Monday, August 18, 2014

My interview on the PreMarket show discussing banks and banking


If you were dying to know my age, or to hear my thoughts on banks and banking you're in luck, all of that and more was covered during my interview on the Benzinga PreMarket show last Friday.

You can watch the interview below:




Wednesday, August 13, 2014

In defense of small businesses

Big is better in America, bigger cars, bigger houses, bigger businesses.  Americans are applauded when they buy a big house, or car, or toy even if they can't afford it.  The bigger is better movement is so strong there has even been an extreme backlash, the minimal lifestyle movement.  This is where people live in tiny houses, or give up everything they own except for a Macbook and some cool vintage clothes, or live an "authentic" life with few possessions and travel the world.  Americans are extreme, lost is the praise of modesty.  Instead of praising someone with a late model car paid for with cash they're ridiculed for being cheap and told to upgrade.

The bigger is better mentality extends to business as well.  To become a business leader all one needs to do is fill the top seat at one of our largest companies.  Big companies grow into their size because they fill a large and scalable customer need.  Take a Wal-Mart for example, they sell a lot of things at low prices.  If a consumer needs a pair of socks, or tupperware chances are Wal-Mart will have the best price.  We need big companies, big companies can get big things done.  A small company can't build an airplane or construct a new chip fab, that's something only a large company with a lot of capital can do.

Too many small companies want to be large.  A mistake they make they try to compete on the terms of their large competitor.  I remember back in 2002/2003 the media rage was to cover the story of how Wal-Mart was killing small town stores.  We were being told to lament the loss of stores whose prices were high and selection was poor.  The problem was these small companies were trying to compete directly with Wal-Mart.  A small business will always lose when going head to head with a big company.  The big company has far more resources, power, and mindshare compared to the small company.

What wasn't killed by Wal-Mart were small stores that were different.  Wal-Mart didn't put the local hardware store that sells hard to find parts out of business.  Wal-Mart didn't put the unique vintage clothing store out of business, or the high end furniture store.  This is because those companies differentiated themselves, they thought and acted different.

A big company usually delivers a product that's 'good enough'.  For most purchases most consumers simply need something good enough.  A good enough product meets the needs of the masses and can be manufactured in quantity.  Because a large company is focused on capturing the largest part of the market they often ignore edge cases, or specialized cases.

Specialization can't be scaled.  There are only so many people with extra wide feet, or only so many people who want swing sets shaped like pirate ships.  The specialized edges of a larger market aren't big enough to support large companies.  Smaller specialized markets don't generate enough revenue for them to be meaningful for large companies either.

It might come as a surprise to someone who's had their head in business books and never peeked out at the real world, but any business that's surviving has a competitive advantage.  Academics in ivory towers can debate this, but for a business to survive they need to have something unique that makes them different from competitors.  Think about your local plumber, there is a reason you call them back for repeat business.  Maybe it's as simple as they pick up the phone and are always on time.  If their competitors don't do this that's their advantage over them.  Maybe you frequent a certain gym because it's cheaper, or their facilities are cleaner.  We all have reasons for choosing companies over each other.  If you think about it the reason you call your specific plumber is probably also the reason others call them as well.

A company that has no competitive advantage ends up out of business.  These are the small companies being killed off by Wal-Mart.  Why would someone want to shop at a store with less selection and higher prices, especially in a small town where salaries have been flat for years?  If a business does the exact same thing as a competitor and does nothing better or nothing different eventually one will go out of business.

Small companies that want to survive need to differentiate themselves and serve a niche.  Serving a niche doesn't always guarantee great profits.  This past weekend I took my son to a hobby store to look at model rockets.  The store has been around since the 1930s and is filled with model tanks, miniature trains, and model rockets.  A hobby shop like this is clearly a niche.  Model rockets and model trains aren't exactly widespread.  Yet this owner has a profitable business that he enjoys working at that's lasted for decades.  The owner is in his 80s and had the same excitement about the toys that my son did.  He raised a family on earnings from the store and by many measures is living the dream.  Yet by Wall Street or investor standards he's most likely failing.  I would be shocked if he's making more than 2-3% on his company's equity, and the location has little resale value.

