Why growth can be a killer

It's as if we're wired for growth.  "Growth is good." "If you're not growing you're dying." Everyone wants to be growing, personally, physically, mentally.  Businesses are no different.  Growing companies are rewarded a high multiple and low growth companies are rewarded low multiples.  But is growth always good?

Growth in businesses is exciting.  When a company is growing it's lively, employees are excited, customers are excited, there is momentum.  It is fun to be a part of something growing.

The problem with growth is that it's hard to manage well.  Humans seem to make the best decisions when they can assess the inputs, thoughtfully consider those inputs and make a decision.  When a company is in the midst of rapid growth management doesn't have the opportunity to make thought out decisions.  People need to be hired yesterday, customers are ordering things that don't exist yet, it's all hands on deck all the time.

Some of the excited from working at a growing company comes from the fact that no two days are the same.  There are always new challenges.  The reason for this is because the workplace is chaotic and employees don't have fixed roles yet.  No two days are the same because on Monday you might be solving an engineering problem, and on Tuesday you're helping to pack boxes in the warehouse.  When a problem comes up everyone huddles to figure out how to tackle it.  Unfortunately playing whack-a-mole with problems isn't efficient, or sustainable way to conduct business.

Companies are successful when they can introspect, identify why they are successful and systematize their success.  This systematization is the process that turns a start-up into something sustainable.  It's also the point where most of the initial cowboy (or cowgirl) employees leave because a company has becoming "too corporate."

Companies are typically started by people who are willing to do anything at any time to get a job done.  These are people who enjoy challenges and thrive in chaos.  They are the people who are willing to try new things, but usually aren't very structured, they can't be.  As a company grows it needs to become organized and organization doesn't come from the initial employees.  It comes from new hires with experience in structured environments.  These new hires usher in the second phase in a company's lifecycle.  The sustainable corporate phase.  Success is systematized and becomes sustainable.

Growth can kill companies when they refuse to systematize their processes and become corporate.  This could be because a company's Founder doesn't want to lose their start-up culture.  Or it could be that the initial management team doesn't know that it needs to systematize. 

Eventually the chaotic fire fighting becomes unsustainable and a company collapses under its own weight.  Unfortunately the collapse is sudden and unexpected.  There isn't always a specific reason for the collapse.  But the underlying reason is always the same.  The chaos became unmanageable and obligations went unfulfilled.

The corollary to growing too fast are companies with little growth that never seem to die.  These low growth companies are some of the stalwarts of value investing.  Just like growth is lauded no growth is despised.  Who wants to work for a company that grows at 3% a year?  Even worse, who wants to invest in such a slow-poke?

The perception around low growth companies is fascinating.  Even though most are exhibiting some absolute level of growth, even if small, investors see these as "dying" companies.  They are dying in the eyes of the market because they're not growing fast.

Just as it's difficult to systematize a fast growing company it's hard to take a systematized low growth company and turn on the growth spigot.  Low growth companies are set in their ways.  Their ways are often successful in generating consistent returns, but not consistently high returns.  Some of this could be due to their products or market, or it could be that the company doesn't know what needs to be changed to generate increased growth.

In the book Security Analysis the author Benjamin Graham discusses buying stocks and encourages the reader to look at a company's past growth history.  He states that if a company had experience with growth or high earnings in the past then management is familiar with what it took to get there, even if they aren't experiencing it currently.  This is preferable to a company that has never had more than middling growth.  The implication is that the management team doesn't know what's necessary to create conditions that generate growth.

The world of venture capital investing is filled with carcasses of companies that grew fast and failed.  Most of the companies didn't fail because customers didn't like their products, or there wasn't market demand, or they couldn't generate revenue.  They failed because they grew too fast.  Their growth was unmanageable and they grew their way to failure.

Venture capitalists are hoping to leech onto a company that can mitigate the growth landmines.  They are looking to find companies that grow fast, but also figure out how to become corporate and sustainable.

Investors in public markets should avoid high straight line growth and instead favor companies with moderate, but sustainable growth.  High paced growth is exciting for a while, but when the bottom falls out shares crash and investors become bewildered wondering "how could this happen?"

A company with sustainable growth can retain excitement from growing.  But without out of control growth the investor stands more of a chance that they'll be able to enjoy the fruit of their growth investment.  If you're in the market for growth don't be a moth attracted to the flame from a rocket investment.  Rather look for sustainable growth identifiable by a management team that is corporate and has systematized their success.  

