J.M. Dutton & Associates

Not "Your Father's" Securities Analyst:
Bob Davis, Senior Analyst, JM Dutton & Associates

Bob Davis has spent much of his professional career in corporate management and for the last five years has been the editor of the highly regarded Napeague Letter, named by Forbes to its 'Best of the Web' list. From 1987 to 1995, he was the Chief Financial Officer of Total Research Corporation (NASDAQ:TOTL), a marketing research and consulting firm in Princeton, NJ. Prior to that he was the Corporate Controller for Waverly Press Inc. (NASDAQ:WAVR), a medical and scientific printing and publishing company, and then co-founder, CFO and divisional general manager of a privately-held company in the transportation services industry. He received a BA degree from Rutgers University and an MBA from Harvard Business School.

Bob, your background is quite unconventional for a securities analyst. How has it prepared you?

I'm definitely not your average securities analyst. I spent my first 25 years in corporate management. First in marketing and then finance, spending about 15 years as CFO of three companies.

Two of these were public, which gave me a lot of exposure to the financial community, and to investor relations. And I've also prepared a lot of different types of SEC filings, so I know my way around these and where to look for the different types of information they contain. I also did some mergers and acquisitions work, which involved quite a bit of due diligence research, so I developed a really good sense of how to go about doing this. And of course I'd developed a solid background in financial analysis.

In 1995, I left corporate management, to spend more time on my portfolio and also to put together an investor relations firm. I had already discovered the Internet bulletin boards for investing that had just been started, but got frustrated by their limitations. As a result, I began putting together analyses of various small-cap stocks and E-mailing them out to those who asked for them. This evolved into The Napeague Letter, which had 1,200 e-mail readers by mid-1996, when the Wall Street Journal first interviewed me. The Napeague Letter grew to over 12,000 subscribers and is listed by Forbes Magazine as one of its "Best of the Web."

What areas do you like to focus on in terms of industries and types of companies?

I'm almost entirely focused on small-caps. Companies that have a real reason for being in business, are making money now and look as though they will continue to do so into the future.

I try to identify those that are undervalued because of the proverbial "market neglect." They are too small to attract the attention of sell-side analysts because they don't have enough trading volume to support research coverage and they haven't needed any investment banking recently.

From an industry point of view, I generally tend to focus on those companies that are in industries that I know something about. But I guess that's a pretty broad description. You know, I've worked in consumer products in one role or another for about 20 years, and also spent a lot of time dealing with manufacturing issues, so I know my way around a plant floor. Also spent some time in the transportation area and in business services.But the Internet and the various information services that I can get access to will often give me information about an industry where I have no direct hands-on experience. And the vast amount of conversation on the Internet also gives me a way of reaching people who can tell me about their own experiences with a company or an industry.

What are some companies you'd like to mention and why do you like them?

As I said a few minutes ago, I tend to like companies that have a "reason-for-being," to use an MBA buzzword. I like those that are filling a real need, are making money now, and look as though they will continue to do so into the future.

I'm a big fan of The Leather Factory (AMEX:TLF) - it meets all of these criteria. It is the clear-cut market leader in supplying tools and materials for leather crafting. Not only is the Company profitable, with positive operating cashflows and a solid balance sheet, but about two years ago it acquired Tandy Leather, and is now rebuilding the Tandy chain of once profitable leathercrafting retail stores that its previous management abandoned. In the past these retail stores have done a lot to teach leathercrafting and I feel that reopening this chain will actively expand the market for their products. But even ignoring this move, this stock is clearly undervalued.

Another stock I really like is ENGlobal Corporation (AMEX:ENG). It has an impressive management team and a reputation for extremely high quality work in the demanding petroleum engineering industry. This stock is also quite solid yet very undervalued currently. An oil shortage could have a dramatic effect on ENG by making it more visible.

I've been following Touchstone Applied Sciences (OTCBB:TASA) for a number of years, and I've felt it was undervalued for a long time. Its strengths in educational testing were hidden by its ownership of a generally unprofitable proprietary school chain, which drained its profits and taxed its balance sheet. However, the Company is divesting these schools and showing them as discontinued operations, which now reveals a much stronger core Company.

I'd also like to mention EasyLink (NASDAQ:EASY). This Company supplies its clients with a wide range of business to business communications tools, and I expect that it will be a beneficiary of the economic rebound that appears to be coming. But more than that, it also has a number of new products that will help to extend the range of Electronic Data Interchange. Right now, only the largest 20% of all US businesses are using the existing VAN-based EDI technologies. EASY's new products will help to change that over the next few years.

What is your approach to valuing companies and researching them, in general?

Because I'm looking for stocks that are undervalued by the market when compared to the financial results they are producing, I'm initially interested in a company's fundamentals. I collect this information from a number of different sources and store it in a database that I also use for initial screening. Right now, it includes close to 10,000 stocks.

After I identify a potentially undervalued stock, I continue to look at it, in greater and greater depth, if it still looks to be all right, including really digging into its financials and those of its competitors, and also looking at what is going on in its industry. I don't use technical analysis to identify candidates, but I do look at a stock's charts to see how the market is reacting to it.

My final analysis is very heavily value oriented. I even go so far as to chart a stock's economic value against its market price over time.

Individual investors can pore through financials, too. What makes your research a added value to them?

I'm distilling and putting it in perspective. Fundamental data by itself can often be misleading and meaningless if it doesn't include a real understanding of what forces drove the numbers. In other words, were the numbers for a particular period driven by one-time sales events, or by inordinate change in cost of goods sold? Or items that were included in operating expenses that really are one time in nature? Or operating expenses that are going to occur in the future because of decisions the company has already made that are not reflected in the current financials? You need to put the data in its proper context.

What trends do you see in small-caps?

Well, for small- and mid-caps, I strongly suspect that there will be even more reductions in sell-side analyst coverage over the next few years. The economics of Wall Street will cause this to happen. If a firm's investment banking group no longer has any control over the content of an analyst's research reports, and especially if analyst research is no longer funded by investment banking, then securities analysis needs to pay for itself by generating trading commissions. But most small- and mid-cap stocks don't produce enough trading volume to justify the cost for an individual firm to publish research reports.

One of the big problems that small-cap investors face is the fact that there just isn't any real ongoing analysis available for these stocks. Yes, there are a number of sites that offer overviews of these stocks, and a few other sites use various "black box tools" that reportedly give stock valuations, but nowhere is there a source for any real analysis that evaluates the company, its industry and its customers in any meaningful depth.

I do think that investors will develop more interest in stocks of smaller companies. They are a lot easier for investors to get their arms around and less likely to conceal surprises like Enron or Worldcom. A portfolio of legitimate and undervalued small-caps, bought at the right prices, can generate really strong returns.