Investing gap between theory and practice

Google the phrase "gap between theory and practice" and you'll end up with dozens of links to scholarly articles attempting to explain why things in practice don't always match an academic theoretical version.  I find it somewhat ironic that academics are attempting to explain why practitioners aren't following their theories with more theories.  I've been confronted with the gap between academic finance theory and the actual practice of investing recently.

A month or two back I purchased a book on bank valuation.  There are a lot of dauntingly large books that with excruciating verbosity explain one small slice of the banking industry.  While there are a lot of books focused on a banking specialty there are not many general books, so I was excited to find one that I thought would be more general.  I was further encouraged when in the introduction the author stated that they intended to lay out a simple comprehensive framework for bank valuation.  My enthusiasm ended when within the first few pages I was confronted with a mathematical proofs showing that a bank with a higher ROE should be worth more than one with a lower ROE.  The proofs didn't end there, the book is anything but simple, and is extremely academic in nature.

I've taken a break from the book for now when I came across the chapter detailing how the author believes bankers make decisions.  The author laid out a very complicated formula for determining if a given loan or deposit would create value for a bank.  It included modeling out a number of future values for everything from rates to risk over the duration of both asset and liability side.  The formula took up most of a page.  I can assure you that most bankers do not use this formula to determine whether an action should be taken or not.  If so the models are faulty at best because no one knows what the bank will be paying on deposits ten years in the future.

I appreciate the input of academics on issues, they look at a problem in a very different and systematic way.  But I've derived the most value from practitioners.  One of the greatest books about value investing, Security Analysis was written by an investing practitioner.  If one were to take a look at the 'best' recommended investment books almost all of them were written by professionals detailing their experiences.  This is valuable because what experience provides an insight to and math misses is the human element.

Why do stores sometimes sell products for below cost?  They do it because they know that people can't resist a good deal, and often enough a good deal gets people in the door to buy more higher priced items.  I'm sure there's a paper out there discussing loss leaders, but selling something for less than cost is not rational, and no academic paper would tell you to do so, unless the paper were explaining why something that works in the real world works on paper.

It seems to be the difference between the way academics see the world verses how practitioners see the world is one of perspective.  Practitioners are forward looking, the academic is working to explain the past.  They want to know why something happen whereas a practitioner wants to know the future.  An academic might apply research on a historical event and attempt to apply it to the future, but it's always the past that's directing their outlook.

The two approaches are so fundamentally different I'm not sure they can be reconciled.  What academic studies miss is the human element, you can't model behavior easily.

Many value investors consider technical analysis as the voodoo science of investing.  It's purported to be this mystical system of trading not grounded in anything but professes to make millionaires out of chart squiggle readers.  I will admit it seems somewhat spacey, but doesn't fundamental investing seem crazy as well?  There are these imaginary values, intrinsic values that fundamental investors claim a business is worth.  Yet companies never trade at these values, and by some mystical mechanism market value will eventually reach intrinsic value and investors will know to sell.  Further these intrinsic values are supposedly easy to calculate, but everyone except the buyer is wrong on what they are.

Often reality is different.  Investors, both value investors or traders purchase a stock because they believe it's either undervalued or some market action/reaction will take place.  In many cases investors with years of experience have a sense about these this and "know" that something will happen.  Sure enough the stock reacts, either with the market, or due to a one-off event, shares run up and the investor sells taking a profit.  All the while patting themselves on the back because they were right about what happened.

The problem is no one knows exactly why stocks appreciate or decline.  We tell ourselves narratives about why something happened, but many times no one truly knows.  There are so many factors and participants at work in a single company's shares that it's impossible to determine what or who caused a price change.

I was at an event recently and was talking to someone who manages a multi-billion dollar mutual fund.  He clearly represents the practitioner of this story.  He could construct a brilliant narrative about almost anything economic happening in the world.  Want to know why Japan's debt was increasing but they didn't have inflation?  He had an answer that sounded great.  He was very skilled at constructing narratives.  But what I found interesting is that didn't seem to drive how he invested.  We discussed the types of stocks I purchase, to which he conceded that they will most likely clobber the market, but without professional participation because they're too small.  He said at the end of the day he's simply a handicapper, not much different from someone at a casino.  He looks at a company and assesses if the likelihood of something good happening is higher than the likelihood of something bad happening.  He buys companies with stable balance sheets at low multiples of cash flow, with the theory that it's unlikely these companies will go out of business, but it's likely that eventually the market will give them a higher valuation.  It seems simple and it is, and he's paid very well to do this.

The idea of handicapping stocks can be extended much further, and at a certain level is the essence of investing.  I prefer to buy extremely cheap stocks with strong balance sheets.  Many of these companies are smaller, but that's only because of what's available.  But what I'm doing is finding companies where the likelihood of something bad happening is small, whereas they are so cheap that I'm betting something better will eventually take place.  I'm not always right, but one doesn't have to be correct 100% of the time.