Podcast interview plus a new investing system course

Planet Microcap Podcast

I recently had the chance to be interviewed by Robert Kraft on the Planet Microcap Podcast.  We had a great conversation that ranged from investing in microcaps, to bank investing, and some background on how I got started.

You can listen below:

If you have a chance listen to some of the other podcasts from Planet Microcap.  There are some interesting guests worth listening to.

My Investing System Course

I have quite the back catalog of content on this blog.  Scattered throughout old posts are theories on how I look at investments and how I find new ideas.  I know a few brave souls have dove into the more than 1,000 pages of material and read from start to finish.  But most of you don't have that much time to go trawling through pages of posts to find what you're looking for.

One question I'm asked over and over is "How do you find investments?" and "How do you evaluate investments?"  In one sense finding an oddball investment is like finding my posts on how I do it.  You start with a lot of content and begin to dig...  We decided to short-circuit the digging step and provide all of this in a simple email newsletter.

If you sign up for the course you'll receive one email a day on the following topics:

  • Day 1: Where to hunt oddballs (Is screening dead?)
  • Day 2: Assets and book value (Where 50 cent dollars hide)
  • Day 3: Earnings (Growth isn’t everything)
  • Day 4: Management: (Roach motel avoidance 101)
  • Day 5: Catalysts (Who needs em?)
  • Day 6: Activism (Can anyone go activist these days?)
  • Day 7: Portfolio Management and When to Sell (The system I use to manage 50+ positions)
You can sign up below:

Homemade economic indicators

It was the summer of 2006, my wife and I had been married a year and we were going on our first real vacation since our honeymoon.  It felt very grown-up.  As a young-20s married couple the offer of a free hotel room at a relative's hotel in Florida was too good to pass up.  I'm not sure we could have afforded anything else.  We packed up our late-90s model Accord and headed down to the Sunshine State.  What we saw when we got there blew us away, and I'm not talking about the blue waters and palm trees.  We arrived in an area that was in a manic state of construction.  There was a palatable euphoria in the air.  Everyone was getting rich on real estate, and developers were building anything anywhere there was a bare patch of sand.

On that trip I had two unshakable observations.  The first was I had trouble envisioning where all the people were going to come from to buy these new construction condos and houses.  The second was I couldn't believe how many banks there were.  On most street corners stood four branches, all different banks.  Again, I couldn't understand what I was seeing.  How could there be enough money to support hundreds of different banks?

It turns out my questions were justified, a mere two years later the bottom fell out on the Florida housing market.  The state's overextended banks were dragged with housing into the abyss.  For a while we were annual visitors to the same free hotel north of Palm Beach and I watched the whole crash and recovery unfold.  In 2006 a condo oceanfront in a tower cost $500k. In March of 2009 condos in the same building were for sale for $150k, and in 2013?  They were back up to $500k.  Most of the bank branches closed, some were redeveloped into Mexican restaurants or stores, others bulldozed, and others still standing with "For Sale" signs.

What I witnessed in 2006 was the euphoric stage near the top of the market.  I didn't know what I'd seen until later, but when looking back it became clear.

I've encountered the same thing a few other times.  In 1999 I was a wide-eyed college student studying computer science dreaming about working for a start-up and becoming rich through options.  I remember going to a party at a frat house with one of the frat brothers bragging about their start-up.  The guy was so convinced he was going to change the world that he took us into his room to show off a 36" TV, which at the time was impressive itself.  It was a Gateway Computer TV, and the TV was hooked up to a computer.  This alone screamed success to everyone in the room.  This guy was creating a website where people could order pizza online and have it delivered.  You wouldn't have to pick up the phone anymore.

I'm curious by nature.  I want to know how and why things work.  This was definitely true when I saw the pizza website on the giant TV.  I was thinking about how much faster calling would be compared to dialing into the internet and waiting for the modem to connect and then the webpage to load.  I even had the gall to ask this guy about it.  He made some broad statements about how great the future would be and how no one would use phones.  It didn't make sense, especially in the age of modems.  And sure enough this guy was out of business a year or two later.

I didn't know what I was witnessing in 2001 when the dot-com bubble bust because I was too young. But I had a vague sense that what I'd seen in the years prior wasn't sustainable.

The last boom I saw was recently, the oil and gas boom in Western Pennsylvania.  The formerly lonely highways I'd take to West Virginia to ski became clogged with water, fracking trucks, and giant diesel pickups.  I had friends from small towns where farmers were leasing their land to gas companies for $5k/acre per year just so they'd have the right to drill.  When drilling took place the farmers would make even more.  Hotels appeared in the strangest places to accommodate the gas workers.  It was a boom scene.

