Sunday, July 20, 2014

The truth about asset investing

Issue 2 of the Oddball Stocks Newsletter has been published and sent to subscribers.  If you're not a subscriber and would like to learn more visit the Oddball Stocks Newsletter website.  If you are a subscriber and didn't receive this issue please send me an email.

Did you ever play the game of telephone when you were a kid?  The game where everyone sits in a line and passes a message along by whispering it to their neighbor.  It didn't matter how many kids were participating, after a few passes a message like "The Indians will win the World Series" would morph into "My aunt Tilda said the world is near us."  My feeling is that the modern value investing view of asset investing is something like the game of telephone.  Between what Benjamin Graham initially wrote in Security Analysis and what we're telling ourselves today something has been lost.

Asset based investing is commonly referred to as cigar butt investing where investors gamble that a depressed stock has 'one last puff'.  The idea is that down and out stocks selling for less than their asset value will sometimes experience what amounts to a dead cat bounce.  Investors are supposed to watch their basket of depressed stocks like a hawk and trade opportunistically to reap the gains.

I've read countless blog posts that describe a company who's assets are melting away like an ice cube  as a Graham-type value play.  The gross mis-characterization of Graham's asset plays has always bothered me.  I realize that Security Analysis is considered a classic text, which means that everyone is aware of it, but no one has read it.  In response to seeing this mis-characterization recently I went back to Security Analysis (6th edition) and re-read a few of the chapters on asset based investing.  I believe a lot could be learned by investors from just reading these few chapters.

Because I know most of my readers won't be reading Security Analysis I've decided to provide a few quotes that illustrate what asset investing should be.

First a definition of liquidation value:

"Liquidating Value.  By the liquidating value of an enterprise we mean the money that the owners could get out of it if they wanted to give it up.  They might sell all or part of it to some one else, on a going-concern basis.  Or else they might turn the various kinds of assets into cash, in piecemeal fashion, taking whatever time is needed to obtain the best realization from each." (p559)

A common complaint about stocks trading at a discount to their asset value is that they have poor earnings, don't cover their cost of capital.

"Common stocks in this category practically always have an unsatisfactory trend of earnings." (p564)

Graham discusses that stocks selling below NCAV have many potential catalysts that could result in value being unlocked including, general industry improvement, a change in operating policies, a sale or merger, complete liquidation, or a partial liquidation.

Finally Graham discusses that even though many of these types of stocks are cheap they need to be approached with caution:

"Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category [below NCAV].  He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above.  Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past.  The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so." (p568-569)

What can we learn from this?  A company's liquidation value is a rough approximation of what value might be realized if management either sold the company entirely or broke it apart.  Many companies that trade for less than their liquidation value are not great companies, if they were they wouldn't be selling that cheap.  Investors should prefer companies at less than NCAV where NCAV is at least stable, if not growing.  Preference should be given to companies that are growing both earnings and asset value.

Instead of speculating on last cigar puffs the texts from Security Analysis paint quite a different picture.  They show an investor carefully examining a stock like a business and making a purchase if the business is of at least average quality and selling at a reasonable discount.

I recognize that asset based investing isn't for everyone.  Some investors aren't comfortable investing like this.  That's perfectly fine, there isn't one correct way to invest.  But for those who have heard, or read about asset based investing I wanted to clarify some of the misconceptions surrounding it.

Disclosure: I receive a small commission if you purchase anything through

Monday, July 14, 2014

Enterprise Bank, a case study in the potential pitfalls of bank investing

A general misconception I've sensed is that value investors who aren't buying Buffett-type companies are usually lumped into a distressed turnaround category.  Our investments are the proverbial one foot  in a hole and one foot on a banana peel.  A mistake or two away from a complete loss.  I know I've been placed in this category many times, and I think many readers believe I'll buy anything as long as it's cheap.  It might be a surprise to some, but that's not the case.  I prefer to buy undervalued companies that don't run the risk of going out of business.  Sure, the occasional good company at a cheap price might find its place into my portfolio, but more often it's an average company at an excellent price.

Enterprise Financial Services Group (EFSG) is a great example to show that not everything that's cheap is an attractive purchase.  The company has a market cap of $5.7m against a book value of $18m.  Their P/B ratio is 32%, and P/TBV is 44%.  The bank is profitable and trades with a P/E of about 8x.  The bank is undeniably cheap, they are trading at a low valuation of both earnings and their book value, both tangible and otherwise.

Purchasing a company at 44% of TBV should in theory give an investor a margin of safety.  This is the buffer between their current market price, and an investors estimate of fair value.  The concept of the margin of safety is to allow for investor mistakes and errors and still enable an investor to profit.  In most cases a company at 44% of TBV and 6x earnings would indeed have a considerable margin of safety.  But Enterprise Financial Services Group isn't a normal company, it's a bank, and in banking there are other factors that need to be considered as well.

