Sitestar shows anything is possible

How many investors have found themselves in an idle moment thinking "If I were the boss at the company I'd do things a lot differently."  My guess is if one invests in struggling companies this thought occurs more often.

The difference between thinking something and taking action is a wide gulf crossed by few.  In the case of Sitestar (SYTE) a group of investors crossed the chasm and took control of an undervalued asset in a way that most investors can only dream of.  Their conquest makes for a great story, and since I'm a sucker for great stories I want to re-tell it, even if there aren't any take-away lessons.

The company came into being during the dot-com boom as an ISP (internet service provider).  They provide service to rural areas where major providers ignore because distances between homes are too far, or there isn't enough density to service profitably.  Markets like these are littered with small companies that somehow find ways to make a profit where large companies can't.

From the start Sitestar had profitability issues.  They earned $200k in revenue in 1999 but spend $3.5m to earn it.  Eventually they found their formula for success and revenue peaked in 2008 at $8.8m with $1.2m in earnings.  It was around this time that their customers discovered they could access the internet from their pocket at speeds that walloped their dial up modems and subscriber numbers began to quickly fall.  In response to the "dying" business the company's management decided that rather than re-invest in dial-up they'd go on a shopping spree and purchase real estate, rehab it and flip for a profit.

I've always been suspicious of public companies that change from one business to something completely different.  It is disjointed and almost reckless.  Yet, if I meet a private entrepreneur who has a number of unrelated businesses under their control I think "what a savvy individual."  But the truth to this is entrepreneurs are always experimenting, always throwing things at walls to see what sticks.  The good ones focus on what has stuck, and if something's stuck they focus on it.  Sitestar found something with potential but failed to execute on it.

Throughout the years the company acquired a real estate portfolio of properties they intended to rent, or renovate.  The key to making money when flipping a house is to buy at low prices, renovate and sell quickly.  There are carrying costs associated with owning a house and each month a house remains unsold the carry costs eat into the potential profit.  If a house remains unsold for too long the potential for any profit disappears.

Fast forward to 2013.  Real estate investor and investment blogger Jeff Moore discovers that the company is trading at a significant discount to it's liquidation value.  He purchases a 7% stake, files a form 13 SEC notice and talks to the CEO about joining the board.  While I said there probably weren't any lessons to be learned this could potentially be one.  From time to time readers will ask me "how do I join a Board?"  Jeff's method is as reasonable as any out there, buy a sizable stake in the company then ask the CEO.  Don't wait to be asked, but be proactive and ask.

All was not butterflies and roses with the Board position for Jeff.  This is where things got interesting.  Jeff as a new Board member had grand plans for the company.  He wanted to do things like determine the cost basis for the properties and sell ones that needed to be sold.  He also requested financials that the company should have easily been able to produce, especially for a Director.  He wanted to get his hands dirty and take action on the renovations, after all this was his area of professional expertise.

Instead he was met with resistance and diversion.  Battling the company's roadblocks led to a trip with fellow shareholder Steve Kiel to Lynchburg, VA (where the company is located) in 2014 to discuss these issues in person.

Jeff and Steve arrived at Sitestar and requested to speak to Dan Judd, the CFO.  One of the company's employees stated he'd come to meet them.  Jeff and Steve waited for hours before the same employee came back and announced she was heading to lunch and locking up.  Jeff and Steve decided to go across the street during the lock-up and at this time the CFO snuck out the back door and drove away.  I can only imagine the CFO peeking out the window all morning wondering "when will they leave?"  I think it speaks volumes as to the character of the CFO.

Based on this experience Jeff and Steve took a more activist approach and engaged in a proxy battle to gain additional seats on the Board.  Jeff and Steve proposed a full slate of new Directors and the company negotiated a settlement where Steve and Jeff would be on the Board.  If at this point the duo worked to fix the company from the inside this would be a very typical activist saves investment story.  But Sitestar is anything but typical.

All was quiet on the Western Virginia front for months until suddenly there was a press release that the CEO, Frank Erhartic, a 30% shareholder had been fired.  Under what circumstances could a significant shareholder who is CEO be fired?  Under suspicious ones.  Kiel and Moore discovered that the CEO had made a series of improper loans from himself and his mother, charged the company rent for a building he likely didn't own, as well as other potential securities violations.  The problems were so bad that this tiny company with a market cap of $5m aroused the interest of the SEC.  The fact that the SEC is spending any time on Sitestar indicates this isn't a simple issue like Steve Jobs accidentally putting a historical and wrong date on his stock options that could be quickly swept under the rug.  No, this appeared to be real fraud, the type of stuff so brazen as to seem unbelievable.  I can almost imagine the exchange an exchange between Frank and his mother.

Frank's Mom: "Honey, this Sitestar piggy bank you own seems quite lucrative, any way I can make some money on it as well?"

Frank: "Well Ma, you can buy shares in the market, but we're just a penny stock and you might never see a return.  Instead why don't you smooth me a check for $50k and I will pay you an above market interest rate on the loan.  You'll get some quick cash that's risk free."

As a result of Erhartic's firing Steve Kiel was appointed interim-CEO.  After the company metaphorically peed in the pool they were swimming in Steve decided it was time to clean things up.  He hired a new audit team and began the process of correcting financial statements and verifying all of their accounts.  If you're a one-person sole proprietorship doing some work on the side it might be alright to handle accounting on a wing and a prayer with only a faint knowledge of what's in your bank account.  But if you're a company with millions in revenue and a public exchange listing the standards are much higher.  You need processes and procedures that are repeatable and auditable, something Sitestar didn't have.

Sitestar's new auditors unsurprisingly found a number of issues.  It turned out no one really knew how many shares were outstanding, an interesting problem itself.  The company also discovered that they were paying $50k in rent a year for space in an office building the CEO claimed to own.  Except it's unclear whether he actually owns it, regardless he still took the rent payments.  There are dozens of other accounting fixes from goodwill impairments to the resolution of an outstanding $900k loan for $90k that had to be taken care of as well.  

While engaged in the audit Kiel and Moore went through the real estate portfolio with a fine toothed comb.  They realized that carrying costs had eaten into most of the potential profits and that the best course of action was to hire contractors and sell the properties as fast as possible.  This was the course of action the company should have taken from the start.  Kiel and Moore also discovered that the internet operations weren't as bad as they thought.  Through some cost cutting and creative growth strategies the ISP holds potential, not a ton, but it holds potential.

The company is still hauling around some of the baggage from their past life.  The company's CFO, Dan Judd was fired and asked to resign from the Board.  He has since refused to resign and dug in his heels.  Kiel and Moore plan on replacing him in the next proxy context, but until then the dead weight is still hanging around.

With the influx of cash from the real estate sales and money saved from cost cutting the new management team invested in an HVAC roll-up fund.  The stated goal of the HVAC fund is to purchase small HVAC operations, implement centralized operations and sweep the additional profit back into the fund.  This is a fund that is being run by a fellow value investor manager who Kiel has known for years.  Sitestar will reap the economic rewards of the situation without having to actively manage the partnership.  Additionally the manager will only earn a salary if they can execute profitably, it's in everyones interest to make this work. 

