Tuesday, September 2, 2014

Portfolio strategies: The definitive guide to net-nets

This is hopefully the first post in a small series detailing my thoughts on a few different types of value investing strategies.  If you've been reading this blog for a while this post might not contain much new, but it's a summation of my thoughts on a subject in one place.

Net-net: A company whose market cap is less than the value of their current assets minus all of their liabilities.  Formula: (Current Assets - All Liabilities) > Market Capitalization

When a company's NCAV (the aforementioned current assets minus all liabilities) is more than a company's market value it's theoretically possible that the company could be liquidated and result in a gain for shareholders.  For an asset to be classified as current a company must have the intent to sell or use the asset in the period of a year or less.

The market is driven by emotions, fear, greed, and is rarely rational.  On the whole it gets things right over time, but in the short term anything can happen.  Some try to use this as an explanation as to why a company can sell below NCAV for any period of time.  The market is just irrational and net-nets are a sort of market fluke.

I don't believe much in life is a fluke.  Before I started this blog and met a large number of investors I would have believed in the net-net fluke theory.  But after meeting a lot of investors I've come to the conclusion that not many people view stocks the same way.  For most investors the balance sheet is a financial statement that holds almost no value.  If a company isn't generating satisfying earnings, cash flow, free cash flow or growth it doesn't matter what the balance sheet says, the company doesn't hold much value.

Net-nets exist because what the market values is different from what a subset of value investors find attractive. In my latest issue of the Oddball Stocks newsletter I discussed the idea that all value stocks have some sort of flaw.  If a stock is perfect and it's cheap then something is wrong, look harder.  A flaw might be something that many market participants find unattractive for a variety of reasons and overweight when evaluating the stock.

An investor should always try to identify why a company is selling for less than NCAV.  Once this has been identified the investor should then determine of the discount for the given flaw is appropriate.  Not all net-nets are good investments, some have gone to zero for a variety of good reasons.

Are they riskier?

For many investors net-nets are viewed as riskier investments due to their low price.  Think about this for a minute, it's a self-reinforcing notion.  Someone looks at a net-net and notices how cheap it is, and because it is cheap avoids it.  Without liquidity the stock becomes cheaper, all because it's already cheap in the first place.  Once a stock becomes undervalued it can become a self-fulfilling valuation trap.  Professional investors dump the stock for liquidity reasons, individuals dump it for lack of earnings or lack of growth, or a low price.  Companies caught in the valuation trap can languish for years before they either post numbers investors like, or become so cheap they attract interest from asset based investors.

If a net-net's assets aren't extremely specialized and the company isn't burning through their assets  then a net-net should be less risky than other stocks.  David Merkel of the Aleph Blog wrote an analogy years ago discussing two types of stability, table stability and bicycle stability.  A bike is stable as long as it's moving forward, once stopped it's extremely unstable.  A table is very stable at rest, but is hard to move.

A lot of companies have bicycle stability, as long as everything is moving the company is stable.  But if sales were to drastically shrink, or the company lose a strategic supplier operations could become unstable quickly.  Many Net-nets exhibit the type of stability found in a table.  The company might have lackluster operations, but the company has a balance sheet that can support the lackluster operations for decades without change.  As David says "..only a severe event will upend a large table."

It's important to invest in net-nets that have a table stability rather than bicycle stability.  Many net-nets are smaller and are prone to sudden business upheavals.

Fraud risk

A newer risk related to net-nets is that investors worry they're fraudulent companies.  This risk is related to the number of Chinese reverse merger companies that had both fantastic numbers, and incredibly low valuations that turned out to be fraudulent.  Outside of the Chinese companies I don't believe net-nets hold any more risk for fraud compared to other areas of the market.

In general my thoughts on fraud are this; if something looks too good to be true it probably is.  Always investigate further, and if you spot serious red flags it's not worth the risk, move on.

Profits or no profits?

One debate between those who invest and research net-nets is whether to invest in ones that are losing money, or only invest in profitable net-nets.  The research suggests that unprofitable net-nets might result in higher investment returns.  The theory is that at a money losing company management has been pushed to their limit and must either take drastic action to save the company or find an alternate outcome through a merger or sale.

It makes sense that unprofitable companies could ultimate make better investments.  But sometimes what the research says needs to be reconciled with investor psychology and emotions.  Most net-nets are average or below average companies to begin with.  Purchasing an unprofitable net-net tests even the strongest investor stomach.  An unprofitable net-net is a potentially bad company that is losing money with no end in sight.  This is a recipe for emotional disaster.

I personally prefer to purchase profitable net-nets even though I know I am sabotaging my potential returns.  The reason for this is I know emotionally I am able to hold a portfolio of net-nets through thick and thin if I know my holdings aren't destroying asset value and will be operating in three or five years.  I know myself and I know that holding a company constantly on the cusp of disaster would test my ability to hold, and I'd probably end up selling at the first opportunity I had to get out of the situation.  I'd rather implement a strategy with slightly lower returns that I know I can stick to rather than shoot for the moon with a strategy that I'm likely to abandon.

