Industry Review (continued....)

Securities Brokerage: Diamond Hill Investment Group, Inc. (DHIL)
The woes of subprime mortgages are well-documented including the collapse of the Bear Stearns hedge of fund of mortgage-backed securities. However, also occurring was an inventory write-down of $940 million by Morgan Stanley mostly related to loans related to leveraged buyouts of below investment grade companies. Securities Brokerage companies benefited from the recent Federal Reserve rate cut because it helped stimulate the equity markets and increase trading. However, problems such as continued housing deterioration and lower consumer spending may affect future commissions revenues. Of note, the New York Stock Exchange and Euronext have combined to form NYSE Euronext. The CME Group is integrating the Chicago Board of Trade into its operations and NASDAQ acquired the Nordic exchange OMX AB.

Diamond Hill Investment Group, Inc. (DHIL) is a company to keep an eye on in this sector. DHIL provides investment management services to individuals and institutions by offering seven mutual funds. In the latest quarter (2Q2007), net income rose 76%, revenues increased 66% and assets under management increased to $4.5 billion from $2.7 billion. The company also announced plans to repurchase 15% of its common shares. What’s even better, their investment philosophy is based on the teaching of Benjamin Graham and the methods of Warren Buffett and all Portfolio Managers are significant investors in the same portfolios in which they manage.


Food Processing: Nutrisystem, Inc. (NTRI)
This is a traditionally defensive sector since food is not a luxury item. However, profits for companies in this industry are being effected by the rise in commodity prices, most notably in record highs for milk and corn. Higher milk prices have affected dairy-based food providers such Dean Foods, Kraft Foods, and Hershey Company. Corn prices are rising due partly to the increased demand for ethanol as a fuel alternative. These prices are cyclical and corn prices should come back down now that farmers are devoting more land to increase corn supplies.

Maybe not a traditional company in this sector, but one that was just too good to pass up is Nutrisystem (NTRI). I mention it is too good to pass up because I did own this stock briefly before selling out of it. While I probably deserved to take the beating that would soon ensure, I feel I still learned a lesson nonetheless. Basically, it is easy to fall in love with numbers for this weight management company. The company has net margins of about 15% and even with no debt, their return on equity is close to 60%. For the first half of 2007 they were growing customers at about 50%. Beyond those numbers, the story is not as nice. I basically sold the stock because after I re-visted my intrinsic value calculation, I was no longer comfortable with the assumptions I made. Basically, I did not really think their product was very good and became convinced their retention rates would deteriorate. I basically became too uncomfortable owning a stock I really didn’t believe in. That was my reason for selling but the reason it landed up dropping from the $50’s to the low $30’s in one day in October was because the new Alli diet drug affected their revenues and growth projections. Why go on a diet when you can pop a pill? Bottom line, Nutrisystem has no established moat for providing weight loss solutions so even after the precipitous drop, the stock still does not seem like a screaming buy. By the way, I also had a similar situation with Prepaid Legal (PPD). I came close to buying it recently after a major drop in stock price but the company seems too much like a giant marketing pyramid. Instead of NTRI, Prepaid has done quite well since I passed on it. But I am convinced it is a matter of time before the house of cards falls on that one too.

Homebuilding: Avatar Holdings (AVTR)
This industry is what you would call in a “downturn”. After years of a rapidly increasing housing market, this industry is in a freefall with no end in sight at the moment. The main problem right now is excess supplies (as I know all too well in San Diego), and high inventories are causing new builders to get creative on how to sell them. It is estimated there is a 9.6 month supply of houses right now. Tighter lending standards are also reducing the number of potential buyers. This has led many homebuilders to take significant impairment charges and write-offs which has sent many into the red. The question now is when will the housing market return? As mentioned in the Countrywide post, industry is expecting a return to price appreciation at the end of 2009 with a bottom in late 2008. What a nice graduation present for me. The Federal Discount rate cut was hoping to provide some relief and potentially make it easier for homeowners adjustable rate mortgage is set to reset. The near-term outlook is bleak for this industry but it should definitely offer opportunities for investors willing to weather this storm.

Avatar Holdings Inc. (AVTR) is a still profitable (for now) real estate operator in Florida and Arizona. It is focused on the development of lifestyle communities, including active adult (55 years and older) and primary residential communities. Despite the near-term turmoil, this should have promising long-term trends on its side with baby boomers retiring. It recently reported 2Q net income of $5.3 million, down from $27.2 million for the same quarter last year. It is currently trading at less than 80% of its book value. A profitable homebuilder in 2007 with favorable long-term trends supporting its business model is worth keeping on a watch list.


Biotechnology: Amer. Oriental Bioengineering (AOB)
Andy Kessler once described the research of biotechnology companies like they were throwing pasta against a wall and seeing what stuck. A company in this industry can obviously become immensely profitable if it can get a winning drug approved with patent protection. There are legislative risks for biotechnology companies in regards to generic alternatives but it will be hard to complete this legislation because the process would have to be established for a generic alternative (“biosimilar”) to prove its molecular structure is the same as the original and the clinical effects are the same. The bottom line is many of the stocks in this industry are speculative and still years from making actual profit. Tread carefully.

American Oriental Bioengineering, Inc. (AOB) is based in Shenzhen, China to engage in the development, manufacture, and commercialization of plant-based pharmaceutical (PBP) and plant-based nutraceutical (PBN) products for the treatment of a variety of conditions and diseases including but not limited to respiratory diseases, incontinence, pelvic inflammations, and neurosis. The company is profitable sporting net margins over 26% and returns on assets over 14%. Also, EPS has grown from $0.15 in 2003 to $0.46 in 2006, a compound annual growth rate of 46.5%. This stock is appealing for both its impressive growth and the fact it is selling in China. Or for some people, it is appealing because it has the word “China” associated with it at all. While the results have been impressive, there is just too much optimism already priced n the stock for me at the moment.

Cable Television: New Frontier Media (NOOF)
Cable television companies can be extremely appealing investments at certain stages because once the high capital expenditures required to install the infrastructure are in place, free cash flows increase rapidly. However, investors tend to punish a stock at the first sign of slowing growth which should be taken into consideration. One interesting company in this industry is LodgeNet, whose shares have dropped considerably recently due to its competitor On Command being acquired by Hilton and Marriott hotels. In general, the industry seems to be have slow basic-cable subscriber growth maybe partly due to the downturn in the housing market. Broadband adoption has also not been as rapid as some expected but the long-term growth potential still seems intact.

New Frontier Media (NOOF) is the stock in focus for this industry. NOOF engages in the production and distribution of adult themed and general motion picture entertainment. It operates in three segments: Pay TV Group, Film Production Group, and Internet Group. Proving the wide belief that catering to the vices of others is profitable, New Frontier is extremely profitable with net profit margins over 17% and returns on assets over 11%. A recent drop in 2Q revenues of over 20% have sent the price of the stock downward and this cash-generating firm now offers an 8.3% dividend yield. It would need to be further investigated to see why the revenues are dropping and if this is a long-term trend or just a bump in the road. But I have limited time and a girlfriend so I will look for other potentially undervalued companies.