The company just released their 10-K from last year as well as Kiel's CEO letter.  So what are shareholders left with at this point?  Sitestar has morphed from an ISP with an undervalued real estate portfolio to an ISP with a liquidating real estate portfolio and an investment in an HVAC roll-up fund with management that is intent on creating value for shareholders.  The company is an interesting investment at these levels.  Think of it as cash and an ISP with optionality.  As properties are sold cash will accumulate on the balance sheet and management can put it to work.  What sweetens the deal is Kiel's track record as a hedge fund manager is above average, and shareholders are getting his skills 'for free'.

I love the story of Sitestar because it shows that determined investors can gain control of a mis-managed company and turn things around.  I don't know the legal costs involved in the proxy battle, but my guess is they aren't substantial.  The biggest thing that Moore and Kiel had was patience, conviction and determination to see the battle through.

Is Sitestar the exception?  Probably not, there are probably a dozen Sitestar's out there on the pink sheets.  I hope there are other determined investors with the resolve to clean those companies up as well.

Disclosure: No position

Don't let these companies hide in the dark!

Imagine for a minute that you had a brilliant idea for a product and needed some capital.  To launch your company with this masterpiece product you need capital, so you find some partners who believe in you and they contribute equity to the new venture.  The product does well, there's growth and everything is going well as you work to build the company.  Years pass, the original investors move on happy with their returns.  New investors come along, ones you don't know as well, but they're happy to collect their dividend checks and talk at the annual meeting.  Eventually these investors even stop coming to the meetings or calling, you are running the company on your own.

Slowly you start to become somewhat resentful of your faceless investors.  They are cashing their dividend checks derived from your hard work, but they aren't involved in the business at all.  They don't even seem to care what's happening with the business.  You adapt to their disinterest and start to release news less often.  Eventually you don't file financial statements as often because you don't think the investors care all that much.  They continue to receive dividends in exchange for no effort, so why should you give them any extra?

This relationship disintegrates to a point where eventually you actively hide information from your investors and pay yourself richly.  You're doing all the work, the investors aren't doing anything, plus they get dividends and don't make a fuss.

Does this story seem right?  Or when you read it does it seem wrong?  Does it make you made or angry?  It should and unfortunately it's not just a story, it's something that is happening throughout the market with companies both large and small, but primarily small.  

Shareholders are the rightful and legal owners of companies they are invested in.  As shareholders they're entitled to returns from the company, either dividends or the assets in a liquidation.  But there is a strange twist to shareholding, outside shareholders contribute nothing towards the success of the company yet reap the rewards.  After a company's initial capital has been contributed outside shareholders are simply trading ownership interests between each other.  It's easy to see how a company's management, or employees could see this as a negative.  The company's management and employees work hard every day to put money in someone else's pocket.  It's also not hard to see how some employees might think "I should take just a little extra for myself and department, we work hard and shareholders will hardly notice."

In financial textbooks shareholders should have power over their ownership interest by virtue of their voting rights for the Board of Director.  Shareholders elect the Board, and the Board makes sure the company is managed in the interest of the shareholders.  The problem is this scenario is only true in textbooks.  Boards consist of people who interact monthly/weekly/daily with management teams, and with that level of interaction it's hard to not become colleagues or friends with management.  It's much harder for the Board to stand up for faceless and nameless shareholders who own 100 shares with the certificates stuffed in savings deposit boxes in Dubuque, Iowa.

The idea that the Board is on friendly terms with management and neutral at best or usually on adversarial terms with shareholders isn't new. This relationship has been well known by investors for at least 100 years.  In theory the Securities Exchange Commission (SEC) was created to combat this problem as well as further promote transparency and fairness in the markets.

Unfortunately the SEC is swamped with leads, both real and imagined and they don't have the staff or inclination to pursue most of them.  A second confounding problem is that the SEC is staffed by people for whom the SEC is a career.  These SEC employees have families, friends and hobbies and earning a paycheck and a promotion is only a portion of how they spend their day.  SEC employees (rightfully so from their perspective) are focused on bagging the biggest cases because high profile or political cases can result in promotions, which means a nicer car, or a better boss, or a window office, or a bigger house in the DC-burbs, or really anything else career related.  But none of those things are "upholding the fairness of the markets". And who could blame SEC employees?  How many employees at any company show up to work each day and while passing the mission statement in the hallway think "I'm going to make the customer #1 and provide value in all aspects of my job today!!"  Most people are thinking about where they want to go to lunch, or about some difficult project, or socializing with work friends.  That work gets done is incidental to the experience.

The area of the market where the lack of a visible regulator or Boards that care about shareholders is most apparent is in small stocks that have "gone dark."  These companies were at one point SEC filing companies that used a loophole in the SEC regulations as a way to cease filing financial reports.  To cease updating shareholders with details about THEIR company.  And to hide in the dark.

The SEC claims that any company with less than 300 registered shareholders (more for a bank) can cease filing financial statements and escape regulatory burdens.  This is called "going dark."  The theory is that a company this small should be considered privately held.  I don't disagree with the SEC's logic, except for one area, the type of shares the SEC counts as 'shareholders'. The SEC believes that only registered shares count as true ownership interests.  A registered share are shares held in certificate form.  These are the fancy certificates that are held in safe deposit boxes and need to be mailed to to sold.  The three day settlement period is an artifact of when everyone owned paper certificates.  Three days gave investors enough time to mail their certificate to their broker after instructing a sale.

Since the markets have modernized most shareholders keep shares in street name at their broker.  The brokerage has a giant digital lookup with each holder's name and the number of shares they own, which is called a beneficial interest.  There is a substantial amount of case law confirming that beneficial holders, investors with street name holdings have the exact same legal standing as a registered shareholding.  And it's because of this that beneficial shares receive dividends just like registered shares.

The problem is these dark companies get to have their cake and eat it too.  They can pay dividends to beneficial shareholders but then hide behind their dark non-filing designation and claim they don't need to provide legally required information to shareholders.  

Companies go dark for a variety of reasons.  For some it's to save costs.  The cost of being public can be onerous to a small company.  Companies that go public for cost reasons often continue to update shareholders with news and their financial condition through the mail and on their website.  The cost savers are the exception.  The majority of dark companies are literally hiding in the dark.  Either management is hiding nefarious dealings with themselves and at times outright theft from shareholders, to other management hiding just how good the company is doing from shareholders.  In both cases management is lurking in the dark and escaping through an SEC loophole.

I own shares in a number of dark companies, they range from the cost savers mentioned above who are good stewards of shareholder capital to a number of cockroaches hoping shareholders never realize they exist.  One company I own, Kopp Glass, decided this year that as a beneficial shareholder I have ceased to exist.  It's almost a comical dance, the company claims I'm not a shareholder and have never been.  Which is ironic because I've been to two annual meetings, and at one the CEO told me he'd looked to see how many shares I owned.  It's worth noting that I have continued to receive my dividends quarterly just like I should.  But if I ask for an annual report I'm "not a shareholder according to our records."  The CEO acknowledged in the past I was an owner, but suddenly I'm not. At a dark company hiding in the shadows away from the SEC they can bend rules to fit whatever they want.

Kopp Glass isn't an exception either, they're just one of many companies that play this game.  The problem is the game is illegal.  In Pennsylvania (where Kopp is incorporated, but this rule also stands in Delaware and other states) it's illegal to grant different rights to shareholders of the same share class.  This means you can't pay dividends to only some of the company's shareholders and not others if they all own the same class of shares.  This also applies to information, a company can't distribute material financial information to a few shareholders and not everyone.  While doing so is illegal it could also be construed as to giving certain shareholders an inside advantage.  In the dark market these sort of occurrences seem normal, but they shouldn't be.  The public would be outraged to find out that GM executives were mailing out pre-released financial figures to a select group of their friends, those executives would probably end up in jail.  Yet with dark companies the SEC has implicitly approved the distribution of material information to whomever a company wants, not everyone by failing to act and take action against this blatantly wrong behavior.