Overweight real estate?

A signature feature of many net-nets, and value companies in general are significant real estate holdings.  At times these real estate holdings can be extremely valuable, and sometimes a source of hidden value.  I have owned many companies where management sold an undervalued real estate holding that resulted in a bonanza for shareholders.

Land can be valuable, if you own the only empty plot in Midtown Manhattan you're sitting on a fortune.  But those cases are rare.  More likely for a net-net is a company owns a plot of land in Altoona, PA or Eaton, OH where land is in ample supply.  For readers who live on the coasts and and are under the impression that the US is overpopulated I'd encourage you to drive across the country.  The United States is a vastly empty place with a few tiny hubs of human activity.  Anyone who's driven across South Dakota, Iowa, Ohio, or Montana would agree.  There is so much empty land it's almost incredible.  In many small towns there is no premium to land.  To build a new facility outside of the city limits would cost as much as getting an existing facility up to code.

Unless a company has a unique real estate holding I don't give a company's real estate much weight.  At times some real estate can be resold for book value, but that's only in certain circumstances.

The curse of real estate is that to sell incurs a high transaction cost and takes a long time.  It's hard to unload a lot of real estate quickly at market rates.  If a seller tries to liquidate their real estate holdings quickly it's likely they'll only realize fire sale values.

Inventory, inventory, inventory

The biggest concern I hear investors voicing about net-nets is that many of them have high levels of inventory and that makes investors uncomfortable.  The problem with inventory is investors think about how quickly it could be liquidated, which I believe is the wrong attitude.

If a company is operating and isn't writing down their inventory it's a sign that the inventory has some value in the market place.  As long as the net-net continues to operate, and isn't constantly writing down inventory it should be valued at something reasonably close to fair value.  The caveat to this is if the company is losing money.  If a company is losing money this means they are unable to sell their goods for more than their cost.  A company that's losing money might merit a discount to the value of their inventory.  Or a discount might be merited if the company has stated that some of their inventory is collecting dust in the back of a warehouse somewhere.

Of all the net-nets that trade in the market only a few will ever progress to a liquidation.  Liquidations are extremely rare.  They're costly, and take a long time.  When Graham first discussed net-nets in Security Analysis he spends a lot of time discussing how a net-net could potentially be liquidated for more than their market value.  He goes through a lengthly analysis of how certain accounts should be discounted to take into account liquidation values.  Many investors seem to get hung up on the prospect of a company liquidating and what accounts receivable, inventory or the real estate should theoretically be marked down to in a liquidation.  Almost no net-nets ever liquidate, and I think fixating on a theoretically liquidation is wasted mental energy.  If a company declares a liquidation it's time to focus on their liquidation value, but until then it's wasted energy.  Graham's point in my view was to emphasize the absurdity of the value these companies were trading with.

Are they bad companies?

Many investors are looking for companies that return 15% a year no matter the market and will make shareholders rich no matter the price purchased at.  These are not net-nets.  It's not uncommon to find a net-net earning a few percent on equity.  Some net-net require a magnifying glass to see their return on equity, it's there, but it's just that small.

A lot of net-nets are under utilizing both their assets and intellectual capital.  Under a different management team, or under different market conditions these companies can earn significant returns.  The reason many of these companies are selling so cheaply is because the management team, or market conditions are not ideal.  Market conditions can always change, and a company that has been left for dead can find itself in an ideal environment and losses can turn to gains.

Keep in mind when you're evaluating net-nets that you're not trying to find a great business at an average price that you can buy and hold, but rather you're investing in an average company at a bargain price.

Think of a net-net investor as someone who's buying reprint paintings at TJ Maxx for $20 and reselling them online for $40.  The Buffett buy and hold value investor is looking for a Van Gogh that they can buy at any price and resell at some point in the future for more.  They know because they own a rare Van Gogh that the painting will always be worth more in the future compared to today's price.  The person buying paintings at TJ Maxx makes their money at the purchase.

Their role in a portfolio?

Net-nets should play a strong supporting role in any value investor portfolio.  A supporting role means that a portfolio isn't concentrated in them entirely, but they're also not so small of a position that they don't have a meaningful impact on the portfolio's returns.

The reason investors shouldn't concentrate in net-nets is because as the market rises higher there are fewer and fewer opportunities to invest in.  At multiple points in the past there have been less than a half dozen net-nets in the US.  When there are few net-nets the quality plummets, it wouldn't be wise to have a portfolio concentrated in three money losing companies selling obsolete products.

A net-net position should be diversified as well.  There's no sense trying to pick the 'best' net-net.  No one knows which companies will strike gold, and which ones will strike out.  It's better to spread a portfolio's best across a variety of net-nets.  Even though these companies trade below NCAV that's no guarantee against any of them eventually going bust, they have been known to do that at times.

Can a bank or financial company be a net-net?