At one point in 2014 I met with a hedge fund manager who started a fund that only invested in banks that did business in Eastern Ohio and Western PA.  Specifically banks with heavy oil and gas exposure.  The manager marketed his fund as the best way to play the gas boom.

Gas prices finally crashed and along with it the roads emptied out and drilling activity slowed to a crawl.

In each of these three boom situations I was observing something that I couldn't quite put my finger on.  The hysteria was real, it was tangible, and it seemed like it couldn't go on forever.  But the energy was such that it's hard to believe something good like that might end.

I was talking with a friend recently and I noticed myself sharing stories that sounded like boom time stories again.  The more we talked the more I realized that I've been seeing some of the same things I was seeing in 2006 and in 1999.  My experiences and observations are all anecdotal, and maybe this is something only happening in the northern suburbs of Pittsburgh.  But what I'm seeing here is crazy, and as an investor a bit scary.

Let me share a few stories.  A few weeks ago my wife and I had a babysitter scheduled and the event we needed the babysitter for fell through so we decided to go to dinner instead.  It was a Wednesday night, and with her being pregnant I decided to let her pick the destination.  She wanted a blooming onion at Outback.  I'll say upfront that I'm not a big Outback fan, but it was a night away from the kids, so you take what you can get.  Outback shockingly had a wait, the waiting area was full and there were people outside.  It was going to be 45 minutes to an hour for a table.  We looked at each other and agreed that Outback isn't worth waiting that long for (or in my mind at all, but I digress).  We then hit up a number of other restaurants in the area and they all had similar waits.  It was simply crazy that on a weeknight these average restaurants would have so many people trying to eat.  The thing is this trend has continued, restaurants are mobbed now, we're back to pre-2008 wait times everywhere.

Another area I like to keep an eye on is my local craigslist.  I will buy and sell on there when I see deals, and I browse to keep a pulse on the market.  The prices have gone nuts in the past year.  Twenty year old F150s with rusted out bodies and 200k miles are selling for $5k, about $2500 too much.  RVs are similar, late 1990s RVs are selling for a few thousand dollars less than models 10 years newer.

Beyond RVs and trucks I like to look at rural land as well as heavy equipment and businesses for sale (can you spot the trend? Items with titles..).  A few years ago I picked up an acre of forested land in Northern PA for $300, and I've been on the hunt for larger tracts in the 10-20 acre range in the same area.  A year ago there were a few sellers who wanted $1,500-2,000/acre for forested land, but there were always caveats.  The places would be next to a sewage treatment facility, or there were easements.  Now in the same area prices have jumped to $10,000/acre.  Same types of lots, same location, just 5x more expensive.  Right before the oil boom you could buy almost any tract for $1,000 an acre or less, when gas crashed I went hunting again.  While prices fell demand remained strong as people looked for lots for second homes.

Even worse is the housing market here.  I sold a house last year, a nice 1,300 sq ft starter home for $160k, what I thought was a reasonable amount.  Similar houses are now listed a year later for $200k, a $40k jump in a single year.  What's worse is some of the stock at $200k needs another $25-30k worth of work to make it livable.  That is unless you like living in a house with decorations circa 1975.  What's crazier is these places are selling almost instantly.  We have friends whose house sold the day it was listed, they're having trouble finding a place because everything is either an overpriced dump or is selling the day it lists.

I find myself asking the same questions again.  How can people at their first job afford a $230k house?  Who's paying $5k for a 20 year old truck that will probably need another $2,500 in parts and a hundred hours of labor?  Is there really demand for this stuff?  And what is the demand that pushed starter home prices up 25% in a year?

As we discussed some of these stories my friend suggested a theory.  The demand for these items is coming from the marginal overtime dollars of middle class and lower middle class workers.  These are hourly jobs that pay $20-25/hr in wages.  Now that the economy is hitting on all cylinders a company might ask employees to pick up a few extra hours a week before they hire additional employees.  For someone making $25/hr ($1,000/wk) picking up an additional five hours of work per week is a 12% pay increase.  Where does that additional $500/mo go?  It creates demand for restaurants, for vehicles, for RV's, for vacation properties, for houses.  Some are using it to pay down debt, but when everyone is offering all the neatest toys with low monthly payments there are a lot of takers.

