Recent interview and podcasts

I recently began co-hosting the Bulldog Investor Podcast with Fred Rockwell.  For anyone who didn't know I was doing this I wanted to share the four recent episodes that I've been on.  Each episode is linked with a short description.

  • Interview with Tim Melvin discussing community banks and banking: Episode here
  • We talk with Tim Stabosz about risk in value investing.  An interesting discussion about distressed turnaround stocks takes place: Episode here
  • John Huber of Base Hit Investing joins us to talk about compounding machines, undervalued stocks, portfolio management and Bank of Utica: Episode here
  • We talk to Philippe Belanger of Espace MicroCaps about finding investments in Canada: Episode here

July Benzinga Interview

Last Wednesday I had the chance to be a guest on the Benzinga PreMarket Prep show again.  The interview can be found below.

Neglected or distressed?

There is a common perception about value investing that it involves purchasing shares of companies on the brink of financial ruin with the hope they turn around.  Viewed through this lens value investing is risky and the value investor one step away from experiencing individual ruin as their investments go bad all at once.

It's not hard to see where this perception could have come from.  In the world of academic finance where everything can be reduced to a formula investment returns are a product of risk.  Riskless assets generate no returns whereas supposedly risky assets generate outsized returns.  Financial practitioners know what the academics don't, that life isn't a set of formulas.  Assets that appear safe can turn out to be risky, and assets that appear risky might be safe.

The question is how can an investor find a safe asset for a depressed price?  The answer to that lies in the distinction between different types of value investments.

In general low priced stocks can be broadly grouped into two opportunity sets: distressed investments, and neglected investments.

Distressed Investments

A distressed investment is any investment situation where the company is experiencing either business/operational distress or financial distress.  These are the stereotypical "value" investments.  Companies with operational difficulties trading at extremely low valuations.

An investment in a distressed company hinges on a few factors.  The first is an investor needs to be able to determine whether the market reaction to the company's results is too pessimistic or if they're accurate.  Then the investor needs to be able to determine if the company can recover from their operational difficulties.  If an investor can determine both of these factors correctly it's likely they will be able to do well investing in distressed investments.

The trouble with distressed investments is determining when the future of the company doesn't look like the past.  When a company faces a fundamental operating issue they need to innovate and solve their issue.  If they can it's likely results in the future will resemble the past, or might even be better.  If the company has a culture that can't react to their situation the chance that the future looks like the past becomes very small.  Short sellers like to look for companies that have stumbled and don't have the business-DNA to reinvent themselves.  Whereas distressed investors are looking for companies with that reinvention DNA.  It's worth noting that very few companies change their business from one industry or market to another successfully.  In many cases the odds are on the short sellers side.

Many novice value investors will find a distressed opportunity and presume the future will look like the past when in fact the business itself is undergoing a dramatic shift and it's likely the company will never recover their former glory.

With all these pitfalls distressed investing can be extremely profitable if done right.  A company on the brink of bankruptcy and trading at 10% of book value might return 500% or 1,000% if they avert disaster.  Where there's a chance for outsized returns there is also a chance for a complete loss.  Companies straddling a thin line between solvency and bankruptcy court usually don't leave much residual value for shareholders.

Even though equity investing in distressed situations is risky one method to reduce risk is to invest is at a higher level in the capital structure such as through preferred stock, or debt.

Neglected Investments

I feel that distressed equity situations tend to have binary outcomes, either the company will do exceptionally well, or a tax write-off is in short order.  I prefer a different type of value investment, the neglected company.

A neglected company is one that the market has mostly, or completely forgotten about.  Sometimes the company's business is so boring it's hard to generate investor excitement.  Investors, and especially the financial media likes whatever is popular or cutting edge.  A landscaping company that schedules appointments via an iPhone is suddenly the Uber of landscaping.  Whereas the hordes of other landscaping companies quickly fall into the camp of neglected investments, regardless of their investment merit.

