Leverage and success

What drives success?  Everyone who succeeds credits something different for their success.  Some credit hard work.  Others credit being in the right place at the right time.  Some credit parents, friends, a boss, a wife, the list goes on.  The problem with success is that it's hard to duplicate.  No two people live the same lives and no two situations are identical.  I've always enjoyed studying failure because there are clear failure patterns.  People fail in many of the same ways.  Failure can be avoided and studied.  Sometimes the absence of failure can results in success, but success is more complicated.

It's bothered me that there is no formula for success.  Of course if there were a formula then everyone would follow it and the formula would stop working.  As I've thought about successful individuals and successful businesses a pattern started to emerge, a recurrence of leverage.  I've been thinking about this idea for a few months and I finally decided that sitting down and typing it out might help me finally solidify my thoughts.

About a year ago I wrote a post on scalable businesses and growth.  Looking back at that post it was the first time I'd really thought about this idea of leverage.

Why is it that some companies start and fail to grow, or take decades to grow?  Why is it that other companies begin to grow and their results compound exponentially?  Is it the managers involved? The business model?  Some secret no one else has discovered?

Most small businesses stay small businesses forever.  A local plumber with a single van isn't likely to grow his business into a plumbing empire with a nationwide network of plumbers.  But why is it that some companies that start small such as a software company can grow large quickly?  The business model has a lot to do with this growth, but that's not all.

Leverage is a misunderstood concept.  When many investors think of leverage they immediately think of financial leverage, that is taking on debt to purchase an asset.  Financial leverage can work in an investors favor, but there are other types of leverage as well.

Think about the plumber and their business.  The plumber makes service calls and charges an hourly fee per service call.  They also sell parts for a small markup.  If the plumber wants to double their income they either need to double their hourly rate, mark up parts, or work double the hours or some combination of all three.  Another alternative is to hire a second plumber.  The problem with hiring a second plumber is part of that plumbers earnings go towards their salary.  For the initial plumber to double their salary they might need to hire two or three additional plumbers.  At this point the original plumber is probably going to be doing less plumbing and more administration, finding additional clients, advertising and working with their accountant.  To make up for this loss of billable hours they might need to hire an additional plumber or two.

Notice in this example each additional plumbers marginal profit for the company shrinks.  This is because each worker incurs overhead that accumulates across all workers.  Eventually if the company grows large enough the owner will need to hire managers to manage plumbers.  These managers aren't billable and aren't selling parts so they are almost a pure expense.  If the company continues to grow managers will need to be hired to manage the managers who manage the plumbers and on and on.  In the business of selling time (billing hourly) a company faces a natural size limit.

Let's consider a different type of business, a company that manufactures shoes.  This company starts out and buys a shoe machine.  Workers throw in raw material and the machine creates a completed shoe.  The machine can be purchased for $1m.  The company purchases some raw material, fires up the machine and starts producing shoes.  Until the company has produced and sold shoes for $1m plus their raw material and labor costs they are operating at a loss.  Their shoe sales have not covered the cost of their expenses yet.  For each additional shoe sold the marginal loss shrinks as they get close to $1m.  Once they hit $1m the company starts to earn a very tiny marginal profit per shoe sold.  If the shoes are popular and they sell tens or hundreds of millions the marginal profit will continue to grow as long as the single machine can keep up with demand.

For the shoe company the way they can increase profits is by increasing sales and maximizing output on their shoe machine.  When the machine's output is maximized they'll need to buy a second machine which will decrease their profits until throughput can be maximized on that machine as well.

The shoe company is ultimately limited by consumer demand for their product.  The capacity to create shoes is much higher than their costs and their cost structure rewards them for output.  They will run out of customers before they run into scaling problems.

I used these examples to illustrate the idea of operating leverage.  The plumbing company has very little operating leverage whereas the shoe company has significant operating leverage.  Operating leverage can come in a few varieties.  One is the shoe company that might make a small profit on many items compared to a business that sells very few items with very high margins.  The best type of operating leverage is a company that sells a lot of products with high margins, a company such as Apple.

Let's take this concept one step further.  Consider an individual working for someone else; the classic cube dweller.  They have the least amount of leverage.  If they double their hours worked their pay remains the same.  Regardless of the amount of effort put into the system they receive the same output.  The office worker has the least leverage because like the plumber they're simply selling their time to a company.  The difference is the plumber can grow their business and hire other plumbers.  Even if the plumbers business is ultimately limited by overhead they have a small amount of leverage whereas the office worker has none.

