Selling positions is often harder than buying. It is all too easy to get married to certain positions and hold on for too long.

To improve my performance in this area, I’ve tried to avoid eking out the last few percentage points as an investment rises closer to my valuation range.

Undoubtedly, I had some flaws in my original analysis (investing is not an exact science), which means my range probably wasn’t perfect in the first place – sometimes it’s best to just move on to a new position.

This is Part 1 of the thought process behind two of my most recent sales.

Stryker Corp (SYK)

My blog currently focuses on microcaps so this giant ($25b market cap) medical company is a bit outside of the blog’s normal scope.

However, the recent financial crisis brought about an amazing opportunity to pick up wonderful businesses at historically low prices. SYK was one of those picks.

The company competes in the ultra-competitive medical device segment with companies like Zimmer and J&J. – think hip replacements, knee replacements, and other medical supplies.

The company is an amazingly stable performer, with sales rising from $5.4B in 2006 to $7.3B in 2010 without a single down year.

EBIT has improved on a similar uptrend, as operating margins increased up to the current 24%.

FCF has followed, growing from $892m in 2006 to $1.5B in 2010, for a current FCF yield of 6.01%

5 year ROE (18.59%), ROIC (17.65%), and CROIC (21.06%) are all outstanding, especially for a company sitting on $3.3B in net cash.

So Why the Sale?

When I purchased SYK in the summer of 2009, the stock was selling for under $40/shr, for an EV of approx $14B.

This translated into an EV/EBIT of 9x and EV/FCF of 10x – very low for a company that showed no signs of slowing down its growth in sales, profits, or cash flow.

The stock is up over 60% since that time and currently trades at an EV/EBIT of ~12.5x and EV/FCF of 14.4x (or 14.4x and 16.5x using 5-year average EBIT & FCF figures respectively).

My conservative DCF valuation provides a valuation range of $65-$70 per share.

While there is still a good chance that the stock is undervalued, the margin of safety has shrunk considerably.

Short-term, the new health care legislation will affect the profitability of medical devices makers, with a 2.3% excise tax due in the next 2-3 years.

Conclusions

Long-term, I think the stock will outperform (the baby boomers are a driving force: older baby boomers = higher demand for joint replacements!) but believe there are better, and significantly more undervalued areas, to place my money.

So I sold.

When I started out investing, I tried to keep a significant portion of my portfolio in these large stable names with a strong competitive moat (many would describe this as the new Buffett philosophy).

Today, I’m more comfortable hustling to find the microcap stocks that are significantly undervalued (the old Buffett philosophy).

Since I’m willing to put in the work, I sometimes make the decision to sell a great stock for the chance to earn even greater returns in another investment idea.

At least for now, I’m sticking with the old.

Part II – Stay tuned!

Disclosure

No positions

P.S. –  Rational Walk has a great summary of closing his position in Noble Energy (NE). I went through a very similar experience with NE – check out his summary for a great write-up.

Span-America Holding (SPAN) has been part of the ValueUncovered portfolio for over a year, my longest holding.

Despite lots of volatility throughout the year (touching almost $20/shr), the stock’s is only slightly up, primarily helped by consistent dividend payouts (including a large special dividend earlier this year).

I am catching up on past SEC filings, and SPAN’s 2010 report came out a few weeks ago.

Financial Review

Total revenues in 2010 declined 6% to $52.4m compared to the prior fiscal year, with declines reported in both operating segments.

SPAN’s therapeutic support surfaces (the largest part of the medical product segment at 62% of sales), are considered a capital expenditure. Although the outlook has improved, the product line continues to face weakness in the company’s main markets.

The acute care market continues to be the bright spot, with several new product lines experiencing double digit YoY growth. Overall, medical sales were down 6% to $35.6m compared to $37.8m in 2009.

In the custom products segment, sales decreased 7% to $16.8m compared to $18.1m last year.

Last year’s numbers were helped by a one-time test program which was not repeated in 2010.

This is the 3rd year in a row of annual revenue decreases.

More worrisome, the company has slowly shifted its product mix towards consumer products and away from therapeutic support surfaces, which command much higher margins – support surfaces are down from 54% of total sales in 2007 to 43% in this latest fiscal year.

Despite the lower top-line, the company remains solidly profitable and continues to throw off generous amounts of free cash flow.

Net income was $4.5m – down slightly from the year before – but the company still managed to produce $5.3m in FCF. Using these figures and the current market cap of 41m equals a solid FCF yield of 13%.

The company paid out $3.9m in dividends, or 86% of net income, a solid way to return cash to shareholders.

The balance sheet remains strong, with a current ratio of 3.39, no debt, and cash and marketable securities of $4.4m

Industry Outlook

While the company continues to be solidly profitable, it is facing headwinds on a number of different fronts:

Increased Foreign Competition – There is no doubt that the company will face increased pressure from foreign competitors in the future, especially China.

This shift will put even greater pressure on margins, and slowly erode the high returns on capital that the company has experienced. Some product segments, such as consumer bedding, have little differentiation aside from price:

“During the last two years, we have experienced increased competition in our medical and custom products segments from low-cost foreign imports. In the medical segment, the number of low-cost, imported mattress products has increased in the last two years, but it has not yet had a significant impact on our medical business. We believe that we have potentially greater exposure to low-cost imports in our consumer bedding product lines because those products have more commodity-like characteristics than our medical products.”