Going dark doesn't mean a company can do anything they want.  It just means they aren't burdened with quarterly SEC filings.  To make an analogy a company that goes dark is acting like a person who moves from a city with zoning and a full time police force to a rural area without zoning and a local sheriff.  Moving out of a city doesn't mean the person can start to distribute drugs, sell weapons, open a brothel and do anything they want because there isn't a full time police force anymore.  They just moved from one form of structure to a different form, but the person would need to abide by the law of the land in both places.  Unfortunately dark companies have decided that they are above the law and since the SEC has failed to enforce the law these companies are getting away with it.

We now have an area of the marke that's lawless and a complete mess.  This is the breeding ground for pump and dump operations, unethical managers and anyone else who wants to hide in the dark.  Is it any surprise that pink sheet and non-SEC filing companies are universally derided as scams and dangerous to investors?

As investors there isn't much we can do to change this.  I have made it a point to write about companies that flaunt their dark status as a ticket to steal from shareholders, but writing can only do so much.  At some point the SEC needs to step in and enforce their own rules.

Investors have a very unique opportunity in that right now the SEC has an open comments period on financial information requests.  I know some investors who have let the SEC know their thoughts on dark companies, and I plan to as well.  I hope you will also write a letter, no matter how long or short telling the SEC that companies need to treat beneficial shareholders the same as registered shareholders in doing dark transactions.  The SEC should also ensure that going dark isn't a license to steal from shareholder pockets either directly or by giving out inside information to select parties.


So you want to buy an entire bank (or just a portion), let's talk about how

"I'm looking to buy an entire bank, have any ideas on what to do?"  That seems like a strange question doesn't it?  Yet it's a question I've been asked a number of times over the past few years, and a question that a number of investors have more than a passing interest in hearing the answer.  Seeing as there isn't much online, I thought I'd provide a bit of a primer on how to buy a bank as well as include information on how regulators and bankers value banks.  This is important because it'd be hard to purchase a bank without knowing how to pay for it.

A bank is just a business like any other except for a few simple details and it's those simple details that make banks seem unlike any other business.  And that's what makes buying a bank appear so difficult.

It wasn't that long ago when a group of business people could form a partnership, raise capital and start a bank from nothing.  The financial crisis ended that practice with only two de novo (from scratch) banks receiving regulator approval since 2008.  That leaves individuals who want to own a bank with only one choice, they need to purchase an existing bank.

The Purchase

Buying a bank seems like a daunting task.  Maybe this is because the stereotypical image of a bank is one of an imposing institution.  This is an image banks have themselves helped propagate.  Rhetorically I ask how many tiny community banks have images on their website of marble buildings with greco columns set high above the road with imposing steps when their actual branches look more like a brick rectangle with a drive through?  We imagine our money being kept in large secure vaults, not on servers stored as bits.

Bankers themselves help to create this impression that "we are different."  There is banking specific lingo, there are banking specific conferences and bank specific magazines.  These things exist in other industries, but other industries share common traits that banking doesn't.  You can have a discussion of logistics or product pricing and most executives in any industry will find information that's useful to their specific business.  When bankers talk about interest rate risk, or net interest margin compression or deposit growth there is no cross over to other industries.

There are barriers to entry for the industry, but they aren't as large as some would think they are.  A little education can go a long way.

When investors think of purchasing companies their minds naturally drift to publicly traded companies.  That's because purchasing a portion of a public company is easy, it's a few clicks, or at most a phone call to a broker.  Gaining control of a public company is much harder and visible.  This is because once investors see another investor is interested in purchasing as much as possible of a company they're less willing to sell their own shares.  This usually forces a potential acquiring investor to make an offer for the company rather than slowly accumulating shares in the open market.  Banks are no different in this regard.

But one significant difference does need to be mentioned.  There are no ownership limits on non-banking companies.  For example as an investor I can purchase 25% of a company if the shares are available for purchase.  The same isn't true for banks.  The most an investor can purchase in a bank is 9.9% of the bank's stock.  This is because at the 10% ownership threshold the FDIC and Federal Reserve consider the owner to be an owner of influence and subject to approval and regulation.  There are two ways to pass the 10% threshold, the first is to obtain an waiver from regulators, the second is if a bank is buying shares in another bank, they aren't subject to the same threshold limits.  If a fund attempts to purchase more than 10% of a bank without a waiver they could be considered a regulated bank holding company and subject to holding company disclosure and regulation.  Not something a casual investment fund wants to deal with, unless they intend to become a bank only investment fund.

At 9.9% an investor can significantly influence a bank, but they don't own it or control it.  A public investor would need to make an offer for the entire bank at this point.  While this is a feasible route, it's akin to taking the longer route to a destination.  There are quicker and better methods.

Of the ~6,000 banks in the US only about 1,000 are publicly traded, and by traded I mean they have a ticker associated with them.  This means there are 5,000 banks in the US where the owners are private individuals or groups of individuals.  These are the types of banks that an investor who wants to own a bank needs to target.  There are a number of reasons for this, the first is it's much easier to talk to a private company verses a public company about confidential or sensitive information.  A public company needs to issue press releases related to various material events.  Private companies don't have this same level of responsibility.  Secondly it's much easier to negotiate a transition plan with a private company compared to a public company.

Let's take a look at how this might work.  The first thing to consider is that banking is a very congenial industry.  Bankers are friendly and politeness and formality is appreciated.  The bull in the china shop approach that's common in the public markets isn't widely accepted or appreciated.  The first place to start would be to talk to the CEO or President of a small bank and make your intentions known.  Maybe take them to lunch and let them know you're interested in purchasing a bank and would be interested in theirs, or an introduction to any bankers they know who might be interested in selling.  This is an important point, you want to work through networks.  A formal introduction from a friendly banker is extremely valuable.  There are always banks shopping themselves formally or informally.  The banker network is aware of these banks, you as an outsider might not be.  The key is to get inside the network.

Once you find a bank that's willing to sell it's a matter of purchasing your ownership stake.  To find the owners of a private bank you need to get a hold of the bank's Y-6 regulatory filing.  I'll make a shameless plug here that we have digital versions of every bank holding company's Y-6 filing inside CompleteBankData along with the ability to search them and obtain contact information for individuals.  A Y-6 will show who the majority owners are, the number of shares they own as well as their ownership percentage.  Interested in buying their shares?  Call these shareholders, or have bank management introduce you to the owners.  Once you've figured out a way to purchase a majority ownership block you need to determine how much you'll pay for the shares, that's the next section.

The Valuation

It never fails to amuse me when I visit a financial information site that presumes banks are the same as any other business.  These sites will prominently show a bank's EV/EBITDA ratio, or other metrics that are completely irrelevant.  Banking financials are unlike other financial statements.  At the most simple level a bank earns a spread between their cost of funding and the interest earned on the loans they extend.  Out of this spread they pay salaries, pay for operating expenses and pay taxes.  What's left over is considered net income.  See banking really is simple!

