.
• Industry, sector or stock specific bull or bear market – In short term, the market overdoes its exuberance or pessimism for certain sectors or even individual companies. Eventually, the market does settle at the correct valuation but the discrepancy may persist for a long time. For example, the real estate bubble lasted much longer than expected. Even after it was plainly clear to most market observers that a bubble exists, most institutions could not simply unwind their positions quickly as that would cause an immediate market collapse. A retail investor can move much more quickly than an institution in these situations and take advantage of the gap between price and value.
  Certain cyclical industries go through a boom to bust cycle regularly. Metals, commodities, shipping, etc are a few examples. If an investor can determine that the demand of the product is not eroding, but rather the sector is doing badly due to excess capacity and over supply issues, than it is just a matter of waiting out until the capacity/supply imbalances are corrected for the stocks to recover. If you do your research right, these can be potentially phenomenal stocks to buy and wait for the cycle to repeat.
• Unwanted stocks, special situation stocks – A stock is sold off by funds when they no longer fit the charter of the fund. This is generally done regardless of the investment merit of the stock. When this happens, a small window of undervaluation is created, that can reward investors handsomely. The following are some of the few common situations where this happens:
  • A stock leaves a popular index causing all the funds that invest in this index to sell the stock
  • A large company spins off a small division and the funds holding the parent company are not interested in the smaller spun off company
  • Mergers and acquisitions involving part or all of the acquired company where the market is not clear about the fundamentals of the business being acquired
• Aggressively marketed stocks – If there is one example of a situation where sellers are privy to more information about the company than the buyers are, it is the IPO market. This is one case where insider selling is legal and it is not a surprise that the buyers in the IPO markets generally lose. Perhaps if a sector is witnessing a lot of IPO activity, an investor might take it as a sign of an overheated market and sell any holdings in that sector (or avoid it like a plague).

Market inefficiencies create undervaluation that an investor can buy into. In some other cases, it can also create overvaluation that an investor can sell into or avoid. It is beneficial for a self managed investor to be alert for these situations as the difference in performance between a value biased portfolio and a market neutral portfolio can be very significant over the life of the portfolio. Make sure you look for investments outside of the typical Wall Street research and research the company deeply to understand its business and prospects. If the stock has been left for dead, but the business is humming along, it can be a terrific investment. These are the hidden corners of the market where great value stocks lie and if you do not look for them yourself, you will never find them

And this is why Warren Buffett and other investors believe that the small investors have great advantage over the Wall Street. We are largely unconcerned with such things as stock liquidity, float, market caps, etc which often stymie the large institutions. We can focus solely on the business fundamentals for our investment decisions.

Note: A version of this article appeared at Business Insider on Jan 7, 2012

I closed out my stake in Xyratex, (XRTX) today for a 29.94 % gain (excluding dividends). The stock was initially purchased on June 30, 2011. Average cost for this and subsequent purchases was $12.39/share.

The position in this stock in the Value Stock Guide portfolio was closed as the stock hit the target price today. Currently I believe the stock to be fairly valued given all the information available. Interestingly, Brean Murray recently reiterated their Buy rating on Xyratex  and raised their price target to $18. I mostly agree that the future of the company is looking better every day, however, I think the stock is fairly valued now and there are other better undervalued opportunities available elsewhere.

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ZIXI stock has shown up on many of my screens before and every time it did not make it to the Value Stock Guide Watch List. At a first glance, the stock indeed looks undervalued on many levels but a deeper look reveals a different picture. I want to outline my reasons on why I do not consider this stock undervalued below.

Zix Corporation Background

Zix Corporation provides secure email and encryption services to law offices, government agencies, health care provides and insurance companies, financial services industry and SEC. This service is provided using Software as a Service (SaaS) model. The company is based out of Dallas, Texas.

There are many other competing service providers for secure email including the open source PGP encryption technology, Cisco Systems, McAfee and Trend Micro.  The barriers to entry in this industry is relatively low, patents notwithstanding. Some of the competitors are large enough to materially erode Zix’s market share if they wish. Zix however looks appealing at the first blush due to its reported PE ratio of 4.49 and what appears to be a trailing 12 month EPS of 0.66. This EPS though translates to a total net income of $42.49 million. Zix’s ttm revenues only amounted to $37 million. So what explains this abnormality?