A business owner has leverage regardless of the size of their company.  This is because they have the ability to hire additional employees if their workload grows.  If a business is selling a product operational leverage is created.  For the office worker looking to increase their income I'd encourage them to set up some sort of size business selling something other than their time.  Any additional amount of leverage can be financially beneficial.

When most people think of leverage they think of financial leverage in the form of debt financing.  Most of the time financing assets doesn't make sense unless the asset has appreciation or cash flow potential.

Non-investors love to talk about how much money they made on their house.  The problem is most don't realize the only reason they made money is because they purchase was highly levered.  Take for example a person purchasing a $100,000 house with $20,000 down.  Presume the house appreciates 2% a year for 10 years before the owner sells it for $120,000.  The final sale price is 20% higher than the purchase price, but for the leveraged individual they approximately doubled their money.

Many of you would point out that home ownership isn't always a guaranteed return.  A lot of homeowners lost money on their houses and their levered investments came to haunt them.

Leverage cuts both ways, both financial and operating leverage.  A company with significant operating leverage can realize large losses the moment their sales volume slides below break-even.  The further the slide the larger the losses.  This isn't true for a business built on selling time.  For a business with no leverage sales scale linearly with hours billed.  If 50% less hours are billed revenue is 50% lower.

Financial leverage enables us to buy more than we can afford with cash, and increase our returns, but if interest payments can't be met it's all for naught.

What does all of this have to do with success?  As I've looked at successful people a theme has become clear, all have leverage in their life.  Some have achieved success through financial leverage, others through operational leverage, but always leverage.

To illustrate this point consider two investment managers, one with $1m in AUM and one with $1b in AUM.  Both work hard and earn 15% for their fund.  The manager with the smaller AUM earned $150,000 for their investors whereas the manager with $1b earned $150,000,000 for their investors.  The exact same return yet vastly different nominal results from asset size.  Incentives reward managers who have larger funds regardless of performance.  This incentive is simply the leverage effect.  Smaller amounts of capital with less leverage require higher returns.

One thing about the leverage effect is it isn't fair.  In the above example both managers might have worked equally as hard but the manager with a larger asset base earned more due to their size.  This is the same in business, in real estate, and in life in general.

I've noticed that sometimes people will look at someone who has used leverage explicitly (such as Buffett's insurance float) and try to discount that factor.  The Economist wrote an article a year or two ago trying to calculate Buffett's returns unlevered.  They weren't anything special, but that's the point.  If one doesn't include some sort of leverage in their life it is hard to get above average results.  I'd go as far as saying that above average results can only be achieved through the use of leverage.  It's impossible to do it unlevered.  Levered results should be rewarded and credited to the individual because the individual who used leverage successfully managed their risk.  For every Warren Buffett there are dozens of investors who levered their portfolios and blew up because they disregarded risk management.

The question then becomes "how do I incorporate leverage into my life?"  The first thing most think of is "I need to better utilize financial leverage, more debt, a bigger mortgage etc."  This is the wrong conclusion.  Financial leverage for individuals is only really acceptable to purchase appreciating assets.  That means financing a house (maybe), or financing a business purchase.  Otherwise leveraging up for depreciating assets (cars, TVs, vacations), or assets that don't generate cash flow limits individual financial success.  But as I discussed above there are other ways to incorporate leverage into ones life.  What about selling a product on the side or starting a business?

I believe it's possible for employees to obtain a slight amount of leverage without starting a business.  One way to do it is to negotiate a pay package based on personal performance.  This is the traditional sales model, a salesperson is paid for the revenue they generate.  But why can't other employees be paid for the impact they make on their business?  Employees who work harder should reap larger rewards.  Part of the reason companies are fearful of doing this is that it exposes that some employees don't work that hard at all and there is likely a lot of fat that could be cut.

Leverage doesn't always need to be obtained through financing or outside investment either.  It's possible to create a business with sweat equity where operational leverage is created through hard work.  If possible this is the best type of leverage to look for.

While there isn't a formula for success one thing is clear.  Abnormal success doesn't occur without some sort of leverage.  The trick is finding how to best incorporate leverage as well as manage the risk.

Listen to Me on the Bulldog Investor Podcast

I was recently a guest on Fred Rockwell's Bulldog Investor podcast.  We talked about a number of things including risk, small stocks and bank stocks.

A Short Essay On Why I Write and Why I Share For Free

You might be wondering why I give interviews like this, or why I give 'secrets' away on the blog freely.  This is a subject I'm not sure I've ever discussed on here and because I love to talk I can't fathom leaving a post as two sentences with a link.  So without further ado..

