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.


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.

Sign-up and receive the chapter "Are Banks Risky?" from the upcoming Oddball Stocks Bank Investor's Handbook

* indicates required

When is enough enough? Research and the curious case of Bozzutos

In many ways I'm both party to and perplexed by the desire to research to death consumer purchases. Looking for a new set of wrenches?  There is someone out there who's written an exhaustive online review of popular wrench sets.  The review might contain things like "the handle wasn't as solid as I would have liked." or "the jaws didn't slide as easily as xyz brand's did."  And it's at this point that suddenly as a consumer you have doubts about a product.  Did you know jaws on wrenches slide differently, or the metal forging process different between brands and that someday, somehow that might be important?  If you didn't you know now, and you're now paranoid you'll purchase a dud when you finally decide to "invest in a wrench", because everything you spend money on these days is an "investment."

I almost can't help myself from reading online reviews.  The detail and descriptions of everyday products by everyday people is fascinating.  Who knew a pair of jeans could change someone's life, or that someone searched for years for just the right backpack?  Prior to the Internet everyone went to a local store (or used a catalog) and purchased what was available.  If there were three wrenches they fell into a general pattern.  There would be a cheap one, a middle grade one and an expensive one.  My dad taught me that the middle quality level product was always the one to buy.  Why? I don't know, but I've heeded his advice since.

The review/research explosion was perfectly timed with the explosion of super computers in people's pockets, or shall we call them smartphones.  In the past if I wanted a rare craft beer I'd have to read about them, write down the names and then see if they were in stock at the local store.  Sometimes I'd drive to a number of stores, or make a series of phone calls and give up.  Now I can go without any prior knowledge of what I want and look up reviews on the spot determining the best of what's available.  This isn't just craft beer, it's vacuum cleaners, pots and pans, cars, anything and everything.  We've become a nation of critics on the finer points of meaninglessness.

This same phenomenon has carried through to stocks.  Investors have become so unsure of themselves that they now reference the 'reviewers.'  "Oh my stock has abc guru invested in it." or "I heard this was pitched at some conference." All of these are shortcuts are ways to reaffirm to ourselves that we've made a good pick.  Maybe some of this stems from the lack of defined processes for individuals, but I think a lot of it is due to the review culture.  If people are blogging about gold toe socks and reading sock reviews in a store it would only make sense that the'd hesitate before purchasing something bigger, such as shares in a company.

Information is just that, a set of numbers or facts or details that describe something.  Information by itself is mostly meaningless.  I can tell you the dimensions of the shed in my backyard, the material it was made out of and variety of precise details.  But it doesn't matter.  You don't care about my shed, I don't really even care about my shed.  It serves a purpose, to hold kid toys, a lawnmower and garden equipment.  The shed's purpose gives meaning to the information about it.  If the purpose is to hold a lawnmower and the shed is too small it won't be able to fulfill it's purpose.

More information about something isn't always better, sometimes it's worse.  Sometimes the minutia of information blinds us from seeing what's really important.  A key skill for an investor is to research a company up to the point of diminishing returns, but not any further.  Anything past the point of diminishing returns is wasted time.  Although I should point out, investors do seem to like wasting time, because there is a feeling of doing something.

I love to invest in stocks that report financials once a year, or maybe twice a year.  For someone who's addicted to the minute by minute ticks of the market this must seem like insanity.  But I don't care about daily ticks, or weekly ticks, or even monthly ticks.  My first rule of investing is to look for a margin of safety, downside protection and the confidence that a company I own isn't going to disappear between my yearly statements.  If I'm comfortable that the business will continue as usual why do I need to check in hourly/daily/monthly how things are going?  Imagine being the part owner of an burger joint and hiring someone to run the place.  Then calling up your partner hourly and asking "how's business right now?"  "Is it slow, is it fast?"  You'd go insane.  In the morning you'd be worried about how slow it is, and at lunch and dinner you'd be patting yourself on the back for how successful your restaurant is.  This seems like a silly analogy, but if you look online people are starved for information, even a steady drip of meaningless information is like water to a thirsty soul.

