Navigating Book-Value Traps

We believe the job cuts, designed to save the company $160 million a year in expenses, and UTStarcom's early success in selling into new markets -- such as India, where UTStarcom's sales were up 37% sequentially in the second quarter -- will be enough to put a floor under the current valuation. And continued strength in the global handset market and UTStarcom's large presence in emerging markets like China and India should drive upside from here. A good quarter or two should put UTStarcom back into the double-digits.

We also like the prospects of market-maker and asset-management company Knight Capital (NITE). Through its trading business, Knight facilitates buy and sell orders for customers and its proprietary trading account that uses in-house money to make bets on the stock market.

Its asset-management business is dominated by its subsidiary, $3.4 billion hedge fund Deephaven, which allows Knight to capitalize on the lucrative fee structure that the hedge fund business affords. At just $8.43, shares trade right at their book value.

In the June quarter, Knight delivered total revenue of $111 million and lost 5 cents a share. This marked a 21% year-over-year decline in total revenue, due in large part to a $34 million decline in trading revenue. The slowdown in trading revenue has been a big red mark on the company's results over the last year as industry pricing for trading has come down and pressured sales and margins.

Although the trading business may not be near an imminent rebound, Knight has about $830 million in cash and investments, and virtually no debt. And since the beginning of the year, Knight has generated $138 million in cash from operating activities. So the stock is trading at less than its cash value, which we believe more than discounts the weakness in its trading business. But it is our view that the current price-to-book valuation completely ignores upside potential in the company's asset-management business, creating a good entry point for readers.

For example, consider the earnings potential from a strong equity market. Not only does Knight have more than $200 million of its own capital invested in Deephaven, it also gets a 50/50 cut of the 20% management take on the fund's profit. It also collects a management fee on the assets under management. Of course, a negative equity market would affect earnings to the downside, but the stock market has averaged a roughly 10% return for investors over the last 100 years, so betting against Knight in anticipation of a negative equity market wouldn't be prudent.

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