I grew up in the pre-Internet era.  If there was a song I heard on the radio and I wanted a copy I had two choices, I could put a blank cassette in my boom box and when I heard the song run across the room and quickly press record.  Or I could go to the local music store and hope they had a copy in stock.  If I didn't know the name of the song I'd have to call the radio station and ask, or ask friends to try to identify it.  It sounds clumsy now, but that's all that existed.

The way to find new music was from the radio or friends.  The radio was the traditional mainstream stuff.  I had a few friends who were a bit more out there and they somehow had this connection to local bands and the weirder music.  If someone had an album that they wanted everyone to hear they'd make cassettes and give out copies.  Outside of spending money at random to find a new band the only way I found something was if a friend gave away music to me for free.  Many times I went on to purchase other albums, or even the album I had the cassette of.  But I needed the introduction first.

I loved the idea that music could be shared freely.  I liked the idea even more that the Grateful Dead and Phish built enormous followings by encouraging fans to give away their music.  Instead of cutting into their revenue the Dead and Phish saw the free sharing increase their revenues.

When I started to write Oddball Stocks I had no goals or ambition about what this site might turn into.  It was a dumping ground for my thoughts as I researched stocks.  An online blog was a place I could access from anywhere so I could recover my thoughts.  This might sound strange, but if you've ever seen me hunt around the house for 30m trying to find my keys it might make sense.  It's not uncommon for me to walk out of one room with a screwdriver in my hand and into the next with nothing and no idea where the screwdriver went.  A blog was a way to make sure I didn't forget what I'd read or researched.  A byproduct of writing is that it helps to clarify thoughts.  The more I wrote the more I realized I was the one benefiting the most from writing.  It helped me form my ideas and remember them.  And if I did by chance forget them I could always re-read them online.

I had the option of keeping my blog private when I started but thought back to my experience with music sharing.  I thought that maybe if someone could benefit from my thoughts then it might be worth it.

A funny thing happened when I gave away my thoughts and ideas, it became like the Phish tapes.  The blog went crazy.  You, my readers started showing up from all corners of the world.  It's humbling to think that while I sleep or take a walk that someone in Mongolia or South Africa is reading something I wrote.  And while the sharing has helped a number of you it's also helped me.  I've made some incredibly meaningful connections through this blog, connections and friendships I wouldn't have otherwise.

With success comes detractors.  I've had a few readers accuse me of giving away too many secrets about small stocks.  My advice to them is if I can find this information out then someone else can as well, and not everyone is bound to some secret pink sheet honor code of conduct if there even is such a thing.  When looking at a small stock there is a natural inclination to think to oneself that you've discovered something new that no one else knows about.  What I've found is the longer I write on here the less I have that feeling.  I can write about the most obscure company in the world and a few readers come out of the woodwork letting me know they and others have been following it for years.

The problem is I'm not selling a magic bullet.  My approach is hard work.  Look at hundreds or thousands of stocks and find the best to research further.  From those whittle it down to a few worth investing in.  There is no magic formula, just time and effort.  It's like dieting, you can tell people to eat less and exercise but not many people follow through with it.  The formula for losing weight is simple, but hard to follow.

What I intended to be a few short paragraphs turned into something a bit longer.  In the end I don't have the slightest bit of regret in sharing with others how to find hidden value stocks.  The rewards to both you and myself have been too great to stop.  So I'll continue writing here and writing about these little names in the Oddball Stocks Newsletter....

The value imposers

I was riding on a ski lift with an apparently successful investor from New Zealand.  Each January he flew to Utah to ski for three weeks with his family.  I couldn't even imagine how much airfare and lodging must have cost.  Our conversation naturally drifted to investing.  He asked what type of investor I was to which I responded "a value investor."  He had a puzzled look and said "what does that mean?" I said "I look for undervalued stocks, companies trading for $,.50 that are worth $1."  The man laughed and said "Isn't that what all investors are doing? Looking for undervalued stocks?"

That ski lift ride was 10 minutes long, but the conversation has stuck with me the last three years.  It serves as a constant reminder to invest differently.

As Warren Buffett's investing style has shifted from small neglected companies to elephants the sentiment of value investing seems to have shifted with him.  Articles about value investors from the 1970s and 1980s are full of quotes about finding companies the market has left for dead yet full of value.  Companies where their real estate is worth more than their market cap alone, or companies where coffers stuffed with cash are disregarded because there is no growth.