Because banks work differently they're viewed differently by the market as well.  There are two short-hand metrics for valuing banks, price to earnings and price to tangible book.  The rest of the market has moved from these simplistic measures onto more sophisticated ratios such as EV/adjusted-EBITDA or price to earnings-when-my-grandkids-are-in-college.  But banking has relied on simplistic short hand measures.  Thrifts and smaller community banks are usually valued on a tangible book basis and larger banks with higher returns on capital valued on their earnings.  These are quick estimates of value for market participants.  Knowing that a bank trades for 105% of tangible book value (TBV) doesn't mean anything itself, it's a relative valuation.  Knowing that a bank trades at 105% of TBV when comparable banks trade for 165% of TBV is meaningful, but it doesn't necessarily mean a bank is cheap either.  It simply means there is a discrepancy that needs to be investigated to determine if there is value in the difference.

When a bank acquires another bank they don't rely on simple metrics.  I'd be laughable to think of a boardroom with a Director saying "our target bank is only trading or 95% of TBV, I think we should purchase it."

Banking is no different than any other industry when it comes to mergers.  A bank looks at an institution to be acquired as an opportunity to maximize scale, put idle assets to work, and save on duplicated operating costs.  What's unique about banking is that at a high level all of these institutions work the same, that means that a merger is more likely to create value compared to a merger outside of banking.  There are differences in operations and cultures, but those chasms can be crossed easily.  The fundamentals of merging bank businesses are the exact same, and that's what's important.

In almost every private market the transaction dynamics of a purchase are similar.  An acquirer is granted a detailed look at the to be acquired institution after a formal letter of interest and the acquirer makes what's considered a fair market offer.  It's rare that a purchaser pays a basement bargain price for a company in the private market deal.  This is because the dynamics of the deal are much different.  Unless the seller needs cash ASAP, or has a impaired asset bargain deals in private markets just don't exist.  This is because both parties receive access to the same financials and a deal is discussed that's agreeable to both parties.  There are no public shareholders to please or worry about.

Instead alpha is generated in the private market through operational improvement.  A buyer and seller will negotiate a fair price for a deal, but the buyer has an idea in the back of their mind on ways they can better utilize the assets they are buying.  Maybe they have better customer service, or can cut costs, or can cross-sell, or a variety of other things.  Buyers pay fair prices and make their money back through operational changes.  That's one of the benefits of being a majority owner, you can make changes as you see fit to change an entire organization.

The way to value a bank is through this lens of operational changes.  The formula we use at CompleteBankData is one made popular by Richard Lashley of P&L Capital.  While ultimate credit goes to him for putting the formula on paper I had heard the sentiments of his formula explained by those in the industry long before I heard of his specific formula.  The formula is as follows: look at the to be acquired bank's operating expenses and estimate after tax cost savings.  Add those savings to the bank's net income and apply a multiple to the projected earnings after cost savings.  The concept makes sense on an intuitive level.  A second level of valuation is to estimate additional earnings from putting excess capital to work.  Typically in a merger cost savings will provide the largest bang for the buck compared to putting capital to work.  That is unless you happen to find one of these banks with 50% of their assets sitting in cash waiting to be deployed, but even in that case my guess is there are more than a few cost synergies.

Now What?

You now know how to find a bank that's looking to sell and then how to value the bank for purchase, so what's next?  You write a big fat check and get working!  It's a fallacy to think that one could buy a bank, sit back and collect checks without doing anything else.  The money to be made from buying a bank is from putting your fingerprint on the institution.  If you do it right a lot of money can be made, if done wrong then at best you can hope there's a government backstop to help you out.

Interested in learning more about banking?  I'm in the process of writing a book on banking.  You can receive a free copy of a chapter "Are Banks Risky?" by signing up for our email updates list.  We rarely will email you, but list subscribers will receive special deals on the book when it's released and advanced notice on the release date.

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Yesterday's strategies from investment gurus

Buffett had his generals and special situations.  Graham his net-nets and low book value stocks.  Lynch invested in what he knew, along with thrifts and good companies at good prices.  Greenblatt has his magic formula stocks, or his spin-offs, or recaps.  Every investing guru has a style or strategy that they're known for along with hordes of investors attempting to mimic these successful strategies.

Wall Street is enamored with survivorship bias.  Let me rephrase that, Wall Street is foaming at the mouth and drooling madly over the survivor strategies and successful investors.  The investment system is practically built on survivorship bias.  Investors that do well are heralded as genius and spoken about in holy terms.  But what about the guy who invented Dogs of the Dow?  He's probably sharpening his pencil on a new strategy, one that works.  Or what about that Dow 100,000 guy? He's a professor now, slogging away until his next prediction hits it big.

The gurus of today were nobodies of yesterday.  Of the tens of thousands or even millions of investors trying to make a buck the current gurus were the ones who were successful.  There are hordes of very smart investors who after making mistakes have ensured that will never become well known, they've been lost to the sands of time.

What further perpetuates this complex is that the financial media loves to highlight investors who are at their peak performance.  There is this common understanding that one or two lucky bets doesn't indicate skill whereas long term results indicate skill.  A flash in the pan manager isn't skilled, but someone who's pan has been flashing for a few years must be skilled.  A few years of outperformance will result in calls to appear on CNBC or Bloomberg.  This neatly coincides with the length of time before the winds shift in the market and the strategies that worked in the past market fail to work in the current market.  It's quite a conundrum.  When someone becomes popular and they are willing to share their secret sauce it's just before the sauce stops working.

Of course this situation is well known.  There is a response to it, which is "buy the index."  Most fund managers underperform the index eventually, and even investing heroes make mistakes, sometimes catastrophic mistakes.  We're told if we buy indexes we can avoid all of this mess.  Success in the market is fleeting, and that's fascinating to me.  It's fascinating because success in the real world isn't the same.  Yes, there are flash in the pan successful people in the real world, but I'm not talking about them.  It's uncommon to find a serial entrepreneur who's built a number of successful businesses and then suddenly every business they start fails.  Or a real estate investor who builds a real estate empire and once large find themselves hemorrhaging money because every new investment is poor.

No, in the real world experience compounds.  This is why a senior executive who has managed through numerous business cycles commands a higher salary compared to a fresh executive who has never seen a business cycle.  The entrepreneur with a string of successful companies becomes a mentor to new entrepreneurs, they have real experience that they can pass on to help others.

The disconnect between the real world and the market is stark.  Why is there a difference between the two?  My belief is the difference is due to the layer of abstraction that exists in the market verses the business world.  Investing is a derivative function.  You are not dealing with customers, suppliers, and employees.  You're pushing little bits of paper around from the arm chair while discussing high and lofty things like the baltic sea index, or inflation expectations or a dovish Fed.  I have yet to meet a non-investor who's mentioned the dovish Fed.  But I've met many that will gripe about how hard it is to get customers to pay on time, an issue that directly impacts the bottom line.

Investors focusing on guru strategies are looking at a derivative of a derivative.  The business is at the bottom of the pile with a stock derivative on top.  The guru strategy usually identifies something related to the underlying business that can be leveraged to outsized profits.  But the investor investing in the strategy is focused on the strategy, not what's happening at the underlying business.  The strategy is a derivative based on stocks and stock movements, a derivative of the underlying business.