The successful investor is one who can identify the steady drip of information as meaningless and focus on what's truly important.

When a company doesn't report financials often it's easy to keep the forest in mind rather than focusing on the trees.  Even focusing on the trees would be progress for some investors. There are investors who are looking at branches and tiny pieces of bark wondering what their greater meaning is, but I digress.

That brings us to Buzzutos, a grocery store distributor and grocery store operator in New England.  The company has the potential to trade, and I say that loosely.  Shares are by appointment, although I was able to snag a few when there was a seller a few years ago.  I purchased the shares based on a tip, and by tip I mean someone sent me their annual report.  I realized that the gap between the market value and what they were worth was fairly sizable.  I also like to lock my money up for years with no return and this seemed opportune, of course on that point I kid, but only slightly.

The company is mainly a distributor, and distributors make the smallest margin in the world.  In 2013 the company reported $1.8b in revenue and $420k in net income.  This is down dramatically from the $5.8m they earned on $1.7b in revenue in 2012.  It's worth noting that if the CEO didn't pay himself $5m that shareholders would be looking at a lot more net income.  This is nothing more than a private company disguised as something public with a tiny float.

The CEO and a relative own 70% of the stock.  There is a company ESOP that controls another 16% of the company's stock.  The company has a 14% free float, not much at all.  This is also why shares never trade.

The attraction for the company is they have a $20m market cap with a book value of $37m or so (as of 2013).  They trade for a significant discount to book, and when they were earning $5m a year they were trading for 4x earnings.  A company at 4x earnings and 54% of book value is my type of investment, even if I have to sit and wait for years for something to happen.  It's also worth pointing out that in 2012 the company generated $15m in operating cash flow, that's almost their market cap thrown off in cash in a single year.  There are a few other items that combined made this potentially attractive.  The company uses LIFO accounting and if they used FIFO like the rest of the world their assets and corresponding book value would be $28m higher.  Suddenly this is a $65m stock trading for $20m, or 30% of book value. The last item of note is that the company owns 50% of the Better Val-U grocery store chain that's held on the books at $900k, it's original cost.  Better Val-U earned $15m in revenue in 2013, if there was profit it was probably washed away into management's coffers.

I'm a sucker for these dead end stocks.  I picked up a few shares and had forgotten about them in the corner of my portfolio.  There is a lot of hair on this stock, and I mean a lot, we're talking Chewbacca levels of hair.  The CEO is basically picking shareholder pockets with a ton of related party transactions, and one-sided agreements to enrich management.  If there's something egregious that management can do to take advantage of shareholders it's probably in their annual report.  I'm not going to even add up all of the related party stuff, it's sickening.  From a quick glance management is pulling $20-30m out of the company a year.  This could be a profitable company, but management has decided against it, it is personally profitable for themselves.

At this point in this post you're probably confused.  How did I start talking about research and end up talking about management's highway robbery of Bozzutos?  The missing link is a piece of mail I received yesterday.  A fund sent a tender offer circular  to me via my broker to buy my shares in an offer for 40,000 total shares.  The offer is at a very slight premium, but not worth trying to take advantage of.

This is where my research antenna went up.  Why is a fund trying to buy almost all of the available float of a tightly held company?  What's the motive here?  Activism is most successful when management owns a minority of a company's shares, not almost every last one.

The first instinct of most shareholders who receive the circular will be to sell their shares to the fund, and I think that's probably a good idea.  The activist fund is providing liquidity, they're offering a fair price, and they can afford to buy out almost everyone.  But I'm not everyone, I'm thinking about this differently.  Once the shareholder base is management, a hedge fund and a few stubborn souls like myself what will happen?  Will this fund petition the company to buy out everyone else?  Will they sue management and arrange a settlement?  Whatever it is it would have to be at a premium to the offer price.  And my cost basis is right around there.  So in a sense I have almost nothing to lose by holding.

