Zuoan Fashion Ltd (ZA): A No-Brainer For Big Returns

Just took a long position in Zuoan Fashion, Ltd. (NYSE: ZA), opportunities like this come few and far between. Not far from its IPO back 2011, Zuoan Fashion is a design-driven fashion menswear company in China that has taken a beating for no apparent reason.

The No-Brainer Aspect

The reason to me this is a no-brainer investment is because while the company is currently priced at $2.17/share, a quick look at their balance sheet in 2012 shows they have $5.96/share in net cash alone (cash minus debt). Furthermore, if we take all the current assets and pay off all outstanding debt, we're left with $11.79/share. What this means is that if the company liquidated everything tomorrow, that's how much shareholders would receive per share, which makes this a textbook Buffet/Graham/Klarman value play with a 82% margin of safety. Wow...

And the story gets better. The company has no long-term debt and no short interest whatsoever. Below is my analysis of the fundamentals versus the stock price over a 5-year period:

Zuoan Fashion Quality of Earnings Vs. Stock Price (2008-2013)

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So what we have is a company who's fundamentals are clearly growing stronger over time while the stock price is diverging to reflect the opposite. No financial shenanigans here either, their financial reports were signed off by Crowe Horwathe, one of the top 10 auditing firms in the United States. Zuoan is essentially like a straight-A student in a bad high school, the top institutions are overlooking her just because she's small and didn't go to Harvard Academy. Their loss...

Not only has their fundamentals improved, but their ability to self fund with cash is getting stronger too (defensive), which means they can weather any storm that may lie ahead because their industry is so competitive.

Industry Recognition

So what about the company? Well, the fashion industry is highly fragmented. While the company has no defensible competitive advantage against competition and its success is dependent upon its ability to recognize and create appealing fashion styles in the years to come, the company has received the #1 spot of fashion designers in China by Apparel Magazine two years in a row now, beating out major competitors such as True Religion, Ralph Lauren, Nike, Urban Outfitters, & lululemon, two times over. From the July 2013 issue of Apparel:

(click to enlarge)

And as apparel magazine mentions, they sponsor and are regularly featured on the Chinese equivalent of Project Runway, "Hello Gorgeous." What better marketing avenue could a fashion company ask for? As China's middle class grows, Zuoan's affordable fashion line stands to benefit which makes this not only a value opportunity, but a growth one as well.

Valuation

Baseline valuation is $9.08/share (assuming a 50% write-off of Accounts Receivable in a liquidation event), but if the trend continues I may hold on until $12-14, making this one a potential 6 or 7-bagger. Estimated time to value realization, 2 years, maybe even sooner.

Why Small and Micro-Cap Companies Are Better For Your Portfolio

I have MSNBC on in the background and they just mentioned that Cisco (CSCO) may now be undervalued due to its recent drop. A quick earnings power calculation using an 8% cost of capital due to their financing mix shows actually that they're pretty fairly valued in my opinion (plus or minus a dollar) which got me thinking about market prices in general.

A lot of investors, especially value investors, like to purchase companies selling for less than what they think they would be sold for. However, the inherent error in this thinking is that it leads one to believe that the market is pricing companies at how much they are truly worth, when its clear that it is pricing companies as a going concern. What does this mean? It means that the market price is only reflective of the expected future earnings power of the companies assets, not its buyout value.

In other words, let's say I have a unique lemonade machine that makes the greatest lemonade ever and I can make $10 a year with it by opening a lemonade stand. Assuming I have a 10% cost of capital (for a lemonade stand, I know this is ridiculous but just to prove a point!), the earnings power of that lemonade stand would be $100 ($10/.10). This $100 would be the reflected market capitalization if my stand was publicly traded. If however, you came along and offered to buy me out, it really wouldn't make sense for me to sell it to you only for a $100.

But that's what it's worth right? Well yes, but its worth that much assuming nothing changes (as a going concern!). However, if you come in and offer to buy, suddenly the perceived value of my stand increases. As the owner I start to think "this is greatest lemonade stand in the world, they'll make a killing...and what about me? The only thing I know how to do is sell lemonade. Where can I find a stand of equal value once I sell? Nowhere! They better pay up then." So we have a small element of reflexivity coming into play here.

In a way, this happens in all acquisitions, that the very premise of an acquisition being proposed ups the perceived value of the entity from a going concern to a total buyout value. This is why when a potential acquisition is announced, the stock price jumps.When a possible acquisition manifests, suddenly book value and intangible asset value get factored in along with earnings power, which puts a premium on the original market price.