This isn't just seen in the hard goods realm either.  Where are the net-nets?  Where is the distressed debt?  Where is anything that isn't having the best quarter and year ever?

If you believe in efficient markets then this doesn't matter.  Because the good times are here to say, they're "right" and "perfect" after all.  I know there is a large contingent of investors who believe that we're just starting a giant bull run and this euphoria won't end.  Maybe it won't.  On the other hand trees don't grow to the sky either.

The problem is when you're in the middle of a situation it's hard to gain a large enough context to make a macro decision.  You can observe and go with your gut, but you can't really ascertain what's happening until after it's happened.  Once it's happened everyone is an expert and everyone has seen it, but in the midst no one knows what they're seeing.

I guess what I'm saying is that we're in the midst of something, it looks like a movie I've seen before, but I'm not sure.  I've had stocks run like crazy since Trump was elected and I'm starting to take money off the table as prices rise.  Unfortunately it's putting me in a spot where I'll have excess cash that needs to be put to work.  Some of it will sit on the sidelines until I find deals on land again.  But for the rest I'll have to look abroad to countries that aren't running as far and fast as the US.

When I consider everything I'm seeing it's easy to say that we must be nearing a market top.  But it was another two years from what I witnessed in 1999, 2006, and 2014 before the top finally blew off. Oddly I've been consistently two years early in noticing these trends, so maybe the bottom won't fall out until 2019?

It's been hard to find deals both in the market and out of the market.  Every official government indicator says it's clear skies and sunny ahead, and maybe it is.  But what I'm seeing on the ground has me questioning things.  Is this demand sustainable?  Can it just last forever?  How many new retail strip malls can be built?  Especially when there is vacancy in prime locations and the world is moving online?

In the end I just don't know.  What I do know is I'll continue to sell as positions become fairly valued.  There are pockets of value here and there, but one needs to dig very deep, or get involved in complex situations.  Maybe in two years I'll look back and this and think "I saw it again.." or maybe I'll be thinking "I wonder how big of a house can I buy with my Tesla gains?"

Why I don't use watch lists

I remember as a kid sitting in a chair near our kitchen with my grandfather two chairs away.  I was leafing through a toy catalog.  The catalog's pages were worn and I knew the items and their prices by heart.  Suddenly my grandfather looked at me and said "What are you doing?  Looking at all the things you can't buy but wish you could?"  I was stung by the criticism, but he was right.  I had almost no ability to purchase any of the items.  I was just envying items I couldn't have.  As I reflected on this story recently it reminded me of why I don't keep a stock watch list or research stocks that I wish I can buy someday.

This current moment is all we have.  What has already happened doesn't exist outside of our memory and what happens next isn't guaranteed and is unknown.  We need to focus on the now, because in the now we can take action.  We might regret action taken in the past, but it can't be changed.  We can imagine what action we might take in the future, but futures never work out like we imagine.

When I'm looking for an investment I survey every potential investment candidate available at the current time.  I do this because these are the opportunities that I can take action on now.  From that pool of opportunities I'll research until I find one I wish to add to my portfolio.  

It's happened that I've purchased a number of names from a given pool at once.  I've also passed on investing anything at all if the current opportunity set isn't desirable.  By regardless of the eventual action I take I'm only evaluating the current opportunity set.

This strategy differs from other investors.  Most investors keep a watch list of companies they'd like to invest in at a given price.  I know investors who spend most of their research time researching companies that they might never have the opportunity to purchase.  The idea behind this is that they put in the research hours before an opportunity occurs so when it does finally happen they can act quickly.  This is the theory at least.

Part of the reason the investing public believes that investors should endlessly research companies, even ones they will never purchase is because this is what "great investors" tell them.  In interviews professional investors who understand Marketing 101 utter things like: "we never stop researching" or "We're always hunting for new ideas."  This makes perfect sense when you look at things from their vantage point.  A professional is getting paid for results, and their clients want the assurance that their manager is always at work always ready to make money for them.

I know a number of professional investment managers, some with great records.  I don't know if they're always working, but what I do know is they're always able to meet for lunch or take a phone call, and they're never in a hurry to leave.  It's a very flexible job, and for those with talent and savvy it's possible to earn great returns with less than full time work.  Not that clients would ever know this..

There's a misnomer that hard work generates results.  Work is required, but hard work alone doesn't guarantee anything except for being tired.  The problem with this myth is that if you look at top athletes or the top of anything skilled activity the highest performers are set apart mentally, physically, or genetically.  Some endurance athletes don't generate as much lactic acid as everyone else enabling them to continue when the crowd quits.  Top musicians have an ear for songs and so on and so forth.