If business were only about economic returns then this hobby shop should close.  As you readers like to point out this business isn't earning its cost of capital.  In this perfect economic world the owner would just close up and somehow deploy the capital for higher returns.  What the theory misses is the role this small niche company plays.  If this store were to close where would the model railroaders who meet in his basement go to drive trains?  The friendships and connections his club has created have value that can't be quantified on paper.  Customers could still buy model rockets online and save a few bucks, but they'd miss out on getting advice from someone who's done it for decades.  It's also debatable that the capital released from an underperforming business could be re-deployed by the owner elsewhere for a higher return.

Should a local plumber, or baker shut down because they aren't earning a 10% return on equity?

A friend sent me an article today discussing the banking landscape.  The author in the article argued that since most banks don't earn 10% on their equity they should be merged into institutions that do.  The author had previously worked at Bank of America, so in many ways his stance was expected.  In this world the only banks that would be left are the Wells Fargo, US Bank, and JP Morgans.

I do all of my banking with a local bank, Dollar Bank.  I previously had accounts with PNC but closed them when I finally got tired of being treated like a number.  PNC is a large and efficient bank, and it shows in their operations.  When I needed to make a deposit I stood in lines that rivaled amusement park lines.  I would be given a number (literally) if I wanted to talk with a banker and then had to sit and wait for 30-45m.  For investors this works well, they earn nice returns and everyone is happy, PNC earns their cost of capital.  For many customers the bank is simply good enough and has what they need too.

On the contrast Dollar Bank went out of their way regarding customer service and inquiring about what I might need and helped me get started.  When I opened my business account I was invited to some local business happy-hours where I could mix with other customers.  Dollar's customer service went above and beyond what I expect from a bank.  Their bankers have called me asking if I had any questions or issues they could help me with.  And their perceived interest in me as a customer makes me feel valued.  

There are a lot of lessons small companies should learn from Dollar and PNC.  Dollar and PNC are both in the same market, and PNC should be running Dollar out of town, except they haven't.  The two banking experiences are dramatically different.  Dollar Bank creates no friction around my banking, I can deposit, withdrawal and go about my business easily.  PNC made it a chore to get my money out.  I was constantly being fee'ed to death because I wasn't a large account.  Dollar has decided that customer service is an area of emphasis, customers feel more like a parter with them rather than a client.  

Small banks in small towns need to focus on serving smaller market segments that large players are ignoring.  Serving those segments will never enable them to grow into a Wells Fargo or earn 15% on their capital.  But serving those segments will ensure their financial health, they will stay in business serving customers and providing community members with jobs.

I think it's easy for investors to become myopically focused on maximizing money.  Companies should earn as much as possible, investors should become as rich as possible, citizens should save as much as possible.  This is just a different spin on the bigger is better theme.  Bigger profits aren't always better if customers aren't being served.  Bigger isn't better if the big profits now come at the expense of a healthy company in the future.  There is more to life besides maximizing money.  Some people are content having enough and enjoying life.  Like the hobby store owner, he will never be rich, but his business has allowed him to play with toys his entire life and make money doing it.

There are thousands of businesses that are serving customer needs in tiny segments of the market.  These needs are often vital to their customers, yet they usually don't translate into fantastic profits.  It's okay for a business to be mediocre, it's okay for a business to stay small.  Bigger isn't always better.  For all of our needs that the big companies neglect there are a number of small companies waiting to fill the gap.

Friday, August 8, 2014

What makes a "good" balance sheet?

As a result of my post on bull markets I've had a few emails and comments asking my thoughts on what makes a good balance sheet.  I want to take a few moments in this post to walk through the elements of a good balance sheet, and discuss how it differs from a bad one.  I realize this post will probably seem too elementary for some readers, but I think it does provide a good thought lesson.  Words like "good", "stable", "bad", and thrown around when discussing balance sheets, but there is no firm definition associated with them.  What is a good balance sheet to one investor or company might be a poor for another.