For a reason unknown to myself financial companies are usually lumped into a "too hard pile" for 90% of the market.  Investors would rather ignore financials over spending a little time learning the specialized industry.  Because of this financials are always excluded from lists of net-nets and deep value stocks.

It's possible to have a bank or a financial services company trading below liquidation value.  There are specific liquidation value calculations for banks and insurance companies that differ from the standard net-net formula.  While the formula is different the idea is the same.  At a certain point investing in a company that's trading for less than liquidation value makes sense because the worst case scenario is better than the current one.

Why don't more investors invest in them?

I think most investors avoid net-nets because they're too simple and too boring.  Juan Matienzo discusses this during his interview with the Manual of Ideas.  Too many investors view net-nets as simplistic and investments for value investing beginners.  A lot of investors want to be like Buffett finding great companies with moats and durable advantages.  In their quest to own these great companies they avoid simple areas of the market that offer great returns.

My portfolio isn't build to impress anyone.  I don't find my value in the stocks I own.  My portfolio serves one purpose, to generate returns on my capital.  If I do that via net-nets or via great companies with moats I don't care.  I want to invest in whatever will give me the greatest safe returns.  Too many investors are trying to impress their peers with fancy shareholder letters, or by discussing their investments at cocktail parties.  Your friends might be impressed that you hold all the value stocks du jour, but they'll be more impressed by your returns if you hold net-nets.

A second reason many investors don't invest in net-nets is because a lot of them are too small.  Many of these stocks are considered uninvestable by Wall Street.  It's hard for a fund managing $500m to build $50m worth of positions in net-net stocks, especially if the market is higher.  If a fund were to look globally it's possible they'd find enough opportunities, but managing the large number of investments could time consuming.  Only at the market bottom does one find enough large net-nets that a large fund could build a position.

When to sell

The time to sell a net-net is when the stock pops near fair value.  These are not buy and hold investments, they are buy and sell quick investments.  Sell when you are given the first opportunity, a second opportunity might not exist.

Thursday, August 28, 2014

Sunnyside bank, severely undervalued on the cusp of a turnaround

I have a portion of my portfolio set aside specifically for cheap bank stocks.  In the terms of some value investors my dedicated cheap bank portfolio might be considered a 'basket'.  That is I buy tiny stakes in many banks if they meet certain criteria.  I purchase larger positions in banks outside of this basket, but inside of it most positions are roughly the same size, about a quarter of a percent.  No single bank is going to make or break the portfolio, but as a group I have a large exposure to undervalued banks.  Sunnyside Bancorp (SNNY) is one of these banks.

Sunnyside Federal is a savings and loan that was established in 1930.  The bank is located in Westchester County about 25 miles north of New York City.  The bank's headquarters and only branch is located on Main Street of the quaint Irvington a few blocks from the Hudson River.  They're also located near a number of country clubs, which should tell you something about the area they're located in.  Westchester is the second wealthiest county in the State of New York with median home values of $533k and median household income of $81k.

The bank started as a mutual meaning the depositors owned the bank.  The bank felt constrained by their mutual structure and in 2013 conducted an IPO.  The IPO raised $7.9m with the sale of 793,500 shares at $10 per share.  Depositors are given the first opportunity to purchase shares and with the completion of the IPO the shares now trade on the secondary market.  The IPO proceeds plus their capital prior to the IPO gives them an equity value of ~$12m or $15.12 a share.  Given that shares most recently traded at $9.45 this is an attractive stock at 63% of book value.

The bank's conversion from a mutual to a stock company was in an effort to pursue growth.  The bank is as safe as they come with a 35% Tier 1 capital ratio and 13.7% Core capital ratio.  They have a very small amount of non-performing assets, and OREO.  Some small banks trade for less than book value because they have an asset quality problem, Sunnyside does not.  Sunnyside has a growth problem.

As I said earlier the bank has a single branch.  The common wisdom is that one branch banks are at a significant disadvantage because they can't spread costs between branches.  In some cases this is true, but it's not a universal truth.  Consider the Bank of Utica (BKUT) that has a single branch and close to $1b in assets and $770m in deposits.  There are other one branch banks that have been able to grow to a large size as well.

The issue of scale in banking isn't related to the number of branches, rather it's related to asset size.  A paper by the FDIC found that most economies of scale were reached when a bank hit $100m in assets, and became insignificant after $500m in assets.

The size of assets is critical for Sunnyside.  With their current $40m in loans and $90m in assets they aren't making enough to keep the lights on.  The bank has been reporting small quarterly losses for a while now.


The bank's management plans to put their excess capital to work by expanding their mortgage origination and SBA lending.  Both mortgage origination and SBA lending are similar in that they're both relying on government guarantees and backing.  With SBA lending a bank makes a loan to a business borrower where the government guarantees a portion of the loan reducing the risk for the bank.  Mortgage origination is similar, a bank makes a loan to a borrower and then either sells the loan to a larger bank, or back to the government and keeps the servicing rights.  The bank makes money servicing the loan plus earns an origination fee without tying up their balance sheet.  This is a good strategy for a bank whose balance sheet doesn't have a lot of firepower, like Sunnyside.

