Paint By Numbers – Brush Engineered Materials (NYSE: BW) and Ash Grove Cement (Pink Sheets: ASHG)

The famous Art of War by Sun Tzu sports a thought that the victory in a battle is actually determined before the battle is actually thought.

I must admit, I spend a fair amount of time watching the intra-day activity of the positions I follow and am long on. Such activity is typically not suggested for long-term investors or any investor that is betting on the merits of the company. I have heard rumors that Warren Buffett shuns the use of stock quote tools and relies strictly on SEC filings and industry information to make his investment decisions. I am unsure if that is true, but I hope you can relate to the above illustration, even if it only a rumor.

Watching the tape tick-by-tick has all sorts of negative consequences that can impact investment decision. More often than not, this behavior lends itself to allowing fear and greed in get in the way. Big long-term winners are often sold on unwelcome large dips and fear sets in. A stock that has had a 20% run-up plummets 5% in a single day and in the excitement, the sell order is placed. After all, you never went broke taking a profit. But, regardless, the stock quickly rebounds from its low and then proceeds to become a double or a triple over the next 12 months. On the converse, a stock you are looking to start a position has a break-out day – and thanks to greed, you chase the bid up, only to give in to placing a market order. The stock then pulls back, naturally, and although perhaps the stock does well over the long haul, you restricted your gain somewhat by buying higher than you should. Sound familiar? I think every investor has shared the above experiences in some form at some point.

However, watching tick-by-tick, especially over long periods of time, can provide valuable insight into the future of the company’s stock performance. The key is being able to remove yourself from the fear, greed, and other emotions that can cloud your investment decisions.

Brush Engineered Materials (NYSE: BW)
One of my recent additions to my portfolio, I jumped in BW when it was trading under $40 after it lowered its earnings guidance. Mind you, that my confidence was strengthened by the 485,000 purchase by 14% holder Tontine Capital Partners. Just recently, BW climbed back to over $47 showing a very strong short-term gain and making some of the $40 calls I bought extremely valuable. What happened? BW pulled back sharply, and traded in the $43s. Although the fundamental reason why I added BW has not changed, the pull back certainly eliminated some of the fat paper gains achieved thus far, particularly in the options which have a limited shelf-life. Watching the tape was gut-wrenching and the temptation to exit was strong, especially since 50% of my gains were lost in a single day and I was still very well in the black. However, recognizing the fundamental reason why I bought in the first place did not change, I took a deep breath and resolved that I would hold my position. I actually considered buying more, but that did not happen – though I should have.

Watching the tape over the past couple of days has been inspiring to my long-term confidence in BW at these levels. There has certainly been some volatility – not unexpected in any stock with a relatively small float and active trading environment. A big dip like BW saw lends itself to all sorts of strange variables into the equation. Momentum traders, shorts covering, shorts being scared into covering on small pops, active option contracts, and value investors looking to scoop up shares. This day to day activity can cause some frenetic activity, but among the battlefield, I noticed some very telling signs.

Intraday, BW would certainly have some swings. Nothing dramatic, but it would fall to $43.50, only to run to $44.50, and fall back to under $44. The trend I have noticed the last several days is that during the many up and down swings, volume at the levels tells the truth. There is no doubt that there is some distribution of shares going on out there. After all, BW has had quite a run up the past 12 months and is still up over 100% from its 52-week low, even after its 35% haircut from its 52-week high.

The important observation is that when BW goes on a little mini-run, money flow and buying of stock is strong. The size of the blocks and total volume in these mini-runs is far greater than it is when it takes a breather. My analysis suggests that there is net buying of BW at these levels. There is certainly stock for sale, no question and the blocks for sale come out in mass when the buyers are ready. Then, the buyers take a break and some net selling comes in – only to be met by fierce accumulation. I could certainly be wrong – I am no psychic and the marketplace is an expression of an environment far too complex to understand. However, making an educated investment decision based on rational though, BW is a buy. Exactly why it is being bought up, well, nobody really knows – everyone has a theory.