The majority of my best investments have been neglected companies.  Companies that are profitable, growing, and trading at depressed valuations because no one knows or cares about them.

In many ways a distressed investment is the opposite of a neglected investment.  Companies that are neglected usually don't release news..ever.  Neglected companies don't hold conference calls, and sometimes it's hard to even obtain financials for them.  Neglected company CFO's are surprised any investors exist, especially ones that have intelligent questions to ask.

Distressed investors often live and die by the news flow.  One news release or announcement can mean the difference between a vacation in the French Riviera or a stay at the Days Inn at the Jersey Shore.

Neglected investments don't appreciate 3-5x in a year, but they might compound in silence at 15% or 20% for decades, all while trading at a large discount to book value.

An investor interested in neglected companies doesn't need to predict the future.  They just need a reasonable assumption that the future will be similar to the past.

The advantage to an investor looking at neglected investments is that these investments are not as risky.  Neglected companies aren't facing an existential crisis.  They can be great companies just operating outside the limelight.

Which is best?

I'm not sure there's a best way, but it's important to understand the differences in each investment you look at on a stand alone basis.  The worst mistakes happen when an investor believes a distressed company is merely neglected.  When this happens the investor misses a significant source of risk in their investment.  The converse can also be true.  An investor mistakes a neglected company for a distressed investment and never invests.  There are many neglected companies silently grinding out significant returns for shareholders.

The Solitron proxy battle heats up

The proxy battle between Solitron management and Eriksen Capital Management has reached new heights.  Solitron is clearly worried that they will lose this battle, and I expect them to.  They've hired an investment relations firm to send shareholders a letter containing their view on Ericksen's nominees.

Eriksen Capital hit back hard with a proxy filing today.  I will let Eriksen's own filing do the talking in this post.

The filing is here.

"Based on SEC filings, Saraf became CEO in December 1992. During the quarter Mr. Saraf was hired (12/1992 through 2/1993) shares traded as high as $8.12 and as low as $3.43 per share, adjusted for the reverse stock split. Solitron’s share price as of June 30, 2015 was just $4.47 per share. Thus under Saraf’s twenty two and half years of leadership, Solitron shareholders total return would range between a loss of 41% and a gain of 39%, including dividends. In comparison the Russell 2000 index, which covers small cap stocks, has risen over 669% since January 1, 1993 through June 30, 2015. Clearly, Solitron’s board has some serious performance issues that they are probably embarrassed to discuss."

"Summary of the facts:

1.  In 1992 Shevach Saraf was named President and CEO of Solitron Devices. The company was in Chapter 11 bankruptcy at the time. He was granted a very generous package that granted him a good salary, 10% ownership of the company at no cost to him, and ten year options to purchase 8% of the company.

2.  Prior to Mr. Saraf becoming CEO in late 1992 the Company made contributions to its 401k and Profit Sharing Plan to help employees in preparing for their retirement. Since becoming CEO, Mr. Saraf has received over $1.6 million in profit related bonuses, in addition to his generous salary. During that time, the company has made zero contributions to the 401k and Profit Sharing Plan for its employees.
3.  For nearly twenty years, from 1993 to 2013, CEO Shevach Saraf and the Board did not hold annual meetings even though Delaware corporate law requires it. From 1996 to 2013 the only directors were Mr. Saraf and two others appointed solely by him after his own term had already expired, and, based on a careful search of SEC filings, it seems clear none were presented to shareholders for affirmation.

