A ‘deep value’ stock pick from my students

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Once again, with the 2019-20 school year at its end (and despite the challenges of the past few months), my Ivey value investing students submitted their final stock picks and analysis, which are a very important element of my value investing classes. It was much easier for them to find truly undervalued stocks this year, given the market’s selloff since February.

As has always been the case for young students/investors, it is much easier to find “deep value” stocks (those Ben Graham would have liked, and which have been largely shunned by investors over the past several years), than finding “quality” stocks (those that would appeal to Warren Buffett). A Graham-type stock that students worked on that got my attention, Fonar Corp. (FONR-Nasdaq), is profiled below. In my next column, I’ll take a look at a “quality” stock pick.

Melville, N.Y.-based Fonar Corp. designs, manufactures and sells magnetic resonance imaging, or MRI, scanners. The stock was identified as a possibly undervalued stock with a price-to-earnings (P/E) ratio of 4.5 times, a price-to-book (P/B) of 0.68 and a market cap of US$85.4-million at the end of March, the time of the student report.

Its flagship and patented product, the Fonar Upright MRI (uMRI) offers an advantage over traditional MRIs – it allows physicians to better visualize patients’ injuries because they can stand upright and in a weight-bearing position. It also reduces claustrophobia in patients.

Fonar has installed more than 300 MRIs worldwide. The company is well diversified and has a multiple stream of revenues from a broad customer base, each locked into long-term contracts.

While its annual sales volume and margins from uMRI are very low, Fonar makes most of its revenues (89.5 per cent in 2019) through high margin management services for diagnostic labs, providing a recurrent and stable source of income. The company’s focus is targeting its services to physicians with centres directly, rather than selling to hospitals and competing with General Electric Co. and other big MRI manufacturers. Moreover, less than 5 per cent of Fonar’s revenue is Medicare-related, compared with the U.S. industry average of 20 per cent. Hence it is less exposed to the risk of reduced reimbursement rates.

Students felt the market may be discounting Fonar for several reasons. First, because of it has had single-digit growth over the past five years. Second, because investors are unaware that Fonar makes most of its revenue not from product sales (as do GE and Siemens AG), but instead through long-term management contracts. Third, management is not shareholder-focused – they have had no dividend or buyback policy to provide shareholders with returns despite sitting on loads of cash over the past three or four years. Finally, third-party shareholders have a non-controlling interest (NCI) of about 30 per cent in the entity that houses Fonar’s management services business. Investors may have difficulty determining the true value of the NCI shareholder stake.

Fonar’s total-debt-to-capital ratio has decreased substantially over the past 10 years, currently standing at about 24 per cent, which is well below the debt level companies should have in the same business risk group as Fonar. This exposes the company to low financial risk.

Timothy Damadian, Fonar’s current chief executive, is the son of previous CEO and majority shareholder Raymond Damadian. Timothy succeeded his father in 2016. The company’s CEO is supported by its board of directors, who are mostly internal members and part of Fonar’s founding committee. One director, however, stands out – Roland Lehman, who is the managing director of investment banking at Bruderman Brothers. From the moment he joined Fonar in 2012, the company’s direction has changed for the better. It refocused its strategy to higher margin service centres and cut costs, leading to a dramatic increase in operating margins from about 11 per cent to 22.5 per cent and a doubling of the company’s return on investing capital.

Fonar has an adjusted return on invested capital of 10.1 per cent and a cost of capital of about 5 per cent. While students felt that the company is currently enjoying some barriers to entry (such as demand advantages, owing to high switching and search costs, as well as cost advantage because of its long pipeline of patents and technological know-how), they were not sure about how sustainable the company’s competitive advantage was, citing its small size and low market share in the manufacturing segment.

Fonar’s intrinsic value was estimated to be US$31.83 and, accounting for a 33-per-cent margin of safety, its entry price to be US$21.20, far exceeding its stock price of US$12.35 at the time of student valuation (March 24), making the stock a “buy” at the time. Even at the current price of US$21.12 the stock is still a buy.

Graham stocks are normally much easier to be found undervalued than Buffett-type stocks, and from the students’ analysis, Fonar fit the bill. ​

George Athanassakos is a professor of finance and holds the Ben Graham Chair in Value Investing at Ivey Business School, Western University.

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