WSJ: "SEC Bolsters Safeguards Against Penny-Stock Fraud"

For the past year, Oddball investors have been worried about a proposed SEC rule change that threatened to make it more difficult to trade in opaque micro cap companies. Over a hundred people wrote in to comment, almost all in opposition, including well-known investors, firms, and funds like: Mitchell Partners, the OTC Markets Group, and the Oddball land company Aztec Land and Cattle Company, Ltd..

The astute comment letter writers raised important objections and proposed workable alternatives. Unfortunately, the investor feedback seemed to fall on deaf ears at the SEC, and the rule change seems to have been approved with little modification:

Still, the proposal drew opposition from critics who said the SEC was going too far in its effort to protect investors, by effectively barring people from investing in small, unlisted companies.

Dozens of public comment letters were filed in opposition to the plan, many of them from value investors who look to the OTC market for opportunities overlooked by others in the market. Such investors will sometimes seek financial data from companies directly, even if the companies don’t post it publicly.

There is a long history of investors seeking undervalued stocks in the OTC markets, where prices were once quoted in a publication called the Pink Sheets.

It is sad because some micro-cap companies are keeping investors in the dark - in violation of their obligations under state law - and this does not address that problem in any way. In fact, it may encourage companies to be even more opaque in order to shut down the OTC trading market in their shares (which they don't control) and more readily enable them to squeeze out shareholders.

Some other highlights:

  • The amended Rule has a compliance date that is nine months after the effective date of the amended Rule, and the compliance date for paragraph (b)(5)(i)(M) of the amended Rule is two years after the effective date of the amended Rule. Prior to the compliance date, broker-dealers may continue to publish quotations in reliance on the piggyback exception even if an issuer’s paragraph (b) information is not current and publicly available.
  • However, the Commission understands that market participants may have unique facts and circumstances as to how the amended Rule affects their activities, and the Commission will consider requests from market participants, including issuers, investors, or broker-dealers, for exemptive relief from the amended Rule for OTC securities that are currently eligible for the piggyback exception yet may lose piggyback eligibility due to the amendments to the Rule (217).
  • In considering whether an exemption from the Rule (pursuant to Section 36 of the Exchange Act and paragraph (g) of the amended Rule (218) under these circumstances is necessary or appropriate and in the public interest, and is consistent with the protection of investors, the Commission may consider a number of factors, such as whether, based on data or other facts and circumstances provided by requestors, the issuers and/or securities are less susceptible to fraud or manipulation.
  • In this regard, the Commission may consider, among other things, securities that have an established prior history of regular quoting and trading activity; issuers that do not have an adverse regulatory history; issuers that have complied with any applicable state or local disclosure regulations that require that the issuer provide its financial information to its shareholders on a regular basis, such as annually; issuers that have complied with any tax obligations as of the most recent tax year; issuers that have recently made material disclosures as part of a reverse merger; or facts and circumstances that present other features that are consistent with the goals of the amended Rule of enhancing protections for investors, particularly retail investors.
  • The Commission encourages requests to be submitted expeditiously during the nine month transition period of the amended Rule to avert potential interruptions in quotations in such securities that may occur on or after implementation.
  • Issuers and investors that may be interested in requesting any such exemptive relief may coordinate with broker dealers to submit requests. Because the amended Rule governs publications or submissions by broker-dealers, the requirements of the amended Rule and any conditions of any such exemptive relief would likely be undertaken to be complied with by a broker-dealer rather than an investor or issuer.
  • See infra Part II.L. Paragraph (g) of the amended Rule states that “[u]pon written application or upon its own motion, the Commission may, conditionally or unconditionally, exempt by order any person, security, or transaction, or any class or classes of persons, securities, or transactions, from any provision or provisions of this section, to the extent that that such exemption is necessary or appropriate in the public interest, and is consistent with the protection of investors.”

We will be continuing to cover this regulatory change in the Oddball Stocks Newsletter. If you haven't yet, give us a try.

State Farm to Acquire GAINSCO ($GANS)

From a press release today:

State Farm Mutual Automobile Insurance Company, America’s largest property and casualty insurance provider, and GAINSCO, Inc. announced today that they have entered into an agreement pursuant to which State Farm will acquire GAINSCO for approximately $400 million in cash.