Investing for many is no different than trawling garage sales for collectables and antiques.  Some garage sale buyers purchase large quantities of small items that they unload at flea markets for a tiny profit.  These are the traders of the garage sale world.  Others will visit sale after sale looking for an extremely mis-priced antique.  When one finds a mis-priced antique they usually don't know what it's blue book value is, but they know that something rare shouldn't be selling for $35, or a similarly low value.  These antique buyers are the value investors of the garage sale world.  There are other garage salers who are hunting for a lost Monet that they plan on hanging in the living room and cherishing forever, these are the Buffett investors.  The academic of the garage sale world is the auctioneer who is trying to piece together the garage sale action from a glass tower in Boston.  They see the sales prices and see the inventory and are trying to construct a narrative about the market.  Even though the auctioneer has all of the market's data it's truly the participants who know what's going on.  They have the 'feel' of the market whereas the auctioneer only knows the results.

The problem is the motivation of a buyer (garage saler or investor) is never clear, it's a human nature problem.  Traders identify patterns in charts that signal a market move.  Technical analysis feeds off itself, if enough traders participate then a signal becomes 'true' because enough people act on it.  Trading rewards those with superior tools and information who can act quicker.  Value investing is for slow traders.  But like in trading value investing incorporates a heavy notion of human judgement.  I have purchase companies that I knew were cheap and I had a sense something might happen.  It was from how management wrote their letters, and how they spoke of the company.  My sense was developed with experience, but it isn't something that can be modeled.

Both parties can benefit from each other.  Academics need to recognize that the market is fueled by human behavior.  Sometimes investors do things that are completely non-rational in an effort to impress someone, to gain a promotion, or just because.  These things don't fit nicely into models.  But practitioners don't get off easily here either.  They need to recognize the limits of models and studies instead of blindly following them.  If one looks hard enough any relationship can be forged out of stats.  It's relationships built on reason that have the highest chance of being true.  There are some investors who are such slaves to the models that they've failed to recognize the world isn't populated by computers.

The one thing I know is that successful investing requires a practitioner mindset.  You will never find the next best investment studying what Buffett was buying in 1952.  Even Buffett himself isn't tied to the past like that.  He like most investors is handicapping the future.  Evaluating stocks and determining that it's more likely that something good will happen verses something bad.  Then buying and waiting.


Aztec Land and Cattle revisited, still as cheap as ever

Many of the stocks I write about make the term 'sleepy' seem exciting.  If only some of these oddball companies would become sleepy, it would be a step up.  Even with companies that appear to be dormant it's helpful to look at them every few years to keep up with developments.  I last wrote about Aztec Land and Cattle (AZLCZ) in 2012, and it's finally time for an update.

If you're an investor dying to buy cheap real estate than Aztec Land and Cattle is a company you need to look at.  When I first took a look at the company their 228,000 acres of land were effectively selling for $49 an acre.  This is land they originally purchased for $.50 an acre in the 1860s.

The company's land is mostly Arizona pasture land.  In 2012 the company submitted a master development plan detailing to the county how they expected to slowly shift land usage from pure pasture to both commercial and residential uses.  

Since my last post on Aztec the stock has appreciated about 50%, which is significant for a company most investors expect to go nowhere for years.  What prompted me to look at Aztec again is a new report by Andrew Slusser of Seven Pines Capital.  Andrew initially emailed me his report, then we talked on the phone about the idea.  What Andrew put together highlights how a small to medium amount of research on some of these oddball companies can give an investor an incredible informational advantage.  Andrew highlighted a few aspects to Aztec Land and Cattle that I hadn't appreciated when I first evaluated the company.

In the past two years the company has been very active.  For the past few years the company has considered leasing out a portion of their land to a windmill farm.  Two years ago this was just a concept, but today 14,000 acres are leased generating $140k in rent income.  There are plans to increase the amount of land for additional wind power, although the timing for that is unknown.

A bigger development in my mind is the purchase of the Catalyst Paper Company and Apache Railroad Company by Aztec.  Both Catalyst Paper and the Apache Railroad fell into financial difficulties recently prompting bankruptcy filings.  Aztec's Chairman led a group of investors that purchased a number of assets out of bankruptcy, including the railroad and 19,000 acres of land.  Control of the railroad could serve as a catalyst for commercial development on Aztec's land.  My suggestion on viewing the railroad is to view it not as a source of potential earnings, but as a reason for potential development.  The company is marketing the commercial land by the railroad as the West Snowflake Railpark development.  The area already has power, natural gas, road and railroad connections.

Even with a wind farm and railroad commercial park the main thesis for Aztec rests on the value of their land.  Their operations are essentially break-even and pay for the carry on their land holdings.

Arizona is unique in that 16% of the state's land is deeded to private citizens and corporations. Arizona essentially has a 16% public float on their land.  This is much less than surrounding states, and is partly the reason that pasture land averages $940 an acre in Arizona vs $360 an acre in New Mexico.  The average price for pasture land in the US is $1,200 an acre.  Also unique to Aztec is that their 228,000 acres are a single continuous segment, in a state little available land a single usable segment of contiguous land is significant.  Pasture land in the US has steadily appreciated over the last decade.

