Portfolio Strategies: Foreign stocks and low information stocks

Most investors hold the majority of their portfolios in domestic stocks.  This isn't a surprise, investing domestically is familiar, and feels 'safer' than investing abroad.  For investors willing to explore the unfamiliar I believe there are advantages to geographically diversifying a portfolio.

Investing exhibits a strong locality bias.  Investors are more likely to invest in a local company compared to a company located on the other side of the country.  Investors are more likely to invest in a company in the same state rather than one in a different state.  I've met investors who only invest in Pittsburgh companies.  It's not uncommon to find a fund that specializes in a small local sector.

The world is a big place with many different types of people and just as many different types of securities.  In a local market there might be 3-5-15 different companies to choose from, whereas worldwide there are over 60,000 public stocks.  Unless an investor specifically wants to limit their strategy to a narrow geographic niche it's reasonable to assume that globally there would be many more potential investment opportunities.

The difficulty with investing abroad is the difficulty with anything abroad, it's different.  I live in the United States and I've traveled to Canada a number of times.  Canada and the US are extremely similar, they look the same, we speak (almost) the same, our cars are the same etc.  But for all the similarities there are slight differences.  When I visit Canada the differences are noticeable, they are slight, but noticeable.  A related thought is that I'm always amazed at is how culturally united the US is. I can travel to the other side of the country and everyone speaks the same, they have the same stores, and I can navigate without any issues.  Going from Pittsburgh to Salt Lake City is more similar than Pittsburgh to Toronto.

Many of the complaints I hear about foreign stocks could also be made about companies that are low information stocks.  These are companies that are dark whose shareholders need to buy a share then contact management for further information.

There are two objections I commonly hear about foreign stocks and low information stocks.  The first is that it's hard to get information, and the second is how do you know it's true?

The first step is finding stocks to research in a broader manner.  I prefer to create wide screens focused on a single country then go through the screen results one by one.  If a country is small enough I won't use a screen, I'll just look at each stock listed in the country.  An example of a screen I might employ would be all stocks in Germany selling for 1.25x book value or less.  I would then work through the list sequentially.

It's at this point that a little creativity needs to be employed.  I prefer to read an annual report for companies that I invest in, but sometimes they're hard to come by.  Most foreign exchanges have information on listed companies such as summary financial statements and a link to news postings.  Some exchanges have full financials, or links to them.  In other countries it's necessary to find the name of the securities regulator and look up companies through their website.  Here's a little trick, Google the company on the domestic Google, you'll get better results.  For example Googling "Precia" on Google.fr brings back much better results compared to the same search on Google.com.

Fortunately for me as an English speaker, and you as an English reader we have an advantage in the investing world.  Many companies worldwide put their full reports in English, or English updates that provide enough context to muddle through the foreign language annual report.  I've used translation sites with some success as well.  I've found that Romance languages translate into English well, whereas Asian languages do not.  English is a very popular language for business and most large companies accommodate this.  Small companies in smaller markets usually don't publish reports in English, but sometimes they do.  My experience has been the smaller the country the more likely it is for a company to publish reports in English.

The language and understanding barrier is a hard one for most investors to get over.  I want to look at the issue differently.  When investing domestically we read annual reports cover to cover because we can, and because we've been told that we need to know all of that information to make an informed decision.

I want to propose that not all of the information in an annual report is necessary to make a good investment decision.  I'd go a step further and say the amount of information needed to make a decision to invest is directly proportional to the company's valuation.  If my investment thesis is that a company will grow at 15% for the next three years then I need to have channel checks and a lot of supporting information before I feel comfortable with that decision.  If a company is selling for 50% of their net cash and are profitable I just need to ensure I'm not walking into a trap.  I prefer to not buy investments where the outcome of my investment hinges on fine print buried on page 178 of an annual report.

