My advice for students

It's an easy time of the year to become reflective, kids are going back to school and life begins the school rhythm.  My oldest starts school again today and it's had me thinking about schooling and maximizing the school experience all weekend.

I never liked school.  In elementary and middle school I'd sit by the window and look out at passing traffic while day dreaming about escaping to do something, anything else.  High school wasn't much different.  I went to college because that was the expectation.  I never buckled down and maximize my schooling in the traditional sense.  What's interesting is neither did my brothers, we all did about average and yet all found our footing in life.  This is contrary to what society and what teachers might lead you to believe, and anyone less than an A student is a failure in life and will be flipping burgers at Wendy's.

There are a lot of very important things taught in the classroom.  But there's a lot that's never taught either.  I put together a few things I believe were crucial for my own development and they're things I want to pass onto my own boys as they get older.  These aren't universal truths, but rather things I've experienced that I value and I want my kids to value.  I've written this as a way to capture my thoughts.  I didn't write it in the corny "letter to my kids format" because my kids will never read this.  Instead I'm hoping someone out there might find some of the lessons I learned to be useful.  I also realize that most students feel they are too smart for advice because they already know everything.  And those of us who've learned these lessons wish we would have listened when we were younger.  But that's the experience of growing up.

Blaze your own path

If you do the same things as everyone else you'll get the same results as everyone else.  You'll also be competing with everyone else for a few scarce positions.  If you want different results you need to do something different.

The brutal reality is that very few people are "the best" at anything, sports, academics, business, whatever.  But we have a system where everyone tries to work hard to be the best.  The end result is a field of people all competing against each other, and if you aren't leaps and bounds better than everyone else the results will be disappointing.

They don't teach you in school that there are other ways to achieve the things you want outside of the traditional path.  I'd consider that standard advice is to do well in school, go to a good college, get a good job, put your head down and work hard then get promoted.  For some this path works well, but for everyone who isn't the best, or the cream of the crop you'll never reach your maximum potential waiting for someone else to promote you or recognize you.

Look for alternative paths to where you want to go.  You need to think creatively, but the results are rewarding.  Some of this can be by doing things others aren't doing.

In high school one of my younger brothers approached me about learning how to play guitar.  I played and he wanted to play too.  I recommended against the guitar and that he play bass instead.  My reasoning was that everyone learns to play guitar and you need to be excellent to do anything with it. Whereas there is always a shortage of good bass players.  My brother took my advice and a few years later I was watching him perform on The Tonight Show amongst other TV appearances.  He is a very good bassist, but not the best, but there is such a demand for bass players that he was able to achieve things most guitar players could only dream of.  By choosing his own path he was able to tour the US and Europe on someone else's dime and get paid for the experience.  But music isn't forever, and he talked his way into a sales job and from there into a computer programming job, which is impressive given his Psychology degree and music related work experience.

My own career path is a set of twists and turns that couldn't be predicted ahead of time.  I've created some roles for myself and fallen into others.  But interestingly enough I've only ever received one promotion, a minor one that was inconsequential.  I've created my own path and leap frogged others who are working their way up the ladder.

I love talking to entrepreneurs about how they got started and why they got started.  Not surprisingly many successful entrepreneurs almost fell into starting a company.  Some became extremely successful by taking chances and doing things others didn't want to do.  This is how you find an alternative route, you do the work, do it well, and do things others aren't interested in doing.

Ability to execute, not credentials

Popular culture has left us with the impression that a graduate from Harvard will be able to open a door at any company in the US whereas a graduate from a community college will be destined to low level white collar jobs the rest of their career.  My dad had an expression "it's not where you go to college, but what you do with it."  It's an expression I've seen lived out as I've grown older.

A related story is a good friend was hired for a job a few years after college designing bridges.  One of his co-workers at the time was someone he knew from college.  The co-worker spent a considerable amount of time working for straight-A grades in college and graduated with a 4.00.  My friend did not, yet they were sitting side by side making the exact same of money doing the exact same thing.  My friend could execute, but he didn't have the grades, it didn't matter.