Sometimes a company gives investors insight into how they view their own assets.  In the case of Aztec the company completed several inter-company transactions where land was swapped between subsidiaries.  In these transactions the company valued their own acreage at $137 an acre, or double what the market values the company at.

I think a very simple and compelling argument could be made that Aztec's land is worth more than the current market value of $77 an acre.  The question I had when I first looked at the company was how long would investors need to wait for value to be realized?  If the land is truly worth a few hundred dollars an acre, but an investor needs to wait 30 years for value to be realized this isn't a great return.  A lot can happen in 30 years, and taking a gamble on something that far out is risky.  Either the land needs to be worth significant more, or a change in value needs to happen relatively quickly, say in the next ten years or so.

In Andrew's report he put together a matrix showing a NPV analysis of land values to years to value realization.  The chart is shown below:

At current prices investors are saying the land is either worth little, or there is very little certainty as to when this thesis might play out.  But an undervalued asset is undervalued regardless of whether it's land in Arizona or New York.  Patience is not a skill that many investors have, which is probably why Aztec is trading for such a low valuation.

If the company were to simply sell themselves as a ranch at today's New Mexico land prices they would receive $529/sh in proceeds.  Let's consider that maybe it takes 20 years before the company decides to sell themselves as a ranch at today's prices, even still the shares would fetch $200, which is higher than the current share price.

Granted no one ever knows what something is worth until it's sold, but there is a considerable margin of safety at these prices.  With the current margin of safety investors also get the optionality of something good coming from the company's recent actions.  Maybe the railroad will spur development, or maybe an additional wind farm will be built.  We don't know, but even if this is 'just' a pasture and never progresses from being a pasture it should at least be priced like similar pastures throughout the state or country.  

My only qualm about the company is that they don't pay a dividend.  When I invest in oddball stocks that are dark and my expected holding period is long I like to be paid something for waiting.  Unfortunately shareholders of Aztec simply need to wait. 

If you're interested in Andrew's report drop me an email.

Disclosure: No position


In search of elusive catalysts and the paradox of managing money

It seems as if a public investment pitch isn't complete without a "catalyst".  The catalyst is some supposed future event that is predicted to unlock value.  Catalysts give many reasons to invest in specific stocks, and the lack of a catalyst is usually given as a reason to avoid a stock.

Many times a catalyst is nothing more than a mirage.  In very inefficient markets catalysts do exist. I have found a number of dark or illiquid companies that issue press releases with future plans to unlock value only to see the stock show no reaction.  In inefficient markets finding a catalyst can be like finding the keys to the kingdom.  But outside of tiny stocks and forgotten foreign markets catalysts are about as rare as NYSE listed net-nets.  Theoretically they're possible, but they seem to have all disappeared in the 1950s.

What is mentioned as an investment catalyst is sometimes a generic statement of how potential value can be unlocked or more often wishful thinking. In many cases the probability of a catalyst prediction coming true is no greater than that of a lucky guess.

A friend of mine is a movie director and he likes to say that all movies fit into one of seven basic movie plot patterns.  Business is similar, companies and industries have profit and lifecycle patterns.  Predicting what might happen at the end of a movie (or business story) because one knows the pattern isn't spotting a catalyst, rather it's good investing.

I understand the attraction to catalysts.  Investing is dominated by professionals, and professionals need to generate results in order to keep their jobs.  While we'd all like to think that investment managers are beholden to their fiduciary duty we should first recognize that they often have a greater duty, the one to their families, friends, significant others, or themselves.  Hungry mouths at home and the pursue of lifestyle ultimately drive investment returns.  A manager is going to take an action that preserves their job over one that maximizes capital.

Markets are short term oriented because the managers who manage the majority of the markets need to be.  They are graded on their weekly, monthly, quarterly and yearly results.  In a world where hourly results can be measured you can be sure someone is measuring them.  I believe the reason that the investment world became short term oriented isn't because managers are greedier now than in the past.  It's rather than short term, and extremely short term results were hard to measure before the mass computerization of finance.  When trades were settled via paper it was hard to know where a fund stood hourly.  The information wasn't available.  Now a manager can know where they stand tick by tick.

We all say that we're not short term oriented, but many of us do check our portfolios daily or hourly.  No one can really turn off the market forever.  Even when we own extremely long dated assets such as a house we're noisy to know what the neighbor two doors down sold for, even if we're not looking to sell.  There is some primal urge to know our financial position when possible.  In the iPhone age we can have our net worth balance at our finger tips.  In the past this was a task to be completed with a calculator and stack of financial statements at year end.