The best starting point for this discussion is to take a step back and consider what the balance sheet even is.  A balance sheet is a point in time snapshot of a company's accounts.  If a company finalized their financial statements on August 1st that would be the day the balance sheet captures.  It's very likely that if the company were to make a second balance sheet on August 2nd that it would be slightly different.  Accounts payable might differ due to vendor bills received, or cash due to slight amounts of overnight interest.

Over time a balance sheet should be relatively stable.  The last thing an investor wants to see are wildly differing amounts for each reporting period.  To see an example of this take a look at a random pink sheet company that spams OTCMarkets with news about significant finds, or notices that the 'books are closed'.  These companies will go from having $37 in their bank account to having $200k then back to $109.

A good balance sheet is one comprised of assets that have realizable value and few liabilities, where assets outweigh liabilities.  In the course of business all businesses will incur liabilities ranging from accounts payable to potentially the obligation to repay borrowed money.  Liabilities aren't something to be feared, they are a byproduct business itself.  Investors should try to avoid liabilities that have the potential to wipe out a shareholder's investment, or put the company at risk.

The first liability that comes to mind for most investors is debt, both short term financing and long term debt.  But I would argue that any liability that has the potential to disrupt a company's operations is one to be avoided.  In some cases the worst liabilities aren't on the balance sheets.  An example of this might be a joint venture that has high ongoing capital needs that the owners fund out of cash flow.  Another liability to watch out for are contingent liabilities.  These liabilities appear in footnotes (not on the balance sheet!) and can have no impact on the business for years until one day they're triggered.  The worst potential liability to watch out for are lawsuits.  These are similar to contingent liabilities, a company will usually incur no cost outside of legal fees and then suddenly they owe millions or billions for a settlement or ruling.

There's an implicit assumption in accounting that assets are good and liabilities are bad.  This is because liabilities are subtracted from assets, and when we subtract we take something away.  Usually we want to take away bad things, but this isn't always the case.  Sometimes we subtract junk food from our diet, that's a good subtraction.  Or we subtract debt from our personal balance sheet, another good subtraction.  In the world of finance some liabilities are good such as deferred revenue, or a permanent deferred tax liability. Just like there are good liabilities there are also bad assets.

Not all assets are created equal, and not everything should be taken at face value.  Most investors when evaluating a balance sheet make similar discounts to assets, they reduce receivables and inventory by some amount and fixed assets by an even greater amount.

I try to value assets by their potential salability.  Marty Whitman discusses this in a video where he comments on Graham's NCAV calculations.  Whitman claims that sometimes a fixed asset such as an occupied apartment building has more value than inventory or receivables because it can be sold quickly to almost any buyer.

I would extend Whitman's thinking with some slight modifications.  Anything that a company owns that can be sold quickly in any market condition should be valued at face value.  In Whitman's example a fully occupied apartment building is worth more than inventory.  The caveat I'd say to that is the apartment building could only be sold in an average or above average market.  In a credit crunch where a buyer needs to line up financing it might be hard to unload the apartment building.  Depending on the nature of inventory it might be easy to unload it.  A manufacturing company could have a hard time selling drill presses, but a textile company should have no problem selling commodity fabric.

During the credit crisis many companies realized that what they thought was cash in the form of auction rate securities turned out to be something far different.  A month before the crisis any investor looking at a balance sheet would have counted the auction rate securities as cash, but a month into the crisis they would have been discounted 30-50-90% to reflect that these securities couldn't be sold at any price.

The most valuable assets are ones that hold their value.  An apartment building, or auction rate securities can be valuable depending on the market they're being sold into.  The same could be said for receivables or inventory.  Cash in the form of Treasuries or CDs can always be considered worth 100%.  An investment in a business that generates cash in all market conditions is also valuable.