The transaction is expected to close in early 2021, subject to approval by GAINSCO’s shareholders, the expiration or termination of the applicable waiting period under the Hart-Scott-Rodino Antitrust Improvements Act of 1976, obtaining regulatory approvals, and satisfaction of other customary closing conditions.

GAINSCO concentrates on the non-standard personal automobile insurance market, specializing in minimum-limits personal auto insurance.

The transaction is the first acquisition of an insurance company by State Farm in its 98-year history. [...]

Under the definitive merger agreement, upon closing State Farm Mutual will acquire 100% of the stock in GAINSCO, Inc., the holding company of MGA Insurance Company, Inc., a Texas-domiciled insurance company, and GAINSCO shareholders will receive approximately $107.38 per share in cash. GAINSCO will continue to operate as a separate company and brand with continued focus on its current objectives. Over time, the parties expect to provide State Farm agents the opportunity to distribute GAINSCO products in addition to State Farm products and services.

Shares of GANS had been trading in the mid-$30 range. We mentioned Gainsco in Issue 25 of the Oddball Stock Newsletter back in June 2019. Here is what we said at the time:

GANS is a Texas-based holding company with an insurance company subsidiary (MGA Insurance Company, Inc.) that specializes in minimum-limits personal auto coverage. The company apparently also owns and operates a Hyundai dealership in Dallas! It had been a public company until 2011 when it terminated its SEC registration and went dark. The company had shareholders' equity of $102.7 million as of the end of 2018, on which they had comprehensive income of $14 million in 2018 compared to $15 million in 2017.

Of course, for an insurance company that's earning double-digit returns on equity, you are going to have to pay up... at the ask price of $38 a share the company market capitalization is $182 million, a price-to-book ratio of 1.77 times. Management seems to think that this is cheap because they repurchased 292,958 net shares of stock in 2018, which was 5.8% of the outstanding. The average price paid, though was $25 – the share price chart over the past five years has been parabolic. There is actually a pretty small public float on this – as of the last proxy statement filing (which was in 2010) the directors and officers as a group owned 74% of the stock.

Minimum-limits policies are obviously a different breed than GEICO. One of the many one-star Yelp reviews says, “Pray you never get hit by someone insured by this company.” It is crazy that anyone is allowed on the roads with the bare bones $25,000 of coverage that Texas allows.

Go figure - you would have almost tripled your money buying the minimum-limits car insurer (with its own Hyundai race car) at a P/B of 1.77x (and a ROE of 14%). Maybe the clue was the aggressive share repurchase?

Nate Tobik on Investor Summit Virtual Happy Hour Discussion

In this Investor Summit Virtual Happy hour Ian Hunter, Dave Waters, and Nate Tobik discuss the valuation gap between small and large stocks.

Pardee Resources in Oddball Stocks Newsletter ($PDER)

We've mentioned Pardee Resources (PDER) on the blog several times lately, and it's one we write about frequently in the Oddball Stocks Newsletter as well. We thought we would share a couple of excerpts from the Newsletter, so that blog readers who haven't experienced it can get a feel for the types of things we discuss in the Newsletter.

Issue 22 (November 2018)
On August 16th [2018], Pardee announced a self-tender for its shares. They offered to purchase up to 26,463 shares at a price of $188.94 per share, which represents a market capitalization for the company of $130 million. The share price was determined as the volume weighted average price over the ten days ended August 15th. We had just been asking “why buy table grape vineyards instead of repurchasing shares” and apparently the company has come to the same conclusion.

We recently obtained and read a copy of Calvin Pardee, 1841-1923: His Family and His Enterprises which is a family history written by descendants (and Pardee executives) C. Pardee Foulke and William G. Foulke. Copies of this are scarce and expensive because it was a small printing of a family history for a wealthy family. A certain number were given to outsiders and have ended up on the used book market. Ours was originally given to Manford O. Lee of VF Corp – a big deal apparel company both now and back when the copy was sent in May 1981.

The Pardee presence in America was founded by a Parliamentarian ancestor who came to New Haven during the English Civil War. During the 19th century a Pardee got interested in Lehigh Valley anthracite coal, and that is where the story of wealth starts. The one mistake they made, or the reason they did not become a household name like Carnegie, is that they did not follow the coal and steel industry west to Pittsburgh. (The reason for the westward shift was that steel-making using bituminous coking coal made more sense in Pittsburgh, nearer to deposits of that type of coal. Plus the market for steel rails was in the expanding west, not the east.)