Patience doesn't exist in the professional investing world.  Many managers can't afford to be patient, they have too much career risk.  Even if a manager has a patient personality their investors do not.  This is especially true for funds that are larger, quoted daily and thrive on asset flows.  Hedge funds have a bit more runway due to redemption periods and lockups.  But make no mistake, no matter how patient John Paulson is assets are running out the door because of a patience mismatch between himself and investors.

It's easier for a smaller manager to practice patience.  At the lowest level someone managing their mother-in-law's wealth might have the most latitude.  A manager who finds a dedicated group of like minded investors will likewise have the ability to think longer term, but they are still beholden to their investors.  Outside investors, unless extremely unusual will never be as patient as many managers.

The textbook solution to this problem is for a manager to adopt permanent capital in the form of buying up an entire business and rolling shareholders in like Berkshire Hathaway did.  The problem with this route is that a business requires attention and dedication to keep the wheels from flying off daily.  Anyone who says anything otherwise has never worked in business.  Where people are involved there are problems.  A business that generates abundant idle free cash flow without any managerial input is mythical and as rare as a goose that lays golden eggs.  Ask yourself, why would someone who owns a company generating cash in absurd amounts with zero management work decide to sell?  Either the seller is stupid and foolish, or there is something unseen.

The only capital that can be invested freely is what I term 'careless capital'.  This is capital that the holder or manager doesn't need.  A wealthy individual can afford to invest in illiquid stocks or private businesses with multi-decade holding periods because they don't need the money.  There is no penalty to locking up money.

This is true for myself in some senses.  I don't live off my portfolio, and the proportion of it invested in illiquid stocks is an amount that I can be eternally patient with.  I don't need the money for anything, and if it turns out that it's passed onto my kids in 50 years that would be a result I'm satisfied with.  I have other parts of my portfolio that will eventually be used, and I can't afford to take the lockup risk with those funds.

When you look at investors who are pursuing permanent capital they're already wealthy.  The ones who aren't wealthy yet and are pursuing it via fund management fees or or buying companies in an effort to turn them around.

If one were to plot investor patience on one axis and wealth on the other I think you'd see an extremely strong correlation between very wealthy and very patient.  Buffett talks about buying and holding forever because he can.  If Berkshire went belly up this week he'd still have around $1b in personal wealth in his personal portfolio.  It's easy to invest 'forever' when you have a $1b backup plan.

Along with the lack of patience another trend I've noticed in finance has been the move towards more extreme investment strategies.  Most investors would be best served with a simple strategy, and most funds fail to beat simple strategies.  It's strange that every professional is pursuing the oddest and most complex approach out there as if doing simple there were too elementary for them.

I like to ski and I enjoy watching ski movies.  But ski movies have been changing in the last decade.  The pioneer of ski films is Warren Miller who made excellent movies that showcased skiers and locations that seemed accessible to anyone with determination and practice.  But that's changed in the last decade.  Now ski films are in a race to outdo each other with bigger mountains and more extreme locations.  If someone could shoot a movie skiing on the moon they would.  Even something formerly extreme like skiing in Antarctica is too passé now.  Instead viewers get to watch skiers on camels and in dune buggies trying to get to the most remote peaks in Africa or Asia.

Investing has followed a similar path.  Everyone wants to be in bankruptcy restructurings or turning retailers into hedge funds.  There are very few investors like Walter Schloss who are happy to continue implementing the same strategy year over year.  Even if Schloss' strategies work for a manager they eventually become boring for full time practitioners who want to move onto more exciting things.  Look at the evolution of any successful large investor.  How they started is not what they're doing now.  In most cases they've moved from buying passive stakes in companies to either actively attempting to influence management, or purchasing entire companies outright.  Ask any investment manager who used to invest in net-nets why they moved on, the answer is always either "too big" or "too boring".

It seems the grass is always greener no matter who you talk to.  Ask any business owner what they see themselves doing someday and you'll probably hear some variation of "quietly managing my investments".  They want to leave the stress of day to day business management to be involved at a more abstract level.  Anyone who's ever ran or owned a business can confirm that simply reading and buying stocks is much easier.

Yet aspiring investors want to take the opposite path.  After having years of abstract experience with business they somehow decide that "getting their hands dirty" is a good next step.  Exchanging annual reports, research, trading and industry gossip for endless meetings about strategy, positioning, growth initiatives and other corporate mumbo-jumbo.  Not to mention actual human interaction with the people doing the work to move a business forward.  Hundreds if not thousands of little fiefdoms with little warlords fighting each other for the status of running high profile projects or having the largest reporting groups.  Why anyone would aspire to this is beyond me, yet many do.

The grass is greener for everyone.  Business people want to get out of business and invest.  And investors want to throw themselves into the fray of buiness and take action.

What's the moral to this story?  The moral is that you need to beware before outsourcing your thinking to someone else.  Everyone in the market and business has different motivations, some visible, most invisible.  Some are playing for status, others for money, some for vengeance, or reasons unknown.