If a company's valuation is low enough, and I can adequately diversify then an investment decision is reduced to defining the thesis and getting enough information to confirm or deny it.  When investing in any lower information stock I think it's worth keeping in mind that there will always be another cheap company.  If there are any unresolved questions, or something that doesn't sit right you should move on without hesitation.  As mentioned above, there are over 60,000 stocks in the world.  If you are going to have a portfolio of 50 names it's likely you'll be able to find 50 stocks that fit your criteria perfectly if you're patient.

My first criteria for a foreign investment is a stable and solid balance sheet.  This is because a strong balance sheet protects me against errors.  If I can buy a company with a net cash position that is generating free cash flow I can afford to be patient and wait for my desired outcome.  A larger gap between fair value and my purchase price gives me room for error.  If I purchase a company at 30% of book value and it turns out it's only worth 60% instead of 100% I will still double my money.  This is an important point, the larger the valuation gap the safer the investment.  This is true as long as the company is operating in a business as usual manner.  A company that was profitable for decades and then lost their biggest client isn't a business as usual investment.

The second criteria for a foreign investment is that it needs to be based on valuation, not a specific event.  In the US it's possible to participate in special situations where the outcome of an event is binary and results in a gain or loss.  Usually these situations require additional research and have the potential to be very profitable.  I won't invest in situations like this in Europe, or abroad.  I want to keep my investments simple.  I am looking for average or above average companies at very low valuations.

One way that I keep myself safe with foreign or low information companies is by buying companies where the owners have a large ownership stake.  Additionally I prefer companies that pay dividends, and especially companies whose owners pay themselves via dividends.  Dividends are more common outside the US.  It isn't hard to meet this criteria.

My process for investing overseas isn't any different from my process investing domestically.  But I've found something interesting.  Earlier this year I looked at my performance from domestic stocks compared to foreign stocks.  I have done much better investing in non-US companies.  I spent a lot of time thinking about this and I believe it can be attributed to the fact that I'm much more selective when investing abroad because I want to ensure a great margin of safety, but also because I'm trying to protect against things I might not know.  In the US I feel more comfortable with companies I research and at times I've been known to take a flyer on a questionable net-net or something else because I feel like I have a good grasp of the situation.  Sometimes these things work out, but sometimes they don't.

A post like this wouldn't be complete without a paragraph on fraud.  My impression is that investors have a universal view of fraud.  That view is that fraud doesn't happen in their own country, but it happens everywhere else.  My own view is that there are fraudulent companies everywhere, nowhere is safe.  Use common sense, if a company appears too good to be true it probably is.  It's not worth spending time on fairy tale companies when there are tens of thousands of other companies to look through.

TTA Holdings, a very cheap Australian net-net

A few years ago I ran a screen for Australia and came back with less than five companies selling below NCAV.  Things change quickly of the 1,905 companies listed in Australia 622 are now trading below 80% of book value.  Of course when that much of the market is selling below book there are bound to be stocks trading below NCAV as well, TTA Holdings (TTA.Australia) is one of them.

TTA Holdings is the Australian subsidiary of TEAC, a Japanese technology company.  TEAC manufactures and sells everything from LED TV's to audio recording equipment to CD-ROM drives. TTA Holdings is the regional distributor of TEAC's products in Australia.

The company fits a common net-net stereotype, a company struggling with revenue declines.  TTA Holdings has seen their revenue shrink from $62m in 2010 to a recent $51m.  As revenue has declined the company's earnings and dividend have fallen as well as seen in the table below:

Even with declining sales and earnings TTA Holdings could be interesting from an investment perspective.  The company has a market cap of $5.8m against a NCAV of $9.8m, and equity of $18m.

From a pure numbers stand point this seems like a decent enough investment.  Buy $9.8m of current assets, and $18m of equity for $5.8m and wait for the company to turn things around.  Management is of course telling investors that they're working to turn things around, although the results tell a different story.

There's a line in the company's annual report and their most recent trading statement that triggered the first red flag for me.  The company attributed losses to incentives offered to dealers to clear out older inventory.  A statement like that seems innocuous, and maybe it is, but I have a reason to believe it's otherwise.