Enterprise Bank is a small one branch bank located a few miles north of me in the suburbs of Pittsburgh.  Their branch is fairly unique, it's a plain office building located next to a heavy equipment rental, and a kids play facility (giant inflatables, indoor playground).  If it weren't for the tiny sign announcing their presence most people wouldn't even know it were a bank.

Enterprise Bank is a great example of potential pitfalls that can trip up a bank investor.  The bank specializes in small business lending.  The bank has $217m loans, of which $20m are for 1-4 family loans, typical single family mortgages.  The rest of their loans are for commercial real estate and commercial ventures.  The bank describes itself as a specialized lend for turnaround financing and startup financing, both categories of risky lending.  For the risk the bank takes on their loans they earn comparatively low rates.  Their yield on earning assets was 4.66% as of Q1 2014.  This is much lower than I'd expect for a company that specializes in lending to borrowers whose future ability to repay loans is suspect.

The bank's funding isn't the more common low cost and stable consumer deposits, but rather wholesale funding via brokered CDs.  The wholesale market is problematic for two reasons.  The first is the funding costs are much higher than what could be achieved via a sticky retail deposit base.  Enterprise Bank is paying .93% for their deposits.  The average funding cost across all banks in the US was .31% as of the last quarter.  Enterprise Bank is paying almost three times more for access to funds compare to the rest of the US banking industry.

The second reason that wholesale deposits are problematic is because they aren't sticky.  Investors putting money into brokered CDs shop for the highest rate.  When a bank's rates aren't competitive they have trouble attracting deposits.  Banks relying on hot money for funding end up in a vicious cycle where they are continually fighting to attract consumers with higher rates, which are costly to the bank.  The types of customers the bank attracts are not the ones a bank would want.  These customers purchased the product for the rate, and when the bank's rate lags competitor's rates many customers cash in their CDs early and move their money.  Wholesale deposits are not a cheap or stable funding source.

If the bank only had a poor deposit base, and a concentrated commercial loan portfolio then their valuation could be potentially attractive.  While the commercial concentration and wholesale funding are not ideal those aspects alone don't merit a 70% discount to book value.  What does merit such a discount is the quality of their loans.

Banks are highly levered companies, and with leverage comes risk.  Enterprise Financial Services Group has a TE/TA (tangible equity/tangible assets) ratio of 5%.  In layman terms this means the company is leveraged 20:1.  The bank's Tier 1 capital ratio is 10.7% and total capital 11%.  The bank's Tier 1 capital also includes their preferred stock as well as loan loss reserves.  Note the difference between the holding company's leverage and the underlying bank's leverage.

The bank's holding company owns a real estate broker, a machinery rental company, an IT consulting firm, a CFO consulting practice, and an insurance brokerage as well as the bank.  From a regulatory standpoint the underlying bank looks alright, although not ideal.  The company doesn't break out the financials for their other businesses, but based on the bank and the holding company information we can surmise that their other companies don't have much in the way of assets, or earnings, but do have debt related to their operations.

Leverage can cut both ways for a bank, when times are good it can allow them to earn outsized profits.  When the environment changes a small percentage of loans gone bad means shareholders can loser their investment.

Enterprise Bank reports that 5.29% of their loans are non-current, which is about $11.4m in nominal terms.  The bank has $2.3m reserved for loan losses.  All things considered their loan losses aren't terrible given that the bank is engaged in speculative venture stage and turnaround lending.

The company's absolute level of loan losses is concerning, but there's something a bit more subtle that's even more concerning.  The company makes mention in their 2013 annual report of an accounting change that their regulator, the FDIC forced them to make.  The change is that the bank is now forced to classify their loans after interest hasn't been paid after 90 days rather than wait for an impairment.

Banks are required to classify loans into different categories quarterly (or more frequently) based on the probability of repayment.  Most loans are classified as satisfactory, this means the loan is current and interest is being paid.  For most banks in the US if borrower fails to make a payment on a loan after 30 days the loan moves from current to non-current and is classified.  Banks bucket loans into 30-90 days past due, 90 days past due, and non-accruing.

Enterprise Bank wasn't classifying loans until the bank had considered them impaired.  In the past the bank would consider a loan performing until all hope was lost and they finally impaired it.  Loans that hadn't paid interest for months might be considered current.  It worries me that in the past the bank was only considering a loan classified when it was impaired.