When following an investor into an investment realize that it's highly unlikely that both of your motivations are the same.  Even if both parties are satisfied with the investment outcome that doesn't mean motivations were aligned.  Searching for a catalyst in the predicted action some investment manager, or corporate manager is a fools errand.  People don't act the way anyone predicts, especially if they're aware of the prediction.

Think about who's money a person making a recommendation is investing.  Many recommend things for other people's money.  The managers share in the upside and very little of the downside.  This is compared to an individual who retains 100% of the upside but also 100% of the downside.  If I ever seem risk-averse consider that it's because I'm investing my own capital verses client capital.

If an investment manager losses all of their clients capital they are out of a job, but will find another one relatively easily, especially with the right brand on their resume.  If an investor losses their portfolio they don't have a backup plan, they are broke and in search of something to keep the lights on and stay off food stamps.

The best catalyst for value is something that's under priced to one who has the patience to hold it until value is realized.  If it sounds simple it's because it is.  Two components are needed, value and patience.  Buying anything at a low enough value and waiting always results in satisfactory returns.

Dyna International, a pile of cheap assets but is there anything else?

If it isn't apparent to readers I have a natural curiosity about life.  I just wonder about things, I don't know why, and I can't help it; I'm curious.  I have young kids who ask 'why' often in an attempt to learn about life and their surroundings.  I've come to realize I'm no different than my kids, I've never stopped asking 'why', it's just that my questions and research have become more structured.

There have been many times where I've been sitting drinking out of a glass with a design on it and had the thought "I wonder who makes this?".  I've also had the thought when looking at similar commodity products "why would anyone want to manufacture or sell these items."  There is a subset of products that people use that don't appear to have a reason to exist.  It's hard to fathom how the companies behind these products make money.  For most companies the answer is that all work is outsourced to China, or Vietnam, or somewhere else cheap.  In a world of automation where I presume plastic and nylon cost the same worldwide I'm not sure why China is a better answer than somewhere closer, but I'll accept it at face value.  Maybe this is my curiosity getting in the way again.

Dyna International (DGIX) is a perfect example of the type of company I've wondered about above.  They make travel coffee mugs with sports team logos as well as a number of belt buckles.  The large majority of belt buckle designs are patriotic in nature with themes of America, guns, trucks, eagles and things associated with motorcycles and the wild west.  There is even a model that incorporates a bottle opener which is ironic because the type of beer I associate with belt buckles comes in cans and screw off tops.

The majority of the company's products are licensed items.  For example a coffee mug with the Steelers logo on it, or drink glasses with logos.  These types of glasses are great gifts for sports fans.  I speak from experience, all of my wife's family has Cincinnati Red's glasses that they love compliments of us.  Items with team logos will remain popular and sell at premium prices as long as sports and sports teams are popular.  Many designs are downright ugly, but they sell.  I'm speaking from experience again as we have a set of ugly Steelers beer mugs from their 2005 Super Bowl win.  At the bottom of the cup visible with each sip is a logo reminding the drinker that the Steelers won the Super Bowl.  I can't quite explain why we purchased these as they're hideous, but at the time we thought they were great.  Maybe some of you are laughing thinking "I'd never do that", that is until your team wins and you find yourself buying kitschy items with logos hanging all over them.

The problem with licensed material is that licensing carries a heavy cost.  The entity that makes the most money on the licensed material are the sports league itself.  Manufacturers creating products with logos are surviving with razor thin margins.  What's even more impressive about the industry surrounding these logo items is that Dyna International is a distributor to retailers.  Either the retailers are heavily marking up their products or there is really no money to be made at the point of sale.  All of the products on their site require a three unit minimum purchase and an approved account.  They aren't targeting a traditional internet buyer.  In the most recent quarter the company earned a net profit of $78,722 with a net margin of 1.7%, slim indeed.

The company's financials follow the same ebb and flow that most retailers do, losses for the first two quarters, a slight profit in Q3 and outsized profits in Q4.  As of September 30th the company had a year to date loss of $20k that should be resolved with fourth quarter earnings.  If history is any guide the company could earn anywhere between $.02 to $.05 a share for the year.  If they hit the low end the stock would be trading for a multiple of 10x earnings.  And at the high end ~4x earnings.

The company typically pays over a million dollars a year in licensing costs.  This gives them incentive to produce and promote their own line of goods without licensed logos such as their belt buckle collection.  If the company were to shift the revenue mix of products from licensed goods to unlicensed goods then earnings could dramatically increase.  But I don't see that as very likely.

What is attractive about Dyna International is their valuation.  The company has $8.3m in equity and $6.5m in net current assets.  With a market cap of $1.4m Dyna International falls deeply into the category of a net-net, and a profitable one at that.  The majority of their assets are receivables and inventory.