If someone doesn't have a musical ear no matter how much they work they will never be a world-renowned musician.  The same is true for any skill set.  Hard work can move you past the average Joe or Jane in the middle of the pack, but hard work won't land you in the top.  The top is reserved for those with an exceptional gifting from birth coupled with time, chance, and some work mixed in.

The same is true for the top investors as well.  Warren Buffett has a gifting that allows him to size up opportunity and act in ways that others can't.  No matter how many annual reports one reads, or how many Munger quotes they parrot, or how many Dempster Mills write-ups they read they'll never replicate him.  It'd be like someone thinking they can become Usain Bolt by wearing the right shoes, practicing in Jamacia and doing the famous bolt stance after each race.

Just because someone famous, or someone in the newspaper (or online) does something doesn't mean that everyone should do it.  In some cases the opposite is true.  Investment managers profiled consider their interviews to be marketing material, not instructional information anyone can use.  In fact the opposite might be true.  Some managers might purposefully leave out their secrets as to give themselves an advantage.  

How does all of this tie into investing watch lists?  I don't think investors need to be researching companies because guru investors proclaim they're constantly researching.  Most professionals are talking to clients, managing their employees, managing their back office systems, prospecting for new clients, and in their remaining time looking for new investments.

Another reason, and possibly a more pertinent reason to avoid watch lists is because the current doesn't mimic the future.  Companies and their results reflect the current and past environments, not the future environment.  This seems like common sense, and it is, but common sense isn't that common either.

Let's take the most common use of a watch list.  One researches a stock that's compounded capital at high rates for years or decades but the current price is too high.  In theory all of this research will enable the investor to act and purchase this quality company once the price is lower.  Here's the problem, no one ever knows what will cause the price to crater.  Maybe the economy hits a recession and this business that's compounded capital sits at the cross hairs of public policy as a result of the recession, will their out-performance continue in the future?  Or how about the situation where the company changes and adapts to the new economic situation, will their past results apply to the future now that they've changed?

When the economic or market situation changes such that watch list stocks are suddenly attractive it's often the case that prior research needs to be discarded.  This is because in the new environment the old research isn't applicable.

Another consideration is whether the prior researched name is still the best opportunity in a market dislocation.  Given two stocks worth a hypothetical $100 per share in a market dip is it better to buy the previously researched company at $80 or another company that isn't quite as high quality for $65?  Maybe the $15 differential in this case is easy to brush away and say "I'd pay $15 for quality and give up that return."  But what happens with the differential grows?  What if it's $80 for the quality company and $25 for a similar company with a few warts?  You'll need a lot of compounding to make up that differential.

When the market crashes dislocations happen quickly and to everyone's repeated surprise prices remain somewhat efficient.  Debt laden companies drop like rocks whereas debt free companies with earnings power don't drop as much.  These quality companies that investors have spent hundreds of hours researching don't drop enough to merit a buy.  Whereas there are companies that drop like rocks that are merely babies thrown out with the bathwater.

I always want to be evaluating the current opportunities, not ones I wish will happen.  Maybe watch lists should be renamed wish lists.  These lists are similar to the toy catalogs I'd browse as a kid.  Full of items that I wished I could purchase.  But now as an adult with the means to purchase any of those toys I don't have a desire to buy them anymore.  This is true for watch lists as well.

Is this bank a quadruple or a zero?

In the market risk equals reward, or so they say.  High risk equals a higher reward.  In the case of Enterprise Bank (EFSG) the bank's business model is low reward high risk, but for investors who are willing to wade through the muck this could be a high risk/extremely high reward stock.

I wrote about the bank a little over two and a half years ago.  They're located near where I live, and I've started to think about them again as one of my running routes takes me near their office.  I hesitate to use the term "branch" because they don't really have a branch, just an awkward office on a weird elbow bend next to pseudo-junkyard (heavy equipment graveyard rental), and an indoor playground for kids.

The bank is a niche lender, they specialize in lending to start-up businesses and small businesses with troubled business models in distress.  I know what you're thinking, this type of niche lending doesn't seem to fit well in a regulated industry especially when the firm is highly levered.  You're right, it doesn't, and why they're a bank mystifies me.