Credentials and a great resume can open doors, but the ability to execute once at the job is what keeps you there.  It's the ability to execute and complete tasks that opens bigger and better doors.  An employer might care about education for the first job because that's the only information they have to work from.  But three or four jobs later it's how you'd done in those jobs that matters.  If a company is evaluating a student with proven experience verses a straight-A student with no experience the student with experience will be chosen every time.

My first job out of college hammered home this point.  It was at a start-up here in Pittsburgh.  The company hired based on experience, not on education.  This was something of an eye-opener as I had just come out of college where the college institution led us to believe that grades and college performance mattered.  This company only cared about what value people could provide, and the more value employees provided the more the company overlooked issues individuals had.  There were a number of high performing employees without college degrees.  And there was one individual who proved this entire point over and over.

This employee was one of the best in the world at his given specialty, he's written books on the topic and hosted conferences.  He also had some personal failings that were quite epic.  From drinking too much and throwing up in the backseat of the CEO's car to sending out resignation emails when drunk in the middle of the night.  The company's response was always the same.  There'd be an apology email from the CEO for the employee's behavior and promises that it'd never happen again.  He provided so much value to the company that they were able to overlook and accommodate behavior that wouldn't be tolerated anywhere else.

Value people

For some in their blind quest for accolades and success trample the very people who help them achieve their goals.  The result is the person's success isn't remembered, but rather how much of a jerk they were.

Very few achieve anything on their own without anyone else's help.  It's how you treat people that's remembered, not what you achieve.

In sales books there are typically chapters written about how to handle "gatekeepers."  These are receptionists and executive assistants who answer the phone and email for deal makers.  Most sales literature includes some combination of tricks, brute force and outright lies to get past gatekeepers to the deal maker.  But here's the thing.  The gatekeeper is a real person showing up to work each day trying to do their job.  You can't blame them for trying to shut down people trying to shove their way through.

I've found a different tactic works wonders, treat the gatekeeper like a real person who is essentially an advisor to the dealmaker.  This approach doesn't use lying, or brute force.  Instead by working with them they start to work for you instead and will sell to the dealmaker on your behalf.

One tactic that's worked well for myself is to always put myself in the other party's shoes.  I try to imagine myself on the other end of whatever I'm engaged in.  How would I view myself?  When I can view a situation from all sides it helps me make decisions that aren't one-sided.  Awareness of how other parties feel and act is important, with this perspective I've been able to make headway numerous times where if I was just focused on myself I would have just been shutdown.

But it's not just people who you work with who need to be valued, value personal relationships even more.  Success, co-workers, and accolades won't love you back, and when times get tough they won't be there to help you out.  But family and good friends will.  Relationships that are built on a solid foundation will last even when there's a storm.  Relationships like this require work, they're tough, sometimes uncomfortable or inconvenient, but they pay off in the long term.  Don't ignore family and friends as you journey down your path.

I've witnessed something that remains somewhat of a mystery to me, but don't let it happen to you.  It's people who ignore their kids in their pursuit of their careers.  Yet once a career is over some of the only people left in their life their ignored kids.  It's short term thinking.  Don't burn bridges today for investments that will pay off in the future.  Spouses, kids and close friends, but especially kids will pay dividends for years and decades, invest in them now instead of putting off the investment for some other time.

Contentment is a key to life

No matter what you achieve, or what you don't achieve you'll never be satisfied if you're not content.  Discontent is a thief that steals joy from your life.  Without contentment you will always be chasing something else.

If we look deep into our souls very few of us are truly content with our position or what we have.  Some justify this discontent saying it's what fuels the fire that drives us.  The problem is that fire can become an uncontrolled raging inferno that will never be quenched.

I think the key to contentment is thankfulness.  Instead of looking ahead at what we want to happen we should look around and be thankful for where we are.  If you're reading this you're alive, that's a great starting point for being thankful.  A thankful attitude breeds contentment.  Thankfulness also breeds optimism.  If you are always looking for reasons why something isn't up to your expectations you'll never be content.

Contentment is a bit of a paradox.  I'd wager that most think if they had unlimited money they'd be content because they could do anything they wanted.  But that's not how it works.  There are people with very little who are content, and others with more money than they could ever use who are discontent.  Contentment is an attitude, not something that can be achieved materially.