If there's a rule about valuing balance sheets it's that there are no rules.  What might be good for one company is bad for another.  I try to shy away from mechanical formulas, they can be misapplied.  It's better to think logically about each company.  Is it good for a holiday goods company to have a lot of cash on hand?  Yes, to survive the seasonality of their business.  For a holiday goods company debt financing might not be bad, they operate from debt for most of the year and then pay back the financing from their seasonal sales.

Excess cash is usually viewed as a good asset, yet in the hands of an acquisitive management team it could be a bad asset.  The management team could squander cash on a business that generates losses or incurs significant liabilities.  While thinking about excess cash an example came to mind.  I was talking to a friend of mine who's a lawyer, we were discussing companies with asbestos liabilities.  He told me a story of a local company that purchased another company in the 70s or 80s.  The acquiring company closed the deal, and as the deal closed they learned the acquired company had significant asbestos exposure.  The acquirer immediately disposed of the newly acquired company, but the asbestos claims hung around.  They owned the company laden with asbestos claims for less than 100 hours, and 30-40 years later they're still paying out on legal liabilities.

Like all of investing I don't believe simple mechanical rules are good enough.  I think one needs to look at each company and think over potential situations and scenarios.  Rules miss a lot, cash is good, debt is bad, except in cases x, y or z.  Instead a better way to approach a balance sheet is to keep in mind that assets that are readily salable and hold value in any market are valuable, and anything that bleeds cash, or anything that puts the company in a bad financial position is bad.

Friday, August 1, 2014

Bull market thinking

In 1999 I was in college, I had the world at my finger tips.  I was studying computer science, which was a perfect degree for the time.  I had stars in my eyes, some friends who were graduating said it was easy to snag a $60k a year job where everyone sat on giant exercise balls, played foosball and built the new economy.  There was palpable excitement in the air.

In 2001 I was looking to change my major, I considered either psychology or a business degree.  I wanted something with a job attached to it when I graduated, which tech didn't have at the time.  I eventually decided to completed my initial degree but added a minor in sociology.  I also got to work at a startup, right out of school.  Except that instead of the heady optimism of the 90s everyone had a bunker mentality.  No one was concerned about IPO-ing, or stock options.  We wanted to generate revenue, earn a profit and stay in business.

Sentiment in the market changes quickly.  Sentiment in the workplace takes longer to change, but when it does it's abrupt.

In a bull market it's hard to differentiate skill verses luck.  The market rewards those with guts, anyone who had the cash and a iron stomach who invested in the fall of 2008, or in March of 2009 has been rewarded with significant gains.  In the midst of a market bottom and recovery academic finance seems to make sense, those who took on the most risk realized the biggest rewards.  Investors in index funds or blue chip companies might only have doubled their money, but those who had fortunate timing and bought highly levered companies on the verge of bankruptcy earned many multiples of their money in 2009 and 2010.

A strong market can lead one to faulty conclusions.  I recently received a comment on a post that buying any company with a high ROE, even at a high multiple is a recipe for investment success.  Maybe that's true, but how did those Nifty Fifty companies work out for investors in the end?  When the market is soaring buying anything and holding seems to work well.

The problem isn't figuring out how to make money, it's figuring out how to keep it.  If an investor is up 80% one year and then down 65% the next it requires a 25% gain just to break even.  I know that in the past five years it seems like 25% or 30% gains are par for the course, but in the context of history gains like that are extremely hard to achieve, especially repeatedly.

In my view the secret to investing isn't hitting grand slams, it's avoiding large losses.  An investor who never has incredible returns can still do very well if they keep their losses to a minimum.  An investor who has outsized gains and outsized losses is really no different from a streaky gambler.  It might be an enjoyable wild ride, but in the end they'd probably be better off investing in an index fund.

Most investors fixate on success.  They want to know what makes a successful investor, or why a company was successful.  Then they work to replicate that success, either with the investments they choose, or how they invest.  Success is multi-faceted and usually due to a variety of factors, most of which are situational and not repeatable.  For every entrepreneur who credits their success to hard work there are five entrepreneurs who worked just as hard and failed.  The same is true of any factor of success.