What has always intrigued me, and why I looked at them again is their valuation.  The bank has a tangible book value per share of $17.99 and a share price of $8.  The bank trades for 44% of tangible book value.  Incidentally this is the same price to tangible book ratio they traded at in 2014 when I last took a look at them.  Two and a half years into a historic small bank bull market and this stock's price is nearly unchanged along with it's valuation.  It's in situations like this that opportunity can exist, it doesn't always exist, but there is potential.

There is a lot to dislike about this bank.  It's easy to go overboard when looking at a bank still trading with a deeply distressed valuation.  I want to do them justice, this can work out very well for investors as you'll see, but you need to accept before buying in at this valuation.  Let's start by clearing the air with everything that's terrible about the bank.

First they are a small business lender and small businesses have a higher failure rate when compared to established business lending.  But if that weren't enough Enterprise Bank seeks out distressed small businesses.  The bank describes themselves in their annual report as lending to start-ups and small businesses in distress.  For the risk they're taking they aren't making that much money.  In the most recent quarter they had a net interest margin of 5%.  That's hardly compensation for the risk, and it's even worse when you realize they're a levered institution with the majority of their funding from the FHLB and brokered CDs.

Their business model is similar to someone driving a car very fast on an icy road.  There aren't any problems as long as the car stays straight and if the drives doesn't make any sudden movements, but the smallest nudge of the wheel can end in catastrophe.  To management's credit the bank has been traveling this icy road for a while without crashing, but that doesn't mean it's safe, or a crash isn't a wheel nudge away.

If anyone is looking for a good sleep aid I'd recommend reading the first 25 pages of their 2015 annual report.  To say it's unique or unusual discounts what it really is.  In the opening letter management summarizes the company's results then launches into a dissertation as to why they disagree with their regulators regarding revenue and income recognition.

Maybe I suffer from insomnia, or I enjoy the nitty gritty detail of bank regulatory disagreements, but whatever it is I charged through.  In the eyes of a bank regulator a loan is to be classified as "non-accrual" when the loan is more than 90 days past due.  A non-accrual loan can be considered in collection when the bank expects to turn their non-accrual loan into cash within 30 days.  The essence of the bank's argument is that they have a lot of non-accrual loans that they believe are in collection even though collection can take months or years for them.  The bank believes they shouldn't have to classify these loans and that any interest received on them should be recognized as income.

The bank believes they're a special case because they deal with distressed commercial borrowers and it's hard to sell commercial real estate.  My contention is it's hard to sell commercial real estate if the price is too high, or if the real estate holds little value.  It's very easy to sell commercial real estate in areas with strong commercial growth and limited space.  Incidentally those are two overriding traits of the area the bank is located in, yet somehow they were stuck with the dud properties.

It turns out the bank wasn't lending where they're located, a prosporous neighborhood (their current location withstanding) down the street from old money estates.  They were lending in distressed neighborhoods betting on a turnaround.  To make matters worse the bank happened to lend to almost all of the borrowers said neighborhood, and in 2008 when everyone ran for the exit Enterprise was left holding the bag.

The bank has dug themselves out of the pit they found themselves in, but this story illustrates some of the issues they face when selling property.  The properties are not prime commercial real estate.

Let's get back to their income argument with the regulator.  The bank argues that it should have $1m more in income that their regulator won't let it recognize because of accounting rules.  They claim they've received $1m in cash payments on non-accrual loans that hasn't been fully recognized on the income statement.  This is partially true, but also misleading.  On their regulatory financials this $1m in cash received has been applied to the balances of the loans.  The resulting loans are de-risked on the balance sheet, but does nothing for their income statement.  On their GAAP financials the bank has pushed through some of this interest income, but it's lumpy rather than consistent as the company would like.  This money didn't just disappear, it found its way onto the financial statements, just not where management would have liked to see it appear.

I find it noteworthy that so much ink was spilled describing this issue.  I could feel management's anger over the issue as I read their annual report.  They feel this is a hidden asset that shareholders should know about.  My sense is they might feel that if this $1m in income had been reported then they wouldn't be trading at the valuation they're trading at.  I'm guessing, but I don't think that's the reason for the low valuation.

The bank is operating in a very risky segment of the market.  They have a risky business model, and it's built on hot money funding.  For all of this risk the bank isn't printing profits.  They have capped their upside, but unlimited downside.  This is why they have a low valuation.

It isn't all bad news though.  The bank weathered the financial crisis and remains well-capitalized.  They paused the hunt for new business in order to ensure Basel III compliance.  The bank will remain compliant once Basel III is implemented and they don't expect any interruptions in their business.