If you want to see lack of contentment visit an airport.  Most everyone is complaining about something or unhappy about some part of the experience.  There are very few who are thankful that they get to fly across the world in a comfortable tube verses riding on a steamship, a cramped train or in a car.  How many travelers are thankful that they air travel enables them to do whatever lies at their destination?


These are the lessons and traits I am hoping to instill in my kids (I have three boys).  Instead of telling them to "get good grades" at the start of the year these are the lessons I want them to learn.  They're timeless, they're just as important in elementary school as they are in college or mid-career.  And they are all attitudes that work in any environment.  They're also how I measure success.  It will be nice if one of my kids is a high performing individual, but if they are never happy and always chasing the next thing while trampling people in their path I'll consider myself a failure.  But if my kids embodies these attitudes I'll be satisfied regardless of what they do in life.

Oddball Stocks Podcast Episode 1

This past Friday I was supposed to be a guest on the Benzinga PreMarket show.  It turned out the show is revising their format and my spot was cancelled.  I had prepared some remarks for the show and instead of letting them go to waste I decided I might as well record them and turn them into a podcast.  What follows is my first attempt at a solo podcast.  I'm hoping to improve the format and production value going forward.

Is the *new* Solitron a worthy investment?

It's fitting personally that investment changing news about Solitron Devices (SODI) hit the wire while I'm on vacation at the beach.  When I think of Solitron I can't help but associate the company with the beach.  It was three years ago in June that my wife and I flew down to West Palm for a beach getaway with a short break away from the beach for Solitron's first annual meeting in 20 years.

If I'm honest with myself then Solitron Devices would be considered a hotel stock for small value investors.  It seems like anyone who's ever looked for value in small and micro cap stocks has either looked at or owned the stock over the past decade.  The stock has at times been a net-net, an activist target and at one point in ancient history a high flying growth stock.  If you can believe it Solitron was the Tesla of the 1960s.

The company designs and manufactures integrated chips and components for satellites and military applications.  The company was a stock market darling before they spiraled out of control and into bankruptcy in the 1990s.  It didn't help that their manufacturing process poisoned the soil leaving an EPA disaster in their wake.  In the 90s the company restructured, established a plan to pay for their environmental sins and continued to manufacture specialized chips.

They operated in obscurity for years, so much obscurity that after the financial crisis the company traded for less than their NCAV.  One could in theory liquidate the company at firesale prices and end up with a sizable gain.  There was only one problem.  The company's CEO, Shevach Saraf stood in the way.

Saraf was one of those people who was enamored with titles.  He was the CEO/CFO/COO/Chairman and whatever else he could fit on a nameplate.  He was also stubborn to a fault and it was his way or the highway when it came to Solitron.  Saraf was appointed CEO during the company's restructuring and served in that role until recently.  The man appeared to be insufferable to work for.  At one point all of the titles he accumulated belonged to other employees, but one by one they quit and he took them for himself.

The allure of the company was that it had a considerable amount of cash and securities sitting idle on their balance sheet.  This alone was enticing, but their core business operations weren't bad either.  Almost any investor could day dream about a scenario where the cash was returned to shareholders and the business sold for a gain.  Outside of outright fraud there weren't any scenarios were shareholders did poorly.  The problem was Saraf, the company's largest shareholder and head executive-everything wanted none of it.  Instead of returning cash to shareholders net income was hoarded on the balance sheet as Treasury securities.  Annual reports were marked with language indicating that the company wasn't certain if it could ever turn a profit in the future and there was an outside chance it might disappear into the night.  Saraf was a classic sandbagger.  He'd proclaim doom and then easily surpass his proclaimed dire circumstances.  He paid himself handsomely and owned a substantial amount of stock.  Enough that any attempt to outvote him would be difficult.

I began writing about the company hoping to shed light on an undervalued situation.  Eventually I realized that the only way to create value was to do something myself.  I helped organize shareholders and bring attention to the company all while pushing them to hold an annual meeting.  The unstated goal of the annual meeting was that with an annual meeting an eventual proxy battle to oust insiders could happen.  Without a meeting there could be no proxy battle, and without a proxy battle no change.  In 2013 we succeeded and shareholders had their first meeting and in some ways the rest is history.