Unlike success failure is easily replicated.  Whereas hard work isn't always a formula for success a company with high leverage that ignores customers in a downturn is a recipe for failure.  Failure is so repeatable there are failure patterns that can be spotted in companies and in people.  If you spot a failure pattern at an investment it's worth considering whether it's time to sell.  If you spot a failure pattern at your own company it's either time to try to correct it or find another job.

Strong earnings alone are no safeguard against losses in a downturn.  I was discussing this with someone a few months back within the context of banks and he said "There were many banks with 15% ROE's until the day they failed in 2008."  In the investment world returns aren't strongly linked to one specific factor.  Great earnings and a high ROE can sometimes mean a stock appreciates, but not always.  A bad balance sheet will always have the potential for failure.  A company with sizable reserves can weather a severe drop in revenue for a prolonged period of time.  A highly levered company operating in the same environment will either fail, or will be hunting for credit at loan shark rates.

A company's balance sheet is what determines whether they survive or fail in a market downturn.  Earnings come and go, but the strength of the company resides in their balance sheet.  A company with a strong balance sheet can take advantage of a downturn by purchasing distressed competitors and bargain prices.  They can use their strength to attract customers who are scared of losing a valuable service.

When the market is racing higher not many investors are thinking about balance sheets.  But downturns happen quickly.  What was a roaring market one day is a correction the next.  By the time the market is starting to correct it's too late to be thinking about safety.  An investor needs to keep the safety and strength of a company in the back of their mind during the entire bull market run. One never knows when the wind will change and a portfolio's result will be determined by the strength of each holding's balance sheet rather than their earning power.

Monday, July 28, 2014

Hammond Manufacturing revisited, still cheap at 54% of BV and 6.2x earnings

If I have one weakness on this blog it's the failure to follow up on companies I've previously posted about.  To readers my process appears to be the following: research a company, write them up, never mention them again.  I tend to keep up with most of the companies I post about, if not intimately at least from a distance.  The shame about my lack of updates is that many companies remain attractive far after I've posted about them, and unless someone reads the initial post or searches the blog they would ever know.  I plan to change that today with a post on Hammond Manufacturing.

The last time I wrote about Hammond Manufacturing (HMM.A:TSX) was in September of 2013 when the company was trading for 88% of NCAV, and 44% of book value.  At the time they had a book value of $2.71 per share, and had earned $.15 per share in 2012.  I made the case that the company was worth at least NCAV, but more likely book value.

The company is located outside of Toronto and manufactures industrial electrical box enclosures.  Earnings have been volatile ranging from $0 in 2009 to $.20 per share in 2013.

In the last 10 months the shares were flat did mostly nothing until recently.  Hammond Manufacturing released results of a great second quarter and the stock started to move.  Even with the recent move up the company remains cheap.  In the past 10 months book value has increased from $2.71 per share to $3.10 per share.  The last time I wrote about them they were selling for 44% of book value, with the run up they're now at 54% of book value, hardly overvalued.

Besides the discount to book the company has shown considerable earning potential in the past year.  On a trailing twelve month basis they earned $.27 per share, giving them a P/E ratio of 6.2.  Management noted in their second quarter letter that sales are finally showing signs of recovery, which could indicate that their quarterly EPS of $.10 run-rate could continue.

Given Hammond Manufacturing's valuation there are only two scenarios I can think of, either I'm wrong, or the market's wrong.  As an investor in the company I clearly think the market's wrong, but I want to put that aside for a minute and consider what I could be missing, let's look at the company's negatives.

The company finances their inventory with debt, they have about $10.6m in debt outstanding, their debt is a negative, but not large enough for their valuation discount.  They also have two classes of stock, the publicly traded A shares, and the privately held B shares.  The controlling family owns the B shares and controls the stock through these shares.  Markets don't like controlled companies, especially ones that have so much control that an activist (theoretically) can't take the company over.