Many investors like to discount a net-net's inventory and receivables then wave the adjusted valuation as an excuse to pass on an investment.  That's not unlike someone who tries on an outfit on sale and then complains that the color isn't right or the fit isn't perfect as an excuse to not buy.  If Dyna International were to declare a fire-sale tomorrow then I agree that it's unlikely they'd realize their inventory or receivable accounts.  But this is a company in motion, they've been profitable for years and this year appears to be no different.  If they've had no issues selling their inventory at stated value, and collecting receivables in the past then why should we presume anything is different now without any evidence?  With evidence that their inventory or receivables are deteriorating I would agree, but in the absence of evidence it's just a flimsy excuse to not purchase a cheap company.

The bigger issue with Dyna International is the size of the company.  With only a $1.4m market cap the float is small and not many investors can build a material position.  The CEO even states in his letter to shareholders that the price is prone to fluctuate dramatically from the purchase of 100 shares, or $22.  With the low share price and lack of available shares it's no wonder investors aren't lining up to buy in size.

Even with the company's small size and mediocre business I think companies like this are worth a position when one can get enough shares.  The company is selling for 16% of book value and 21% of NCAV. At these prices there isn't much downside left, maybe something good will happen and shareholders will finally be rewarded.

Disclosure: No position

The math of returns

I just released the fourth issue of the Oddball Stocks Newsletter and wanted to share a short excerpt from the introduction letter.

The topic is the timing and security selection criteria necessary to achieve market beating returns:

"To demonstrate my thinking here is a simple example.  Let’s consider a hypothetical $1,000,000 portfolio comprised of 10 equal weighted undervalued stocks.  In our portfolio we’ll assume that each stock is trading for 66 2/3% of book value and is worth 100% of book value for a potential 50% return.  Let’s imagine that three positions ($300,000) appreciate 50% to fair value each year, which would be $450,000.  If the rest of the portfolio remained flat for the year the investor’s return would be a quite satisfactory 15%.  Now at this point in time it isn’t as if we’ve lost hope in the other seven names, but they haven’t done much yet.  If an investor sells the appreciated securities and reinvests them in securities selling for 2/3 of BV and repeats this process year after year the portfolio will continue to earn above-market satisfactory returns.

For one to achieve market beating returns only 1/3 of the portfolio needs to appreciate at least 50% a year.  The rest of the portfolio can stagnate or even fall slightly.  The key to this is accepting that different portions of a portfolio are in different stages of value realization. One needs the patience to see ideas through, and the wisdom to minimize losses.  In this imaginary portfolio positions are held for a maximum of three years, if at that point they haven’t appreciated it’s time to sell and find a replacement.  Or if a position appreciated before the three year holding period was realized the position was sold and replaced by a new lower valued position."

When reading investment blogs or message boards I'm struck by how many people are looking for home run investments.  Rather finding investments with at least 50% appreciation potential and not losing money can generate market beating returns.  It's much harder to find stocks that will reliably double, triple, quadruple or more in a few years.

The above example should be a great gut check for what's in your portfolio.  A single loss or two requires gains from the rest of the holdings to be higher.  It's easier to avoid losses rather than finding home run stocks.  A portfolio with market generating returns doesn't need to be comprised of multi-bagger stocks, it needs to be one that avoids losses.

When a portfolio continues to hold losing positions, or invest in positions that consistently drop it's like a paddler trying to navigate a boat against the current.  It's possible to paddle upstream but it's a lot of work.  Avoiding losses is like paddling with the current, a bit of effort combined with the current results in a quick journey.

If you're interested in reading the rest of my thoughts on the subject, or reading about a number of very attractive companies profiled in this issue consider subscribing to the Oddball Stocks Newsletter.


Orange County Business Bank: Undervalued with a catalyst

Not all banks are created equal.  While all banks take in deposits and make loans the type of deposits and loans make a difference when it comes to the quality of the bank.  In the banking world the ideal customer is a business customer.  Business deposits are larger, business loans are larger, business customers are less needy and a bank can differentiate itself through customer service.  While all banks aspire to business banking it shouldn't be a surprise that there are specific 'business banks'.

Orange County Business Bank (OCBB) is one such bank located in Orange County, California.  While researching the bank I found a newspaper article where the CEO explained why the bank was founded.  From 1992 to 2000 the number of local Orange County banks declined from 42 to 9.  At the same time there were over 100,000 businesses registered in the county alone.  The bank's founders saw an opportunity to serve a unique market niche.  The bank was formed in the depths of the market crisis in 2002, which is when they IPO'ed and raised $20m.  The bank then went back to the market a second time and raised an additional $30m in 2004.

The following table grabbed from CompleteBankData.com shows how the bank has performed over the past nine years:


With this bank the numbers tell the story.  Here is a bank that grew from zero at their IPO to $249m in assets in 2009.  The bank wasn't immune from the financial crisis when their portfolio took a hit in 2010.  In 2010 the bank charged off 4.57% of their loans, a significant amount.  Since then charge-offs and non-performing loans have declined.

The bank's troubled loans never came close to causing problems for the bank because the bank has been significantly overcapitalized since their founding.  Since the IPO the bank's Tier 1 capital has never dropped below 25% and recently has risen above 30%.