The best gurus adapt.  Arguably the best investor of the world, Warren Buffett has changed his stripes multiple times.  From cigar butts and low book value stocks to compounders, to buying regulated utilities and negotiating sweetheart deals for outsized yields.  At each step he's recognized when his strategy is topping out and moved onto something more profitable.  The problem for investors trying to mimic gurus is that no one knows when the strategy will stop working, or if it's already stopped.  Buffett knows when it's time to move on, but unfortunately for his followers he's not going on CNBC announcing "I just wanted to let everyone know that I won't be buying utility-like companies anymore, it's time for something else."  He silently moves onto the next thing, eventually people take notice and then start to write about the next thing.  But there is always a contingent focusing on the last thing.  Far after Buffett has moved on there are still investors discussing how great utility type companies are and that Buffett has invested in them so they must be good.

The world changes quickly.  Businesses that survive need to change with it.  At the core a successful businesses is always changing.  They're adapting to the needs of their clients, employees and stakeholders.  But surprisingly investors are looking for The One True Formula, that investment strategy that always works, and will work forever.  The strategy that they can plug in and grind out profits until they're rich and drinking fancy drinks on the beach with little umbrellas in their glass.  They're constantly searching for The One True Formula.  This formula is a fallacy.  No formula exists, nothing always works, nothing will ever work forever.

Maybe this comes as a shock.  Lynch's strategies will underperform for years or decades.  Graham's net-nets aren't always a buy.  Low book value stocks should be avoided sometimes.  There is a time to buy the compounder, and a time to avoid it.  Most if not all investing strategies in the hallowed investing cannon will fail from time to time.

This made me think of the section of the Bible that became a famous Byrds song (listen to the song here while you read), the section of the Bible discusses how there's a time for everything.  I took an enormous step of artistic liberty and decided to re-write this in the context of investing:

   There is a time for everything,
    and a season for every activity under the heavens:

    a time to invest and a time to spend,
    a time for growth stocks and a time for bankruptcies,

    a time to research and a time to act,
    a time for low multiple companies and a time for Internet rockstars,

    a time for compounders and a time for cyclicals,
    a time for pink sheet names and to trawl the NYSE,

    a time to diversify and a time to concentrate,
    a time to embrace cash and a time to be fully invested

    a time to search and a time to give up,
    a time to avoid speculations and never a time to look at them again,

    a time to listen to gurus and a time to shut them out,
    a time to be silent and a time to turn on CNBC,

    a time to love your positions and a time to hate them,
    a time for failure and a time for success.  

Is there value in listening to an investing gurus? Or reading a classic investment book? Or looking at successful investing strategies?  I believe there's a lot of value, but not in the way most expect.

The first is I ignore investors who claim to have The One True Formula.  They don't, and if they think they do it'll eventually fail.  Flexibility is to be admired.  Flexible investors will say "I usually look for x, but sometimes it's y that matters more."

One of the reasons I really like Benjamin Graham's Security Analysis is because it lays out a framework on how to think about businesses.  Even in his famous chapter on net-nets there more about how to think about value rather than him pushing an investment strategy.  It'd be crazy to blindly stick to Graham's strategies 60-70 years on, but it isn't crazy to apply how he thought to the modern market.  If a company is selling for less than their liquidation value then it's reasonable to consider that the company is probably undervalued.  The question becomes what is liquidation value?  That's something that you the investor need to consider and determine yourself.  I've seen blog posts where people argue whether inventory or receivables or real estate should be included in a liquidation value, I would answer both yes and no.  Sometimes they should, and other times they shouldn't, it just depends.  But "it depends" isn't a satisfactory answer for most, they want to be told what to do, not the way to think about a problem.

But ultimately what gets investors in trouble is when they outsource their thinking.  You can't outsource your thinking when you're running an actual business.  We need to think like a business person, not figure out if a company fits the formula or if it doesn't fit the formula.  When we outsource our thinking and start to rely on formulas we've made a mistake, a big mistake.

The best investors are those who've figured out that nothing works all the time and are constantly thinking about the next thing.  What is an investor to do?  We need to look at guru's and investing books as guideposts, not as maps.  The popular investment books should be telling us how to think, not what to do.  Each step of the way should be informed by what exists now, not blindly following a strategy that worked well in the past.  Sometimes what works now is the same thing that worked in the past, but it usually isn't.  And if it is it's sufficiently long enough that everyone forgot it worked at some point previously.  At the end of the day we need to be flexible and independent, not beholden to any one idea or strategy, but willing to adapt as market and business conditions merit.

The large cap myth

In America bigger is better.  Houses are getting bigger, trucks are getting bigger, TV's are bigger, smart phones are getting bigger, and Americans are even growing bigger.  A neighbor mentioned that they rarely watch TV yet felt compelled to buy a monster sized TV.  We have an obsession with large things.  Big cities, big roads, big anything and big everything.  Our culture says larger is bigger.  Bigger portions, bigger trips, bigger weddings, everything is fancier and more extravagant.  The American culture attaches significance to largeness.  And as such we've somehow come to think that large companies are universally better than small companies, why? It's because they're large and large is good.

The market worships large companies.  Large companies are on the news, they're in the papers, everyone wants them on their resume.  It doesn't matter how they got there, growth, mergers, fiat, as long as a company they are considered important.  For the working public working for a brand name in the mail room is better than being a decision maker someplace no one has heard of.  I have a neighbor who lamented to me that there are no more good jobs left in Pittsburgh.  He then went on to rattle off a list of large companies that were located here in the 60s and 70s that have since left or been merged away.  He made comments like "without these good jobs [the large companies] where will kids work these days?"  Maybe kids, which to him is anyone in their 30s and younger, will work for some of the hundreds of tech startups here, or maybe a smaller local company that fills a niche, or maybe they'll be a lucky cube-jockey at a few of the large places we have left.

Investors usually regard management at smaller companies as dopey or out of touch.  The theory is why would someone want to work at xzy tiny company when they could have a lavish office, nice perks and status at abc large company?  There are a variety of reasons, but often people who work at small places want to have an impact on where they work, not become an office politician.

All large companies have a moat, a moat is a durable competitive advantage.  One doesn't need to look hard to identify a large company's moat, it is always the same, it's their size.  A large company can be successfully by simply being large.  Most large companies are near monopolies, or duopolies or oligopolies for their market.  Interested in cable internet for your home?  There is always only one provider.  What about trash collection?  Same thing, a mandated provider.  If you're lucky there are two options, usually equally bad.  Our township mandates that we use Waste Management (WM), a company where if I were to call them unreliable would be a compliment.  Trash pickup schedule?  They don't need a schedule, they just expect citizens to leave their waste out for days and when they decide to pick it up they will.  Somehow this company is a bastion of capitalism, the type of company that Barrons thinks every investor should own in their portfolio.  My Waste Management experience isn't an isolated incident.  I have many other experiences as both a client, and as an employee at large companies, too many to count, and most I'd never share online.

What investors don't seem to understand about large companies is what they think is happening on isn't really what's happening at the company.  I've seen numerous write-ups that talk about capital allocation or earnings growth or innovation.  The only people who care about capital allocation at a large company is the CFO who's massaging the earnings and the CEO who has to remember to mention the term on the quarterly conference calls to assuage investors.  Do companies with excellent capital allocation have employees who pad their budgets or "have to spend $500k by the end of the month on *something*" so their budget isn't axed?  I've sat in meetings where it has been said "we don't care about ROI" before money was spent on significant initiatives.  Failed projects that cost $20m+ and are cancelled with an "oops, guess that was a mistake" are the norm without repercussions.  Except to the shareholder capital that's destroyed in the process.