Here is the bank's current lending mix:

The bank currently does almost no commercial or business lending other than residential business lending.  This gives rise to the question of whether the bank has enough experience with business borrowers to tap into loan demand.  If the bank can't generate SBA loans like they want they will need to find other routes for growth.

Fortunately the bank doesn't need to do much to become profitable.  Their net interest margin, the measure of interest taken in minus interest paid out is below the industry average.  Raising their NIM from the current 2.8% to the industry average of 3.37% would bring in an additional $521k in net interest income, and after taxes would be more than enough to propel the bank to sustained profitability.

I like investing in companies where small improvements in the company's operations can result in large financial improvements.  It might seem outlandish for a tiny bank to raise their NIM by half a percent, but given all the bank's excess capital I don't think it's unreasonable.

If the bank is able to achieve profitability again there are a number of other catalysts for shareholder value.  As a newly demutualized bank they are prohibited from buying back shares or paying a dividend until certain anniversaries are met.  The company can buy back shares on the first anniversary from their IPO, pay a dividend on the second, and sell themselves after the third.  One branch banks are great tuck-in acquisitions.  The top management at Sunnyside makes a combined $514k in compensation, which given the area they're located in is reasonable.  Yet if the bank were to sell and top management redundancies eliminated the acquiring bank would realize those savings in their earnings.  This money losing bank is suddenly profitable without the top level salaries.  If an acquirer were able to both remove management and raise the NIM to industry averages it could result in an additional $700k in earnings, or about $1 per share.  So while investors see a tiny bank that's losing money a potential acquirer sees $1 per share in earnings or more depending on other cost savings.

As I was writing this post I read an article about the new football coach where I went to high school.  He discussed his plan to turn the team around.  He said the team had problems executing consistently and doing the small things right.  If they could consistently get the small things right he believes they'll see success.  That statement is appropriate for Sunnyside as well.  It might seem crazy to invest in a money losing bank. At 63% of book value if management can consistently execute on the small things, and loan out some of their excess cash I have no doubt shareholders will be rewarded.

Disclosure: Long SNNY

Sunday, August 24, 2014

Schuff, can investors defeat a billionaire?

Americans love money.  A horrible person with no money is a horrible person.  A horrible person with a lot of money isn't all that bad.  As a country we have a love affair with money, it's practically indoctrinated that we should desire more, want more and strive for more.  There is common phrase that goes as follows "he who has the gold makes the rules."  In the United States whoever has the money does make the rules.

Yet for the love of money, riches and wealth we also love the underdog and David and Goliath stories.  The crowd cheers when the pauper defeats the rich man, we root for the underdog.  The story of Schuff (SHFK) is a David and Goliath type story, a billionaire and his holding company trying to squeeze out minority shareholders.

Two years ago I wrote about Schuff International, a steel fabrication business.  At the time the company's management had mortgaged the business to buy back half of their outstanding shares.  The company wasn't earning much at the time, but they're a cyclical and had considerable potential earning power.  Schuff had earned as much as $14.44 per share in 2007.  Since my post the company's operations and earnings have recovered.

In the latest fiscal year Schuff earned $2.94 a share and reported a backlog of $426m, an all time high.  The company is poised to earn $5-6 per share in 2014 given their backlog and run-rate.

The Schuff family had run the company for years.  The Schuffs sold their shares to HC2 Holdings (HCHC) at around $31 a share.  With the completion of this transaction HC2 Holdings became the owner of over 60% of the company.

HC2 is controlled by Philip Falcone, a storied billionaire.  Falcone made $1.7b shorting subprime before the crash in 2008.  He then invested in Lightsquared, a failed wireless venture.  In the meantime Falcone played fast and loose with his investors money and was fined and admitted wrong doing to the SEC in a 2013 settlement.

In the SEC settlement Falcone admitted to using investor money to pay his own personal taxes, secretly favored some customers over others, and engaged in illegal market manipulation forcing a short squeeze on a Canadian bond issue.  The SEC settlement is fascinating on a number of levels.  The first is that in most cases the SEC simply settles without an investor admitting wrongdoing.  In Falcone's case he admitted wrongdoing, paid a fine and was banned from the securities industry for five years.

I'm not privy to the terms of the ban, but I guess in the SEC's eyes investing via a hedge fund is different from investing via a private investment vehicle (HC2 Holdings).

HC2 Holdings recently commenced a tender offer to purchase the rest of Schuff's outstanding shares at $31.50.  Currently HC2 Holdings owns 70% of Schuff's shares and for the tender to be successful  either 15% of non HC2 shareholders need to tender, or the company needs to own at least 90% of Schuff.

My question is why would shareholders tender their shares?  If shareholders decide to tender they're giving up shares in a company that's trading at maybe 5-6x earnings, a rarity in today's market.  If they don't tender, and many others decide to do the same there's a chance that HC2 might raise their bid.

