Due Diligence Is YOUR Job

Due diligence can mean different things to different people. But, as an investor, it is your job and responsibility to do it. Otherwise, it can be very costly. Don't count on anyone to do it for you. Some think that reading annual reports, proxy statements, and other documents filed with the SEC is due diligence. I don't think this is good enough, especially for small-cap companies. Remember that these documents are drafted in a way to make the company look as good as possible. If reading available information is not good enough, what should investors do? I believe that investors should call the management, industry experts, reporters, former employees, or anyone else who can answer their questions.

This year, I invested in FortuNet (FNET), a manufacturer of multi-game and multi-player server-based gaming platforms. The company has had very stable revenues and earnings. Earnings per share were $0.27, $0.28, $0.27, $0.18, $0.35, and $0.25 in Years 2003, 2004, 2005, 2006, 2007, and 2008, respectively. I paid $1.20 per share for FortuNet's stock, which is equivalent to a P/E ratio of 4.44 using the average earnings per share of $0.27. However, there was an issue - Aces Wired, parent company of K&B Sales Incorporated, was involved in illegal activities and was raided by Texas authorities who shut down its operations. K&B Sales Incorporated provides 36% of FortuNet's revenues. If K&B Sales Incorporated lost its distribution license because of Aces Wired's illegal activities, this would be detrimental to FortuNet's revenues. The stock price could take a huge beating. However, at a price of $1.20, I felt that this risk was already priced into FortuNet's stock price.

On one day in September, the price of the stock soared over 200% to almost $4.00 per share within minutes on no news. It finally settled around $2.00. After several days, a market participant enlightened everyone on the Yahoo message board that the reason for the stock's rally was that the Texas authorities had settled the case with Aces Wired and kept K&B Sales Incorporated's license intact. With this new information, the stock seemed a good deal even at $2.00 per share.

Before committing more money into FortuNet's position, I decided to confirm the new information about K&B Sales Incorporated. I called Bruce Miner, Licensing Services Manager from Texas Lottery Commission, a governmental body in charge of approving and revoking gaming licenses. He told me that the case is not settled. K&B Sales Incorporated's license is still under review. If the commission finds anything out of line, the license will be revoked. Now, it seems like the market is pricing FortuNet's stock as if K&B Sales Incorporated's license is safe. Even though I believe that FortuNet has a bright future, I am not willing to see my investment get cut in half because the market is misinformed. I think there is a good chance that K&B Sales Incorporated will lose its license. If this happens, the stock is likely to get punished severely, and I will be waiting to pick up some shares at incredible prices. As of now, I exited my position after making over 50%.

I think that investors can lose a lot of money by relying only on information that is contained in reports filed with the SEC. I passed on several companies this year that looked great on paper because after making several phone calls, I learned that the risks were too high. You never know what you might learn about a company after you speak with industry experts. You will not know until you call.

Disclosure: I, or persons whose accounts I manage, do not own shares of FortuNet at the time of this posting.

A Pittsburgh Diamond

Some of you may have listened to my radio interviews on The American Entrepreneur on September 12 and October 10. If you wish to and were not able to, you can listen to them by clicking on the links below.

http://recordings.talkshoe.com/TC-139/TS-268470.mp3

http://recordings.talkshoe.com/TC-139/TS-278506.mp3

I became acquainted with the host, Ron Morris, while researching a small company called Mastech (MHH). I called him to ask a question, and after speaking with him, he invited me to do an interview on his show.

Background of Mastech

Mastech is a provider of IT and brokerage operations staffing, and consulting services to Fortune 500 companies. In the most basic terms, the company pays an IT specialist $50,000 a year and contracts him or her for $250,000 to major companies who need IT services. With today's technological complexities, who doesn't need IT help?

Mastech has been in business for more than 20 years but was formerly part of a parent company called iGate. Credit Suisse advised iGate's management to split the two companies so that each one would have a higher value in the marketplace. In September 2008, they spun off Mastech from iGate at around $10 per share. Within several days, the stock went down to about $1 per share. Why did this happen? The shares of Mastech were given to shareholders of iGate upon the spin-off. iGate shareholders were not interested in Mastech because they had purchased iGate's shares for the purpose of owning iGate, not Mastech, so when they received shares of Mastech, it was easier for them to sell the stock because they lacked an understanding of its underlying business.

While researching the company, I learned that when Mastech was part of iGate, it had earnings per share of $0.98, $1.51, $1.92, $1.60, and $1.76 in Years 2008, 2007, 2006, 2005, and 2004, respectively. I did a double take when I saw this because it meant that the average earnings per share were $1.55 - higher than the stock price of $1 per share. Conservatively, using a P/E ratio of 10, the stock of Mastech should be trading at approximately $15 per share. In contrast, Mastech had a P/E ratio of less than 1. Unfortunately, the $1 per share price didn't last long because the management began buying the stock for their personal portfolios, bidding the price substantially higher.

When I discovered this company, the price was already at $3.50 per share, which is over 200% higher than what I would have paid had I purchased it at $1 per share. But, it was still an incredible deal. However, one event really bothered me - the CEO, Steve Shangold, resigned during the first quarter of 2009. He was with the company for over 15 years. I needed to find out why he left. In doing my research, I ran across a radio interview between Steve Shangold and Ron Morris of The American Entrepreneur, and it seemed like Ron and Steve knew each other. So I called Ron to ask if he knew why Steve left and was pleased to learn that his reasons for leaving had nothing to do with the company or its performance. In addition, I also learned that Ron was one of the founders of Mastech and had actually hired Steve Shangold himself.

Currently, the price of Mastech's stock is slightly below $5.00 per share. I was fortunate enough to purchase shares for myself and my clients for prices between $3.60 and $4.80 per share. I still think that the stock is a steal, but it will take some time for the market to realize the true potential of Mastech. Because Mastech is a staffing company, its business doesn't perform very well when the unemployment rate is high. Mastech provides temporary employment services, and when companies are laying employees off, they start with temporary employees. But, when the economy starts recovering, companies are likely to hire temporary employees before permanent ones. So, Mastech will be one of the first to benefit from the recovery.

Disclosure: I, or persons whose accounts I manage, own shares of Mastech at the time of this posting.