I liken it to an options contract. For instance, say a buyer (individual or a fund, more likely) thinks that BW is worth $60/share. Basic logic should say that the buyer should just buy up everything in sight, but we all know that makes no sense for many reasons. Why artificially drive the price up before $60 is due? For instance, today, say I believe that BW is going to $60 and I am willing to pay say only $44.25 for BW. If I am a fund managing large sums of money, I have to have a risk formula or reason for doing do. I may be 100% confident in the future of BW and hitting $60, and while I have some ideas of how it will get there, I do not know exactly when or how it will transpire. All I know is that each trading day that goes by is one day closer until it hits $60. So, today, I am willing to buy at $44.25, but say next week, as the $60 timeframe draws nearer (although it is an unknown), I am willing to pay $44.75. The duration is shorter, so I am willing to pay an additional premium to own the shares that I know are going to $60. So, I go in and buy everything in sight up until $44.75, then I back down…the sellers show up and maybe the stock even gets a pop on the incoming volume to $44.90. I patiently then will wait for it to come down below $44.75 to reinitiate my buying. As time goes on, as long as I remain convinced that $60 is the target price, I will be willing to pay more for it. For instance, say BW is at $44.25 and a buy out at $60 is 100% guaranteed to happen (I am not saying it is). Well, in one scenario, the buyout is 12 months away. Why buy now at $44.25? You may be able to do better elsewhere. However, if the stock is at $55 and the buyout at $60 is coming tomorrow, you would be all in.

The above is lengthy, but to summarize, the battle for the future of BW is being decided right now. The action that I am seeing, at least to me, is indicating that there are more buyers than sellers and more people that believe that BW has an upside versus those that believe it has a downside. One day, it will be very likely that the gap will be filled and BW may even be able to go on to even higher levels than it touched on earlier this year. There are no assurances of that, but the profits are being made now by the sophisticated buyers that will not get caught chasing BW up the tree when it breaks out. The activity I am seeing corroborates my fundamental business reasons for liking BW. I like when the stars align.

Ash Grove Cement (Pink Sheets: ASHG)
ASHG has not posted a trade in nearly two months. The spread occasionally moves, which is obviously indicative of some activity taking place, most likely in odd lot transactions. I know how this works because I will often go and buy 1, 5, 10, or even 25 shares – and the trade will never hit the tape, but I do own the shares. The spread, however, will change.

Armed with this knowledge, even when I am merely watching the inside market and taking notice of the change, I am able to learn a great deal about the marketplace out there. The fact that is hardly ever trades really brings some clarity to the table.

Just a couple of days ago, with no volume whatsoever, and after the spread ticked up to $240 x $265, without notice, the spread was $230 x $240. Now, instant reaction is obviously fear, but because I have watched the inside market on this one daily for over 2 years, I know what this means. I am not 100% certain of the specifics, but my strong bullish stance on ASHG (which I make no secret) screams out buying opportunity. Dips in the spread like this are common and I take advantage to nibble and add to my position. Long term, it likely will not matter that much if I paid $5 more per share, but it is nice to get a lower cost basis and to take advantage of such dips to cheaply add to your position. I think investors often forget that buy and hold really needs to be buy, buy, and buy. If it is a great company and there appears to be value in the price being offered, take it. For example, I am glad I bought and hold my first shares of ASHG that I purchased at $160 – but I am even happier that I added more at $180, $195, $205, $210, etc. Of course, in the end, I may be wrong, but only time will tell.

Anyway, seeing the spread at $230 x $240, I knew it would not last long. I added to my position at $240. About 45 minutes later, the spread went to $235 x $240. Within minutes of that, the spread moved to $235 x $243. I actually went to add more at $243, but before the order could even be placed, the spread went to $235 x $250 and then quickly to $235 x $255. I then added a little more at $255. My limit orders at $231, $236, and $240 have gone unfilled, which is typically how this stock works. Good luck buying at the bid or not at the ask, especially if you are working with odd lots. The odd lot approach makes sense as it can be done under the radar. Who knows how much a 100 or 200 share market order would do to the spread – it could be a disaster. I’ve taken out asks before with 5 and 10 share offers.

Today, the spread is $235 x $260. The $255 ask went away the following trading day. I am glad I took the $255 shares when I did – or else I would have had to pay $260. My fundamental reasons for buying ASHG have not changed and I still think it is a value at these levels, so I will continue to add where appropriate. Being attentive to the inside market and learning how this stock behaves afforded me the opportunity to add some shares at an 8% discount to what they are currently fetching – and that fire sale lasted only a few minutes.
Obviously, other people are watching ASHG closely – likely far more closely than I am. I am not sure what happened, but my theory suggests that maybe an employee or a fund wanted out of a handful of shares – bringing the price down. And as usual, someone was there to buy them to keep the marketplace clean. It could have been another fund, though I think it is the founding family doing most of the cleanup work. They will part with a handful of shares here and there for the benefit of their employees and other investors, including institutions and goofballs like myself, but that suggests that a time for these latter groups to sell will come. If you had to bet who is more likely to sell their shares first, would you bet on me or the founding family that has owned them for 100+ years. I feel confident in the future of ASHG and its business prospects (I have written about those already in other articles, so I will spare you that) and I feel even more confident that when those decide it is time to move on from ASHG, the family will acquire those shares to keep the marketplace in balance. The battle for me has already been won. When ASHG hits $300 and potentially $400 – that is when I will remember it is on days like this where there is some form of arbitrage or what not going on that the real money was made.