Why should investors let Falcone, someone who admitted to being a market manipulator to the SECtry to acquire shares from minority shareholders on the cheap?  Falcone has wealth, but what he doesn't have is the other 30% of Schuff shares, and it appears it will be hard to get those shares.

I know there are multiple investors out there trying to tally up share counts for tender abstainers.  One person reported 8% abstaining, another 6% abstaining.  These are larger fund holders, none of these are individuals like many readers on this blog.  It's possible that there is another 5-10% spread across many smaller holders.  I wouldn't be surprised if 15% of Schuff's shareholders read this blog, or will read this post.

I would encourage all of Schuff shareholders refuse to tender their shares to HC2 Holdings with the hope that HC2 would offer a fair amount for shares.  I would rather hold onto my shares than tender them to an unsavory character like Philip Falcone.  Falcone might own 70% of Schuff, but there is 30% that he wants that he still can't get.

If you're a Schuff shareholder hold onto your shares and refuse to tender them.  If you aren't a shareholder but are intrigued by this David and Goliath story please share this with media contacts to gain as much exposure as possible.  This story is perfect for the media, a billionaire with a history with the SEC tries to steamroll minority shareholders into a bad deal.

If you doubt the power of this blog it's worth reminding readers that digital words on this site were the catalyst for a closely held company to open up and hold an annual meeting and pay a dividend.  Let's hope there's a similarly successful outcome with Schuff.

If you are a shareholder and wish to abstain from tendering your shares and want one of the managers I mentioned to include your shares in the tally please email me.

Disclosure: Long Schuff

Wednesday, August 20, 2014

Prodware and its 47% BV growth rate selling for 6.5x earnings and 70% of book, why?

I received a text recently from Dave Waters saying he was convinced France is the best place in the developed world for a value investor to hunt for bargains.  Armed with a screener I went to work to proving his point.  I ran a number of screens on France looking for companies trading below book value with high returns on equity, and what I've found has been interested.  Interesting enough that I'd wholeheartedly agree with his statement.  If you feel the well is dry in terms of investment ideas I'd recommend looking at France.

One French company that appeared in my screening result was Prodware (ALPRO.France) an IT integrator that was founded in 1989 and is listed in Paris.  The company has three main business segments, business solutions, network and security solutions and integration solutions.  Their business solutions division creates custom software solutions as well as proprietary solutions that they resell to clients.  Network and integration solutions are implementation experts, they build networks or integrated disparate systems.

Prodware is a fairly large company with 1,500 employees spread across Europe, Africa and the Middle East.  They're the leading Microsoft partner in EMEA with over 20,000 clients.  The company has no operations in the US, but that's not an issue as the US IT consulting market is already saturated.

Technical consulting is a very straight-forward business model.  A consulting company places a consultant at a client and bills them out at an hourly rate.  The consulting company takes a large cut and pays the remainder to the consultant.  As long as a consultant is billing a client both the employee and consulting company are earning money.  If a client cancels a contract often a consulting company will let the employee go saving the ongoing expense.

The company screened well, it is trading for about 70% of book value and 6.5x earnings.  They earned about 9% on their equity in 2013.  They've had returns as high as 30% in 2004, and recently 21% in 2011.  On the basis of the company's initial stats alone this had the making of a great investment.  It's not often that 'good' companies trade for such a discount.

If the company's current stats weren't impressive enough then one could look at their growth.  The company had €2m in equity in 2004, and in the last ten years has grown it to €95.5m for a annual growth rate of 47% a year.  They've grown revenue from €22m in 2005 to €176m in 2013, an eight fold increase in the past nine years.  The company's net income also followed a similar path, from almost nothing in 2005 to €7.7m in 2013.

A picture of the company's revenue is shown below:

Everything about this company seemed great when I first start to research them, their valuation, their growth, the modest executive income.  Prodware seemed like a slam dunk investment.  Unfortunately the veneer fell off quickly.

Prodware the company itself has a great growth story, unfortunately for investors it's a different situation. The company has financed itself in the past with convertible bonds and share issuance.  At the end of 2013 they had €7m in convertible bonds outstanding, which converted would result in 798k shares being issued.  This is on top of the 2m shares issued since 2011.  If one looks at their equity statement it becomes clear that issuing shares isn't a one-off event, but rather something that happens yearly.

Here's a picture of the share issuance, and potential dilution from their bonds since 2012:


Many growth companies continually re-invest for more growth, Prodware is no different.  The company earned €7.7m in 2013 but generated €22m in operating cash flow.  They then spent €21m on software and development costs.  This should result in the company having free cash flow of €1m, except that they had debt coming due which was paid off with equity issuance.  This seems to be common from what I've seen.  The company generates considerable cash, but then consumes all of the cash generated for re-investment.  They're left in a situation where they can't pay their financing costs and have been issuing shares.