4.  In 2000, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors voted to approve an employment agreement granting Mr. Saraf 15% of Solitron’s earnings in excess of a fixed $250,000 per year. The employment agreement also granted the CEO an automatically renewing five year contract along with generous change in control benefits.
5.  In 2000, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors granted a massive stock option plan, without shareholder approval, primarily for Mr. Saraf’s benefit. By our calculations 64% of options granted went to CEO Saraf, and 12% to the other directors.
6.  CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors granted these massive options to him at ridiculously low prices. The first grant issued in December 2000 was for 10% of the company’s shares, and was priced at just one-third of book value. The second grant issued in May 2004 to replace the original 1992 grant, was for 8% of the company’s shares, and was priced at a substantial discount to book value. 3

7.  In 2007, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors approved a second 700,000 share option plan without shareholder approval. Thankfully Solitron has not issued shares on it, but they did recently file with the SEC in order to do so. One of our requests to the Board was that they put the plan up for shareholder approval at this year’s annual meeting. They refused. Wonder why?

8.  CEO Saraf’s option grants under the 2000 Stock Option Plan had ten year expirations from the date of the grant. Just prior to expiration, the Board changed the grants to having no expiration even though the plan expressly forbade such action. While Section 10(a) of the 2000 Stock Option Plan grants the Board the right to extend an option grant, it expressly states “that in no event shall the aggregate option period with respect to any Option, including the initial term of such Option and any extensions thereof, exceed (10) years.” No amendments to the Plan were ever filed, and we would add that an attorney representing Solitron stated in a letter to us that “I understand that the 2000 Stock Option Plan has not been amended since the date of its public filing.”

In case you weren’t keeping track. CEO Saraf was granted 10% of shares at his hiring for free. He was later granted options for another 18% of the company, plus 15% of profits in excess of $250,000 per year. If you add that up it is up to 43% of economic gains in addition to his significant $321,500 annual salary. By our calculation, CEO Saraf has received nearly half of Solitron’s economic gains during his twenty plus year tenure.4 Yet Solitron has the audacity to slander Mr. Eriksen and Mr. Pointer as “opportunists” who “care only about themselves.

Disclosure: Long SODI

Announcing The Microcap Conference

One of the most common questions I'm asked regarding micro cap stocks is "how do you find new investment ideas?"

One problem with microcap stocks is there are so many of them.  In the US and Canada there are over 10,000 stocks with market caps below $500m, and 8,600 companies have market caps below $100m.  This is compared to the 3,600 companies with market caps greater than $500m.  These numbers don't include the hundreds of semi-public companies where information is at times harder to find.

Microcaps have a reputation of being scammy, risky, fly by night operations.  And there definitely are a number of companies that fit that profile.  But within the universe of 10,000 small companies there are also some incredible investment bargains.  The problem is digging through 10,000 names to find those hidden gems.

I've teamed up with Fred Rockwell (I co-host the Bulldog Investor Podcast with Fred) to create a new type of microcap investment conference.

We wanted to create a unique investment conference combining some of the best financial bloggers with microcap companies that deserve to be on your radar.

You will have the ability to choose between sessions on two different tracks on November 5th.  We have dedicated one track to microcap companies so they can tell their story to investors.  You'll have the opportunity to listen and ask questions directly to executives at these companies.  We have also reserved space for investors to schedule one on one sessions with attending companies.  This is your opportunity to meet with an executive and get a feel for how they think about capital allocation, how they view the future of their business, or anything else you feel relevant to your investment thesis.

At the same time we're also going to have sessions featuring some of the biggest names in the value investing blogosphere.  The day will be divided into presentations from bloggers, special panels (such as an activist investing panel), Q&A sessions as well as a stock pitch contest.  These sessions are more educational in nature.  Micro cap experts will spill their secrets on how to find ideas, how to look at companies, how to engage management and more.

You don't have to pick one session track or the other, you can pick and choose to attend whatever piques your interest.  You can attend presentations by companies you find interesting and then pepper a panel of activist micro cap investors with questions

We realize that some of the best ideas and connections happen in the halls and outside of sessions so we've built in plenty of time to network with other investors and companies over drinks or food.

The Microcap Conference will take place on November 4th and 5th at the Marriott in downtown Philadelphia.  There will be a happy hour on the 4th for attendees arriving the night before.  The conference starts early on the 5th and is jam packed with presentations, sessions and plenty of networking time.