This is also where my points about the minimum threshold of research apply as well.  One doesn't need to drive around New England checking out grocery stores and distribution centers.  One also doesn't need to spend much time looking at the annual report.  This is a company with a lot of revenue where much of the revenue is siphoned off to management.  But if management were forced to cut their pay 10% that would be an enormous payout for shareholders in the form of increased net income.

At current prices (if you can get shares, and it's doubtful you can) Bozzutos offers investors a lot of optionality.  At worst shares continue to do what they've done for years, absolutely nothing.  But with someone stirring the pot there's no hope that maybe something else might happen.  Maybe we'll be bought out at book value.  I wouldn't mind a 2.5-3x return on this.  And a return like that annualized even over a long time is still attractive.  That's one of the reasons I get into stocks like this.  Flat for years then a 3x return is significant.

So what now?  Nothing really.  I'm not doing anything, I'm just going to continue to wait and see what happens.  I think shareholders who want liquidity should get out, and everyone else should sit around and see what happens.

The SFB Bancorp activist battle

I could write a novel about SFB Bancorp.  It would include all the usual characters, the entrenched bank management that's missing in action, the activist shareholder, and the legions of silent shareholders hoping for a satisfactory return.  The story has become VERY interesting, mostly because a group of value investors have taken it upon themselves to unlock value at a cheap company.

I wrote about the company in December and linked to my initial Oddball Stocks Newsletter writeup and also included an interview with the managing director at Trondheim Capital.  You can read that here.

For those of you with a tight time budget let me summarize.  This could be the story of most small community banks.

A long time ago in a rural area no one has heard of a group of people started a bank.  The bank operated mostly untouched for decades.  At some point shares began to trade, either from an IPO or a mutual conversion.  The bank likes to proclaim their record of profitability, although it's worth noting they don't differentiate between merely profitable and earning a satisfactory return.  That's probably because management has no idea what "satisfactory return" or "cost of capital" means, to them earning $1 more than $0 is considered success.

SFB Bancorp IPO'ed in the late 1990s and shares traded at almost the exact same price for the next 13 years.  The only return anyone earned besides interest was the free toasters (I'm presuming, it's that caliber of bank) given away to depositors for opening accounts.  Shares traded for ~30% of book value in 2013.  This was when Trondheim Capital discovered the bank and began the process of unlocking shareholder value.

There is a paradox at this bank, management repurchased 40% of their outstanding shares, yet they claim they don't understand how to correctly compute book value.  The company would deliberately compute book value per share based on the number of issued shares, not their outstanding shares.  And when a company re-purchases as much stock as they did a significant difference in the value is created.  The company was re-purchasing shares from shareholders and claiming shareholders got a good deal compared to "book value", the erroneously calculated value.  Does that sound like a bait and switch? It was.  And it speaks volumes to the quality of the people running the bank.

I spoke with a banker recently who made the comment that "most bankers are playing bank." Management at SFB Bancorp is clearly "playing bank."

Many community bankers like the idea of being a stalwart in the community, belonging to a country club, knowing business leaders by name and having status in a small town.  This is desirable, and it's understandable, and perfectly acceptable if the bank is private.  The CEO of SFB Bancorp is also an attorney and for all intensive purposes is 100% focused on his law practice verses the day to day operations of the bank, or even the long term bank strategy.  I tried to call him twice a little over a year ago, the first time he was unavailable due to his attorney obligations, and the second time he said he didn't have time to chat because he had a case he was preparing for.  Is this the type of person who should be running a public bank?  It's like he's moonlighting as a bank CEO.  If it's a slow week at the law practice maybe he'll think about banking a little bit.

I don't want to get into character details too much because anyone can sling mud.  And what I might find disagreeable might be acceptable to others.  But I think any and all shareholders can agree that management who cares more about their law practice rather than the bank shouldn't be employed by the bank any longer.  And management that doesn't care about shareholders earning a satisfactory return need to be replaced.  I don't know of any investment strategy where earning 0% over 13 years is considered successful.