There is also an issue of a potential environmental liability.  The company had a suit filed against them in 2013 alleging that contaminants from a property they once owned have leaked onto a nearby, but not adjoining property.  The company isn't sure whether the contaminants were from their property or somewhere else.  They note that a scenario exists where they need to pay $2m to have a barrier erected between the properties.  If the company lost the lawsuit and were required to pay the full $2m their book value would be reduced to $2.92 a share from $3.10.  While a legal loss and resulting environmental remedy is not ideal it hardly justifies the valuation.

The comments on my last post give additional insight as to why investors, and the market think this company should be cheap.  Someone thought that a company that doesn't generate at least a 10% ROE shouldn't be worth book value.  Someone else claims that the closely held nature is the reason for the discount.  Another claimed if they paid a dividend they would be worthy of a higher valuation; the company did pay out a dividend and shares barely budged.  Lastly, my favorite response is someone who said the stock has always been cheap and it should remain that way.

In a market where investors are claiming there is no value to be found I would tout Hammond Manufacturing as the exception to that rule.  This is a profitable company with recovering earnings selling for 54% of book value.  Maybe they're only worth 80% of book value, but if that were the case investors would still earn an acceptable return from this investment.  For myself I voted with my cash and have been holding onto my position.

Disclosure: Long Hammond Manufacturing

Friday, July 25, 2014

Valuing community banks

Most investors are familiar with the valuation techniques used to value non-financial companies.  A number of different models are used from relative valuation, to discounted cash flows,  multiples comparison, dividend yield, and others.  To a beginning investor these techniques seem foreign and complicated, but after some use they become accepted and familiar.

For a reason I don't understand investors are comfortable with industrials, but not financials.  Often banks are lumped into the "too hard" pile.  An investor might feel comfortable investing in an industrial who's product they can't explain or understand, yet will avoid investing in a bank whose product is used daily and whose business model is both simple and straight forward.  If I were to summarize banking in a few sentence it would read as follows:

"A bank takes money from depositors and lends it to borrowers. The bank makes a spread between the rate borrowers pay the bank and what depositors are paid.  Out of their spread they pay their operating expenses, taxes and are left with net income."

Investors are willing to put their money in IBM, an extremely complex business, but avoid banks, a very simple business.  I would love to see a survey of IBM's investors answering the following question: "Why would a customer choose WebSphere over Weblogic?"  I would put a question like this on the same level as "What's the difference between a McDonald's hamburger and a Burger King hamburger?"  Imagine trying to summarize IBM, or Medtronic in a few sentences like above, I'm not sure it's possible.

I've made a case in the past that banks are a portion of the market that investors can't ignore.  Of the 14,077 stocks in the US 5,628 are classified as financials.  Of those classified as financials 1,200 are banks.  To disregard financials completely is throwing away 1/3 of the stocks in the US.

Let me share some stats I shared with my newsletter readers regarding community banks.  There are 6,739 banks in the US, of which 5,734 have less than $1b in assets and are profitable.  There are only 275 traded banks with more than $1b in assets.  This means of the 1,200 or so traded banks almost 1,000 are below $1b in assets, the magic threshold where most of Wall Street tunes out.  I spoke with an analyst recently who said that anything below $10b in assets is considered too small to consider.  His fund has limited themselves to looking at about 70 banks, I'm sure they're not alone in this view.

 Maybe I've convinced you that it's worth looking at community banks as an investment.  The next question is how do you value a community bank?  I recently read a PDF by David Moore where he detailed his approach on valuing community banks.  I agree with his methodology and have summarized it below.  There isn't one way to value a community bank, but multiple ways.  Each way could yield a different value, but ultimate all methods of valuation should somewhat agree on a potential value.

Relative Valuation

This is the most common valuation technique and the one most accepted by the market.  The technique is simple, a bank is compared to a set of their peers across a number of financial metrics. If their peers are trading at 1.5x book and they're at 90% of book it's reasonable to assume they are undervalued.  Moore contents that the market is driven by relative valuations in the short term.  That is if you're looking at a 2-3 year window for investing in a bank relative valuations are paramount.  The key to determining if a bank is relatively undervalued is getting the correct peer group.  What constitutes a correct peer group could be up for endless debate.  The FDIC sets arbitrary peer group classification by asset size.