The cost to attend is $150 and includes the conference on the 5th as well as the happy hour and all meals on the 5th.  Space is limited, so booking early will guarantee your seat.

I will be presenting and spilling some of my secrets on sourcing ideas, analyzing microcaps and why I love bank stocks.

We also want to make this conference about you, and to do that we want your feedback on what panels you'd like to see or topics you'd like to see presented.  You can reply in the comments or send me an email directly (address on the sidebar).

Date: Evening of November 4th, all day November 5th
Where: Marriott Downtown Philadelphia (link)
Cost: $150

Winland Electronics a case of hidden value laying in plain sight

It's not often that a value fund piles into a stock with a $5m market cap.  Especially a fund with billions under management, but that's exactly what's happened with Winland Electronics (WELX).  The small company was noted in FRMO's latest quarterly remarks (read here).  FRMO, a part owner of Horizon Kinetics a multi-billion dollar asset manager purchased 15% of the company, a strange acquisition given FRMO's size.  The second largest shareholder after FRMO is another value investor named Thomas Braziel, the manager at B.E. Capital. (note: If you're looking for some interesting reading this interview with Braziel is a must read.)

Between FRMO, Braziel, and Matthew Houk (an associate of FRMO) 41% of the company's shares are spoken for.  

Apparently more than a few FRMO shareholders reached out to Murray Stahl (one of the company's two executives) and asked why a $390m market cap company making a roughly $500k investment, and was it even worth their time?  We know this because Stahl took the time to write about FRMO's Winland Electronics investment in the company's Q3 report.

What Stahl pointed out in his letter was two things.  The first was that at one point FRMO was a small company as well and has grown and they believe Winland can do the same.  The second was that the company sells a well known niche product that has very unique characteristics.

Winland specializes in monitoring systems.  They sell monitors to detect smoke, water, chemicals, temperature, and vehicles.  They've built detection devices for most anything that can be detected.  The products are not expensive and are potentially an easy sell to clients.  They're a form of cheap insurance.  If a company's building is flooded the company could incur hundreds of thousands to millions of dollars of losses from damages or outages.  It's easier to purchase a small sensor to detect water and mitigate the flood rather verses dealing with the effects after it has happened.

When one looks at Winland's product page it's easy to visualize how each of their sensors could protect a company against a catastrophic scenario.  Even though the probability of a catastrophe might be remote it's an easy decision to purchase a relatively inexpensive sensor that could detect an issue before it becomes a catastrophe.

Besides selling monitoring devices Winland also sells a subscription software monitoring solution that Stahl believes holds a lot of potential.  The company doesn't break out their sources of revenue, but subscription software is a good business model.

If the business is interesting but the company is overvalued there is not much to research.  But given Stahl's recent purchase it's likely that value is lurking at Winland, and I decided to take a closer look.

The company used to file with the SEC before delisting in 2014.  Before their delisting they had a history of losses before Braziel took an outsized position and gained control of the company.  Braziel moved the company from continued losses to sustained profits.

They earned $272k in 2014 compared to a loss of $2.6m in 2013.  Their book value increased from $1.3m to $1.6m between 2013 and 2014.  The company is clearly on better footing, but one needs to ask "where's the value?"

Winland is trading for 19x earnings and 3x book value, not exactly a deep value investment.  But a closer look reveals more.  Of the company's $5.3m market cap a little more than 20% of it consists of cash.  Ex-cash the company earned $272k on $538k worth of equity, for an incredible 51% return on equity.  What's even more encouraging is the company has expanding net margins.  They earned $31k on $964k in sales in Q1 2014, and in Q1 2015 they earned $129k on $936k in sales.  At this run rate they could potentially generate $600k in earnings in 2015 and ex-cash would trade for a 6.8 times earnings.

An additional sweetener for investors is the company's net operating losses carry forwards of $6.3m that expire in 2022.  There is a valuation allowance against them so these are an off balance sheet asset worth $1.64 per share, or more than the current price of the stock.

