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Wednesday, November 24, 2010

Sonic Foundry (SOFO): Passing the Torch, Plus Key Investment Musings

Per our Sonic Foundry (SOFO, $15.31) post just over one week ago, we hoped to provide additional commentary headed into the company's earnings report last Thursday morning. Two things happened:
  • First, it was a hectic week.
  • Second -- and more significantly -- along with our colleagues, we received information last week that limits us from blogging on the information technology (IT) sector.
The first challenge is no doubt the normal course of life for most of us. But, alas, we regret to relay that the second development prevents us from discussing global trends in Webcasting, lecture capture, and rich media. In other words: all things around Sonic Foundry's Mediasite.

However, let us digress for a few moments to discuss general investment considerations and our CS$ approach, starting with one of several leading headlines from Yahoo Finance (YHOO) last Friday:
The article opens with the following:
  • NEW YORK (Reuters) - Leanne Chase took her money out of stocks in early June 2008 before the collapse of Lehman Brothers sparked a near-panic. She said she and her husband had the same feeling they had during the dot-com bubble: The market had become just "weird."
  • Though the couple had been in and out of the market before, Chase, a 42-year-old part-time consultant and self-described conservative investor, said she has no intention of getting back in again.
  • "It makes me nuts when I get out early and there's more money to be made, or I get out late when I could have made more if I'd gotten out early," she said. "The stock market's not an investment, it's gambling."
  • The faith -- and money -- individual investors once held in the stock market has severely eroded. Two painful major stock market crashes over the last decade combined with the advent of arcane, complicated trading practices has created widespread suspicion of Wall Street, which many people now regard as no better than a roulette table.
  • The last crash wiped out all of the gains made during the 2000s after the dot-com wipeout. The worry now is that a Lost Decade will create a Lost Generation of investors who avoid the market in a way not seen since the Great Depression.
Her story reminds us of something a friend's father used to say: "There's no happiness in investing: when something goes up, you wish you had more; when something goes down, you wish you'd sold."

No question: timing share price moves is near impossible, especially in the short-run, and sometimes even over the medium term, as share prices can fluctuate widely without relation to underlying business fundamentals. Yet, we wholeheartedly disagree with her view that "the stock market" is "gambling."

In this regard, we share advice from one of our favorite reads, Peter Lynch's One Up on Wall Street (first published 1989 and mentioned before):
  • "The basic story remains the same and never-ending. Stocks aren't lottery tickets. There's a company attached to every share. Companies do better or they do worse. If a company does worse than before, its stock will fall. If a company does better, its stock will rise. If you own good companies that continue to increase their earnings, you'll do well. Corporate profits are up fifty-five fold since World War II, and the stock market is up sixtyfold. Four wars, nine recessions, eight presidents, and one impeachment didn't change that."
At CS$, the view that "stocks aren't lottery tickets" is one of our fundamental beliefs. As such, we approach every investment from an owner's perspective. This means we ask a set of questions detailed in our February post, Which Way from Here? An Investment Strategy for All Markets + Stock Ideas, included here with a slight change in ordering:
1. What would happen if the business went away tomorrow? Would anyone care?
2. Will the business be bigger, better, stronger if five years?
3. Does the business have a strong financial position?
4. Is management capable and motivated? Is disclosure full and adequate?
5. Can the business be acquired with a margin of safety?
6. Price is extremely important
Points one to three speak to quality of a company's economic "franchise," while points four through six cover management and valuation. Point number six is included to emphasize that, as Fairholme Fund’s Bruce Berkowitz puts it, “Investing is all about what you pay and what you get.” This statement is a variation of advice from Ben Graham and Warren Buffett.

Let's drill further into valuation to make a point we consider paramount to making money through equities over time:
  • People often look at a share price and think, well, this must be what the business is worth. If the price is low, then management and/or the business are horrible. If the price is high, then management and/or the business must be fantastic.
  • YET, based on the events of the last several years, we're not sure who still subscribes to this perspective, which is essentially the efficient markets hypothesis. Our own investing experience over time directly contradicts "EMH," as does the performance of other long-term oriented investors.
  • In reality, manic market prices of equities swing widely and are often completely disconnected from reasonable estimates of intrinsic (fair) values based on earnings power, private market valuation, and/or other sensible valuation approaches.
  • Understanding that market value and intrinsic value are two entirely different things enables informed investors (business owners) to buy and sell companies against the broader Market, taking advantage of Ben Graham's "Mr. Market."
Moreover, here's another important point: just because shares of a business are up 100, 200, or even 300% from extremely depressed levels does not mean we need to sell our position because, as Jim Cramer says, "pigs get slaughtered." How do we make the decision to buy more, keep holding, or fold? We again refer to our estimate of intrinsic value while also considering the fundamentals of the underlying business.

When evaluating fundamentals, let's revisit a piece of advice we previously shared from the late investment legend Philip Carret in March. Augmenting a video with Mr. Carret relayed in February, our March post included an insightful article from 1999 where he directly shares his investment advice - we'll again note that it's well worth a read.

On when to sell, Mr. Carret says, "How long should you hold a stock? As long as the good things that attracted you to the company are still there." We might add that valuation discipline also remains important, particularly whenever multiples move well beyond a reasonable range (e.g. our posts on alternative energy/clean tech and Blue Nile/NILE in October 2009).