What's even better is the opportunity set for investors if the bank does nothing other than work down their non-accrual loans and sell off their foreclosed real estate.  The bank has $10m in non-accrual loans, and at any other bank if those loans were brought current they'd continue to accrue interest and generate income.  In a traditional setting with a 5% NIM the bank would earn $500k in additional operating income if the $10m in non-accrual loans were current.  But given Enterprises specialty with investing in distressed and liquidating opportunities we can presume that the bank intends to collect and liquidate the $10m worth of troubled assets.  They also have $4m in foreclosed property on their balance sheet.  This means there is $14m worth of assets waiting to be realized once the bank can find buyers.  Let's discount these assets by 25% and say they ultimately collect $10m.  This is an overly conservative hair-cut, the bank has never charged off loans in an amount that's anywhere near this haircut.  The $10m collected would become equity and the bank's tangible equity would increase from $15.9m to $26m, which is $29.84 per share.

To summarize the opportunity, if the bank does nothing else related to banking, but instead focuses entirely on selling down their OREO portfolio and collecting on non-accrual loans they can almost double tangible book value per share for shareholders.

Beyond this the bank has worked to improve their operations.  Their return on equity is slightly over 7%, which is average for a bank their size.  The bank's efficiency ratio is in the 80s, and management noted in their letter they are working to lower it.  If the bank were to drop five to ten points of their efficiency ratio as well as work down bad assets investors could be looking at a tangible book value per share in the low to mid $30s.  That's attractive considering shares are at $8 right now.

I really like bank investments where the investment thesis rests on the company working off bad assets compared instead of needing to improve their internal operations.  It's easier to work off assets versus changing company culture, or changing morale.  In my newsletter I wrote about Summit Financial (SMMF), a bank that was in a similar position a few years ago, since then it's up over 150% as bad assets have dropped out of view.  Enterprise Bank has a worse starting point, but the appreciation potential is higher as well.

The risk to a situation like this is making sure the bank itself will stay strong and healthy long enough to work off the bad assets.  If the economy takes a dive before they can collect on their non-accrual loans and sell foreclosed properties then the bank will be in a bad situation.  New foreclosures and bad loans could swamp the bank's capital, especially given their focus on distressed assets.  In that situation the bank would be taken over by the FDIC and assets sold, ultimately to another bank that was stronger capitalized would realize those gains.

The reason this bank is trading at such a steep discount is because the market isn't sure whether they can work off their bad assets before the next crisis hits.  If they can this stock should quadruple or quintuple, if they can't then it's a zero.  Lottery ticket?  Perhaps..

Disclosure: No position

Benzinga PreMarket bank discussion

Last week I had the opportunity to be a guest on the Benzinga PreMarket show again.  A link to the segment is below.

While on the show I discussed a few ideas:

  • Opportunity amongst the busted merger of New York Community Bank and Astoria Financial.
  • Avoiding banks with long dated exposure
  • BNC Bancorp as a potential idea
  • High priced bank stocks.
You can listen here:

Why investors and management don't see eye to eye

Why is it that businesspeople and investors see businesses differently?  A friend mentioned a derivation of this analogy to me years ago and I brushed it off.  But recently I started to think about it again, and the simplicity of it hit me as brilliant.  As an analogy there are obvious flaws, but maybe, just maybe this will be good enough to become a framework, or a mental model, or latticework, or whatever other trendy thing analogies are now called.

I present to you The Box.

Think of every business as a box, a very simple box.  The box takes inputs, these inputs are materials, labor, or really anything.  The box outputs a something.  Some boxes create things for other boxes and some boxes create things for people.  These boxes all live together in their box world.

Every box can be described the exact same way with three statements, a balance sheet, an income statement and a cash flow statement.  These three statements describe everything the box is doing.  It describes the items the box is purchasing from other boxes as well as the output of the box itself.  The statements describe what the boxes are doing inside the box.

Using the same three statements every box can be compared to any other box and measured against any other box.  In the box world there is an industry of box watchers.  The box watchers aren't allowed to look inside any of the boxes.  Although from time to time a box watcher will take a peek inside a box, or talk to someone who works in a box.  