Investors are continually being diluted by management's financing decisions.  Cost control on projects appears non-existent with shortfalls being made up via equity issuance.  If management were able to reign in costs and repay debt out of cash flow shareholders would be duly rewarded.  For example, if the company hadn't issued shares in 2012 and 2013 their 2013 EPS would have been €1.66 per share instead of €1.09 per share.  While shareholders pat their backs for the company's €1.09 in earnings they could have had 50% more if management hadn't been issuing shares.  In 2006 the company had 2.8m shares outstanding, as of their last fiscal year they had 7.3m shares outstanding, and 8.4m fully diluted shares.

In 2006 the company earned €14.47 per share in revenue on a gross €46m in revenue.  In 2013 the company's per share revenue was €24.30 against €176m in revenue.  Revenue increased 3.8x, but on a per share basis it didn't even double.  It might seem like I'm overstating the company's dilution, but to investors who are purchasing shares on an open market this is the biggest issue facing the company.  If the company's revenue and earnings triple, but the company dilutes shareholders it's possible they might not see any of the gains.

The ultimate endgame for a company like Prodware is unknown, but I believe we have some hints.  One of their largest investors is a venture capital firm, and venture capital loves growth.  The company has been growing like a weed, and at some point maybe they'll sell out to a larger consulting firm.  The venture capital backers and executives will probably do well for themselves, how shareholders will do is unknown.  It seems the longer it takes for the company to sell the more shareholders will be diluted.  Even though the company is experiencing great growth it's unlikely that shareholders will get to experience it themselves, which is most likely why this company is selling for such a low valuation.

Disclosure: No position

Monday, August 18, 2014

My interview on the PreMarket show discussing banks and banking


If you were dying to know my age, or to hear my thoughts on banks and banking you're in luck, all of that and more was covered during my interview on the Benzinga PreMarket show last Friday.

You can watch the interview below:




Wednesday, August 13, 2014

In defense of small businesses

Big is better in America, bigger cars, bigger houses, bigger businesses.  Americans are applauded when they buy a big house, or car, or toy even if they can't afford it.  The bigger is better movement is so strong there has even been an extreme backlash, the minimal lifestyle movement.  This is where people live in tiny houses, or give up everything they own except for a Macbook and some cool vintage clothes, or live an "authentic" life with few possessions and travel the world.  Americans are extreme, lost is the praise of modesty.  Instead of praising someone with a late model car paid for with cash they're ridiculed for being cheap and told to upgrade.

The bigger is better mentality extends to business as well.  To become a business leader all one needs to do is fill the top seat at one of our largest companies.  Big companies grow into their size because they fill a large and scalable customer need.  Take a Wal-Mart for example, they sell a lot of things at low prices.  If a consumer needs a pair of socks, or tupperware chances are Wal-Mart will have the best price.  We need big companies, big companies can get big things done.  A small company can't build an airplane or construct a new chip fab, that's something only a large company with a lot of capital can do.

Too many small companies want to be large.  A mistake they make they try to compete on the terms of their large competitor.  I remember back in 2002/2003 the media rage was to cover the story of how Wal-Mart was killing small town stores.  We were being told to lament the loss of stores whose prices were high and selection was poor.  The problem was these small companies were trying to compete directly with Wal-Mart.  A small business will always lose when going head to head with a big company.  The big company has far more resources, power, and mindshare compared to the small company.

What wasn't killed by Wal-Mart were small stores that were different.  Wal-Mart didn't put the local hardware store that sells hard to find parts out of business.  Wal-Mart didn't put the unique vintage clothing store out of business, or the high end furniture store.  This is because those companies differentiated themselves, they thought and acted different.

A big company usually delivers a product that's 'good enough'.  For most purchases most consumers simply need something good enough.  A good enough product meets the needs of the masses and can be manufactured in quantity.  Because a large company is focused on capturing the largest part of the market they often ignore edge cases, or specialized cases.

Specialization can't be scaled.  There are only so many people with extra wide feet, or only so many people who want swing sets shaped like pirate ships.  The specialized edges of a larger market aren't big enough to support large companies.  Smaller specialized markets don't generate enough revenue for them to be meaningful for large companies either.

It might come as a surprise to someone who's had their head in business books and never peeked out at the real world, but any business that's surviving has a competitive advantage.  Academics in ivory towers can debate this, but for a business to survive they need to have something unique that makes them different from competitors.  Think about your local plumber, there is a reason you call them back for repeat business.  Maybe it's as simple as they pick up the phone and are always on time.  If their competitors don't do this that's their advantage over them.  Maybe you frequent a certain gym because it's cheaper, or their facilities are cleaner.  We all have reasons for choosing companies over each other.  If you think about it the reason you call your specific plumber is probably also the reason others call them as well.

A company that has no competitive advantage ends up out of business.  These are the small companies being killed off by Wal-Mart.  Why would someone want to shop at a store with less selection and higher prices, especially in a small town where salaries have been flat for years?  If a business does the exact same thing as a competitor and does nothing better or nothing different eventually one will go out of business.