Tax Benefits

Zix has accumulated $75.35 million in accumulated US deferred tax assets. These are a result of its historical losses. These deferred tax assets are recognized if it is more likely than not that they can be used to offset future earnings. In Dec 2010, Zix chose to recognize a large portion of these assets. $35.5 million was applied right away as a benefit on the income statement, and another $34.3 million was moved to the balance sheet as deferred tax assets. As a result, this has added $0.53/share in EPS to its ttm earnings.

Without the use of these tax assets, Zix’s EPS for the trailing 12 month is $0.12/share which gives it an adjusted PE ratio of 23.82.

This of course, is a far cry from the reported PE ratio of 4.49 at popular financial sites.

Balance Sheet Strength

Currently Zix sports a Price to Book ratio of 4.46. It has $22 million in cash out of the total assets of $63.66 million. With a market value of $191 million, Zix shares are terribly over priced based on its balance sheet strength. One can argue, that for a software company that relies much more on its intellectual capital to generate revenues (rather than factories and equipment), it is to be expected that P/B ratio will be high. I will accept this argument but we should also consider the following.

Zix reported negative shareholders equity until Mar 2010 quarter. Subsequent to that the equity turned positive due to improving business conditions. However, the equity got a quantum boost in Dec 2010 quarter when $34.3 million in deferred and unapplied tax assets were moved to the balance sheet. Excluding this asset, the P/B ratio is 22.

But then, an asset is an asset and if business continues to improve this asset will retain value. This is just a cautionary insight to illustrate the fact that one must look beyond the numbers to understand what is really going on in the business.

Earnings are Rising

The table above is adjusted to net out the deferred tax income from the Dec, 2010 and ttm columns. As you can see, the company has been consistently improving its operating margin over the years as its SG&A costs are spread over an increasing revenue base. The R&D expense has been consistent as a percent of sales. Whether the company is able to increase its net income depends on whether it is able to keep its sales growing as well as how much SG&A leverage it still has left.

As a value investor, I tend to be a bit skeptical of a company’s future growth. In this case, next 5 year growth is estimated to be at 20.83% which still gives the shares a PEG ratio of 23.82/20.83 = 1.14. This shows that the stock is fairly valued based on the expected growth rate. However, as the table above shows, the EPS is fairly sensitive to the revenue growth and even a slight decline in revenue will have a disproportionate effect on the EPS. This is largely due to the fact that in a highly competitive market like this, Zix has to continue investing in R&D to keep its market share.

Share Repurchase

Improvement in the balance sheet and the outlook for future business has given the management confidence to announce a $15 million share repurchase program that expires in Jul 2012. For a $191 million market value company that is NOT undervalued by most measures, I believe that this share repurchase program is ill advised and will have very little to no effect on the stock price when completed.

Bottom Line

The stock is fairly valued to over valued and therefore I have no interest and cannot recommend a purchase of ZIXI stock. The future may be rosy, but the historical losses do not inspire much confidence in the management’s ability to keep executing. Neither does the level of competition in the industry.

Avoid at current levels. Purchase when the stock falls to $1.5 or below.

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Just a quick update about the Premium membership program. I am pleased to offer a monthly membership option in addition to the annual membership. Both of these choices are equivalent in terms of benefits and access, except for the cost. Annual membership works out to be about 33% cheaper than the monthly option over a 12 month period. Or you can say, with annual membership, you get 4 months free!

Choice  is always better than no choice, and it is a crying shame I did not offer this earlier.

To make this possible, I did have to re-work the guarantee (existing subscribers, guarantee you signed up under will be honored). So while annual subscribers still have 90 day satisfaction guarantee, monthly subscribers only get 30 days. No, I will not work less hard for monthly subscribers It just means that if you are a monthly subscriber and you renew for the next month there is a tacit implication that you want to continue. Remember, guarantee starts from the day you sign up for the first time.