To the box watchers all boxes are the same.  They all have inputs, produce output and can be described the same way.  Box watchers are hyper focused on the size of the box.  Is the box growing or shrinking?  Box watchers live for the four times a year that the boxes produce their description statements.  Box watchers believe that boxes should combine with other boxes, or at times cut themselves in half.  Small boxes should combine with other small boxes, but once a box is too big it should split itself apart.  The combinations rarely alter anything inside the box, or change the box's inputs or outputs, but that doesn't matter.  These combinations and reductions are important to the watchers.

For a box watcher differences in a box's input and outputs can be described with simple mathematical formulas.  They believe that two boxes the exact same size should be described the exact same way with their financial description documents.  After all, if both boxes have the same inputs, are the same size, and produce the same output how could their financials be different?

The reality inside of each box is much different than what box watchers see.  On the outside a box is a box is a box.  It's inside that box where the action happens.

Each box is completely different, no two boxes have the same workers, and the workers are what set each box apart.  The managers who are in charge of the boxes are worried about securing their box's inputs and making sure production inside the box continues.  Workers are fickle.  They are constantly dealing with issues related to other workers and outside issues (with family, friends, and relatives).  Sometimes workers have kids who get sick, and the sick kid preoccupies their mind for the day reducing output.  Other times workers don't get along but are forced by a manager to work together.  The output from feuding workers is drastically less than the output from workers who enjoy each others company, or workers who have complimentary skills.  All of these preoccupations and personality conflicts multiply across the box.  It is rarely one issue that impacts inefficiencies, but hundreds or thousands of issues, all different, all happening at once.

Box managers spend most of their time worrying about issues related to their workers.  And when it's not their own workers it's workers from other boxes.  Sometimes the workers of a supplying box are so distracted their quality suffers and downstream boxes are forced to implement processes and procedures to handle the poor quality inputs.  

Inside the boxes everything can be reduced to a people problem.  It's the people who work together that take the inputs and generate the outputs.  It's the people at other boxes that consume the output, and people at other boxes that create the inputs.  Inside the box world what's happening takes the backseat to people.  People are everything inside the box world.  A motivational manager is the difference between underperforming workers and performing workers.

Boxes themselves are interchangeable.  A box with a specific input can find that input as the output from a number of different boxes.  Likewise what a box produces can be consumed by people or other boxes, interchangeably.  It's different inside a box.  People are an ecosystem.  They aren't interchangeable.  People have specific skills and personalities, taking a person from one box and putting them in a different boxes doesn't mean the results generated in the first will follow to the second.  

What frustrates box watchers is they don't understand what's happening inside the box.  To them all boxes are the same.  Boxes that are shaped the same and do the same things should have the same results given a set of inputs.  To a box watcher fixing outputs is as simple as fixing the inputs and tweaking a few items on the financial statements.

Box management is frustrated by the box watchers.  Everything is so simple to the box watchers, if only those watchers knew what happened inside the box!  Box managers try to appease the watchers by using their terms and superficially managing inputs and outputs, but box managers know that changing the box's financials isn't as simple as rearranging the inputs and outputs.  Box managers know that production is efficient because of their people, or that production is inefficient because of a few people.  People that need to be nurtured and coddled and dealt with individually.

Box watchers can exert enough pressure that a box tries to change itself.  It rarely works, the box is the way it is due to the people it has.  The only way a box can reinvent itself is by gutting the inside of the box and starting over.  A process that isn't much different than creating a box from scratch.

It should be apparent that the box watchers and box dwellers will never see eye to eye.  They won't because they're looking at different things.  Inside the box (business) employees are concerned about the day to day operational aspects.  The box watchers (investment analysts/investment industry) is only concerned with the financial statements the businesses produce.  Without the detailed operational knowledge about what happens in a business an investor can only make broad claims and judgements.

The danger to investors is when they adopt the box watcher mentality.  Box watchers are paid to watch boxes, not produce investment returns.  Investors are paid by understanding what happens inside the box.  A curious quirk to this entire analogy is that one doesn't need to become an expert on what's in the boxes to take advantage of this knowledge that each box is different.  Some investors recognize this situation and believe the key to earning outsize returns is to know who is in each box and what they're doing.  My own view is that this is the wrong approach.

The right approach is to understand that what happens in each box is different, but why things happen isn't as important as understanding the differences reflected in the financial statements.  Understanding the differences between the boxes is fundamental to making an investment decision.  Ineffient boxes will rarely become efficient boxes.  And efficient boxes will probably remain efficient .  Don't invest in an inefficient box thinking it'll become efficient, instead incorporate a discount or premium for these differences.  Just because a box is inefficient doesn't mean it doesn't have value either.