The last item that the bank mentioned that helps justify their valuation is the impact of Basel III.  The bank said they will be about 10% short on Basel III capital requirements.  Instead of raising capital they suspended the dividend and instituted a pay freeze.

The fact that the bank is so close to capital inadequacy under Basel III, and that they had previously been lax in classifying loans is what made me pass on this bank as an investment.  Maybe everything will go well in the future and this is a good value.  But I don't invest based on rosy scenarios, I want to make sure companies I invest in can weather a storm or two, and a potentially bad storm.  I'm not convinced that Enterprise Bank can weather a strong storm.  So even though the bank is trading for a very low valuation this doesn't look like a safe investment to me.

Disclosure: No position

Monday, July 7, 2014

Selling cheap to buy cheaper

I apologize for the lack of recent posts, in many ways it' a bit unusual.  I started this blog in 2010 and became serious about blogging during 2011.  Since then I set a goal of posting twice a week.  If you look at my post history you can see a giant gap over the last few weeks.  We took a nice long summer vacation and I decided to abstain from posting while away.

We drove from Pittsburgh down to New Orleans to visit my brother, his wife and our new nephew. Then we headed over to Pensacola for some time at the beach.  Before this trip I hadn't spent any time in the Deep South.  It was really nice, we had a great experience.  We had some good food, relaxing days, and I was even able to meet up with a reader for coffee, which was awesome.  While away my inbox filled up and I kept my eyes off the market.

Now that I'm back I want to get back into my two posts a week routine; here's to starting!

A friend emailed me recently musing about buying when the market is falling.  It might sound like a strange topic to discuss when markets are soaring higher, but it's always good to be prepared.  My friend asked my thoughts on selling cheap stocks to buy cheaper stocks in the midst of a downturn.  In his view this is the ultimate act of a investor.  The ability to ignore emotions and sell stocks that at other times would be considered extremely attractive for stocks that one deems are even cheaper.

If an investor wants to have the ability to sell a cheap stock and purchase a cheaper one they must have some sense of potential value.  Is a stock at 50% of book value cheaper than a stock at 60% of book value?  Not necessarily.

Some investors (the disciplined ones) keep spreadsheets of all of their holdings and what they feel is the discount to intrinsic value of each holding.  The investing cowboys, of which I am one, tend to play it a bit more loose.  No spreadsheets are necessary, just a rough gut feel of when a stock is getting a bit frothy.  My own process works as follows.  I will initially research a stock and often will write a post about the stock.  The purpose of the post is to help formulate my thoughts on an idea, and to preserve a record of my initial thinking.  If I like the stock I make a purchase and usually forget that I even own it.  I don't follow the news for stocks, or set alerts.  I will check my entire portfolio on  a semi-regular basis.  I check each stock for news or activity and then go back on ignore mode.  If during my check I notice a stock that's run up significantly I will look for news, and evaluate if I need to sell out of the position.

When considering my investments against each other I like to look at what I consider their potential value.  This is the stock's undervaluation plus their business value.  In Security Analysis Benjamin Graham discusses selling a stock after three to five years if it hadn't reached intrinsic value.  I want to walk through an example of how I calculate potential value.  Let's take a stock at 60% of book value that's earning 3% on equity.  Many readers bash stocks I pick with low returns on equity, but maybe understanding how I view things will help to clarify why some of these low ROE companies can be good investments.

Take the example of a stock that has a book value of $10 and is selling for $6.  The company earns $.30 a year, or 3% on equity.  If the stock reaches its intrinsic value in five years, our maximum holding period, the investor would earn 19% a year.  Between year one and five the company grew their equity at a paltry 3% a year.  Five years of 3% book value growth equals $11.59 in book value at the terminal date.  If an investor held the entire five years, and the stock rose to book value they'd realize a gain of 93%, or 19% a year over their holding period.

The above example shows how even poor companies that don't earn their cost of capital can result in significant gains if the company's market price eventually reverts to intrinsic value.  Of course nothing is guaranteed, and not all investments drift up to what a reasonable investor might consider intrinsic value ever.  At times management is directly opposed to shareholders and works to keep the value of the company low.  Other times there are structural factors that keep the value of a company low forever.

If one believes in the concept of mean reversion then this theory holds.  The key variables to the equation are the company's intrinsic value, and the time period of the holding.  If a short time period is used then potential returns increase.  If a longer period is used then potential returns decrease.  There are a few investments I hold where I've figured that even with a 10-15 year holding period my potential returns could be well above 15% a year.  It's situations like that where I'll potentially hold a stock for a decade or more.