The bank's extra capital is part of the reason their returns on equity is so low.  With excess capital the bank has capacity to make additional loans or conduct an acquisition.  In the most recent quarter the bank announced that assets and loans grew as well as net income.

While excess capital give management options for the future it's also a thorn in the side of shareholders.  Shareholders contributed $50m in initial capital to create the bank and then watched management sit on the cash for the last decade.  The bank managed to survive the crisis due to the war chest but has since seen capital erode from crisis losses.  It's no wonder that the stock is ignored and investors are frustrated.

There are two things that make this bank attractive from an investment perspective.  The first is their valuation.  The bank is trading for $5.85 whereas book value stands at $8.59 per share.  At current prices the bank is trading for 68% of book value.  There are not many banks trading for less than 70% of book value at this point in the market cycle.  For a bank to be trading around 2/3 of book value either signifies that the bank has serious problems, or it's seriously ignored.

The second attractive aspect is related to the bank's troubled loans.  Most of the time a bank charges off bad loans and the loss is forgotten.  The bankers at Orange County Business bank have continued to pursue loan recovery even after their loans were written off.  In their second quarter press release the bank included a statement that was bolded announcing that they'd made a loan recovery in the amount of $2m plus interest.

The bank passed through the recovery in the recent quarter reporting $.46 per share in earnings and an increase to book value of $3.5m.  While the record earnings were a one-off event the book value increase was not.  The bank reported that they are continuing to aggressively pursue loans that have been charged off, which means it's possible there could be some potential future recoveries.

In the end this is a small bank trading at a sizable discount to book value that continues to be profitable.  If anyone is building a basket of cheap banks this is one to include.

Disclosure: No position

Value investing myths

If something is repeated often enough people will eventually start to believe it.  Buffett always buys "good" companies, and Graham bought companies on the verge of bankruptcy.  Investors who buy into good companies doen't need to worry about the price they pay.  Whereas Graham investors need to be worried because eventually all net-nets go to zero.

Sometimes the truth is more nuanced.  Would Buffett disciples be surprised to read a story about Buffett buying in and out of a small stocks in his personal portfolio?  Would investors be surprised to read a quote by Graham about preferring quality factors in companies they look at?

On Buffett: In 1999 he purchased a $3.3m stake in Bell Industries.  The technology company was in the process of restructuring and had sold off a large division.  Buffett purchased his Bell stake in December of 1999 and by January 18th of 2000 he had already sold out for a quick 50% gain.  The famed 'buy and hold' investor had purchased into a tiny tech stock and flipped it for an 80% gain in less than two months.  The LA Times sums up the investment perfectly:

"Buffett, 70, made his wealth and reputation as a long-term, buy-and-hold investor by using Berkshire as his vehicle for buying major stakes in companies and then patiently waiting years for those investments to soar in value.

But as his earlier experience with Bell showed, that's not always Buffett's practice when he pulls out his own wallet. In that case, Buffett bought a 5.3% stake in Bell in early December 1999, triggered a surge in Bell's market price, and then dumped his stake a month later for a profit of about $1 million, or 50% on his original investment." (source)

Now onto Benjamin Graham.  Graham is often associated with purchasing stocks feature low statistical measures such as price to book, or price to earnings.  One area that Graham has left a mark is by suggesting investors who purchase companies trading below NCAV can consistently outperform the market.  Lost in the past 70s years has been some of Grahams warnings and suggestions around buying net-nets.  Graham as shown below suggested investors purchase net-nets with high earning power, high returns on equity, or an imminent catalyst.  His original framework has been diluted to "buy anything trading below NCAV no matter how terrible the company is".  Here is what Graham originally wrote:

"Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category. He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above. Or else he will be partial to such as reveal other attractive statistical features  besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past. The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so." (Security Analysis p595-596)

His plea to appreciate quality wasn't isolated to those paragraphs.  Sprinkled throughout Security Analysis are recommendations that investors look for higher quality companies over lower quality companies.  At one point he even recommended that investors simply buy the best company in each industry when the entire industry hit its low point in the business cycle.

How is it that these messages have been lost to the sands of time?  But more importantly does that mean anything for us now?

CreditBubbleStocks has captured the current sentiment towards value investing with his post titled "Value Investors Obsessed With "Compounders", ROE; Don't Care About Liquidation Value Or Margin Of Safety"  The post is short and worth reading, his point is that what is considered value investing today bears little resemblance to what value investing has traditionally been.

Value investing has morphed from buying average things cheap to buying companies with high returns on equity.  I have read a few blog posts where Buffett disciples proclaim that there is no price too high to pay for a company with high returns on equity.  Of course this line of thinking is lunacy.  As a company grows larger their returns fall, this isn't math, it's common sense.  If a company can grow at 20% forever they will eventually run out of humans to sell things to.  A perfect example is Wells Fargo, which is praised for their high returns on equity.  A few months back I ran a simple simulation and if they can continue to grow at 15% a year in less than 20 years they will be the only bank in the US with 100% marketshare.  It's possibly they can keep up their high returns on equity due to financial engineering, but it's more likely their returns will naturally fall as they grow.  Nothing can grow forever.