Small companies that want to survive need to differentiate themselves and serve a niche.  Serving a niche doesn't always guarantee great profits.  This past weekend I took my son to a hobby store to look at model rockets.  The store has been around since the 1930s and is filled with model tanks, miniature trains, and model rockets.  A hobby shop like this is clearly a niche.  Model rockets and model trains aren't exactly widespread.  Yet this owner has a profitable business that he enjoys working at that's lasted for decades.  The owner is in his 80s and had the same excitement about the toys that my son did.  He raised a family on earnings from the store and by many measures is living the dream.  Yet by Wall Street or investor standards he's most likely failing.  I would be shocked if he's making more than 2-3% on his company's equity, and the location has little resale value.

If business were only about economic returns then this hobby shop should close.  As you readers like to point out this business isn't earning its cost of capital.  In this perfect economic world the owner would just close up and somehow deploy the capital for higher returns.  What the theory misses is the role this small niche company plays.  If this store were to close where would the model railroaders who meet in his basement go to drive trains?  The friendships and connections his club has created have value that can't be quantified on paper.  Customers could still buy model rockets online and save a few bucks, but they'd miss out on getting advice from someone who's done it for decades.  It's also debatable that the capital released from an underperforming business could be re-deployed by the owner elsewhere for a higher return.

Should a local plumber, or baker shut down because they aren't earning a 10% return on equity?

A friend sent me an article today discussing the banking landscape.  The author in the article argued that since most banks don't earn 10% on their equity they should be merged into institutions that do.  The author had previously worked at Bank of America, so in many ways his stance was expected.  In this world the only banks that would be left are the Wells Fargo, US Bank, and JP Morgans.

I do all of my banking with a local bank, Dollar Bank.  I previously had accounts with PNC but closed them when I finally got tired of being treated like a number.  PNC is a large and efficient bank, and it shows in their operations.  When I needed to make a deposit I stood in lines that rivaled amusement park lines.  I would be given a number (literally) if I wanted to talk with a banker and then had to sit and wait for 30-45m.  For investors this works well, they earn nice returns and everyone is happy, PNC earns their cost of capital.  For many customers the bank is simply good enough and has what they need too.

On the contrast Dollar Bank went out of their way regarding customer service and inquiring about what I might need and helped me get started.  When I opened my business account I was invited to some local business happy-hours where I could mix with other customers.  Dollar's customer service went above and beyond what I expect from a bank.  Their bankers have called me asking if I had any questions or issues they could help me with.  And their perceived interest in me as a customer makes me feel valued.  

There are a lot of lessons small companies should learn from Dollar and PNC.  Dollar and PNC are both in the same market, and PNC should be running Dollar out of town, except they haven't.  The two banking experiences are dramatically different.  Dollar Bank creates no friction around my banking, I can deposit, withdrawal and go about my business easily.  PNC made it a chore to get my money out.  I was constantly being fee'ed to death because I wasn't a large account.  Dollar has decided that customer service is an area of emphasis, customers feel more like a parter with them rather than a client.  

Small banks in small towns need to focus on serving smaller market segments that large players are ignoring.  Serving those segments will never enable them to grow into a Wells Fargo or earn 15% on their capital.  But serving those segments will ensure their financial health, they will stay in business serving customers and providing community members with jobs.

I think it's easy for investors to become myopically focused on maximizing money.  Companies should earn as much as possible, investors should become as rich as possible, citizens should save as much as possible.  This is just a different spin on the bigger is better theme.  Bigger profits aren't always better if customers aren't being served.  Bigger isn't better if the big profits now come at the expense of a healthy company in the future.  There is more to life besides maximizing money.  Some people are content having enough and enjoying life.  Like the hobby store owner, he will never be rich, but his business has allowed him to play with toys his entire life and make money doing it.

There are thousands of businesses that are serving customer needs in tiny segments of the market.  These needs are often vital to their customers, yet they usually don't translate into fantastic profits.  It's okay for a business to be mediocre, it's okay for a business to stay small.  Bigger isn't always better.  For all of our needs that the big companies neglect there are a number of small companies waiting to fill the gap.

Friday, August 8, 2014

What makes a "good" balance sheet?

As a result of my post on bull markets I've had a few emails and comments asking my thoughts on what makes a good balance sheet.  I want to take a few moments in this post to walk through the elements of a good balance sheet, and discuss how it differs from a bad one.  I realize this post will probably seem too elementary for some readers, but I think it does provide a good thought lesson.  Words like "good", "stable", "bad", and thrown around when discussing balance sheets, but there is no firm definition associated with them.  What is a good balance sheet to one investor or company might be a poor for another.

The best starting point for this discussion is to take a step back and consider what the balance sheet even is.  A balance sheet is a point in time snapshot of a company's accounts.  If a company finalized their financial statements on August 1st that would be the day the balance sheet captures.  It's very likely that if the company were to make a second balance sheet on August 2nd that it would be slightly different.  Accounts payable might differ due to vendor bills received, or cash due to slight amounts of overnight interest.