So what does the idea of potential valuation have to do with selling cheap stocks to buy cheaper stocks?  It's the only way I can think of that one can rationally rank investments in a way that lets them compare two potentially cheap investments.  I mentioned above that a company at 50% of book value might not be cheaper than one at 60% of book value.  If the company at 60% of book value is earning 8% on equity and the one at 50% is earning 2% the company selling at the initially higher price is cheaper overall over the same holding period.

When a stock appreciates towards what I might consider a fair value I will go through this exercise to determine out what the potential return is for the stock going forward.  My personal hurdle rate is 10-15% a year.  My hurdle probably seems low for most readers, but if I can earn between 10-15% a year for the next 30 years I'd be extremely satisfied.

In a downturn an investor could use the above system to classify all of their investments.  Then evaluate new investments against the set of current investments.  A company with a potential return of 20% a year could be sold to purchase a company with a potential return of 30% a year.

The caveat with this system is that in a downturn it's hard to know what past numbers could be repeated in the future, and secondly you need to invest in companies that will survive.

I want to come full circle and answer my friend's question.  I agree that selling what's cheap to buy what's cheaper is the ultimate test of emotions.  An investor in that situation is facing a portfolio that's  losing value, and they are out of cash if they're in this situation.  They need to ignore their gut and trust the numbers, sell companies with low expected returns and purchase ones with higher expected returns.  I don't know what different in potential return is meaningful, but I think it's an individual preference.  Based on the potential error from estimated time ranges I wouldn't be exchanging stocks for a few percentage point differences in potential returns.  But I would exchange something with a 15% potential annual return for something with a 30% potential annual return.

In my own portfolio I like to keep 5-10% in cash at all times.  I feel this gives me the ability to act quickly on a new investment idea should I come across something attractive.  I haven't found my cash levels to be correlated with the market levels in generate.  I'm currently floating closer to the lower end of my cash cushion, whereas a year or two ago I was closer to 15% in cash.  As opportunities become available I take positions.  And if the opportunity has a potential annual return of 10-15% I will seriously consider a place for them in my portfolio.

Monday, June 16, 2014

Good enough investing

Investing attracts a lot of smart people.  Investors are good with numbers, good with details, and competitive.  Many smart investors are on a quest to find the perfect investment or investing style.  Until he's surpassed Buffett holds the title of the best investor.  He grew almost nothing to a pile of money that makes him one of the richest people in the world.  He isn't just rich, he's also considered a sage with people looking to him for life advice alongside of investing advice.

I've held for a long time that the best investment style is Buffett's style if one can replicate it.  Whether or not Buffett's style can be successfully replicated is up for debate, but his results are not.  He is undeniably the best living investor, and possibly the best investor to have ever lived.

If Buffett is the best then why am I not following his investment style?  Why do I invest in a manner that's similar to Benjamin Graham, Buffett's teacher?  Graham and others who followed his style had great investing records, but none as great as Buffett.  My sense is that many readers don't understand why I would chose to invest in an inferior strategy.

The path most investors take is they start out looking for statistically cheap stocks such as net-nets, low P/B stocks or depressed earners.  Then once they've gained some experience they graduate to companies with moats and quality compounders.  The Coke's of the world that a buy at any price will result in incredible wealth eventually.  It seems to be accepted that investing like Graham is fine for those who are starting out, but all good investors eventually graduate to the big leagues.

Why am I investing in a knowingly inferior strategy when a better one (Buffett investing) is available?  The answer is simple, value investing Graham style is 'good enough' for me.

A good friend uses a great analogy to discuss investing.  He talks about his portfolio like a hardware store.  One one shelf there are hammers, screw drivers, nuts and bolts, ladders and other small items. The owner makes a small margin on each item.  They might make a few pennies on each nail sold, but in aggregate the pennies on the nails and dollars on hammers add up to a living for the owner.  In contrast a Buffett style investor is like someone who owns a Maserati dealership.  Not many cars are sold, or need to be sold, but the dealer makes a larger profit on each transaction.  The Maserati dealer is mostly sitting on their hands, and one can say removes ignorance by sticking to only the best cars.

There isn't much pride in owning a hardware store.  The store provides a living, but doesn't provide great conversation at a cocktail party.  Owning a Maserati dealership is quite different, the owner is probably wealthy and their cars are always great topics for parties.

This analogy works well on many different levels.  The hardware store owner is like a Graham investor.  There is no pride in owning many different types of stocks that no one has heard of.  But in aggregate buying cheap stocks below book value, or NCAV, selling once appreciated and repeating provides a living.  At a party not many people are going to know who Decker Manufacturing, Conduril or West End Indiana Bank are.  Buffett investors have a remarkably different experience, their portfolios are much more party topic worthy.  There's a pride in owning stocks that rise 5x or 10x.  No one wants to hear about little companies that can be churned for 50% gains, people want to hear about the big winners.