If you have considered becoming a member in the past (or even if it just occurred to you), a monthly membership is a good way to test things out.

(Hint: When you decide you like the Premium service and want to continue, just cancel your monthly subscription and sign up for the annual subscription and you save 33%)

Sign Up for the membership here and before clicking on the Subscribe button, choose which payment option you prefer – Monthly or Annual. Everything from there on should be auto-magic. If you do encounter any problems at all, let me know and I will take care of you.

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Often stocks fall to prices so low it becomes a compelling value based on assets or book value even when the operations and profitability are a mess. Understanding this, it can be very profitable to find the worst stocks in any time period – perhaps stocks hitting 52 week lows, and then looking to see if there is enough value in them to justify a purchase.

In this screen, I list 11 stocks for 2011 that have destroyed most value for its shareholders this year. The stock price declines are justifiable to a large degree, but one also needs to consider the tangible value in the business to determine if the declines are over done.

There is also an Excel data sheet attached to this list with additional valuation columns that will help you filter for your own valuation criteria. Please note that I have not included stocks that are trading on the pink sheets and have only included companies with market capitalization greater than $30 million.

*American Airlines (AMR) has received notice that it is being delisted from NYSE.

How to Analyze These Stocks?

Traditional profitability and earnings metrics are generally not very useful to analyze these stocks, except in situations where the business is profitable and the market has been totally irrational. Such situations might exist but are generally very rare. More likely you will find that the sales/profits have declined significantly and the market is assuming the worst. In situations like this, investors are in a hurry to sell their positions and the price declines may be over done.

It is important to focus on the following 3 things:

1. Whether the book value, tangible book value and liquidation values all exceed the current market valuation?
2. Is the company likely to destroy more value in the future eroding some of the value in its assets?
3. Is there a possible catalyst – a turnaround plan, a potential suitor, a very valuable asset that can be sold, etc to unlock some value in the future

The ideal answers to this question should be yes, no and yes. As can be expected, this analysis goes deeper than a normal stock valuation but the rewards can be astounding so it is worth while to do. In the attached Excel data sheet, I have included the Price/Book, Cash/Price and Debt/Asset values for these companies to quickly get you started on which stocks you may want to analyze further and determine if some of these are real value stock picks meriting a purchase.

Download: Excel List

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Coming off a roller coaster year in the stock market, it is quite natural to be apprehensive about what lurks as 2012 rolls in. Should you buy stocks in 2012 or if you are out of the market now, than should you continue to wait and see? I will let the professional economists look in the crystal ball and tell us what the future holds. It gives me a great satisfaction to ignore the pronouncements of the economists. As an investor, I am solely concerned about how I can maximize profits next year, and every year. Both for me, and my members.

All said and done, 2011 is likely to end as it opened, with S&P 500 around 1250 – 1270 range. The flat index belies the fact that the market remained highly volatile throughout the year. Many have gone on to say that the volatility is the new normal. Perhaps it is, or perhaps there is just too much economic angst around the world that is affecting investor sentiment today. Whatever the case may be, volatility is something that should be embraced, not feared.

Great fortunes are made when the world is awash in uncertainty. This is still true today.

Navigating the Chaos – Focus on the Core Principles

Invest with the market and you will get the market returns. However, the market as a whole is dysfunctional today. There are too many strings that pull the market and the direction it takes depends on what is tugging the hardest. Maybe there are some who know or can predict how the markets will behave tomorrow, or the next week or month. I certainly don’t.

What I do know is the following:

• Ignore the market noise, and focus on good businesses to invest in
• Buy the stock in these businesses if the price is below the intrinsic value
• Ignore the market but obsessively track the underlying business of the stocks you own
• If the price/intrinsic value ratio goes up beyond your comfort zone, sell the stock

Rinse and repeat.

Investing success is closely linked to investing discipline and adherence to a proven and reliable system, in this case it being value investing.

Diversify or Concentrate?