Buffett is arguably one of the most successful investors of all time.  He might be outdone by Rockefeller or Carnegie, but until Buffett passes from this life into the History Channel no one's counting.  Buffett has matured from a small time investor at the fringe of the market to a star that the rest of the market orbits around.  If Buffett wants to speak anyone with a camera listens.  His quotes have found a home in almost any market situation.  Even a trader might be caught saying "Be fearful when others are greedy."  Buffett quotes are like horoscopes, ambiguous enough that they apply to any investor in any market situation.

As Buffett's company Berkshire Hathaway grew from cigar butt stocks (small neglected companies) to larger names his strategy shifted.  He started to buy larger companies whose growth wasn't appreciated.  After all with billions of dollars in capital he was effectively forced out of smaller names.  When Buffett bought undervalued growth the market purchased it too.  Then another shift happened, Buffett could no longer buy undervalued growth and simply had to look for wonderful companies selling at any price that wasn't outrageous.  If a large enough company comes calling and they aren't asking too much he'll probably buy.  Why?  He has to keep feeding the beast.  Berkshire Hathaway is a victim of compounding.  The company has grown so large and so successful they have an increasing amount of cash that needs to be put to work each year.  Buffett could hardly be criticized, he has built one of America's largest companies and made himself into one of America's richest men in the process.  So what if he has to lower his standards a bit?

Berkshire Hathaway's pool of potential investments is limited to maybe 100 public companies and a similar number of private companies.  But just because he's limited doesn't mean we should be limited.  Buffett will probably outperform the market over the next decade, but my guess is Berkshire's returns gently glide to be inline with the market.  Why?  Because at a certain size his company is a proxy for the market.  As the American economy goes so goes Berkshire Hathaway.

My point is that Buffett has become the market, and at this point mimicking what he does gives results no different than what the market generally does.  Why not buy an index fund?

If as an investor you want different results from the market you need to do something different than the market.  Everyone in the market wants growing companies.  How do I know this?  Browse the mutual fund selection at any discount brokerage.  What is the term that appears most? Growth.  I did a quick search and Fidelity offers me 374 growth funds verses 288 value funds.  But I'd say this number is skewed.  I read the summaries on a few of the value funds and they all mentioned they look for growing high quality companies in a value manner.  Even the value funds are growth funds.

Is growth bad?  Not at all, we all want things to grow.  If something isn't growing it's shrinking.  I want my portfolio to grow, my relationships to grow, my knowledge to grow, my kids to grow, everything to grow.  And so does everyone else.  We all want growth.  If most mutual funds are looking for the same thing is there any question as to why most slightly under-perform roughly by the amount of their fees?  Of course not, it's because they're all doing the same thing, looking in the same places for the same types of companies doing the same things.

When everyone is doing the same thing an industry becomes an arms race.  Who can find the growth the quickest, who has the better tools, who has the smartest analysts and who can get better information.  This is the efficient market, the knowledge arms race for growth.

This arms race extends beyond mutual funds to hedge funds.  Many hedge funds think differently together resulting in crowded trades.  Individual investors see these clusters of fund managers in the same names and naturally gravitate towards the same companies, like moths to a light.

There is an alternative.  For those of us without Wharton, Harvard, or Columbia analysts or those of us who aren't managing billions, or even for those of us who are.  The answer is to think and act differently.

One of the reasons value investing was so unique when Graham first wrote about it was because it was so different.  At the time investors wanted high yielding stocks.  A high yielding stock was desirable.  It didn't matter what assets or earnings the company had, only their dividend.  As time has progressed the metrics the market considers important have shifted.  Instead of dividends it's ROE, growth, moats and EV/EBITDA multiples.

If you want different results from the market then you need to think and act differently.  There will always be a few managers who win the arms race, but silently mimicking them isn't helpful unless you want to join the race.  One needs to look at things differently.  If the market is looking for growth and high ROE then what are they glossing over that's important?  The key to success is finding what others have missed.

Being different is difficult, there are few friends and you need to pave your own path.  I have never marched with the crowd, for some reason I came out of my mother's womb wanting to go my own path.  To me marching in a different direction is natural, I'm curious, I follow seemingly endless hunches or attractions and hope to learn a little on the way.  This extends to my investing, I'm attracted to the nooks and crannies of the market simply because no one else is there.  If what I do is unnatural for you that's fine, don't mimic me, do your own thing.  To me the key to success is being different and thinking differently.