When an investor looks slightly beyond the financial statements it's easy to see why Winland Electronics is an attractive investment.  For the current price of $1.43 an investor is buying $.33 per share of cash, a business that has turned around, is growing, and has the potential to generate upwards of $.15 per share in earnings this year plus $1.64 a share worth of NOLs.  On top of all these things is the fact that the largest shareholders are value investors with an interest in maximizing shareholder value.

In the interview with Braziel linked to above he mentions that his best investments require digging beyond the initial financial statements.  I find it very fitting that the company where he is Chairman needs to be analyzed in the same manner.  There is value in Winland if one does a little bit of digging.

Disclosure: No position.

Benzinga interview plus thoughts on Goldman vs Lending Club

I had the chance to be a guest on the Benzinga PreMarket Prep show again in June.  A video of the interview can be found below.  One of the topics we discussed at the beginning of the interview was the report that Goldman Sachs might be entering the consumer lending market.  I want to elaborate on my thoughts regarding that in this post.  First the interview:

The NY Times had a report this week that Goldman Sachs (GS) is exploring an entrance into the consumer lending market.  Comparisons have been made between what Goldman has in mind for consumer lending and the company Lending Club (LC) that went public last year.

To understand Lending Club and Goldman's vision of consumer lending we need to discussion traditional lending first.

Traditional Lending

In a traditional banking model, a bank funds a loan through customer deposits.  A bank's source of funding is their customer's deposits.  Traditionally banks pay a small amount on deposits to compensate depositors for access to their money.  Deposit funding costs are low.  In the first quarter of 2015 banks paid an average of .44% in funding costs.

A bank makes money on the spread between the interest received on the loan and the interest paid on their funding (deposits).  If a bank makes a mortgage loan to a borrower at 4% and pays .5% in funding costs they earn a 3.5% net interest margin.  Operating costs to service the loan as well as providing the infrastructure to take in deposits and make loans is subtracted from that 3.5% spread as well as taxes and the resulting value is a bank's net income.

Banks can make money by lending to consumers then keeping the loan on their books and earning the spread.  Banks engage in all types of lending, consumer, credit card, auto, residential, and commercial.  Of those types residential lending is viewed as the safest and rates are the lowest as a result.  Moving up the ladder commercial loans are viewed as risker followed by auto, consumer loans and finally credit cards.

The truth is it's really a toss-up in terms of risk, sometimes commercial loans are much safer than residential loans, and residential loans aren't always safe.  On average banks are usually good at assessing risk.  A loan to IBM might carry a 1% rate, whereas a loan for a sub-prime auto might carry a 15% or 20% rate.  IBM is a good credit and it's almost assured they will pay back their notes.  A troubled car borrower is dicier.  Compound that with little residual value for the auto itself and it's easy to see why rates are so high for poor credits.

Banks usually like to diversify their lending mix.  This is in an effort to both manage risk, exposure, and increase their net interest margin.

The New Model

Lending Club is not a traditional bank as most consumers think of banks.  They own a small bank, Webbank located in Utah, but they are not a traditional lender.  The company is not funded via customer deposits, and they aren't focused on earning a spread via the bank.  There bank holds certain types of loans on their books and for the most part are just an intermediary for the rest of the Lending Club system.

Lending Club makes money by originating loans and selling those loans to investors.  The company takes a 5% origination cut off the top of the loan and then receive 1% of interest for each loan.  As an example if a borrower were to take out a $10,000 loan at 9% Lending Club would receive 1% in interest and investors would receive 8% for backing this loan.  Loans are funded by selling notes to investors.

From a borrowers perspective Lending Club is no different than a traditional bank.  A consumer requests a loan, the company conducts a credit check and if they deem them worthy they'll extend credit.  The borrower then pays back their loan with monthly payments.  Lending Club takes a portion of the payments and passes the rest onto investors in their notes.