Over time a balance sheet should be relatively stable.  The last thing an investor wants to see are wildly differing amounts for each reporting period.  To see an example of this take a look at a random pink sheet company that spams OTCMarkets with news about significant finds, or notices that the 'books are closed'.  These companies will go from having $37 in their bank account to having $200k then back to $109.

A good balance sheet is one comprised of assets that have realizable value and few liabilities, where assets outweigh liabilities.  In the course of business all businesses will incur liabilities ranging from accounts payable to potentially the obligation to repay borrowed money.  Liabilities aren't something to be feared, they are a byproduct business itself.  Investors should try to avoid liabilities that have the potential to wipe out a shareholder's investment, or put the company at risk.

The first liability that comes to mind for most investors is debt, both short term financing and long term debt.  But I would argue that any liability that has the potential to disrupt a company's operations is one to be avoided.  In some cases the worst liabilities aren't on the balance sheets.  An example of this might be a joint venture that has high ongoing capital needs that the owners fund out of cash flow.  Another liability to watch out for are contingent liabilities.  These liabilities appear in footnotes (not on the balance sheet!) and can have no impact on the business for years until one day they're triggered.  The worst potential liability to watch out for are lawsuits.  These are similar to contingent liabilities, a company will usually incur no cost outside of legal fees and then suddenly they owe millions or billions for a settlement or ruling.

There's an implicit assumption in accounting that assets are good and liabilities are bad.  This is because liabilities are subtracted from assets, and when we subtract we take something away.  Usually we want to take away bad things, but this isn't always the case.  Sometimes we subtract junk food from our diet, that's a good subtraction.  Or we subtract debt from our personal balance sheet, another good subtraction.  In the world of finance some liabilities are good such as deferred revenue, or a permanent deferred tax liability. Just like there are good liabilities there are also bad assets.

Not all assets are created equal, and not everything should be taken at face value.  Most investors when evaluating a balance sheet make similar discounts to assets, they reduce receivables and inventory by some amount and fixed assets by an even greater amount.

I try to value assets by their potential salability.  Marty Whitman discusses this in a video where he comments on Graham's NCAV calculations.  Whitman claims that sometimes a fixed asset such as an occupied apartment building has more value than inventory or receivables because it can be sold quickly to almost any buyer.

I would extend Whitman's thinking with some slight modifications.  Anything that a company owns that can be sold quickly in any market condition should be valued at face value.  In Whitman's example a fully occupied apartment building is worth more than inventory.  The caveat I'd say to that is the apartment building could only be sold in an average or above average market.  In a credit crunch where a buyer needs to line up financing it might be hard to unload the apartment building.  Depending on the nature of inventory it might be easy to unload it.  A manufacturing company could have a hard time selling drill presses, but a textile company should have no problem selling commodity fabric.

During the credit crisis many companies realized that what they thought was cash in the form of auction rate securities turned out to be something far different.  A month before the crisis any investor looking at a balance sheet would have counted the auction rate securities as cash, but a month into the crisis they would have been discounted 30-50-90% to reflect that these securities couldn't be sold at any price.

The most valuable assets are ones that hold their value.  An apartment building, or auction rate securities can be valuable depending on the market they're being sold into.  The same could be said for receivables or inventory.  Cash in the form of Treasuries or CDs can always be considered worth 100%.  An investment in a business that generates cash in all market conditions is also valuable.

If there's a rule about valuing balance sheets it's that there are no rules.  What might be good for one company is bad for another.  I try to shy away from mechanical formulas, they can be misapplied.  It's better to think logically about each company.  Is it good for a holiday goods company to have a lot of cash on hand?  Yes, to survive the seasonality of their business.  For a holiday goods company debt financing might not be bad, they operate from debt for most of the year and then pay back the financing from their seasonal sales.

Excess cash is usually viewed as a good asset, yet in the hands of an acquisitive management team it could be a bad asset.  The management team could squander cash on a business that generates losses or incurs significant liabilities.  While thinking about excess cash an example came to mind.  I was talking to a friend of mine who's a lawyer, we were discussing companies with asbestos liabilities.  He told me a story of a local company that purchased another company in the 70s or 80s.  The acquiring company closed the deal, and as the deal closed they learned the acquired company had significant asbestos exposure.  The acquirer immediately disposed of the newly acquired company, but the asbestos claims hung around.  They owned the company laden with asbestos claims for less than 100 hours, and 30-40 years later they're still paying out on legal liabilities.

Like all of investing I don't believe simple mechanical rules are good enough.  I think one needs to look at each company and think over potential situations and scenarios.  Rules miss a lot, cash is good, debt is bad, except in cases x, y or z.  Instead a better way to approach a balance sheet is to keep in mind that assets that are readily salable and hold value in any market are valuable, and anything that bleeds cash, or anything that puts the company in a bad financial position is bad.