Success at a large organization is determined by political savvy not by the ability to get a job done.  If someone is able to build a small empire of loyal troops and obtain high profile projects that person will move up rapidly.  They'll move up even if the projects are an outright failure.  Political savvy has nothing to do with how well a job is getting done.  It's all about alliances and maneuvering and situation handling.  Sometimes a threat needs to be neutralized, that threat might be fired, or more likely they'll be stuck on a team with some truly pathetic employees and forced out.  Get in the right group and all goes well, the wrong one, and well.... you're bouncing to the competitor across town.  I had an old boss who explained that success at a large company was measured by the ability to build a fiefdom.  People who could build fiefdoms quickly and grow them moved up, while those who didn't have this ability were cursed to do the actual work while languishing at the bottom of the org chart.

Once one realizes that incentives and motivations at large companies are political much of what they do, or how customers experience the company begins to make sense.  One company I knew of was focused on how many times new features were released to clients, not the usefulness of the actual features.  More features more often equalled success with management being rewarded with bonuses.  Whereas a single impactful feature that took months to implement would be considered a failure.  I am also knew of a situation where management was incentivized based on their department's EBITDA.  Hiring employees reduced department EBITDA, whereas hiring contractors even at double or triple the cost of employees didn't impact EBITDA because the contractors could be capitalized.  I realize that this accounting treatment was dubious at best, but it's how it worked.  What was the outcome?  The company was very light on employees and very heavy on expensive contractors.  Who bore the brunt of this?  Shareholders who owned a company that lost money on a GAAP basis, but was wildly profitable if one only looked at Adjusted-EBITDA.  This was a company that happily purchased shares at $40-50 a share, but during the crisis when shares traded below $10 decided that instead of repurchasing stock it was more prudent to obtain debt financing with coupons ranging between 15% and 20%.  Low and behold, once the stock appreciated management decided to repurchase shares again.

I could go on and on, the stories are crazy.  One place was having a bad quarter and told employees to disregard expenses that quarter and spend as much as they wanted.  This was because once Wall St saw a loss they wouldn't care about the size of the loss.  It was better to shove future expenses in the lost quarter to inflate future earnings.  This was a very transparent communication to employees.  These aren't one-off things either, but rather the pattern of business.  This is just how large companies work.

It isn't to say that employees at large companies are nefarious or evil.  There are plenty of great employees who do their best every day and take pride in their job.  There are people deep in the bowels of some of these organizations pushing for change and trying to make things better.  This is why sometimes our interactions with large companies can be great.  Maybe as a customer we cross paths with a department led by a manager who's an agent for change, or someone not satisfied with the status quo. 

The problem isn't the people, it's the scale and challenges due to size.  At a tiny company waste is noticeable.  On a larger scale a small amount of waste across an entire organization becomes a massive amount of waste.

The more one learns the worse it gets.  It's almost as if some of these large companies are doing well in spite of themselves.  How do they do it?  It's all due to their size.  Let's go back to the example of my township and Waste Management.  Envision the township evaluating waste collection companies for a new contract that grants a monopoly.  There is Waste Management, Allied Waste and then Joe's Trash Hauling.  Joe's Trash Hauling is a small local company.  They are responsive, care about their reputation and are efficient at their job.  None of that matters.  The township is going to worry about what happens if Joe gets cancer and can't run the company, or if Joe's company can handle the capacity or a million other flimsy reasons that prevent a small company from competing.  Everyone has heard of the larger companies, and the larger companies are well equipped to put together a government service proposal.  And so citizens are saddled with an inferior provider.  This is true for anything at scale.  

There is a second aspect that's under appreciated.  Large companies love to do business with other large companies.  There is repetitional risk for an employee if they decide to use a smaller service provider and then there's an issue.  But if it's a large company there is no risk.  Large companies presume they will receive premium levels of service from their large company suppliers because they're large.  This is the opposite of what happens.  I've seen terrible levels of service at large companies because the providing company is large itself and is inefficient (or doesn't care), or they realize that the client either has no alternative, or isn't willing to use a smaller company.  The large company becomes a captive client to a monopoly provider.  This is one of the reasons why large companies can earn above average rates of return, they have a captive client market and a dominant market position.  They can charge above market rates and their clients have no choice but to use them.  Zoom out a bit and there is an interconnected network of large companies all bilking each other for services and products.  This is not dissimilar to how large companies all have under funded pensions invested in every other large company with an underfunded pension.  The network of underfunded pensions all investing in other companies with the same underfunded status is a discussion for another day.

A significant advantage large companies have due to their size is easy access to financing and capital.  This comes in handy when a small upstart company begins to threaten their market.  The natural large company response is to acquire the threat.  Investors often wonder why companies overpay for acquisitions.  To anyone who's been in the guts of the machine there is no mystery.  They aren't acquiring for technology, expertise or investment return, they're neutralizing a threat.  The acquirer has determined that no matter the cost they will eliminate a potential threat.  This might be a real or imagined threat, but in the company's mind it is a threat.

I don't want this post to come across with the idea that small companies are perfect, they aren't.  But large company actions at a small company level are expressed quickly as poor financial results.  Smaller companies don't have the scale to get away with some of the antics that are acceptable at scale.  Waste and poor acquisitions impact the bottom line right away.  In a large company there might be a rotting dead core that takes a decade to expose itself.  The reason spin-offs usually work so well is because when the branch is cut from the trunk all of the waste endemic from being part of a large company is exposed and can be cleaned up quickly.  For the management at a spin-off it's almost like shooting ducks in a barrel.  Shrink expenses and watch profit grow then earn a giant bonus.  It's not like cutting expenses is even hard for them.  They just stop doing things like flying a team across the country for a day of useless meetings.

The point of this post isn't to say that large caps are "bad" and small caps are "good", but rather to point out that these are two different types of companies with very different business models and dynamics.  Smaller companies are focused on products, growing and gaining marketshare.  Large companies are focused on staying where they are and keeping their dominant position.  Investors buying large caps should be aware that they're buying pseudo-monopoly players who will spend any and all shareholder money to retain or grow their position.  When a company has a dominant market position they will extract as much money from clients as possible until a viable alternative comes along.  A discussion about viable alternatives is better left for Clayton Christensen to explain in his excellent book The Innovators Dilemma.  

This post might generate a lot of push back from large cap investors.  But I'd offer you this.  Most investors have never worked at a large cap, most of Wall Street or value investors, or mutual funds have never worked at any of these companies.  Their exposure is annual reports and investor conferences.  The perspective of Wall Street on large companies is like a person sitting in a timeshare sales meeting.  Everything about the resort is great, the views are perfect, and the price is a bargain.  Yet for those of us who have worked at the resort we know the true story, the salesmen aren't selling empty desert land, but it's pretty darn close.  But the sales team can sell, and as long as they keep selling then all is well.

You might argue that maybe I'm cynical, or maybe I'm jaded, or maybe I'm just pessimistic.  I'm not,  I'm simply calling a spade a spade and pointing out that the Wizard of Oz is just a man behind a curtain.  What I've found so amazing is that anyone who's worked at a large company will agree with me, yet the investor world in general is somehow ignorant to this notion.  It's important to know what we're buying, and what motivates people at a company we've invested in.  There are ways to make money on both large and small caps, but the dynamics of business due to size are very different.  Don't confuse what motivates a small company with what motivates a large company.