The hardware store owner isn't going to earn as much as the Maserati dealer, likewise a Graham investor probably won't ever be as successful as someone who can invest like Buffett.  An obvious question is if someone had the ability to own either the hardware store, or the dealership why would they pick the hardware store?  That same question can be asked about the two investing styles.

There is a cost to each style of investing, the cost is the time to research, the time to follow companies, and the emotional energy required to implement each strategy.  The cost is less to invest in a manner similar to Graham.  There are many companies that I've found, researched and invested in where the time I devoted to do so was less than two hours.  Many of my holdings require an hour to an hour and a half of time annually to stay up to date.

Buffett's style of investing requires obsession.  He is consumed with investing, he lives and breathes it and has since he started.  It took priority in his marriage, in his relationship with his children, and with anything else in his life, investing is number one.  The results of this obsession are apparent, he's become the most successful investor.  I see this same level of obsession with many who are following in his path.  On the Corner of Berkshire and Fairfax message board there are threads detailing Buffett-style companies that stretch into the hundreds of pages.   Seemingly every possibly piece of legal information is rendered useful and important to the investment thesis of these sorts of companies.

I don't have the time or ability to become obsessed about my investments.  I have a family, have a job, have a business and have lots of other activities that I enjoy outside of investing.  In a lot of ways Graham's departure from the investing world later in life is attractive.  He had enough money to pursue other interests that had his attention, didn't need more success, or more money, he had enough.  I enjoy looking at companies and researching investments, but I also enjoy doing other things too. I enjoy playing with my kids on a warm summer after in the backyard.  Time like that is priceless, is giving that up worth it for another 2/3/5% increase in my portfolio?

When I survey the value investing landscape Graham's methods are attractive.  Over the long term they beat the market and reduce risk (the risk of permanent loss of capital).  They aren't glamorous, but they work.  When I look at my own needs, both monetary, and otherwise I realize that finding the best investment strategy isn't important.  If over the next 30 years the market returns 10% annualized and I can earn 10-15% investing on my own I will have more than enough.  It's possible that if I were to graduate to Buffett's style of investing that maybe I could do 15%+ annualized.  I am not investing to impress anyone, and if what's considered beginner value investing achieves my goals why graduate to something more complicated?

Like a hardware store owner who might decide to own the store because of the hours, the location, or the speed of life, I've made a similar choice with investing.  I've taken a path that might not be the best possible, but it's good enough.  Over the long term I believe I'll have acceptable above market returns, but will also have time for life outside of investing.  Because of this choice I'll probably never enter the world of the super rich, but that's something I'm alright with.

In the end I've chosen a good enough investing style, but not the best.

Friday, June 13, 2014

The fallacy of the "best idea".

There is an idea floating around in the value investing world that investors should only purchase their five or ten best ideas.  The idea is that if a stock being considered for a portfolio isn't as good as the 'best idea' then why buy something sub-par? Instead investors should continue to pile into their best idea instead of finding new ideas.

The best idea line of thinking gets a lot of traction and has become incredibly popular after the 2009 market recovery where concentrated investors have trounced the market.  Investors are always chasing the best strategy and seeing as how concentrated investing has done so well recently it's no surprise that it's the strategy du jour.  I've posted in the past regarding my thoughts on diversification, and this post isn't intended to re-hash those thoughts.

I've always thought that there's a disconnect between academic investing and real world investing.  In an academic study an investor has a starting point, they pick a portfolio of some number of stocks according to specific criteria and then their performance is measured against a benchmark for a limited time range.  A study like this is intended to show how specific criteria, or a style of investing matches up against the market, with the market being the control group.  Numerous academic studies have shown that low-anything (P/B, EV/EBITDA,P/S,P/E) investing works.  An investor who purchases something for less than a chosen average metric and holds for a period of time will do better on average compared to an investor who purchases the market.

From these studies the notion that value investing, momentum investing, small stock investing beat the market is established.  The concept of value investing as defined through academic literature, or investment classics like like Security Analysis or the Intelligent Investor are usually the starting point for an investor defining their strategy.  There is a natural inclination in all of us to take something that works and think about how it can be improved.  We look at a study that shows buying all low-P/B stocks and think "what if I could remove the obvious duds, then I'd do better."

The idea of investing in a few best ideas is simply an extension of this concept.  What starts as investing in all low P/B stocks turns into only investing in the 'best' low P/B stocks, which leads to investing in only the 'best' cheap stocks.  On paper this makes perfect sense, it's intuitive.  It's been reinforced by the bull market coming out of 2009 where every concentrated investor has killed the market by investing in the best turnarounds.