The question you're probably wondering is "where do things stand right now?"  This is where the story gets interesting.  Trondheim Capital, Meixler Investment Management, and outside investors have amassed a position that is equal to or greater than management's own stake.  And Trondheim is pushing for two Board seats, a request that isn't unusual given their ownership position.  Suddenly bank management has been woken up from their very deep slumber, they hired an expensive DC law firm and have been stone-walling shareholders.  No one knows when the annual meeting is, what the record date for voting, and any further questions are met with sham responses.  I submitted my own proposal that the bank convert to an S-Corp, buy shareholders out at book ($40 per share) and pay out 90% of net income as dividends post conversion.  The company could do a conversion like this with cash on hand.  Their response to me was a copy and paste letter stating that I failed to meet certain bylaw requirements in how I worded my request.  This is the same transaction that North State Bank undertook last year.  I wrote about it for Seeking Alpha.

A friend of mine decided to pursue his shareholder proposal further than I did, I gave up after receiving my form letter.  My friend has found that each iteration has been met with more phony rules and requirements that are seemingly created on the fly.

Predictably the bank is sending letters to shareholders about the "out of town" activists and how they want to take over the bank.  The implication is these activists are from evil big city hedge funds looking to pillage this helpless bank.  There are two ironies with this branding.  The first is one of the funds, Meixler Investment Management, is located in rural Arizona and the fund principle is involved in an organic farm co-op project.  A rural investment fund that is working on a project to help farmers probably has more in common with SFB depositors than SFB management itself does.  The second irony is that management is willing to sell the bank and they don't need hedge funds to force a sale.  Rumors have floated around that SFB Bancorp shopped itself a few years back but the price they wanted was too high.  Management is willing to dump the bank, but only if they get to set the rules.

I've really only scratched the surface on SFB Bancorp, but if I've whetted your appetite there is a lot more reading available.  Trondheim in a very rare and unusual move has published ALL of their correspondence with the bank and bank management.  They've also provided a number of other resources on the website .  The website is a case study on small company activism.  If you've ever thought of attempting this yourself Trondheim has paved the way by making all of this information public and free.

If you are a shareholder I'd ask that you vote for Trondheim and Meixler Investment Management on your proxy.

Disclosure: Long SFBK

Why "dead money" stocks can still be valuable

There's an expression in real estate investing that you "make money when you buy."  The expression means a real estate investor makes money not on growing rents, outsized appreciation, or through cosmetic improvements, but rather by buying a property at a large discount to what comps are selling for (real estate's intrinsic value).  Often a purchase discount is obtained because some material deficiency needs to be remediated and other buyers aren't interested in tackling the project.  Other times the buyer has a vision and means to implement it for a project that other buyers don't.

A real estate investor can make money from appreciation, or growing rents, but the surest way to ensure an adequate return on investment is to pay less at the purchase.  The same principle applies for investors who buy extremely illiquid stocks, or stocks that the market considers "dead money."  These are the stocks that are covered in dust bunnies and haven't seen daylight since the Nixon administration.

Investors have very little patience.  CNBC's entire premise is that you're missing out on something this exact second if you're not watching them.  The WSJ makes money on daily news. Financial websites on the internet are biased to what's happening right now.  This urgency has predictably trickled down investors.  Funds like to talk about how they look for investments with a catalyst, some event that will unlock value quickly.  They need a catalyst because their investors, the ones watching CNBC and reading the WSJ don't have patience anymore to see an idea develop and won't tolerate their managers waiting a few quarters, or gasp, a year or more for a thesis to play out.  This obsession with catalysts has made its way to individual investors as well.  Not many investors have much patience anymore.

This lack of patience becomes a problem with deep value investing because there are some stocks that require extreme patience.  I'm not talking about holding stocks a few months or even a year before value is realized, instead these are companies that might need to be held a decade, or even two decades before an eventual liquidity event or sale near intrinsic value.  Holding a stock this long required extreme conviction, extreme patience, or willful neglect.

Value investors fishing in the deepest ends of the value pool need to be like real estate investors who lock in their gains when they purchase.  Buying at an extremely steep discounts is warranted for these types of stocks.