On what to buy, similar to Peter Lynch's familiar recommendation to buy what you know, one of Mr. Carret's guidelines is as follows -- directly from the article:
  • For your best investment ideas, look around you. I've been following this strategy for more than 70 years.
  • Example I: In the early 1920s, not all water was metered in New York City. That wasn't going to last forever because water is a scarce resource, and there was no incentive for people to conserve water. Sooner or later, they were going to have meters for everyone. So I bought stock in a company called Neptune Meter, and it turned out very well.
Put another way, what are the market sectors or areas we encounter daily poised for growth? What business models are fundamentally disrupting the way things were done previously? The Internet arena immediately comes to mind. And, we don't need to look too far -- we're all familiar with Amazon.com (AMZN), Priceline.com (PCLN), and Netflix (NFLX).

We've long admired these businesses, touching briefly on Amazon last December and incorrectly calling out Netflix's rich valuation several times only to see shares surge much higher - whoops! We actually started a post on Priceline.com in summer 2009 but never found time to finish it.

In addition to being primarily online businesses -- putting aside physical supply chain, distribution, etc. for Amazon and Netflix -- these businesses all have another attribute in common: customers love their products/services and, thus, brand equity (economic goodwill) continues to build and build. Hence, franchise value continues to accrete for these consumer-facing companies.

While we don't own these companies, we continue to own shares in disruptive secular growers such as eBay (EBAY), Yahoo (YHOO), and our microcap Sonic Foundry (SOFO). Admittedly, wide debate has surrounded, and continues to surround, the two Internet giants, which are not delivering the blistering growth of the aforementioned companies. We discussed Facebook versus Yahoo and eBay's franchise in prior posts. We've done well with both names, although nowhere near the approximate eight times return of Priceline.com and Netflix over the past two years (assuming entry points at their respective bottoms), or even better over the past five years. Although we're making money on all three of our chosen holdings, our opportunity cost has been significant. Here's Priceline's long-term chart from Yahoo Finance:

Side-bar: our Netflix-like investment was Audible.com (formerly ADBL), which was [for us] unfortunately scooped up by Amazon.com on the cheap in 2008. Although we still received a decent premium to our cost basis, Amazon made quite a deal, buying an asset-light (no inventory), rapidly growing subscription business for less than ten times trailing free cash flow. But, this is another story.

A couple more important points: our investment approach is sector agnostic and, in fact, not primarily focused on Internet or other "growthy" companies. We go where we find value, whether in forlorn container shipping companies such as Seaspan (SSW) or Global Ship Lease (GSL), or off-the-run companies such as Parlux Fragrances (PARL) and Casella Waste Systems (CWST). With Parlux, recall that one dollar of tangible value can be had for only ~60 cents, which makes no sense whatsoever for a viable business! Lastly, we believe that the best kind of business is the kind that keeps on giving in the form of increasing net cash flows that can be used to (1) further expand the business with favorable returns on capital or (2), if option one is not feasible, return to shareholders.

OKAY, back to Sonic Foundry. While we can no longer provide commentary on IT-related happenings, we can say that the recent Capital Times article, Sonic Foundry rebounding with new focus on online teaching tools, correctly revealed that we initiated our position in 2006. Our original cost basis was in the low teens (after reverse split) and we added to our position in the mid-$5s and $6s over the past two years.

Why take such action?
  1. Favorable fundamentals -- revenue grew 19% Y/Y in fiscal 2009, margins improved, and cash operating income was near break-even (not for the most recent fiscal 2010 year, but for the prior year - for the year ended September 2009).
  2. Confidence in our estimate of the company's reasonable private market valuation and the growing Mediasite franchise.
Importantly, the recent and ongoing M&A frenzy supports our fair value estimates and, as with the June quarter, the company's report last week provides more evidence of earnings power. On this basis, we can look to our March earnings scenario range, remembering that significant NOLs should shield cash taxes for a very long time to come. One caveat is the degree to which incremental dollars are funneled into marketing and selling, which is okay so long as this investment accelerates top-line growth.

Given our stake in the company, we will continue to follow Sonic Foundry and, where possible, include Mediasite presentations into CS$ posts, such as those included in our recent Weight Watchers (WTW) post. Truly fascinating information. We'll also try to Tweet interesting/helpful links such as this re-Tweet (please feel free to follow us):
OR
Summarizing: we need to remember that the "Market" does what it does and is also often irrational because of human psychology, which tends to accentuate extremes. Likewise, shares of a company may behave like a yo-yo as traders whip them around day to day or week to week, not to mention countless mutual funds that churn through portfolios 200 or 300% per year (which we think is crazy and casino-like).

Fortunately, fundamentals always win. Always.

THUS, over the long-term, the market (lower-case "m") is efficient as share prices track earnings and should continue to appreciate so long as a business grows bigger, better, stronger. This means short-term heart burn can be mitigated or avoided by thinking of equity positions as a business owner, asking the right questions, and acquiring ownership with an initial margin of safety.

While all investors have their own risk profiles and circumstances, we are fairly confident that a common sense approach can help individual investors such as Ms. Leanne Chase regain confidence in equities and generate the necessary returns to help fund retirement. Even with lingering economic worries on many fronts, there are always opportunities.

Happy investing,

Jeffrey Walkenhorst
CommonStock$ense

Disclosure: long SOFO, EBAY, YHOO, PARL, CWST, WTW.

© 2010 Jeffrey Walkenhorst
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