Within this environment I'm asked continually why I'm diluting my portfolio by investing in my 10th idea or my 30th idea or my 50th idea.

I believe there are two problems with the best idea type of thinking: portfolios are built over time, and we don't know our best idea.

Not many investors start with a blank slate.  A new fund manager might start with a pile of cash that needs to be invested in a portfolio, but most managers start gradually as well as funding is received.  Individual investors create a portfolio through savings over time.  A portfolio is built over time, not in a single day.  During the building period new is released about holdings and prices are continuously changing.  What was the best idea initially might become a mediocre idea after a news release.  Or the best idea might experience a run-up that leaves it much less attractive.

The investment landscape is always changing, it's foolish to think that on the day one sits down to create their portfolio they will have they will already have their best idea.  Some investors go years ambling along before they find an idea that multiplies their portfolio many times over.  Other investors never hit it out of the ballpark, but consistently do well with most investments.  If the best idea isn't known on day one then what's an investor to do when they find this new best investment?  Should they sell everything and concentrate their entire portfolio in it?  Logic would say if you find a true best investment you should concentrate everything in it.  Why dilute your best idea with your second best idea?

The problem is we don't truly know our best ideas, even if we think we do.  Some ideas resemble situations that worked out well in the past, but there is no guarantee that they'll work well in the future.  There are no situations where one can be absolutely certain about an outcome.  Even an executive guiding their company through a merger isn't certain until the deal closes, the other party could pull out at the last minute.  There is always an element of chance involved in any and all investments.  We all know this, and this is why we don't see investors with one stock portfolios.  Of course there are exceptions, there are some super human investors who can pick five stocks that all triple and crush the market.  I don't know if they have a crystal ball or if they're just that much smarter, but they do exist.  The question one needs to ask themselves is whether they have that crystal ball ability.  I know I don't, and most probably don't either.  I know it's fun to think we're all above average, but math doesn't allow that.

When I say I don't know my best idea what a lot of people hear is "I don't know a good idea from a bad idea, they all look the same to me."  There is a subtle nuance here that needs to be clarified.  A company with high returns on equity selling at a low price has the potential to generate better returns compared to a net-net at 2/3 of NCAV over the long term, I know this.  When I say we don't know our best idea I mean we don't know what idea will perform the best.  It's possible a net-net will turn itself around and come roaring back with a magnificent gain.  On the other hand a great company with an indelible brand such as Coke could become yesterday's value if attitudes turn against sugary drinks and consumption drops.

Here's an exercise, go back through your portfolio statements from previous years and mark down what you thought was the best idea at the time.  Of those best ideas how many worked out exactly as you expected?  If the number is 70-80% then you should probably be concentrating in half a dozen stocks or less.  But if your ability to predict the future isn't that high then it's worth broadening up the portfolio and start hitting singles and doubles instead of gunning for home runs.  When I look at my portfolio I have had many companies I thought were potential rockets that did nothing, and other companies that were just simply cheap go on to double or triple.  It's much more common that I had a plain undervalued stock double rather than some turnaround story stock with a catalyst quadruple.  I find it easier to find stocks that are likely to gain 50-100% rather than finding ones that will return 400%.

I like to minimize the number of assumptions or moving parts necessary for a thesis to work.  A healthy company with an extremely low valuation is easier to purchase compared to a 'good' company at a reasonable valuation.  The low valued company just needs to survive long enough for their market value to correct, the good company needs to continue to execute at a high level without making mistakes to hold up their valuation.

Monday, June 9, 2014

Calling all growth investors a 24% ROE at 5x earnings; Trius Investments

Sometimes the strangest collections of assets can yield incredible hidden value.  Little collections of assets are also interesting to research, it's like trying to put the pieces of a puzzle together.  I've found that as I leave the major exchanges, and drift down in market cap the collections of assets can become bizarre, which is the case for Trius Investments (TRU.Canada).

Trius Investments calls themselves an investment holding company, which is approximately right.  This is because at one point they  had lofty ambitions of being a hedge fund, a venture that eventually fizzled.  They currently own a garbage collection company and investment interests in drug rehab clinics.  Their garbage collection business is named Trius Disposal and operates in municipalities located throughout New Brunswick.

The company owns both the garbage trucks and the trash cans that customers use.  Customers rent the trash cans from the company, an arrangement that reminds me of how AT&T used to rent phones to customers.  Garbage cans can be rented for $5.69/mo or $64.40 a year, or they can be purchased outright for $184-240.  Considering I just purchased a trash can at Home Depot that looks similar to theirs for $24.99 I think these prices are crazy, but maybe they're just charging what the market will bear.  The company claims their competitive advantage is operating at a lower cost through the use of automated trucks.  I appreciate this narrative, but I don't understand why competing companies don't buy the same trucks.