If any investor were to read the Lending Club website it would appear that investors fund specific loans and receive payments from said loans.  But that's only partially true.  The Lending Club notes are simply derivative securities, the note itself is to Lending Club corporate, and the company then promises to forward on payments from borrowers to the investor minus service fees.

Lending Club makes money on the initial origination as well as service fees and the 1% of the interest rate paid by borrowers.

The actual notes are fairly complex.  A prospectus is available on the SEC website and contains general details of how the mechanics of the investing and loan funding process work.  Investors are buying Lending Club notes, and then Lending Club pays investors based on what notes the investor has selected via the website.  If a borrower defaults the investor has zero recourse, they don't have an actual claim on the loan like a bank would.  If Lending Club were to declare bankruptcy the investors don't have a claim on Lending Club, the claim directs to the interest in the underlying note.

Lending Club's costs are much higher than a traditional bank's costs.  Any student of the capital markets knows that equity financing carries the highest cost of all types of financing.  But for Lending Club the equity financing isn't borne by them, it's someone else's money.

Can it work?

The Lending Club model is different from a traditional banking model.  Lending Club needs to keep their origination volume strong and growing if they want to increase their revenue stream.  They aren't making much money on each loan so they can't just originate loans then sit and collect interest for years like a bank can.

This creates a unique incentive, the incentive is for Lending Club to drive loan volume regardless of credit quality.  If borrowers default Lending Club itself doesn't recognize a loan loss, they simply lose their 1% ongoing interest stream.  The company makes the bulk of their money upfront.

The company claims on their website that they have a premier platform and can conduct this type of lending profitably because of a low cost IT platform.  Supposedly banks with their high cost personnel and traditional infrastructure are outdated compared to this new IT paradigm.

The problem is the company's financial statements don't match up with what they're saying publicly.  In the most recent quarter they generated $81m from originations and service fees and had $86m in expenses.  Expenses broke down as following, $35m in sales and marketing (to keep the origination machine running), $12m in origination costs, $12m in engineering and development and $27m in "other".  The company reported a GAAP loss, but if investors pretend that stock compensation isn't a true expense then the company was profitable on an adjusted-EBITDA basis.

Lending Club has originated over $9b in loans since they started.  For comparisons sake let's look at them compared to a bank with $9b in loans.  I ran a search on and came up with Apple Bank for Savings located in NY.  They had slightly over $9b worth of loans in the first quarter of 2015.  As a comparison it only took Apple Bank for Savings $29m ($16m in salaries, $13m in premise, data etc) to manage this amount of money.  Apple Bank for Savings earned $10.2m for the quarter, a far cry from Lending Club's loss of $6m.

Of course this isn't a perfect comparison.  Apple Bank for Savings specializes in mostly residential and commercial lending.  And they are funded by deposits.  But the comparison shows that there is a lot of value in being able to keep lower interest but profitable loans on the balance sheet and earning a spread.

Lending Club is a fundamentally different model compared to traditional banking.  Lending Club's model is driven by originations and fees on their loans, not the rates charged to consumers.

The attraction to this model for Goldman Sachs should be obvious.  Lending Club is raising funding capital from ordinary investors for their derivative notes whereas Goldman Sachs has a pipeline to institutional capital.  Goldman Sachs are experts at raising funds for special purpose entities that are eventually repackaged and then sold again to other (or the same) investors.

Lending Club is raising money at the retail level, $25 at a time.  Goldman Sachs can come into the market as a whale given their connections to capital and experience securitizing loans.

If I were to wager I'd say that Goldman Sachs will create a newly named consumer loan unit without the Goldman name on the letter head.  This newly created entity will begin to spam American mailboxes offering loans at 15-25% rates.  Goldman will then package these loans and sell them back into the market pushing the risk of a default onto investors, the same way Lending Club does.