Because some of this is such a foreign concept to most investors let's look at an example of one of my favorite dead stocks; a stock that has lost all investor interest, Hanover Foods (HNFSA, HNFSB).  The A shares trade for $82, the same price they were trading for in 2003.  The stock has seesawed in the intervening years climbing as high as $120, and then subsequently falling back to the $80 level multiple times.  What's interesting is that while the share price is unchanged from 13 years ago the business has continued to grow.

I put together a small table comparing a few aspects from 2003 and 2016:

The company has also paid $14.30 in dividends since 2003.  A shareholder holding for the past 13 years would have a 17% cumulative gain, entirely from dividends.  Yet the discount gap has grown from shares trading at 66% of book value in 2003 to shares trading for 27% of book value today.  

Let's look at this from the perspective of a 2003 buyer.  They've made a measly 17% return over 13 years, or 1.3% per year.  Yet the company's book value has grown at 7% a year over the past 13 years.

Now imagine that the market continues to ignore the company for another 10 years as the company continues to grow as it has for the past 13 years.  If the company continued to trade for about 30% of book value and an investor sold in 10 years they'd have a roughly 11% annualized return over that period.  This is due to the discount price at purchase plus the growth of the company's book value.  The math for this is compelling, I've built out a table of potential sale prices based on P/B multiples factoring in the company's growth rate as well as the holding period.  The rate of return calculation is a simple cumulative return divided by the holding period.  This table presumes an investor holds the shares the entire time and doesn't add or sell anything.

At worst the company continues to trade at their current discount and an investor sells in five or 10 years and makes 10% annualized plus a percent or so in dividends.  But maybe one day the market might realize there is value in Hanover Foods and the shares potentially trade at 50% or even 75% of book value.  If an investor were to buy today and sell their shares at 75% of book value in 20 years they'd be looking at a 47% annualized rate or return on their investment.  These are numbers that fortunes are made of.  But only fortunes for those patient (or stupid) enough to hold a dead money stock for decades. 

The issue is very few investors have the patience to sit idly and watch a stock do nothing.  Even fewer investors can do this with a stock that isn't SEC filing, is hard to purchase and the market has left for dead.  But those few investors who have an iron constitution can stand to make sizable returns.  A return for doing nothing, just buying into something with a little growth at an eye-poppingly low valuation.

The largest risk for an investor in a dead money situation is if the valuation gap widens.  This is what happened to Hanover over the past 13 years, they traded down from 66% of book value in 2003 to 27% of book value currently.  If in 10 more years the company still trades for $82 they'll be trading for 14% of book value.

At some point the discount becomes too large and value becomes its own catalyst.  Clearly 27% of book value isn't cheap enough  Maybe 14% of book value will be?  Maybe 7% of book value will be?  I don't know, but at some point the market quote for a growing profitable company simply becomes too great and investors start to take notice.  Of course most investors will find a million reasons to avoid the company.  And most are valid, and they'd be very valid at 80% or 100% of book value.  But can some of those issues be overlooked at 27% of book value?  Apparently not.  Maybe at 15% they'll be overlooked, or maybe at 7%.

If it seems like there are no investors left interested in Hanover it's because that's true.  Almost every long time shareholder I have spoken to has thrown in the towel and moved on.  At this point I'm not sure who owns shares anymore, but as shareholders give up the discount widens.  

Stocks like this aren't for everyone.  There is no catalyst in sight.  Interested investors don't need to act soon, you'll probably be able to pick up shares for $80 next year, and in three years and probably again in five years, there's no rush at all.  My kids will probably grow up and graduate college before I ever see a return with this stock.  But if shares ever do trade up to 50% of book value or even 75% of book value over that time I could end up with an excellent return, and I'm willing to sit on my hands until that happens.

Hanover is a simple example of this principle, but there are a number of companies that are like this.  Shares trade for significant discounts to ultimate realizable value, but gains will only be realized by those willing to wait what's considered an eternity in our fast driven market.

Disclosure: Long Hanover