Trius' other major asset are their investments in a number of Recovery Ways drug rehab clinics throughout the US.  Trius owns ownership interests in the buildings that the clinics rent.  The rental income has provided a significant boost to earnings and has fueled the company's growth.

Both of the company's investments are stable and non-cyclical.  Homeowners will always need their trash picked up, and drug use doesn't appear to be on the decline either.

The company's results are phenomenal.  Since 2008 they have grown book value from $1.05m to $3.9m today.  The majority of this growth is a result of their real estate investments.  The company's earnings have grown from $0.009 per share in 2008 to $.0794 per share at the end of last year.  The company trades for $.395 or about 5 times earnings.  Their financial results are shown below:

After looking at the company's results I found it hard to believe that a company with such strong earnings growth and a high ROE was trading for such a low multiple.

A common explanation for the low multiple might be that the market doesn't expect the company's earnings to hold up in the future.  This theory might even be believed when looking at first quarter results, which are trended lower than last year.  I don't believe that's the case because the company stated that their results were affected by the timing of a distribution from their real estate holdings.  Last year the distribution was received in the first quarter, and this year it was received in April.  A second plausible explanation might be that the company is small and trading is limited.  I don't believe that's a reasonable explanation either, there are many small and illiquid companies selling for fair value or above.  Simply being small doesn't guarantee an undervaluation.

I believe the reason this is trading for such a low price is because investors are worried about what management might do.  The company is run by Gordon Wheaton who founded the company in 1972. He founded Trius Inc (note the difference in name) as a three car taxi company.  The taxi company was eventually sold and Wheaton diversified into charter busses, garbage collection, a package delivery company, car care, and a truck rental business.  All of these investments are held under the Trius Inc company which is private and still held by Wheaton.

It's unclear why Wheaton decided to list his disposal business publicly.  But one thing is clear, he has profited from it.  Since 2005 he has done private placements and distributed options as prices far below the market price at the time of issuance.  By doing so he has enriched himself at the expense of shareholders.  The company doesn't pay a dividend either, so shareholders need to rely on price appreciation alone.

The CEO appears to be running the Trius Investments as his private company.  This shouldn't be a surprise considering he has a collection of small little businesses that he owns outside of Trius Investments.  It's unclear where his focus is too.  He has a Twitter account where he posts fuel prices for his service station.  I can't remember the last time I thought to check Twitter to find out who's gas prices were 1 cent cheaper, but it seems like a few people do.

I recently wrote a post on where I discussed the risks related to owning closely held companies, I kept thinking about that post as I researched Trius.  I desperately want to like Trius Investments, I have a feeling this company will continue to grow.  Yet I continued to remind myself of the lessons from the post.  Trius Investments appears to be run for the benefit of the owner and shareholders can tag along for as long as Wheaton allows it.  Sometimes it's alright to tag along if there's a chance the company could be sold for a far greater price in the future.  Instead Wheaton appears to be taking advantage of the public market to acquire more of the company for himself at below market prices.  A sale to an outside party is unlikely, what's more likely is the company goes private at a low valuation.

For investors with a strong stomach for management risk, or those who've seen something like this before and had it work out Trius Investments might be a great purchase here.  For myself I'm going to pass.

Disclosure: No position

Monday, June 2, 2014

Bank balance sheets are not black boxes: AMB Financial

A bank's source of a strength can also be a source of doubt or weakness; their balance sheet.  A bank's balance sheet is their most important financial statement.  A bank makes or loses money via their balance sheet.  If they have a poor balance sheet they won't generate earnings, a strong balance sheet translates into a strong earning stream.

A criticism many investors have of banks is that bank balance sheets are "black boxes" and that it's hard to value a black box.  This criticism is true for the large money center banks with trading operations and portfolios of derivatives, but I don't believe it applies to community banks.  The stereotype of black box balance sheets is unfortunately applied across the entire banking sector.  Not only do I think community bank balance sheets aren't black boxes, I would go further and say they are much more transparent than most non-bank balance sheets.

As outside investors we have to take the financial statements presented to us on faith.  If a company says they spend $1.2m on capex we have to trust management's judgement that the company will earn a return with the equipment purchase, and that the money was spent wisely.  If a company claims their property is worth $30m we have to take that on faith.  An outside investor will always be at a disadvantage regarding the true value of a company's assets.  We can't conduct a full audit of everything a company owns.  We can obtain what we think is a close proxy for value using heuristics, but we can never know the true value unless management conducts a full audit themselves and releases the value to the public.