Ultimately, though, Calvin Pardee did take the cash generated by the eastern PA mines and reinvested it towards the end of the 19th century in lands in Louisiana (timber, later oil and gas), West Virginia, Kentucky, and Virginia (the latter three all coal). The Louisiana lands that were bought based on timber value but proved to have oil were the big winner. That leaves PDER as a family owned resource company that has been mining coal, growing timber, and producing oil and gas for more than a century. I can't think of anything else quite like it. Texas Pacific Land Trust has been around since 1888 but is not actively managed.

Last Issue we also did a comparison of Pardee and Keweenaw based on implied timberland value, but of course the valuation of Keweenaw has fallen to $641 per acre for the timber. If you assumed, just for ballpark, that the acreage of Pardee was worth the same as KEWL, then the almost quarter acre per share of land at PDER would be worth $154 now instead of $192 when KEWL was trading at a higher price.

Inverting this calculation, the market capitalization of Pardee is about $789 per acre of timber, ignoring the value of the other resources. Given that Pardee has paid over $1,000 per acre for some of its timberland, why not up the ante on share repurchases? We'll see what the company does.
Issue 25 (June 2019)
We recently attended the 180th Pardee Resources annual shareholder meeting on May 16th [2019] at the top of the BNY Mellon Center building in downtown Philadelphia. While management was friendly, gave a very detailed presentation, took almost a dozen audience questions, and even served a (cold) lunch, we came away with a pessimistic view on the principal-agent problem that exists here.

[O]ne thing that has been bothering us recently are the paltry earnings from Oddball companies' timber holdings. In most investors' sum of the parts valuations of Pardee, timber is the single largest asset. If you value the timber at anything more than $704 per acre, it covers the entire enterprise value with the stock at $170 per share. However, with its 165,000 acres of timber, Pardee's timber division earned $2.1 million in 2018 and $2.9 million the previous year. In 2016 it earned $2.6 million. That is $15 per acre, average, per year. The company's land and timber is on the books at $45.2 million (which is $274 per acre). If you take those three year average earnings and capitalize them at a 5% cap rate it's $50 million; about book value. This is way less than comparable transactions for timber or the prices that Pardee has bought and sold timber, and yet... why would you want to pay more than this? At the $1,000/acre numbers that are bandied about, you get a 1.5% plus or minus inflation, very long duration cash flow that might be attractive to a college endowment or an insurance company, but how is it attractive to a micro cap value investor? (If nothing else, the timber could be dumped just as a way to get less long of long term government bonds.)

Sure, we believe that if all the assets of Pardee were sold the proceeds would be more than the current enterprise value. The shares might be worth double. Even selling the timber alone would probably result in proceeds greater than the current enterprise value. But management is not incentivized to do that, and the biggest shareholders (some of whom might be, if they knew) seem more concerned with keeping the company around as a family monument than maximizing their net worth. (If you want your descendants to maximize the value of a family business, leave your name off of it.)

Here is the problem with management's incentives. They have $189 million of assets at book value. The annual SG&A expense is $6.95 million which is 3.7% of this. If they were to sell land at anything over $700 per acre after tax, which they probably could, they could buy back stock at the current price of $170 and get the rest of their coal, oil, gas, solar, and agricultural assets for free. (Note that their current book value of land and timber is about $45 million, so a hypothetical sale of 165,000 acres of timber for after-tax proceeds of $116 million is not totally implausible.) But shrinking the asset base, and pre-SG&A operating income, would leave the company with a top heavy, too-high expense structure and overhead burden. A Pardee executive pointed out during the meeting that the company has only 26 employees, one fewer than 20 years ago. Unfortunately, it is also about the same number that Berkshire Hathaway has at the Omaha headquarters with 4,000 times more assets.

This incentive misalignment was made awkwardly clear at the meeting (which was the best attended we have seen this season, with some writers from Motley Fool, some institutional asset managers, and a number of private value investors). Many of these shareholders asked questions during the Q&A, and the questions fit into two categories: will you promise not to dabble in any more weird investments, and will you buy back more stock?