How to eliminate "bad" microcap companies

I remember reading an account years ago of how the Secret Service trained their agents to identify counterfeit money.  The agents are never shown fake money, but intently studied real bills.  They spent hours studying bills and memorizing what a real bill looked like.  Once the agent had memorized every aspect of a real bill they could identify when bill differed in any way and know it's counterfeit.  It's a very interesting approach, and has some applications for investors looking for potential investments.

There are a lot of investors spending their time reading and looking at "good" companies.  These are usually success story companies such as Coke, Proctor and Gamble, anything Buffett has invested in, compounders (before they blow up) etc.  In theory if one had memorized the characteristics of a good company then identifying something that's not good should be easy.  And I think in many cases this is probably true.  If you spend your time studying good companies you will be able to identify something that isn't good.

Where investing and counterfeit training differ is the Secret Service knows what good means.  There is a standard of good, a bill that adheres to the Treasury specifications.  In the world of investing we don't have a standard like that.  What makes a good company?  Is it a company that compounds at high rates of return internally?  One whose shares appreciate so significantly that investors put the ticker on their license plate?  The largest companies? Innovative companies?  "Good" can mean anything, and it's different for every investor.

I don't spend my time looking at good companies, I've taken a different approach to my investing.  I look for bad things in companies, and when I find a company with either an acceptable level of bad, or no bad then I'll invest.  I find it easier to turn over rocks and eliminate the bad ones rather than hunting for the gemstone.  The difference can be described in an analogy.  Instead of picking through the fruit at the supermarket looking for a perfect apple, I'm looking at all of the apples and just trying to find ones without imperfections.  Some without imperfections might taste worse than others, but I'm not going to spend the afternoon comparing the firmness of every apple trying to find the best one.

This week I spent some time on OTC Markets looking through all of the recently released financials.  I used to do this weekly, but the habit has since fallen off for reasons you'll understand in a few minutes.  All I did was open each financial report, skim it for imperfections or items I don't want to deal with and move on.  In the past I could usually find a company worth further research with this method.  But this week I went through 12 pages of filings and just looked at junk, junk, and more junk.

It occurred to me as I was going through these junky companies that other value investors dipping their toes in the micro cap waters might want a bit of help on what to avoid.  This is not an exhaustive list, but I haven't been served wrong so far by avoiding companies with the following attributes either.

Constant share dilution or preferred stock issuances

In many small company annual reports there is a section towards the top detailing the capital structure.  There are a number of these companies that have lists of issuances dating back years, or preferred stock outstanding that is iterated into the N's, O's and P's of the alphabet.  If you see this move on.  The company is surviving on outside investor capital.  You are their business model.

Companies paying for services in stock

This is usually closely tied to constant dilution, but sometimes it isn't.  Equity capital is the most valuable capital a company can have.  If management has determined that they're willing to hand out shares to newsletters, ad agencies and websites for the equivalent of a Google Ad mention it gives investors good idea of how valuable management believes their shares are.  If management treats their equity like toilet paper then the equity is probably as valuable as toilet paper.

A Nevada incorporation

The State of Nevada is notorious for how easy it is to setup a business.  A few forms and a check and you're on your way.  They're also notorious for having the fewest protections for shareholders.  There are legitimate companies with Nevada charters, but they are few and far between.  If you find a company suddenly went dark with your investment you won't have the right to look at the books unless you own a significant and potentially controlling interest in the company.  This isn't true for other states where a single share grants you legal rights.

Constant name changes

When a business formerly named "Southern California Hot Dogs" changes their name to "BioHealth Sciences" and then "EcoWater Tech"  you know you have a winner on your hands.  Companies like this usually have a world changing invention that they refuse to demo as well.  Avoid companies that use "enterprises" in their name, or ones that have faux fancy names.  "The Park Avenue Warehouse Holdings" sounds fancy until you see they're located in Des Moines, Iowa and they own Wendy's franchises.

Annual reports that appear to be copy and pasted from Excel

Maybe this is a minor nitpick, but it's a pet peeve of mine.  There are companies that either take screen shots, and yes they're sometimes blurry, of their financials and paste them into the annual report.  Or outright copy and paste them, with cell borders and all into the annual report.  It strikes me as lazy.  That the CFO couldn't spend an additional two minutes removing the cell borders, or cleaning up the sheet.

Closely related to this item are annual reports in goofy fonts.  If a company's annual report looks like it was typed up by a 13 year old in comic sans for their art history class you need to run, not walk from that company.

Conclusion

As I said earlier this isn't an exhaustive list, but these are some items that I kept seeing as I looked at pink sheet companies.  I mentioned earlier that I wasn't able to maintain my habit of weekly reviews of every company that filed.  You might be wondering why.  The reason is companies worth additional research started to become too few and far between.  In the past I could spend a few hours looking at names and walk away with one or two prospects for further research.  Now I just spend hours ending up empty handed and wondering if I just wasted a lot of time.

There are a lot of companies that trade over the counter, there are thousands of them.  There is no reason to fill a portfolio, or even let in one or two companies that have glaring issues such as the ones I detailed above.  Maybe a company or two that exhibits some of these characteristics will buck the trend, but more likely investors will be marking the investment as a tax loss.

How do small community banks survive?

I grew up in a suburban area outside of Cleveland, Ohio.  There were houses, businesses, and people everywhere.  The college I attended and graduated from was Miami University (in Ohio, not Florida).  It's located in a very small town in a rural area of Southwestern, Ohio.  One of the things I did in college was take epic bike rides through the Ohio countryside.  I'd skip classes and ride for hours exploring farms, finding new little towns and just riding to ride.  I did all my riding on a mountain bike, which goes to show that when you're young and in shape having the right tool for the job doesn't matter much.  On one of my rides I'd pass through a small town named Bath, Indiana.  I'm not even sure you could call it a town, it's more of a collection of houses, a grain elevator, a post office  and an enormous bank branch for the Bath State Bank.

Whenever I rode past Bath State Bank I would think "how do they stay in business? Who banks here in the middle of nowhere?"  I could never reconcile that a dozen houses and a grain elevator could keep a bank in business, let alone prosper to the level that they did as evidenced by their branch.

Fast forward 16 years and I still wonder the same thing when I pass through small towns with local banks.  How can a tiny town with a boarded up business district support two or three local banks?Welcome to the world of small community banking.

There are over 6,000 banks in the US, but the majority of these banks are small.  Of the 6,000 US banks only 709 have more than $1b in assets, and 4,808 are under $500m in assets.  Even more astonishing 3,189 have less than $200m in assets.  We can look even further and find 1,689 banks with less than $100m in assets.  Let's walk through the math on how a small bank like this can stay in business using Bath State Bank as an example.

The bank has $143m in assets.  They are earning 4.68% on their earning assets and pay .7% to fund those earning assets.  This leaves them with a 3.98% net interest margin, the difference between the two values.  From this they pay expenses such as salaries, back office expenses and whatever else is necessary to keep the lights on.  Bath State Bank was able to earn $1.4m in 2015, which is a reasonable return.  The bank generated a 10% ROE, a respectable return for a bank any size, but especially respectable for a bank that has under $200m in assets.

The question isn't "how can such a tiny bank stay profitable?" but rather "why does such a bank exist?"  Who are their customers?  Where in the world did that $143m come from if this bank is located in the middle of nowhere?  This is especially the case when one considers that the median income for most of these rural counties is less than $30,000 a year.  How much is someone making $27,000 a year able to save?  And how many families with $5,000 and $10,000 in savings does it take to hit $120m in deposits?

