Taking Profits In FONAR (NASDAQ:FONR)

It’s been about 8 ½ months since I added to my FONAR Corporation (NASDAQ:FONR) position, expressed in an article with the snappy title “Adding To My Fonar Corporation Position”, and in that time the shares have returned about 14.4% against a gain of about .75% for the S&P 500. I thought I’d follow up with the company today to see if it makes sense to add to the position, hold, or take my profits and leave this party. I’ll make that determination by looking at the most recent financial information, and by looking at the stock as a thing distinct from the business.

Welcome to the “thesis statement” portion of the article. It’s at this point where I present to you the “gist” of my thinking so you can read this paragraph, understand my thinking, and then get out before being exposed to too much Doyle mojo. You’re welcome. Although the balance sheet is very strong, I’m of the view that Fonar’s financial history has been slow recently, and so the shares would need to be very cheap for me to decide to add more. The problem is that the shares are not cheap at the moment, and so for that reason I’ll be selling my stake. Although there’s a fear that the shares will continue to rise from current levels, I’d rather lose potential upside than risk losing capital. In my experience, the two most important lessons I’ve learned about investing involve avoiding loss, and limiting position sizes. If I added at current prices, I’d be violating those principles, and for that reason, I’m selling my stake. The shares may rise further from here, but I’m much more inclined to preserve capital than continue to risk it in this stock.

Financial Snapshot

The financial performance over the past while has been sclerotic in my view. Specifically, revenue has basically stalled from last year to this, though it’s still up about 6.6% when compared to the same period in 2019. Net income is down massively relative to both last year and the pre-pandemic period. This doesn’t fill me with great feelings, as I like to see growth in the companies in which I invest. On the bright side, interest expenses have dropped, largely as a result of the improvement in the capital structure as outlined below. Specifically, interest expenses have declined by about 17.7% compared to the same time last year, and by about ⅓ relative to the same period in 2019.

The reduction in interest expense relates to the strength of the capital structure. Specifically, as of the most recent financial statement date, the company had cash and short term equivalents on the books of $48.728 million, and total liabilities of $50.892 million. That means that the company has 95.75% of total liabilities in cash. So, although growth is sclerotic, I don’t foresee any kind of credit or solvency crisis here anytime soon. For that reason, I’d be very happy to buy more at the right price.

The Stock

My regulars know that I’ve talked myself out of some profitable trades with the words “at the right price.” I insist on only ever paying “the right price” because I’m of the view that it’s better to miss out on some gains than lose capital. My regulars also know that I consider the “business” and the “stock” to be quite different things. Every business buys a number of inputs and turns them into a final product or service. The stock, on the other hand, is an ownership stake in the business that gets traded around in a market that aggregates the crowd’s rapidly changing views about the future health of the business, future demand for MRI scanners, future margins, and so on. The stock also moves around because it gets taken along for the ride when the crowd changes its views about “the market” in general. A reasonable sounding, if counterfactual, argument can be made to suggest that my returns on Fonar were aided by a generally flat market since early June of last year. If the market dropped precipitously since then, it’d be hard to imagine this stock holding up well. Of course, it’s impossible to prove this point definitively, but it’s worth considering. In any case, the stock is affected by a host of variables that may be only peripherally related to the health of the business, and that can be frustrating.

This stock price volatility driven by all these factors is troublesome, but it’s a potential source of profit because these price movements have the potential to create a disconnect between market expectations and subsequent reality. In my experience, this is the only way to generate profits trading stocks: By determining the crowd’s expectations about a given company’s performance, spotting discrepancies between those assumptions and stock price, and placing a trade accordingly. I’ve also found it’s the case that investors do better/less badly when they buy shares that are relatively cheap, because cheap shares correlate with low expectations. Cheap shares are insulated from the buffeting that more expensive shares are hit by.

As my regulars know, I measure the relative cheapness of a stock in a few ways, ranging from the simple to the more complex. For example, I like to look at the ratio of price to some measure of economic value, like earnings, sales, free cash, and the like. I like to see a company trading at a discount to both the overall market, and to its own history. I became quite bullish on this stock last June when the price to free cash flow was floating around 9.3, and the market was paying $1.1 for $1 of sales. The shares are now between 7.5% and 16% more expensive per the following:

My regulars know that I think ratios can be instructive, but I also want to try to work out what the market is “thinking” about a given investment. If you read my stuff regularly, you know that the way I do this is by turning to the work of Professor Stephen Penman and his book “Accounting for Value” for this. In this book, Penman walks investors through how they can apply some pretty basic math to a standard finance formula in order to work out what the market is “thinking” about a given company’s future growth. This involves isolating the “g” (growth) variable in this formula. In case you find Penman’s writing a bit opaque, you might want to try “Expectations Investing” by Mauboussin and Rappaport. These two also have introduced the idea of using the stock price itself as a source of information, and we can infer what the market is currently “expecting” about the future. Applying this approach to Fonar at the moment suggests the market is assuming that this company will grow earnings at a rate of ~7.5% in perpetuity. I consider that to be a pretty optimistic forecast, especially given what’s going on with the company. Given the above, and given my strong desire to preserve capital, I’m going to take my winnings off the table at this point.