The risk to this business model is it requires a steady stream of new originations.  If loan origination volume doesn't stay steady or grow the company could have issues coving their costs.  Lending Club hopes to eventually make money on their origination and service fees.  I'd imagine Goldman Sachs has the same idea, although I'm sure they'll make a little extra on the back end of the deal as well when they resell their packaged securities.  This is where Goldman has an edge.  They can make money up front and make money on the back trading these securities between clients.

Risk will appear when the "good" (good in a relative sense, not many truly good credits are borrowing at high rates) credit dries up and the company continues to make loans to poor quality borrowers in order to hit their origination metrics.

The real risk will be borne by the investors in these notes.  Whereas Lending Club investors can select the types of loans they'd like to be exposed to it's likely Goldman will do the selecting themselves and offer their clients pre-packaged securities.  We've seen what can happen to pre-packaged securitizations of low quality credits in the past, let's hope history doesn't repeat.

West End Indiana, a cheap bank with a slate full of activists

I grew up on the edge of nothing, well it seemed like the edge of nothing; a few miles from the county line.  The invisible county line was the border between corn fields, orchards and the encroaching suburbs.  A scene replayed throughout the Midwest.

The Midwest can be described as a sea of fields broken up by small towns and occasionally larger cities.  The Midwest is homogeneous, a small town in Ohio looks similar to a small town in Iowa.  Omaha doesn't differ that much from Columbus or Indianapolis.

Under all of those seemingly endless fields lies one thing, a lot of tied up capital.  Farming has enormous barriers to entry, the machines, the land, the labor.  Take a minute and imagine starting a farm from scratch.  You would need to spend a few million dollars to buy land, tractors, and plant seeds.  Then you sit and wait and hope your crop grows before attempting to sell it into a speculative market.  A farmer's input prices fluctuate as well as their final output price.  When they purchase their inputs they have no idea if they'll be able to sell their product at a profit or loss.  The scale of speculation that farmers undertake would make many traders blush.

While farming is speculative, one thing that's not speculative is selling services to farmers.  This is the role that West End Indiana Bankshares (WEIN) finds themselves in.  They are a small town Indiana bank located in Richmond.  They provide banking services to farmers and the farming community.  While the bank services the farming community they have very little direct farming exposure themselves.

What makes West End Indiana an interesting investment is they are trading for slightly less than book value and their shareholder register is filled with a slate of activist funds.  Activist bank investors own 38.02% of the bank compared to the 11.46% that the Directors and Executives own.

Fundamentally West End Indiana is a quality small bank.  They are small in the sense that they have a $27.5m market cap and only $263m in assets.  But given their size the bank has impressive financial metrics.

The bank earns an above average 5.05% on their assets and pays .65% on their deposits, which is slightly below average.  This enables them to earn a higher than normal net interest margin of 4.4%.  The bank's ROE has increased from .84% in 2006 to their current 6.73%.  What makes this rise even more incredible is that it's been a steady climb, straight through the crisis.

The bank has five branches, including limited service branches at the Richmond city schools with $2,000 in deposits.  There are at least a few students at the school off to a good start saving!

I went to college in the area where West End Indiana operates.  I've been through Liberty, where they have a branch countless times, as well as Richmond where they are located.  It's amazing the amount of money the bank has considering the area, a very rural area filled with farms and small towns.

The reason the bank has a higher than average NIM is because they specialize in auto-lending.  As shown in the picture below they have $75m in auto lending as of Q1 2015.  Of the bank's total loans at the end of Q1 2015 36% were auto loans.

Sometimes auto lending has a negative connotation associated with it.  Auto loans can go bad quickly if a borrower loses their job.  Typically an auto loan is for an amount higher than what might be realized in a repo and sale situation.  If a bank has a book of auto loans that go bad quickly they could face charge-offs as they sell a glut of used cars for a loss.

On the other hand an argument could be made that auto lending is safer than residential lending.  A borrower needs a car to get to their job and make money for their payments, whereas it's easier to find shelter with family or friends if necessary.