Uncertainty around Medicare – As a medical company, a number of SPAN’s products are eligible for reimbursement from Medicare. There has been a ton of proposed regulation and controversy over the recent healthcare laws.

While the fallout is still undetermined, it will create additional fear and hesitation on the part of consumers when purchasing new medical products, potentially cutting into SPAN’s sales.

Continued Economic Weakness – While the stock market has enjoyed a record run, the economy and job market are definitely not back to full speed. SPAN has benefited tremendously over the past five years by an increase in its therapeutic support surfaces – in 2010, they made up 42% of total sales.

The sale of these products significantly boosted SPAN’s FCF rate, up to the current levels of $5-$6m per year. It is unclear whether the company can continue aggressive growth in this area.

Conclusion

I recently came across another post regarding the author’s equity investing philosophy. In addition to laying out a solid set of ground rules, it also included this quote from Warren Buffett’s 1977 annual letter:

“One of the lessons your management has learned – and, unfortunately, sometimes re-learned – is the importance of being in businesses where tailwinds prevail rather than headwinds.”

I think that this valuable lesson applies to SPAN.

While the balance sheet remains strong and the company continues to throw off lots of cash, the overall trend is headed in the wrong direction.

While there still appears to be a gap between the stock’s intrinsic value and the current market price, I’m afraid that the value may fall to meet the price instead of the other way around.

The stock is releasing earnings in the next few weeks. As a general rule, I try to avoid holding stocks through an earnings release unless I plan to hold for long-term.

In addition, I’ve been growingly increasingly nervous of the broader market and therefore actively trimming my positions in order to raise more cash.

With that in mind, I’m closing out my position in SPAN at today’s closing price of $15.55, a gain of 10.06% vs 16.74% for the S&P.

Disclosure

No positions.

Check out my last post on SPAN’s 2nd Quarter Earnings.

After announcing a sizable special dividend last quarter (and an overall bullish report), Span-America Systems, Inc (SPAN) followed by reporting fiscal 3rd quarter results last week.

After an initial glance at the financials, it was a tough quarter and the price took a corresponding dive. Despite the quarterly volatility, the stock remains significantly undervalued.

Q3 Results

Quarterly revenue and earnings dropped 8% and 17% respectively, as the company reported lower sales volume across each business segment.

The majority of the decline occurred in the consumer sales division (down 19% and part of the custom product segment), due to a market test program last year that was halted for 2010.

Without the effects of the test program, the division would have actually reported a sales increase.

Quarterly Cost Fluctuations

Although the company has done a great job of streamlining its manufacturing process to control and trim costs, quarterly earnings can still be affected by unavoidable changes in administrative expenses.

Example:

As of April 3, SPAN owned a $1.9m life insurance policy for its founder and former chairman. This policy is invested in mutual funds and fixed income contracts, and therefore exposed to fluctuations in equity markets and interest rates.

According to the company,

“The cash value decreased by $71,000 in the third quarter this year compared with a $68,000 increase in the third quarter last year. The $139,000 swing in cash value was the primary factor in administrative expenses rising 16% compared with the prior year’s third quarter.

Excluding the effect of the changes in cash value for both quarters, administrative expenses would have declined by 2% in the third quarter”

As with all stock investments, these short-term fluctuations can impact the stock price on a given day or quarter, but longer-term (where value investors focus), the business fundamentals and intrinsic value should win out.

YTD Financials

Despite the rough quarter, net income for the year was up 8% to $3.3m as the company continues to focus on controlling costs.

Going into the fourth quarter (usually the company’s strongest) SPAN is still on-track to produce its best FCF and earnings year in history.

Capital Goods vs. Consumables

The company’s product mix includes a mixture of capital goods (such as therapeutic support surfaces) and consumables.

As in most recessions, the recent economic downturn has forced many businesses to delay investments in capital equipment.

These delays have affected SPAN’s quarterly numbers, but longer-term, this scenario should lead to pent-up demand as the economy turns around.

“We believe this is due to economic pressures facing our customers over the short-term and should result in higher future demand as customers eventually replace and upgrade therapeutic support surfaces in their facilities.”

Investing in the Future

The company continues to invest in expanding its product line, with several new products rolling out in the fourth quarter.

I’m particularly interested in SPAN’s new high-end therapeutic support surface for the acute care industry, as this market reported significant growth across a number of product lines in the third quarter.

Outlook

Management has managed to control costs nicely, and seems to have positioned the company for a strong end to the year.

According to Jim Ferguson, SPAN’s CEO:

“We expect to report improved operating results in the fourth quarter compared with the third quarter. Our fourth quarter usually outperforms the first three quarters based on seasonal sales trends. We believe our consumer sales will grow due to a new program with a large retailer, and our industrial business should benefit from the expanding manufacturing activity in our region.

Q4 should be a big quarter for SPAN.  Mid to long-term investors should be rewarded as SPAN’s stock price rises to meet its intrinsic value.

Disclosure

Long SPAN