Using Buffett's Geiger Counter

Motley Fool
Using Buffett's Geiger Counter
Friday October 13, 3:32 pm ET
By Emil Lee

In 1956, Warren Buffett started a small hedge fund and, over the next decade, trounced the market with a 930% cumulative return, compared to the Dow Jones' 165% return. Keep in mind, this is after fees. Buffett's return, before fees, was 1,600%.

How was Buffett able to achieve such stellar returns? Charlie Munger once said that he and Warren made their first hundred million or so by running their Geiger counter over everything. By turning over enough rocks, they eventually found hidden treasures lying there for the taking.

The $60 wallet
After reading Buffett's shareholder letters from those early days, I see that Munger wasn't lying. For example, one of Buffett's largest holdings in the late '50s and early '60s was a company called Sanborn Maps, which eventually became a whopping 35% of Buffet's fund. Amazingly, Sanborn Maps had a securities portfolio worth $65 per share, but the stock sold at $45 per share. The mapping business, although declining, was still profitable, and it had a positive intrinsic value. Buffett was able to buy up enough stock to gain control of the company and liquidate the securities portfolio, giving him a fabulous return. In essence, Buffett bought a wallet with $100 in it for $60, and not only got to keep the money, but also sell the wallet.

Although rare, there are bound to be similar opportunities out of the thousands of companies trading on the stock markets. I believe that continually turning over stones will eventually lead to hidden treasures. I plan on looking at five companies a day at least, or roughly 1,300 companies a year (assuming roughly 260 business days a year), and I'll write about some of the more interesting companies I stumble across. If only 13, or 1%, of these companies are worth investing in, then as Ben Graham says, satisfactory investment results can be achieved.

Although I'm not making any buy or sell recommendations on any of the following, I hope to identify companies worth doing further research on. Here are two to consider:

Tarragon (Nasdaq: TARR - News):When insiders own 48% of a company and are buying fistfuls of shares, I usually sit up and take notice. Tarragon's insiders began buying shares at $16 per share, far higher than the stock's recent $11 price tag. Why the downturn? To the general public, Tarragon has three strikes against it: It's a homebuilder, it focuses on condos, and it operates in Florida -- the most crash-prone state in the U.S. So why have insiders been buying up shares?
Tarragon's market cap of $316 million is about equal to its $287 million book value. Book value, or assets minus liabilities, is an accounting approximation of a company's liquidation value. When a company trades near book value, as homebuilders often do, investors are either saying that the present value of the company's future free cash flow are worthless, or that the company's intrinsic (or true) value is less than the company's book (or accounting) value.

However, Tarragon not only has a profitable homebuilding division, but also owns investment properties with decent returns. Tarragon has been divesting its real estate holdings and earning substantial investment gains in the process. In fiscal 2005, this investment property division earned $54 million in net operating income. If the homebuilding division can continue to stay profitable (Tarragon's total net income was $28 million in the first half of 2006) and not take any huge losses on its land holdings, then Tarragon's future free cash flows are worth something, and Tarragon's stock could skyrocket. Clearly, management thinks that Tarragon's value is substantially more than its current stock price, and this is definitely a company worth researching further. Although it carries a substantial amount of debt, the company was able to extend its debt payment terms, which should buy it time to sell off more real estate and increase the company's intrinsic value.

Valassis (NYSE: VCI - News):About half of Valassis' sales come from free-standing inserts, which are advertisement booklets placed into weekend newspapers. Another 30% of sales are from neighborhood-targeted ads such as posters and samples delivered with newspapers, and 10% of sales are from run of press, or ads printed directly onto newspapers.
Surprisingly, Valassis' sales growth has managed to hold up despite deteriorating newspaper sales. Valassis' free-standing insert business has a decent economic moat because of the long-term contracts involved; aggressive pricing by the only major competitor, News America, a subsidiary of News Corp. (NYSE: NWS - News); the need to leverage purchasing power; and the large expenditures required to build a distribution system.

As a result, Valassis operates in a duopoly, and the business has extremely high returns on capital and throws off extremely healthy free cash flows. In fiscal 2005, sales increased 8%, and the company earned $158 million in operating income and $95 million in net income. The balance sheet is also healthy, with $100 million in net debt. Although the first half of 2006 has been pressured by aggressive pricing by News America, Valassis' $850 million market cap and 11 price-to-earnings ratio are both extremely low for a company of this quality. Investors can expect anywhere from an 8%-11% free cash flow yield from investing in Valassis, with the possibility of further growth.

Of course, as with all cheap stocks, there's a catch. Valassis recently agreed to buy Advo (NYSE: AD - News), a direct marketer, at a hefty premium. After agreeing to the deal, Valassis moved to terminate the agreement based on allegations that Advo used faulty accounting. If the courts decide in Valassis' favor, then the company's stock should see a nice bump upward. If not, then Valassis will be forced to pay an expensive price for a company it doesn't want, which would erode shareholder value. Meanwhile, Valassis has sued News America in a $1.5 billion lawsuit, alleging monopolistic practices, which is sort of "free call option" on Valassis being awarded a significant amount of money.

Although the Advo deal introduces a certain amount of risk, Valassis' stock is cheap enough that it might be undervalued even if the Advo deal goes through, so I'd also put this in the "do more work" pile.

Well, that's it for today. Stay tuned for additional stock ideas.

Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. The Motley Fool has a disclosure policy. Emil appreciates comments, concerns, and complaints.