Winners Among The Losers – Corus Bankshares (NASDAQ:CORS), Brush Engineered Materials (NYSE:BW)

Generally speaking, the stock market does more than an average job of pricing a stock right where it should be at a given moment. The stock market leverages all of the publicly available information about the company, including things such as SEC filings, industry trends, and even less definitive things such as earnings expectations. Furthermore, with the availability of information out there and the speed at which information travels, it becomes increasingly difficult to find companies that appear to have more value to them than the market is currently giving them credit for. Now, obviously, we should pay careful attention to defer to the stock market, as since it is a reflection of all current information and a multitude of investors, odds are, you will not outsmart it. However, to outperform, you have to take risks, and for lack of a better phrase, take bets on the unexpected or unanticipated.

Now, when a stock takes a nosedive, there is typically a good reason for it. For instance, if a company is trading at less than book value, well, there is likely a reason for it. They may be burning cash and in one year's time, the price to book will go from say 0.8 to 1.6, so it is not as good of a deal as it seems. However, sometimes companies seem to be undervalued or take a massive hit without any real justification for it. Sure, there is a news item that is driving the selling, but if you look at the numbers, it just does not make sense. This is where value can be found, though, it can sometimes take months or even years to materialize and the world to wake up.

Corus Bankshares, Inc. (NASDAQ: CORS)
CORS is a bank that primarily provides financing and loans, particularly in the commercial real estate and condominium construction arenas. CORS is typically not financing the consumer, but the developer of a condominium. The stock has basically been halved in the past year, although they continue to maintain strong book value and pay out $1 share in dividends – a 5.9% yield at current prices. CORS has also increased the dividend payable to shareholders every year the past 27 years. CORS also operates as a holding company and has an extensive portfolio of securities, primarily the common stock of other banks – about $203M, or 20% of market capitalization, per their April 30, 2007 filing with the SEC.

CORS has taken a beating during this subprime lending slowdown, and rightfully slow. CORS has increased their reserve for loss and acknowledges they will have some losses in 2007 and perhaps in the future. However, if you look at the nature of the beat down, there are many things that are not adding up.

CORS is run and owned by the Glickmans, who are regarded as very astute bankers. Now, any company or bank is potentially subject to going under or making bad decisions, but if you read the method in which this company provides financing and operates as a lender, anyone would find it hard to believe that this bank is going under – especially since it has been around for nearly 50 years. CORS is trading at 5.7x current earnings and at 7.6x forward estimated earnings – and yes, the analysts have thought hard about the increase in bad loans, loss reserves, and other negative items. CORS has raised the dividend every year the past 27 years and the other day announced a $1 special cash dividend to shareholders on top of the regular dividend. While handing out cash can look bad, considering that CORS is trading at 1.12x book value as of March 31, 2007, and it is likely that the company's book value has increased since then, this distribution has a nominal impact on the per share ratios when it comes to book value. Sure, the $1 payout will take the $1 out of the price and book value, which are essentially the same, but CORS feels pretty strongly about their position, especially considering they have a $300M free and clear cash cushion to be considered well capitalized per their recent press release.

Also playing a factor is that as of May 15, 2007, a little over 19M shares were reported as being sold short. That is impressive considering CORS has 56.25M shares outstanding and only 19.5M in the float. So, this is suggesting that the entire float is sold short? It has also been suggested that there is extensive naked shorting of CORS taking place.

Let's look at the dynamics here. We have a 50-year old bank, that yes, has taken some hits – but they have proven they are prepared for such and expected these hits. CORS continues to pay out dividends to shareholders, at only a 30% payout ratio, and has a $300M cash cushion that they will use to fund the special dividend – and perhaps additional special dividends. Furthermore, assuming the 19M shares short number holds true, in 2007, we are looking at a total of about $150M in payouts to long shareholders. $56M comes from regular dividend, $56M comes from special dividend, and $38M comes from each of the short sellers paying their $2 to the lender of the shares they have shorted. Now, it is unclear exactly where that excess $38M will go, but it will go somewhere into the hands of the longs. Some longs may not get any of that additional special treatment, but someone will. In short, we are looking at a total yield of up to 15.4% to long shareholders. Additionally, the bank remains to be well capitalized, profitable, and have plenty of breathing room – both in terms of cash in the bank and bad loan strategy.