My own belief is that there is more of a "black box" component to industrial balance sheets when compared to bank balance sheets.  How do we know that a parcel of land held at cost is really worth it's stated value?  Or how do we know that a company's capex went into purchasing long lived equipment that will generate returns?  How do we know a company is prudently managing their purchases?  Business is built on relationships, a company could be purchasing items at a higher cost from suppliers because they've had relationships for years.  If so then shareholders lose out.  We also don't know the condition of a company's equipment or property.  Maybe management is willing to give shareholders a tour, but even still shareholders only see what management wants to show them.  It's not uncommon for investors to be led on a dog and pony show through a facility.  Even more common is when management shows off their newest facility completely ignoring their old plant and equipment ignoring their old facilities.  Do those old facilities have any value?

There are three ways to assess the quality of a balance sheet, through a third party sale, through an audit, or through returns it generates.  When a company sells itself in most cases the acquiring company pays fair value.  Through the sale to a third party a company's balance sheet value can be unlocked.  The second way a company's balance sheet value can be revealed is through an audit.  Some companies with extensive supplemental holdings conduct asset audits from time to time and publish their results.  Often the audited value and balance sheet value differ dramatically, which is why management conducts the audit.  The last way to assess the value of a company's assets are through their returns.  If a company has a significant asset base that is barely generating earnings it's likely the assets are underutilized.  If a company is earning phenomenal returns on their assets it's likely the assets aren't recorded at their current value.

All of this brings us to bank balance sheets.  Much of a bank's balance sheet is transparent, it usually consists of securities, cash, loans, and real estate (both branches and OREO).  Of those components most are marked to market.  Even loans held to maturity are marked to market if you consider the value of the portfolio and their allowance for loan and lease losses (ALLL) as one unit.  I say that held to maturity loans are marked to market because a bank has to continually adjust their ALLL depending on the condition of their loans.  If the quality of their loans improves their ALLL shrinks, if the quality deteriorates their ALLL increases.  By monitoring a bank's ALLL investors can get a sense to the true value of a bank's loan portfolio.

Unlike industrial companies banks are regulated by a regulator who is supposed to ensure that a bank is well reserved for losses and is not engaged in any risky lending.  In other words the regulator's job is to protect the value of the bank's balance sheet.  Regulators aren't perfect, no human is.  Some investors like to pin the blame for the financial crisis on the backs of regulators, and others claim the system wouldn't work without them.  In my view the truth is in the middle.  On the whole the existence of regulators gives investors better information from which they can make decisions.  

My own belief is that a bank with a strong balance sheet has value regardless of whether the current management can generate a return with it.  This is especially true in banking where regulatory and market forces push underperforming banks to merge with stronger banks.  Regulators, and bank activists are powerful catalysts unlocking value for shareholders.

All of this leads to the bank I want to talk about, AMB Financial (AMFC).  AMB Financial is the holding company for American Savings FSB in Munster, Indiana.  Even though the bank has an Indiana address they're more appropriately viewed as a Chicago bank.  The bank is located less than a mile from the Illinois border in the Indiana suburbs south of Chicago.

AMB Financial is as plain and vanilla as community banks come.  They have a sound balance sheet comprised of deposits and loans from which they generate ample interest income.  The bank is small with only $135m in loans, $8m in mortgage backed securities and $13m in cash.  They are funded with deposits and a small amount of borrowing.

The bank is cheap too, they're selling for 61% of tangible book value.  This is especially low for a profitable bank.  They earned $.66 per share last year, and in the first quarter of 2014 they earned $.21 per share.  Banking isn't seasonal, and their quarterly income isn't from a loan loss reversal, so it's likely they could earn $.84 per share this fiscal year barring any issues.

Like most banks in the US AMB Financial's non-performing assets peaked in the 2009/2010 time frame and have been declining since.  They have about $5.2m in classified assets and a loan loss reserve of $1.7m.  The bank is well capitalized with a 15% Tier 1 ratio and tangible equity/total assets of 7.2%.

There are a number of reasons investors would avoid the bank, let me try to encapsulate all of them in one sentence.  They are too small, don't earn a high enough ROE, have too high of an efficiency ratio, don't have a great deposit market share, have preferred stock, are illiquid, aren't growing, aren't Wells Fargo.  Despite all of this the fact remains, this is a cheap and profitable bank.  If this bank were trading at 1.5x TBV I wouldn't be interested in the stock, but at 61% of TBV I think they're attractive.  I have a large portion of my portfolio set aside for banks such as this.  I buy my cheap banks in bulk, most positions are small, but in aggregate they're significant.

Disclosure: Long AMFC