In my view a good peer group is one that's composed of banks competing in a similar market that are similar sizes.  The First Bank of Tennessee shouldn't be compared against Regions Financial, even if they have branches in the same area.  Just because Wells Fargo and Bank of America have blanketed the country with branches doesn't mean they are automatically peers to every other bank in the US.

Moore posits that in the short term relative valuation rules the market.  Over a 2-3 time period a bank should trade in line with their peers.

Discount Dividend Valuation

Much of the market disregards dividend discount models as too simplistic but Moore makes the case that over the long term the dividend discount model (DDM) value of a bank will approximate its long term shareholder return.

The dividend discount model is the present value of future dividends the bank is expected to pay over a specified period of time.  If one can accurately predict earnings growth, as well as the future dividend payout ratio and discount rate this method of valuation can be accurate.  In my view the problem with a DDM model is there are too many assumptions taken into account.  A difference between a 9% and a 12% discount rate can result in a dramatically different terminal value.  The same could be said about earnings growth or a bank's payout ratio.

Along with the DDM value another potential forecasted value is the deposit premium of the bank.  This can be calculated by taking the spread between the bank's borrowing cost and their deposit cost discounted at the 10-year Treasury rate.  This future value of the bank's deposit premium could be added to either book value, or checked against peers to evaluate whether the bank is trading at a premium to their deposits or a discount to their deposits.

Take-out Valuation

A bank's take-out value is my preferred way to value a bank.  Moore is somewhat dismissive of this model.  He states that he's heard rumors of bank sales that have never come to fruition, and betting on a bank merger can be foolish.  While I agree that it's foolish to speculate on potential mergers I disagree that this value has no merit.  I believe that a bank's take-out value is ultimately what a well informed private buyer might pay for the bank.  I also believe that stocks are mean reverting with the mean being the private market value of businesses.  This means that the anchor of value for banks should float around the take-out values of similar banks.

To estimate the take-out valuation of a bank one needs to look at a bank and estimate the expenses that could be eliminated in an acquisition as well as the potential improvement to earnings for a potential acquirer.  Many barely profitable one branch banks can suddenly become attractive acquisition candidates if executive pay were eliminated.  Consider a bank barely scraping by with earnings of $30k.  If acquired the acquiring bank might eliminate the CEO/CFO/COO and other redundant personal resulting in a $500k or more savings a year.  Earnings could jump 10x in an acquisition by retiring the executive team alone.  Other potential cost savings could be realized by economies of scale too.

Liquidation Valuation

The last valuation model discussed in the paper is one I'm very familiar with, but also one that's extremely rare in the banking world, liquidation value.  Banking is a regulated industry and if a bank finds themselves in trouble the FDIC will step in and force an orderly liquidation or acquisition.  It's very rare that a bank enters liquidation proceedings willingly and without FDIC meddling.

The liquidation value for a bank is calculated in a similar way to how one might calculate it for a non-financial company.  A bank's liabilities are viewed as being worth 100% of their stated value whereas their assets are discounted based on an investor estimate of quality.  Cash and certain securities are given full value, loans are discounted based on the type and quality.  Other assets are discounted as well.

A bank's liquidation value should be viewed as the lower bounds of potential value unless the bank is living under the shadow of a potential FDIC takeover.

Conclusion

There is no single correct way to value any company.  A company's valuation can change depending on market circumstances, management circumstances, or owner circumstances.  A company that is attractive when long term rates are 4% might not be attractive when rates are at 8%.

A bank investor should use as many valuation tools as they see reasonable to determine a range of values for a community bank.  If a bank's price is at enough of a discount to the range of values it should be considered for a portfolio.  The idea of using multiple valuation techniques is because each model uses different assumptions, and the combination of varying assumptions should flush out any faulty assumptions an investor might be making about a company.


Sunday, July 20, 2014

The truth about asset investing

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

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

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

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

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

First a definition of liquidation value:

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

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

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

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

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

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

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

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

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

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