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Invest To Protect

Posted: Nov 12, 2009 14:40 PM by Sham Gad

Tickers in this Article: FL, CX, KHD, KSWS

Believe it or not, there still remain some businesses that offer investors strong downside protection. In this hyper-rally-based market, that's a big plus. But remember that downside protection has nothing to do with upside gains. Nonetheless, the following businesses are worth a closer look as they offer potential value-creating upside in various ways.

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An Exception
There are several reasons why the discretionary consumer goods sector should be avoided right now. The economy's problems - namely unemployment and housing - have a long way to go before getting to levels just near those in 2007. As a result, people are going to buy a lot less of things they don't need. Yet athletic footwear maker K-Swiss (Nasdaq:KSWS) may be an exception due simply to the cash rich balance sheet.

The shares fetch approximately $8.50 and for each share, you are getting about $5 in cash. And at current prices, shares trade at a slight discount to book value. These numbers compare favorably to giant Foot Locker (NYSE:FL) which trades for $11 a share, has about $2 a share in net cash and a per share book value of $12.68.

What is most impressive about K-Swiss is the fact that its cash balance has not materially deteriorated over the past couple of years. Such excellent cash management by the company coincides with the fact that insiders own 11% of the stock. The company isn't posting profits - the most recent quarter was a net loss - but the cash is being managed: SG&A expense was down by nearly 20% in the third quarter. (For more, see Can Insiders Help You Make Better Trades?)

Waiting For An Economic Turnaround
KHD Humboldt (NYSE:KHD) does a lot of things for the coal and cement industries. But the purpose of KHD's engineering and processing services is to help make those industries more efficient. Since most businesses have heavily cut back on capex over the past year, that means less work for KHD. Cement giant Cemex (NYSE:CX) spent $1.5 billion on capex in 2008, down from $2 billion in 2007. While 2009 is not over, it looks as if full year capex will be substantially less than 2008.

As the economy improves, so will business spending. In the meantime, you get a business with a $300 million market cap with about $350 million in net cash. But before you get really excited, there is a bit of uncertainty as to how much of this cash is actually KHD's and how much is from projects already paid for.

On the liability side, there's about $180 in deferred revenue work, so if take that out, you're left with about $170 million in cash or just under $6 per share in cash against a stock price of $9.75. This math implies paying $4 a share or about $120 million for the entire business.

In 2008, KHD did over $600 million in sales. Business is terrible today and it may be a year or two before the company starts earning profits like it did in 2007 when it earned over $30 million. But in the meantime, the current price paid relative to the assets received offers a favorable risk-reward scenario.

Protection First
Many investors spend far too much time focusing on upside potential and not enough time on downside protection. That's a backward way to invest and often leads to expensive mistakes. (For related reading, check out Breaking Down The Balance Sheet.)

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By Sham Gad

Sham Gad is the Managing Partner of Gad Partners Fund's, value inspired investment partnerships modeled after the Buffett Partnerships of the 1950's. Previously, Gad ran the Gad Investment Group and delivered annualized returns of 22% from 2002 to 2005. Gad is also the author of "The Business of Value Investing" which will be out in the fall of 2009. Gad earned his MBA at the University of Georgia in May of 2007. Gad runs a value investing blog. He can also be reached by visiting the Gad Partners Funds site. When not writing or analyzing businesses, Gad enjoys hanging out with his wife Maggie, reading, golf, and yoga

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