What Buffett, Graham, Schloss and others realized was that buying anything for far below what it was worth was a winning proposition.  These famed value investors kept things simple, they purchased obvious values and didn't base their investment on assumptions or approximations of the future.  American Express in the wake of a scandal was a good purchase for Buffett and is a great example.  If one thinks about the salad oil scandal it fits Graham's advice better than the platitude of a great company at a marginal (high?) price.

For those who manage billions of dollars it is difficult to find truly cheap companies.  But for anyone who isn't managing billions I firmly believe the best course of action is to find decent companies selling for absurdly low values.  But like Buffett and Bell Industries I'm also not opposed to buying something below average if the price warrants it and selling when the opportunity arises.

One characterization I hate is that companies that don't earn their cost of capital are worthless.  When I read things like this I have the thought that if this statement were true then American enterprise would cease to exist.  Do you think the company that services your furnace earns their cost of capital?  Or the local grocery store, or your mechanic, or almost any non-Wall Street company?  The large majority of companies in America and around the world provide a service for customers, pay employees an income and provide an owner a modest income with a little bit left over to reinvest in the future.  Without these companies our lives would be much more difficult, imagine fixing your own furnace, car, and growing your own food!  It seems like we would all be a lot poorer if it weren't for low margin companies that don't earn their cost of capital.

Yet in the world of Wall Street and academic finance a family owned grocery store should either close their doors, or engage in financial engineering to artificially boost their financial metrics that pile on risk.  Of course Wall Street is very happy to sell said products that achieve these goals, maybe that's why there's such a push?

This about the absurdity of return on equity for a few moments.  Consider a company that has $100 in capital, and earns $5 a year.  At present they have a paltry 5% return on equity.  If the company were to take on $99 in debt that costs 3% a year their earnings are now reduced to $2 a year.  But that $2 in earnings on $1 in equity is now an astounding 200% return on equity.  My example is clearly simplified, the $99 in debt goes somewhere and doesn't magically make equity disappear.  Of course if a company did want to make that money disappear they'd simply buy back shares.  This example company would be a darling of Wall Street, with high returns on equity and giant per-share figures.  Of course to hit these metrics the company went from being stable to increasingly fragile.  A slight bump in revenue could send the company into bankruptcy court for a default.

I had a conversation with someone recently where they mentioned they considered a 10% return on equity to be the bare minimum a bank should be making, and that banks below that were considered below average.  This investor said they only looked at banks that earned 15% on their equity, a value they considered appropriate for a US bank.  Interesting enough a bank earning 10% on equity or higher isn't just average, they're far above average.  In the most recent quarter the average return on equity for all banks in the US was 7.75%.  Banks earning 15% or more on their equity are in the top 12% of US banks, of which only a handful are traded.  What this person considered average criteria to themselves was actually very stringent criteria for an investment.

Many investors need to stop fooling themselves about what they're doing.  There is nothing special to buying high growth companies, or companies with great brands.  This alone forms the basis for most of the market, the market is obsessed with growth and growing companies.  There's nothing wrong with looking for good companies, or for looking for great brands, but don't make the mistake of paying too much.  There are many wealthy investors who have made fortunes buying stocks of great companies in bear markets from disenfranchised investors whose growth narrative vanished before their eyes.

At the right price many companies are worth a purchase.  But to me the sweet spot is finding a good company at a very low price.  These companies don't always have great ROE's, but at some point 50% of book value and a few times earnings is good enough for me.  Two examples of companies that fit this description are Pardee Resources or Citizens Bancshares that I profiled recently.  My portfolio is filled with companies like this, Installux, PD-Rx, Solitron, Precia Molen, Conduril, Kopp Glass, Conrad Industries and others to name a few.  It's easier to find small companies with average or above average operations at great prices compared to compounders at anything less than nosebleed prices.  Would I ever consider buying a compounding company?  Absolutely, when the price is right.  I purchased some Berkshire in the midst of the financial crisis for example.

If I could encourage value investors, or aspiring value investors to do one thing it would be to use their imagination.  Acquiring companies, private equity firms, and budding managers use their imagination to take many sleepy companies to great companies by thinning the ranks, introducing new products, or selling unprofitable divisions.  Yet many value investors invest as if what is happening now will happen forever.  Just like Wells Fargo won't grow at 15% forever a small company with a profitable niche selling for a few times earnings won't be independent for long, they'll be acquired.  The most dangerous type of thinking of investing is to think about things as if they were linear events.

The whole premise of valuing investing is purchasing something for less than it's worth.  But I feel that value investing has hit it's 1998 moment where we're inventing new metrics like 'eyeballs per click' and other goofy things to justify a new narrative.  If one looks deep enough, or in enough offbeat corners of the market they will always find value.