I find success fascinating.  There are plenty of high powered CEO's who grew up in the right suburbs, went to the right colleges and climbed the right ladders.  The financial media loves them, but to me they're boring.  I find the successful entrepreneurs fascinating.  People who never went to college and own multi-million dollar landscaping companies.  People who left high powered jobs to start something different like a cupcake business.  The ones who saw opportunity and acted on it.  The ones who risked failure, or the loss of their reputation to do something different.  People who are obsessed with something and won't give up until they are satisfied with a solution.  These are the success stories I love to hear about.

While I love success I am even more fascinated by failure.  There are common failure paths that most companies or individuals take.  These are well trod out paths that some can see coming.  Why do so many companies with well educated executives fail so miserably?  As an investor spotting failure and avoiding it can be extremely profitable.  Most companies that fail follow the crowd, they fail to take risks and do things differently.  Some industries fail together as each company marches in lock step toward imminent death.

Buffett's success came from being different.  He created a new type of investment company.  It's a shame that instead of learning that lesson from him investors have instead embraced trying to copy him.  If you want different investment results than the market you need to think and invest differently.  If you don't you might as well invest in an index fund and forget about the market.

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But why aren't there activists?

A recurring theme to many of my posts on small caps is the reader question "Why aren't activist investors involved?"  For a lot of small undervalued situations the solution to undervaluation looks simple on paper.  An activist investor buys shares, they distribute or sell assets and then sell the company with everyone reaping large rewards.  On paper everything is simple.  In life nothing is simple.

In the book The Guns of August author Barbara Tuchman writes about the difference between German planning and French planning for World War I.  The French relied on L'Esprit, an idea that plans were loose but soldiers would fight with so much enthusiasm that they would win battles.  The Germans didn't rely on an emotional edge, instead they relied on planning.  They wrote battle plans for all situations they could imagine, and wrote contingency plans, and logistic plans and plans for plans.  Everything was planned and detailed.  The book is excellent and I'd recommend it if you're interested in the pivotal first six weeks of World War 1.  The summary is this, the French army's enthusiasm wasn't enough to win, their lack of planning was a downfall.  On the other hand the German army could have won if they would have been flexible.  They had a number of opportunities they never took advantage of because they weren't in the plans.

The market is filled with activist investors who embody both the French and the German approaches to war.  Some investors plot and plan, they build 500 page Powerpoint slide decks and carefully telegraph their intentions at investment conferences.  Others take the approach of buying a stock with gusto and approach the target company with guns a-blazin'.  Sometimes these approaches work, but they're both prone to backfiring as well.

Activists are surprised when their massive Powerpoint snoozer doesn't move the needle, or when management takes offense to a new investor trying to throw their weight around.  To those of us on the sidelines an activist investment appears simple.  To those in the media activism is simple.  To everyone it seems so simple.  Yet activist investments are anything but simple, and if they were simple and straightforward why aren't more activists hovering around small undervalued companies?

Legally shareholders are considered owners of a company.  There is a long list of rights shareholders have according to the law.  The problem is shareholders are passive and management holds all of the power, no matter how many shares managers do or don't own.

In theory a company's Board of Directors answers to the company's shareholders.  The Board is entrusted with managing the company for their shareholders.  The Board is supposed to be responsive to shareholder requests and be independent.

Typically the Board of Directors for a given company has a very cozy relationship with the company's management.  This is expected.  A company's Board hires the CEO and potentially other top candidates.  People naturally defend their choices, so if a Board picks a CEO it means they liked the candidate enough at some point to hire them.  Most CEO's sit on the board of the companies they work for, and some are even Chairman of the Board.

What all of this means is that instead of standing up for shareholders Boards usually stand up for management.  In many cases, especially small companies the Board and management are one in the same.

There is no legal requirement for a board member to own a certain amount of stock.  Board members simply need to be elected by shareholders after being nominated by management.  In most companies shareholders are asleep at the switch and simply elect whomever management decides to nominate.  Managers are fond of nominating friends and others who are sympathetic to their own interests.  This about this for a few minutes.  The people who are entrusted with managing a company for shareholders often have no ownership interest themselves.

I've gone into the weeds to show how disadvantaged shareholders are before they even consider an activist approach.  The proxy for shareholder interests don't stand for shareholder interests at all, they stand for management interests.

Many small companies are ripe for activist takeovers.  There are just two problems, the first is acquiring enough shares, the second is taking control without management taking action to block the activist.