Once the company held a meeting activists and proxy battles followed and culminated last week with the company filing an 8-K announcing Saraf's departure from the company.  But if that wasn't enough the company is buying out his shares.  This removes the largest stumbling block to value while at the same time returning cash to investors.  The Board is now firmly under control of activist investors and the CEO is Tim Eriksen, the hedge fund manager who mounted a successful proxy fight last year.

The question is whether Solitron post-stubborn CEO is worth an investment or not.  To decide let's walk through the adjusted balance sheet after the transaction.

Before the transaction the company had $6.48m in securities and $507k in cash on their balance sheet amongst other assets.  The company is debt free and liabilities consist of accounts payable and accrued expenses.  Let's presume that their cash is needed for ongoing operations and their investment securities (treasuries) are excess and can be used to fund their transformation.

The first thing the company did was repurchase all of Saraf's shares at $3.91 per share.  The company spent $1.3m repurchasing 331k shares.  This reduces the number of shares outstanding from 2.2m to 1.9m for a more than 10% reduction in shares at less than book value.  This action alone is highly value accretive itself.  The second action taken was to repurchase all of Saraf's outstanding options for 290k shares for slightly less than $1m, paying $3.43 per option.  This buyback removed the options overhang and reduced the fully diluted share count.

Both of these actions are shareholder friend, the company used $2.3m worth of excess cash to eliminate Saraf's share holding and his option position.  This is the type of thing value investors dream of, a company using their cash to repurchase shares below book value.  While value was created for investors it also eliminated the company's largest shareholder.

Beyond the initial $2.3m share and option repurchase the rest of the buyout can be framed within the context that the buyout expenses were necessary to get rid of a stumbling block for shareholder value.  The company paid $410k in severance costs, $45k for health insurance, $18k to transfer ownership of the company car to Saraf, $96k for earned vacation time and other incidentals such as his cell phone.

In total the company is paying $2.859m to rid Solitron of Saraf, with the bulk of the company's expense being spent towards repurchasing shares and options.  The company is also reimbursing Eriksen Capital $110k for their proxy fight last year.  I know some shareholders antsy about a repayment such as this, but in my mind paying $110k to unlock value is very cheap.  If shareholders could unlock value other management-trap companies for $110k we'd all be a LOT richer.

Once the agreement is executed the company's equity will drop from $11.36m to $8.391m, which is $4.41 per share.  At current prices post transaction the company is trading for 89% of book value, which is cheap in light of recent facts.

One negative is the company has started to report negative earnings.  We could speculate all we want, but it's possible that the earnings drop was the catalyst that pushed Saraf out the door.  Until recently the company had steady revenue and earnings, and suddenly with activists onboard the company's results took a nose dive.  Was this Saraf trying to payback shareholders with bad results?  As a one-man executive and selling machine it's possible.  But if that were the case his plan backfired badly.

At current prices investors have the ability to purchase $4.41 for $4.01 with an activist investor as CEO and shareholder friendly Directors.  The company still has about $3m in excess cash that can be returned to shareholders as a buyback or a dividend and a core business that had a history of earning above average returns.  The best course of action would be for Eriksen to negotiate a sale to a private buyer at an above market price.  It isn't unreasonable to presume that the core company might be worth $5-6 per share plus the additional $1.50 per share in excess cash.  I don't think it's a stretch to say the company is worth 50% more than current prices if not more.

Most readers will brush this writeup off saying that "a 50% gain isn't big enough" but I don't know many other investments that are controlled by activist investors with an upside of 50% or more. Even if it takes Eriksen two years to realize value with Solitron it's still a very respectable 25% a year return.

If you're looking for a cheap investment with a catalyst look no further than Solitron Devices.

Disclosure: Long SODI

Sitestar shows anything is possible

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Disclosure: No position

Don't let these companies hide in the dark!

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

The Purchase

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

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

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

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

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

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

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

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

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

The Valuation

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

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

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

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

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

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

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

Now What?

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

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

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Yesterday's strategies from investment gurus

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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