I have written earlier about the fact that excess diversification is useless, to the chagrin of quite a few. To me, either you are an active investor or a passive one. If you want to invest passively, buy an index fund. If you actively buy stocks, than you need to spend time to understand what you are buying, and concentrate your portfolio with 10-20 high quality stock picks. This is enough diversification (assuming you do not buy 20 semi-conductor stocks ) and will keep your portfolio highly responsive to any one or more stocks doing exceptionally well. For the stocks that do not perform, you will conduct the Price/Intrinsic value test outlined above at frequent intervals and either sell the stock or buy more. This brings the discipline needed to cut your losses and stay invested in businesses that continue to build value.

What About the Macro Economic Trends?

Once you are invested in a stock, the only criteria to hold or sell should be based on the valuation of the company. It is best to ignore the market and macro trends in these situations. However, macro trends can be useful in that they often create excellent buying opportunities. So if you have a few predictions, go ahead and build what-if scenarios around it, and put relevant stocks on your watch list. When the opportunity comes, and you find that the risk/reward is favorable, go ahead and buy. If the scenario does not play out, you just change your watch list. You do not have to commit capital to a scenario that has not occurred. Focus on the knowns. Be aware of what might be but don’t move until it comes.

There are 1000s of stocks in the market to choose from, so you will not miss out on anything. And just in case, if there is a shortage of stocks to buy using these principles, stay in cash. The market is probably over valued in this situation.

There you have it. My investment advice for 2012. It is the same as 2011 and it will be the same in 2013. Fundamentals don’t change.

Need ideas to start your research for 2012? Check out the following:

1. Best Dividend Stocks
2. Best Large Cap Stocks to Buy
3. Best Mid Cap Investments
4. Best Small Cap Stock Picks

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This article was featured in the Canadian Finance Carnival

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More in Best Stocks for 2012

• 31 Best Large Cap Stocks to Buy for 2012
• 50 Best Small Cap Stocks for 2012
• 32 Best Dividend Stocks for 2012

Mid cap stocks often offer a good balance between safety and potential returns. These stocks have greater liquidity than the small cap stocks and as a result a greater participation from funds of all types. This means that any undervaluation tends to be low and seldom persists.

In this screen I have picked the best investments in mid cap stocks with market values between $0.63 B and $2.31 B. Many of these stocks also offer good dividends for income oriented investor. The screen is primarily for value with earnings growth being a secondary concern. Interested investors should review the stock(s) deeper for more research before allocating any capital to them.

An Excel sheet with more data is attached to this article at the bottom and can be downloaded at your convenience.

This list is well represented with businesses in a variety of sectors and industries and can form a good basis for further diligence for investors looking for stocks to buy as part of a well diversified portfolio. Some of these stocks will make it to the Value Stock Guide watch list, and few might even become part of the Value Stock Guide portfolio that our members have access to.

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Download Excel Data

More in Best Stocks for 2012

• 31 Best Large Cap Stocks to Buy for 2012
• 21 Best Investments in Mid Cap Stocks for 2012
• 32 Best Dividend Stocks for 2012

Small cap stocks have traditionally outperformed all other asset classes. Small cap value is the best performing asset class over the years. There is also evidence that small cap value stocks lead the market when coming out of recessions. As we look forward to improving economy in 2012, it is important that we keep an healthy allocation to small cap value stocks in our portfolio.

Here at Value Stock Guide, we generally tend to favor small cap stock picks. This screen below is a shortlist of some of the best values in the small caps I see in the stock market right now. You may want to download the Excel sheet attached to this post and do your own due diligence as small caps generally carry greater company risk than other asset classes. These stocks have been picked for reasonable Price to Earnings, Price to Book Value, Earnings Growth and PEG ratios. Still, it is important to dig deeper in the financials to understand the capital structure and other key operating indicators.

Be sure to read the other value screens in this series. They are accessible from links on the right at the beginning of this post.

The Value Stock Guide Premium Portfolio does own a few names in this list. It is expected that some of the stocks in this list will pass my further filters and make it to the VSG Watch List (available to our free email subscribers). A smaller number might be attractive enough to be rated as a Buy for our members. Deeper due diligence report is published for all the Buy recommended stocks inside the member’s area, so if you are interested you may want to sign up.

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This post is included in the Self Directed Investing for Retirement Carnival