Let me share a small story.  A few years ago Dave Waters texted me about a potentially lucrative small company.  The situation was so lucrative we both dropped what we were doing to meet and discuss over coffee.  The company had about $4m worth of NCAV and was selling with a market cap of $500k.  Management owned less than 6%.  This is the type of situation that is begging for an outside acquirer.  This is also a situation that looks perfect on paper.  Buy the company for $500k and instantly own $4m worth of value.  Or fire the overpaid executives and free up operating cash flow increasing the valuation.

I went ahead and purchased as many shares as I could, which came out to about $2,000.  Shares have been somewhat liquid on and off and someone could have built a position of maybe $50k relatively easily if they were patient.  I stopped buying as I researched the company further.

A takeover had two issues, the first was the activist would need to fire the CEO and Chairman to free up operating cash flow.  The majority of the company's operating income goes towards paying high salaries.  Both of these officers had golden parachute packages that eliminated much of the potential gain.  On the flip side with both officers gone operating income would be north of $1m per year.

The second hurdle related to the company's incorporation.  They are incorporated in Florida and supposedly have operations there.  Their operations consist of the CEO's home office in Southern Florida.  The company actually operates out of Alabama.  Here is the quirk, according to Florida law a shareholder loses their voting rights at certain thresholds, 15%, 25% and 50%.  If a shareholder owns 14.9% of a company they have voting rights, if they acquire .1% more the voting rights are lost until the company's Board of Directors reinstates them.  This means it's impossible to take over a Florida corporation without the company's cooperation.  Of course there is a wrinkle to this.  The Florida law only applies to companies incorporated in the state with the majority of their operations in the state.  It remained unclear whether this statute applied to the company in question.  I didn't know, and lawyers I talked to didn't know.

I did a lot of research on this company including talking to lawyers about the situation.  My plan was to tender at 2-3x the bid for investors shares.  Then fire the execs freeing up cash and figure out how to go forward from there.

Here is the math on the situation.  Pay $1.5m to purchase a majority stake, pay $1.5m in a golden parachute fee.  Then pay a substantial amount in legal fees to get the execs to actually leave.  The unknown was the legal fees.  The problem is management held so many cards that lawyer fees could be racked up quickly without much real progress.  I could end up in a lawsuit regarding the Florida shareholder issue, or in a lawsuit over the firing, or in a lawsuit over a poison pill or almost any other situation that management could dream up.  By the time I put together a worst case scenario the margin of safety between what the shares could be purchase for and what the company might be worth shrank dramatically.  The potential margin shrank so much that it wasn't worth the opportunity cost and hassle to move forward.

I did nothing and the opportunity still exists.  I have a stock certificate for the company sitting on my desk.  In some ways it's a reminder to the potential opportunity, but it's also a reminder of the potential pain.  In the end it's possible I would have made my lawyer rich and walked away with nothing.

My experience isn't unique.  Jeff Moore who writes at Ragnar is a Pirate recently engaged in a battle with the small company Sitestar (SYTE).   Jeff had managed to get a Board seat and management still pulled out a bag of tricks, from fraudulently signing his name to documents to making false claims.  Jeff and a group of shareholders filed a lawsuit against the company to which the company responded with their own litany of tricks.  Moore eventually prevailed, but it's yet to be seen if any change can happen.

If you walk away with nothing else from this post it should be that sometimes something that looks good on paper doesn't work out well in real life.  The balance of power in a company is heavily tilted towards management and that power imbalance can cause costs to rise, or even thwart a legitimate takeover or activist attempt.

Danier Leather, a retrospective on a cheap stock.

Almost three years ago to the day I looked at Danier Leather -a Canadian leather retailer- and walked away because I couldn't identify a margin of safety.  The company was cheap at 2x EV/EBIT, earned an ROE of 12% and traded for slightly more than NCAV.  After passing on the investment I mostly forgot about them until recently when I came across a post on a message board mentioning they were pursuing strategic alternatives.  This news grabbed my attention although as you'll see in this post my interest faded quickly once I realized what had happened to the company in the years since I looked at them.

Danier Leather (DL.Toronto) is a Canadian leather retailer.  They sell leather handbags, coats, belts and most anything that can be made out of leather.  The company has a large sales presence in malls throughout the country.

Common sense would dictate that a leather company would be seasonal with most sales coming in the colder months.  This is partly due to weather (winter coats) but also due to holidays and the fashion calendar.  It was certainly true for Danier Leather up until a few years ago.  The company made an incredible claim for a winter coat company in a recent report, they stated that last year's winter was too cold and sales were down as a result.  Maybe sometimes there really is too much of a good thing.  Danier Leather hoped to sell warmer winter coats this year to compensate for last year's cold and long winter.