The positive outlook one could take from this then is that technically all public companies are undervalued to what they are really worth. The bad side about this is that "buyout" value will not justifiably manifest unless someone comes along to buy the company (it could manifest from market gyrations, but there's no fundamental basis to support this). With this in mind, what do you think the odds are of someone coming along and buying, say, Exxon-Mobil? ZERO!! Its one of the biggest companies in the world, who would even have the money to do so?

Which leads me to my premise that the individual investor has a better shot at having value realized by investing in smaller companies. Not only because smaller companies have a better chance at being acquired (that's a crapshoot, don't start trying to predict that stuff), but because less market participants are paying attention to them. If 10,000 CFA's are watching CSCO and valuing it accordingly so that the market prices it at around $19, what are the odds that all 10,000 CFA's and all the other market participants are wrong?

In the book The Wisdom of Crowds by James Surowiecki, he makes a point about this using the popular game show "Who Wants To Be A Millionaire." He noted that when someone Phoned a Friend, on average they received a correct answer about 65% of the time (actually seems pretty high to me!). Compare that to the Ask The Audience lifeline, which yielded a correct answer about 91% of the time. What does this tell you about market prices? They are usually right when lots of people are looking at them.

However, the less people looking at a company, the more of chance it could be unfairly valued. Perhaps only 100 CFA's looked at a particular small company, and because their priorities lie in getting through a ton of small caps and micro caps to move onto bigger and better projects, they might have overlooked crucial information. And that is where the individual investor's edge comes in. Those who are willing to do their homework and find value where a small amount of people were too rushed or lazy to look will get the payoff when the fundamentally supported value manifests in the price.

Something to think about...

Is Intrinsic Value the Most Important Thing in Investing?

Many people may be familiar with investing in common stocks as growth vehicles in their financial portfolio. With information a click away on the internet and various books just as available on investing, it seems that everyone has the power to manage their own portfolio like they were a professional investment manager.

Many of these sources point toward Warren Buffet's style of investing, commonly known as value investing. The premise behind the strategy cites that investors own a small piece of a company. The basic philosophy is that a good investment is made in good companies selling at a discount to their intrinsic value.

However, caution and an analytical approach should be taken when defining intrinsic value, which is loosely defined as the price at which a person would be willing to pay for the whole business. This assumption is vague and not useful in practicum at all.

The truth about intrinsic value is that it is subject to the participants involved, meaning that, depending on the buyers and sellers own reasoning, intrinsic value will differ. If you were a small bank up for sale, you would most likely charge a far lower price to a private buyer than you would, say to Bank of America. This is mostly because variables such as the size of the buyer and synergy value come into play.

Furthermore, intrinsic value differs between how the buyer or the seller are evaluating it. While things such as future earnings are factored into both perspective values, there are variables that will discount the value of the business on the side of the buyer that would not affect the value to the seller. These are things such as lack of liquidity and non-diversifiable risk.

Likewise, the value of the business to the seller will factor in the size of the buyer that would not affect the value calculation on the part of the buyer. As a buyer, how big the company is should not make me change my estimate of what another prospective company is worth to me, but it will to the seller.

How Much Is That Business In The Window?

Let's pretend for a second, you are the owner of a dry cleaners business. Business has been good the past few years, you've managed to grow your business at about 20% per year by opening a few new locations. You've even managed to sock away about $50k per year in cash after all expenses and re-investments. You remember back only four years ago that with only a $15,000 investment, you've come a long way.

One day, a representative from a larger chain of dry cleaners, comes in and offers you $250,000 to buy you out. Do you take the money?

Knowing the value of your business is a crucial part of being a business owner. Unfortunately, the price of a business is not as clearly defined as say, the value of your house, which has comparables and mortgage value assigned to it by a bank. Unlike a single asset such as a house, anything that produces a profit takes a significant amount of financial analysis, future projections, and discounting to determine what the true value is.

In this example above, you'd be foolish to accept such a low price since a worst case scenario, valuation would still put your worth at well over $200,000. Ironically, about five years ago, insurance agents found themselves in the same scenario when a large insurance corporation came around offering independent agents a buyout price. Most of them had no idea what they were worth and were ill-prepared for the situation.

The truth of the matter is, a buyout proposition can happen at any time to any business, especially in highly fragmented industries that are cost competitive. It is the responsibility of the business owner to know what they're worth in multiple income scenarios so they can make sure the price offered is fair.

Hiring a skilled business appraiser is an investment in your business that will pay for itself many times over in the future.

I would suggest this to anyone who in the future plans to sell their business or pass it on to their children through their estate. You can do an online search for one in your area. Just make sure they have credible experience or are certified by one of the accredited valuation bureaus (IBA, ASA, NACVA, CFA Institute, or a CPA with a ABV distinction).

Having the financial transparency of a proper business appraisal will give you and anyone else the proper assurance that your business is worth the time and effort you put into it.