It honestly does not seem like this bank is in as much trouble as the market is suggesting it is. I do not know how much longer the shorts will want to be writing checks to the long shareholders simply to bet that CORS will continue to go down. Sure, CORS could have bought back stock, but why? To drive the prices up only to have the short sellers drive it down? CORS is saying the special dividend is a function of having some extra cash and wanting to take advantage of the 15% tax rate on qualified dividends while it lasts. Those absolutely make sense, but there is more going on here. Without sounding too vindictive, if someone wants to bet against me and write me a check for the privilege to do so, well that is beautiful news for me. That is exactly what seems to be happening here.

Now, it is possible that CORS is trying to clean out the coffers to give back to the owners before they go belly-up, but that would be borderline fraud and illegal, so that does not sound like what is going to happen. CORS may also have nothing to do with their extra money, which is doubtful considering they could easily just invest more in banks (as they have done historically) if their prospects for new loans are slow. I am not a sophisticated banking expert by any means and yes, there is a degree of unknown risk here so zero is a possibility, but should CORS really be trading at 7.5x future earnings and right at book value? The potential for a short squeeze alone, plus the excess cash being put into the pot from the shorts is indicative of how shrewd CORS can be. It is hard to say what the actual valuation of CORS is – I have read anywhere from $0 to $40 – but nevertheless, it appears that a war is being waged here between a family of established, reputable bankers and a stock market trying to fairly value the stock based on current information. It is difficult to forecast where this one is going – it certainly can go down more, but it does not look that way. However, the stars are lining up for some very aggressive movement in the stock price – and since it is trading at book value with a slew of news priced in and a big cash pile, well, do the math and figure out what bet makes the most sense here.

Brush Engineered Materials, Inc. (NYSE: BW)
I have never been a big fan of earnings guidance, particularly for companies that are not as widely followed or held as the big blue chips. These smaller companies, relatively speaking, are more susceptible to the impacts from all sorts of factors that can have significant impacts on their operating revenue. Furthermore, because of this increased susceptibility, volatile movements in the stock price – both up or down – become more likely to happen. It is not like companies to try to sandbag their guidance or get too aggressive with it to drive the stock price to the brink, but sometimes it just pans out that way. Of course, such volatility, especially downward volatility, can bring buying opportunities into the mix.

BW engineers and supplies worldwide markets with beryllium products, alloy products, electronic products, precious metal products, and engineered material systems. Specifically, BW services a wide array of industries including telecommunications, automobile electronics, and industrial components. The beryllium and alloy products they produce help electronic devices, such as PDAs, perform better. Additionally, BW is the only fully-integrated producer of beryllium and related products in the world, giving them somewhat of a lock on the market.

BW is off about 33% from its 52 week high and when they reduced their earnings guidance for Q2, the stock took nearly 20% hit on a single day. BW altered its earnings guidance range to $2.00-$2.55 from $2.20-$2.75. While it is no fun to make less than what you thought you might, there is a strong chance that their results will fall within their original estimated range. The reason for the lower guidance? Production problems and ramp-up problems – which will impact 2Q results and hence the total year results. >However, these issues are cited as being temporary and are resolved. Additionally, the weaker market BW is blaming for some of the slowdown is not a disaster as it appears it is seasonal in nature and their other divisions are performing exceptionally well. In other words, although growth may slow somewhat, BW is still going to make a lot of money and they are serving industries that are growing and continuously have the need for better products, that BW can help provide.

Although empirical results are not the best to go off of, this is reminding me a great deal of Astec Industries' (NASDAQ: ASTE) 50% decline from its early 2006 highs. ASTE ran up to around $42 on the excitement of the 2007 Highway Spending Bill. They missed expectations and the stock took a 50%+ hit. Ignored was the fact that ASTE was producing record sales and net income and had record levels of backlog. Value investors took the time to load up – and thus far, they have been rewarded. ASTE has exceeded its previous 52-week high in recent weeks. Notably, Tontine Capital Partners led by Jeffrey Gendell was and big buyer of ASTE post-decline. Gendell is also a 10% holder of BW – and added to his positions on the BW decline to the tune of 485,000 shares purchased around $41.

Downside for BW is limited and the upside is there. BW has had a huge run up as it is still up over 100% from its 52-week low. I anticipate a return to $50 and this healthy breather may allow BW to exceed its previous 52-week high in the coming 12 months. I am hesitant to put a $75 price target on it, as I have seen floating around, but I feel it is a fairly safe bet for a deep-in-the-money options strategy – both September 2007 and December 2007 calls with a $40 strike price should yield some significant returns – and that is exactly where I am putting my money.