I believe Danier Leather illustrates a number of different points regarding potential value investments: cheapness alone isn't a thesis, buybacks aren't always good, and that a margin of safety is essential for any investment.

Cheapness Alone Isn't a Thesis

Most people prefer to pay less for something verses paying more for the exact same thing.  But just because something is cheap doesn't make it good.  On weekends neighborhoods near us are littered with garage sales and estate sales in the spring and summer.  Shoppers can browse through items sellers have determined aren't necessary anymore.  Most things for sale are cheap, almost astounding cheap, but not much is worth purchasing.

At a garage sale an object needs to be both cheap and useful.  An old lampshade for $.50 is cheap, but if you don't have a lamp to put it on the shade is money wasted.  The same is true for investments.  A company can only have a low EV/EBIT (or EBITDA) ratio by having a lot of cash, or abnormally high earnings.  Companies with a lot of cash might be cheap, but if the cash is squandered or the market never values it what's the point?  Likewise a stock trading below book value could own valuable assets the market doesn't recognize, or it could own a bunch of worthless assets and IOU's in the form of uncollectable receivables.

When a company re-rates higher it's due to business improvement, market awareness about an asset or earnings, or from a management action.  If a cheap stock remains obscure and management continues with a faulty business plan it's likely the price will remain depressed.

At the time of my first writeup Danier Leather was trading with an EV/EBIT of 2, an extremely low valuation.  And at barely above NCAV the stock was clearly cheap.  The problem was the outcome for the stock rested on what management did with the cash, and how the business performed.  In the ensuing years management mismanaged both the company's operations and their pile of cash.

Buybacks Aren't Always Good

There is a piece of common wisdom passed around amongst investors that stock buybacks are always a good thing if the stock trades below intrinsic value.  This is mostly true.  When a company buys shares below their intrinsic value buybacks are value accretive.  If buybacks happen when a company trades below book value the buybacks increase book value per share.  Both of these scenarios are good for investors.

Investors prefer buybacks over dividends because they're tax efficient.  But buybacks make an assumption that isn't always true for value type companies.  Stock buybacks presume that the company conducting the buybacks is stable or growing.  If the company is losing money and the stock price continues an unrelenting fall buybacks are merely throwing money into the wind.  The list of companies that have purchased their shares at high levels only to see them trade lower on a semi-permanent basis is long.

Danier Leather has been buying back their shares since I last wrote about them.  The company has also been incurring losses as revenue has declined.  The company's net loss decreased book value, and while the company repurchased shares it wasn't enough to counteract their losses.  To make matters worse the company repurchased shares at a value about 3x higher than where shares trade today.  Investors have realized nothing from the buybacks whereas if the company paid out the cash used for buybacks as a dividend it would have helped investors reduce their losses, or reinvest elsewhere.

If a company is growing or stable I appreciate buybacks.  If the company is very small, has illiquid shares, or the future is uncertain I'd prefer a cash dividend.  With cash I can make the decision myself to reinvest back into the company or invest elsewhere.  Of course it's never possible to know what the future holds and sometimes it's better to have one bird in the hand (dividends) verses two in the bush (buybacks).

A Margin of Safety Is Essential

A cheap company with a future of losses is akin to a melting ice cube.  At the time of my post I couldn't foresee their losses.  The problem with a retailing company is they run with a high level of operating leverage.  Operating leverage cuts both ways, once fixed costs are paid income increases rapidly as sales volume increases.  On the downside losses accelerate on slight sales declines.  Danier Leather's sales have been on a decreasing trend for years.  They finally hit the tipping point and revenue declines have finally led to losses.

A retailer can be caught in a vicious cycle where in an effort to increase sales they incur even larger losses with investments in sales and deeper product discounts.  Danier Leather has finally unveiled a way for potential customers to order online.  This is astounding to me, outside of a few luxury brands the inability to purchase something online is a hindrance to the brand.  They touted their online marketplace as a replacement for their phone ordering system.  An order by phone system is reminiscent of the 80s and 90s.  With telephone ordering I wonder who their target market is?

If there was a margin of safety in the shares it has been eroded with the operating losses.  The company's cash pile shrunk with their share buybacks and now the company is in a defensive position.  Their products appear to be out of fashion and they're caught in a deep discount loop.

What's Next?