The bank's loan portfolio summary is shown below:

When most investors think of a small rural bank they think of a savings and loan.  A bank making loans to residential borrowers for their homes.  West End Indiana doesn't follow that mold, they only have $64.7m in mortgages while the rest of their loans are auto and commercial.  Bank management has clearly figured out the best way to maximize profit.

While maximizing profits the bank has also kept their asset quality in check.  Non-performing assets as a percentage of assets peaked at 3.53% in 2013.

The bank was a mutual bank and demutualized in 2012.  A demutualization is when a mutually owned bank raises money from depositors and outside investors as part of an IPO process.  The proceeds from the IPO are generally used for growth.  As you can see from the loan table above the bank was able to apply their funds from the IPO into growing their loans from $160m in 2012 to the current $203m.

When a bank demutualizes they are allowed to buy back shares after their first year public, pay a dividend after their second, and sell after their third.  West End Indiana completed their demutualization in January of 2012, making them eligible to sell the bank at any time.

Often activist bank investors are attracted to bank's that are easy to sell.  These activists will push for a sale and investors will realize a nice gain.  Banks that are easy to sell usually have either a lot of costs that could be cut, or a nice niche franchise, such as West End Indiana's auto lending business.

When trying to determine if a bank is salable two things are worth considering, who would buy the bank, and what's the bank worth.

Let's look at who might want to buy West End Indiana.  A new feature recently released in is the ability to view deposit market share information.  The following table shows the metro area ranking for West End Indiana's branches.

The bank has $63.67m worth of deposits that are classified as within the Cincinnati, OH metro area.  Inside this metro area they are ranked 57 out of 70 banks in terms of deposits.  The following picture shows the aggregate metro area details for Cincinnati:

West End Indiana isn't much more than a bit player in the Cincinnati market.  Cincinnati is ruled by heavyweights US Bank, Fifth Third and PNC.  When looking at the overall deposit market share West End Indiana isn't more than a rounding error.

But a rounding error in Cincinnati is ok.  West End Indiana isn't focused on the urban market, they are focused on rural customers across the border in Indiana.  Most of their branches are un-classified, this means they operate outside of statistical metropolitan areas.

A bank looking to acquire a foothold in Cincinnati would have other better options for purchase.  But a bank with experience in a rural area, that wants further exposure to rural Indiana might find West End Indiana a great acquisition.

The second question is what's the bank worth?  The bank has a 66% efficiency ratio; this is a well run bank.  Some small banks are acquired due to their value after costs are cut.  It's  not likely that enough costs could be cut at West End Indiana to make it valuable from this perspective.  Instead of a cost cutting story West End Indiana looks more like a growth story in a niche market.  The bank took the capital from their IPO and put it to work right away generating earnings.  Earnings have grown at the bank from a $600k profit in 2012 to $1.4m in 2014. The bank earned $418k in the last quarter, and if earnings remain on track they could earn more than $1.6m in 2015.

What's limiting the bank's growth is they don't have enough capital.  They have a very efficient auto and commercial lending platform with low losses.  If they had more capital they could grow even quicker.  This is where an acquirer could come in.  A larger bank could acquire West End Indiana and inject more capital into their lending platform fueling growth.  The acquiring bank might realize some cost savings from back office synergies, but I think the majority of the value would come from increased growth.

If a bank were to realize 10-15% in cost savings and growth with additional capital it's not unrealistic to value the bank in line with peers at 1.3x TBV.  If the bank were to trade in line with peers it would mean a 40% gain for investors.  Often times a niche lending franchise can merit a premium.  With 38% of the company's shares owned by investors it's likely this bank will be sold, and probably be sold for at least 1.3x TBV if not more.  If a quick sale doesn't materialize an investor will be left owning shares in a growing bank with a valuable niche lending business at less than book value.  That's not a bad outcome either.

Disclosure: Long WEIN