Two shareholders mentioned Texas Pacific Land Trust and its capital allocation policy that has consisted of dividends and share-cannibalization. The name did not seem to ring any bells with Pardee management, which is sad because it is one of the most successful non-operating resource investment vehicles of all time. The Chairman said that more money has been returned to shareholders than used to buy assets over the past five years, and they do not want to decapitalize the company by buying back “too much” stock. Also, and specifically regarding SG&A at 20% of revenues, the Chairman said that they still have the same expense base that they had when revenue was much higher, and they would rather have higher revenue than try to cut expenses.

So now we know why the company has been experimenting with solar and agricultural investments instead of dumping overpriced timberlands and returning that cash. The company has been forced out of its comfort zone with predictable results: as they said at the meeting “wild cards & skunks” like the mobile solar generator Ponzi scheme and the table grapes that had a $2.1 million loss because of unseasonably warm followed by unseasonably cold weather. (The CEO did say that they are going to “take a breather” and are not investing in subsequent phases of the grape and almond projects.)

Our current thought on Pardee is as follows. If management is not going to sell the timber at a once in a lifetime high valuation (due to low interest rates) then those need to be capitalized at a reasonable interest rate. Book value seems like a reasonably attractive price. If you make that assumption, then all of a sudden you really need to sharpen your pencil on the coal, oil, and gas assets. We did a little digging on Pardee's coal mines. The operator of their biggest tract actually went bankrupt, although is continuing to operate and made good on its royalties. But the West Virginia metallurgical coal is high enough cost that there is a risk that mining could one day stop.

Meanwhile, the SG&A burden ticks on. And the need to replace the asset base creates pressure to do deals – like the agriculture, solar, or the biggest recent one: the $54.5 million invested in oil and gas in 2013. That was year that crude hit $110, before collapsing into the $20s from the second half of 2014 through the beginning of 2016.
Keep in mind these excerpts are from a couple years ago. If you want to stay up to date with what's happening at Oddballs like Pardee Resources, join the Oddball Stocks Newsletter.

Hanover Foods FY 2020 Annual Report

Hanover Foods is a classic Oddball that has been written about on this blog a number of times over the years: the original posts (parts 1 and 2) back in 2012, and an update in 2013, their quarterly results this June, and the recent obituary of John Alan Warehime.

It has been a year since we last looked at Hanover Foods Corp's FY 2019 results, and now the FY 2020 annual report has arrived in the mail.

At a share price of $75 for the HNFSA (non-voting) share class, the market capitalization of the company (with 715,205 common shares outstanding) is now about $54 million, compared with net current assets of $126 million ($176 per share), and a book value of $245 million ($342 per share).

Hanover's results improved from FY 2019 to FY 2020. Their revenue went from $395 million to $401 million, but more impressively gross profit grew from $32 million to $41 million. Meanwhile, SG&A shrank by $2 million, with the result that operating profit went from just over breakeven to $12 million.

We'll have more about Hanover Foods in the upcoming November Issue of the Oddball Stocks Newsletter.

Pardee Resources Reports Q2 2020 Results

In June we posted Pardee's annual meeting slides. Also see our recent posts on Pardee's 2019 annual report and its share repurchases. We just received the second quarter (2020) report for Pardee:

Quick takeaways: met coal was idled because of covid, so their coal division income fell from $8.3 million for the first half of 2019 to $2.4 million for the first half of 2020. Oil and gas division and timber were both down as well. Interestingly, the alternative energy division produced more power and had higher revenue than in the year prior.

We will have more to say about Pardee in the November Issue of the Oddball Stocks Newsletter.

Nate Tobik on "The Widest Valuation Gap This Millennium!" - Tonight

Nate Tobik is going to be on a panel for the Investor Summit this evening from 6pm-7pm ET. He will be discussing the valuation gap between small caps and the market in general. You can register here.
Right now we are experiencing the widest valuation gap between value and growth stocks in decades. What does this mean and how can we act on this opportunity?

Thursday, August 27th at 6 PM EST

The Widest Valuation Gap This Millennium!

Ian Hunter from Hunter Value Capital
Nate Tobik from Oddball Stocks
Dave Waters from OTC Adventures & Alluvial Capital

6 PM Opening remarks from CEO Fred Rockwell
6:15 PM Panel
6:40 PM Table talks and open networking
7 PM Event ends