The biggest question shareholders are asking at this point is what's next for Danier Leather?  If the company can't stop the sales decline this ice cube will melt fast.  Management finally decided to take action and issued a press release stating they are looking at strategic alternatives.  This should be encouraging, with a book value north of $10 per share shareholders stand to benefit if management were to liquidate or sell.  I'm not sure of the likelihood of that happening.  The press release mentioned that management will consider raising debt, issuing equity or selling the company.  I'd presume the strategic alternatives were in the order that management might attempt to act.  They will issue debt first then issue equity and finally when all hope is lost sell or liquidate.

Maybe there is a play here for savvy investors.  I've learned a lot reviewing the company and where they've been the last three years.  I'll end this post the same way I ended the last one.  There still isn't a margin of safety in Danier Leather for me to consider investing, I'll continue to watch from the sidelines.

Disclosure: No position

A market analogy

Have you ever walked through the woods and considered the trees?  I mean really considered the trees, looked deeply at them, thought about them, and pondered them?  I recently spent some time in the woods and the similarities between the woods and the markets were striking.

Forests do not consist of just one type of plant.  There are no forests with only oak trees.  A forest is a complete system of plants and animals that all rely on each other for growth, or shelter or food.

Forests grow in cycles.  What starts out as an empty field eventually harbors saplings that turn into full grown trees.  As trees age they drop seeds that form new trees continuing the cycle.  Not all trees grow to maturity, some become vulnerable to disease, some don't have the right growing conditions, and others are timbered.  A tree might drop thousands of seeds before one takes root and grows into a sapling.

Not every sapling grows into a mature tree.  There are many factors that need to be just right for the tree, the soil, the sunlight, the other trees.

The variety of trees is awe inspiring.  No two trees are identical, they grow subject to their location, the light, the soil, amount of rain.  Some trees grow very tall, others are short and stubby.  Some race straight to the sky not sparing any branches on their trip to the top of the canopy.  Others sit low and flat spreading branches in all possible directions.  Some are gnarled and twisted in their search for light.  A few trees like to grow in the company of others while some are perfectly content to alone be the centerpiece of a field.

A natural disaster can change the course of a forest.  Fire, generally viewed as bad for forests are essential for the boreal forest to regenerate.  The jack pine in the boreal forest drops seeds in pine cones that only germinate in the presence of extremely high heat.  Other forests wither in the face of fire.

It's hard to predict what trees will do well and grow to maturity.  In many cases it's easy to tell which trees will not grow to full maturity.  A poor sapling trying to scratch out an existence in rocky and nutrient poor soil will never grow as tall as a majestic oak planted in fertile soil.  Some trees such as the giant sequoia seem resistant to almost anything nature throws at them.

When I walk through the forest and think about the trees the parallels to the market are unescapable.  All companies start out small, no company is born into existence as a mega-cap.  Even the largest mega-cap grew from a small seed of thought in some entrepreneur's mind.  These seeds turned into small companies over time that grew.  Of all of the small companies only a few become medium sized companies and only a few medium sized companies become large corporations.  The largest companies in the world might be similar to the giant sequoias.  They have grown so large that their size alone becomes an advantage.

A company needs the right conditions to grow from a small company into a larger company.  Sometimes the conditions need to exist inside the company itself, other times the conditional elements are external to the company.  Some companies are in the right place at the right time and they find success.

Companies like trees need time to grow.  Some trees grow extremely fast, but their height is limited.  The largest companies weren't founded recently, they've endured business cycle after business cycle.  Their size and strength is their advantage, but also a weakness.  The largest trees in the forest are susceptible to high winds.  Smaller trees are more flexible whereas large trees don't flex as much due to their size.  In a severe storm the largest trees are at risk for snapping off limbs or falling altogether. In market disruptions some of the largest companies might find a division without a market, or find themselves out of business entirely.

Sometimes investors believe buying small stocks is easier because there are more companies to choose from.  This is like saying it's easy to find which sapling will become a mature tree because there are so many saplings.  Neither is easy and both require expertise about both the tree and the tree's environment.  A company is reliant on their external environment as much as a tree is.  While many managers may not want to admit it a company's success is reliant on external factors, the market, other competition, the management at competitors.

Lastly the market grows and shrinks through cycles like the forest.  At times a market can be thriving and growing like crazy.  Other times it's stable or shrinking.  Extrapolating growth from one period will always result in faulty conclusions.  If the growth rate of young trees were extrapolated we'd have trees that touched space.  A tree's growth rate slows down with age, the same as a company's growth rate.

No one tree can be viewed in isolation, it must be viewed within the context of the forest.  No one company can be viewed in isolation either, the context should always be considered.