If one were to decide today in 2016 that they wanted to create a network of financial institutions to take deposits and make loans across the country I can guarantee that branch locations, and especially branch locations in small population centers would not be the model used.  But in the US we are living with the legacy of our past, and the past is the reason for the present.

From the founding of the US until the 1950s banks weren't allowed to have branches.  Each bank had its own building and a small town might have a half dozen competing banks, all in their own buildings, all doing business slightly differently.  From the 1950s to the 1980s government agencies slowly deregulated the banking industry and allowed branch banking, interstate banking and finally a regulatory banking free-for-all where anything was kosher until it met its end in the Great Financial Crisis of 2008.  The pendulum had swung too far, and now we're quickly swinging the other way towards increased regulation.

Banks, like small town hardware stores started where there was a need for their services.  If there was a crossroad with a railroad station then there was probably reason enough to consider starting a bank. This was back when pictures were black and white and men chopped down trees and farmed wearing three piece suits. As the banking industry has consolidated from over 14,000 banks in the mid 1980s to the current 6,000 banks a number of rural and small town branches have closed, but there are still many that remain.

While riding the "L" train in Chicago a few months ago I had a bit of an epiphany.  For those who've never been to Chicago the "L" train is an elevated public train system.  The system is a few stories up and weaves in and out of the city's downtown close to buildings and above the road.  While sitting in the train and roaring past apartment and office windows just a few feet from the track a though occurred to me.  This system that moves almost a million people a day couldn't have been built today.  No citizen of Chicago would allow a train to pass two feet from their bedroom window every five minutes if it were a newly proposed system.  But since this is a system that was built when the common good mattered more than the individual good, or when politicians just didn't care what people thought we have a situation where people gladly pay thousands a month for an apartment right on the main drag where window rattling is a feature.  This idea of investment isn't limited to public transit, it's most infrastructure in our country, and a lot of small business investments as well.  What was easy to build 50 to 100 years ago is impossible to build now.  Or if it were to be built now the project would be measured in decades and cost billions.  Many of the rewards we're reaping now are a result of investments earlier generations made.  How many small businesses are running and turning a profit with machinery that was built in the 1950s and has been fully depreciated for longer than most of their workers lives?

The same concept is true in banking, and even more true with community banking.  Up until recently banking was a relationship business.  People would build relationships with a local bank for decades and sometimes their entire lives.  My step-father-in-law lived in a small town in rural Ohio and still drives 35m out of his way to bank with the local small town bank.  He knows the names of everyone at "his" branch.  It's a testament to community banking that relationships can be built this strong.  The problem is that many banks put in the hard work to build those relationships decades ago and are now on autopilot and have never re-invested in new relationships.  There are a lot of very forward-thinking and progressive community banks that are still engaged in relationship banking.  They have established themselves inside valuable niches and are a trusted resource for their area.  But there are many more that are aging along with their depositors riding on the coattails of yesterdays investment.

Every once in a while I'll check out an older bank branch, or investigate a small town branch just to see what it's like.  I can tell when a bank is aging within minutes of stepping into the branch, sometimes I don't even need to enter.  These branches are time capsules for when they were built.  Want to know what banking was like in 1978?  There is a branch around here I can direct you to, it's perfectly preserved down to the carpet.  Feeling nostalgic for the 1980s?  There are thousands of branches sporting that luxury dark wood panel look where you can rest your body on a nicely worn period chair or couch.  For all the mockery the Post Office receives I've never been in a Post Office location that is as badly out of date as some bank's branches.

For a bank to thrive and grow they constantly need to acquire new depositors and generate new loans.  From the day a loan is originated it starts to pay itself down towards zero over a fixed length of time.  Banking is a race against the clock.  Generate enough loans each month to offset principle repayments and generate additional loans to register growth.  The same is true for a bank's deposits.  Deposits are usually steadier, but they age with their account holders.  Older depositors have more money and on average keep higher deposit balances.  But eventually these account holders pass away and their money is distributed to relatives, charity or wherever else.  Maximizing deposits is tricky for a bank.  They want older depositors with higher balances, but they need a constant flow of newer older depositors to counteract aging and death.

It is fascinating to observe an aging bank.  This is typically a bank that's in a shrinking town with a shrinking loan book and deposits that are dying and being passed onto heirs.  A common thread with these banks is their management is aging along with the deposit base, but they don't know what to do to fix the situation.  The problem is very few executives in their 70s will embrace spending significant amounts of money on iPhone apps or online banking websites.  Those things are for kids, not for serious banking like it was done in the 1980s.  And speaking of such let me take a slight diversion for a second. If you ever want to reminisce about the good old days I know of no better place than the annual meeting of many community banks.  I have found myself caught in conversations with bankers passing around stories from the late 1970s and mid 1980s like they just happened.  I'm all for story-telling and great war-stories.  But when the only stories are war-stories and the same executives are missing relevant issues of the day it's probably time for them to retire or recalibrate to what's important to the business today.  For better or worse the world has changed, and companies need to change with it.

The longer one thinks about this problem of aging banks the bigger the problem becomes.  We have thousands of aging community banks in aging areas that don't need these banks anymore.  Much of banking can be replaced with a phone.  I can deposit a check anywhere my iPhone has coverage.  I can transfer money while commuting on the train, or waiting for my food at a restaurant or anywhere.  I don't have to be physically present to do any of these activities anymore.  A human doesn't need to approve my deposit or withdrawal slip to conduct a transaction.  And this technology isn't just limited to customers who live in cities.  The US has become so blanketed with wireless and smart phones that anyone anywhere can conduct banking from the palm of their hand.

If a bank doesn't continually re-invest in new relationships then it has lost the only edge it had in business, the local niche.  A community bank can be flexible where larger banks cannot, but the bank can only be flexible if they are investing in the up and coming younger generation.  The best way to develop a lifelong banking relationship is with a customer when they're younger.  Young banking customers are loss-leaders.  A teenager with a bank account that rarely has a balance above $138 doesn't generate much in the way of income.  But as the teenager grows up, gets a job, starts a family, buys a house, and starts a business they will continue to add banking services and products most likely at the bank they started with, if they're treated well and given an opportunity to grow.

The natural question is what happens to these community banks that are on the edge of retirement?  I think eventually what will happen is a larger bank will buy them out, take their deposits and loans, close their branches and move branch banking online.  They keep a branch or two in the area that's well lit, updated, and modern.

I want to circle bank and answer my original question "How do small community banks survive?" the answer is "many don't."  For bankers, customers and investors I think we're witnessing an interesting time.  Since the financial crisis banks have been forced to adapt to a low rate environment.  Some have done this very well.  But others have decided to blame rates, politics, or the weather for their lack of investing and aging business.  We're witnessing what happens when small town banks that refuse to re-invest age themselves out of the market.  Many will sell to competitors across the street or across town.  And competitors will take what they've learned in the past eight years and turn sleepy deposits into profit engines through IT re-investment, increased cross-selling and other opportunities.

As investors we can profit from being on both sides of the table.  By owning aging banks on the cusp of retirement, or by purchasing banks that are buying aging banks.  For those that like the cheap flip look for banks trading below book value with elderly executives, shrinking deposits and shrinking loans all while maintaining too much capital.  For investors with patience and an eye for quality look for banks that are becoming successful serial acquirers for these retiring banks, buy in and hold on tight.

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