Sometimes with an investment we can gain insight from unusual sources.  In the case of TTA Holdings I have a very close relative who was in sales at a US TEAC subsidiary.  The stories he told were legendary, channel stuffing, tricks to make quarterly numbers, pressure tactics, and others.  If you can imagine a terrible sales tactic they were encouraged to use it.  Not only by the local US branch, but by their Japanese parent.  Their parent company had a culture that cared about the numbers and not much else.  Whereas most investors praise companies that are focused on the numbers it's cultures like this that worry me as an investor.  

What are the incentives offered to customers to clear their old inventory?  Are they simply rebates, or are they more aggressive tactics?  The problem with a company whose sales forces does whatever it takes to get the job done is that they can burn relationships with clients.  A company can get away with this for a while if they're in a market leading position.  Comcast can ignore customers without fear of customer attrition.  If a smaller company ignores or alienates their customers they'll find themselves without any customers.  Reputations travel fast in the business world.

Besides the company's sales tactics there are a few issues with their financial statements that make me hesitant to invest in TTA Holdings.  The first is that the company is deriving a significant amount of their earnings from foreign currency gains.  If one only looks at their bottom line then TTA Holdings earned a profit last year.  But on further inspection they incurred an operating loss and had a currency translation gain for a profit.  Currencies are very volatile and shouldn't be relied on for continued profits.  It's better to invest in a business who can price their products for more than their cost and sell at that price.

The company has also begun to incur debt to fund their operations.  While they had a $464k profit on their income statement they consumed $6.7m according to their cash flow statement.  I don't make a big deal about cash flow on this site because in most cases the companies I look at have cash flow that mirrors earnings.  When those two values diverge it's a warning flag to research further.

In the case of TTA Holdings the company is paying out more to suppliers and employees than they're bringing in from receipts.  They're funding the shortfall with short term debt to the tune of $7m.  The bank borrowing is due in less than a year, which indicates the company expects things to turn around quickly from a cash flow perspective.

Unfortunately their latest press release is more bad news.  In the first four months of the latest year the company lost $3.2m that they again attribute to inventory issues.  The press release didn't include financial information but with a loss this size it's possible much of the margin of safety provided by the company's assets has been eroded.

While the company initially appeared cheap after a much closer inspection the investment case began to fall apart.  In the most recent annual meeting transcript for FRMO Murray Stahl has an insightful point.  He said if a fund manager were tracking the S&P and wanted to outperform instead of looking for stocks that would do better they should purchase the index and not invest in the worst constitution.  Buying 499 S&P companies and avoiding the worst would result in the index being beat.

Many times investors are so blinded to potential gains that they forget to look at what could be lost.  When I looked at TTA Holdings I see a very cheap company at a low valuation.  But I also see a situation where the potential for a loss is very significant, potentially greater than the potential for a gain.  This stock could shoot higher, but if I think of Stahl's statement I merely need to avoid the losers to do well.

Disclosure: No position

Free Value Investing Seminar this Saturday

I often get asked how I find the types of stocks I find, or what my research process is.  I've shared bits and pieces on the blog, but never my full process from start to finish.  This weekend on Saturday the 11th I'm going to be participating in a value investing strategies webinar where I will be walking through my investment process from start to finish.

I'm going to show how I look for unlisted stocks, and what makes a good investment verses what should be avoided.  I'll be sharing examples of investments that haven't been mentioned publicly on this blog.

I will also be walking attendees through my bank investing process.  Again I will be sharing a few banks that I find unusually attractive.

This seminar is free to attend and all attendees will get a full recording of the event.  I will be taking questions during my session, if you have ever had a question on my investment process this could be the time to ask.

The seminar starts at 11am on Saturday October 11th.  I will be presenting from 11am-12pm.  The speaker lineup is excellent with Toby Carlisle, Dave Waters, Tim Melvin, and Kristin Bentz also presenting.

Portfolio Strategies: Growth Investing and Wonderful Businesses

Everyone is special these days.  Everyone a winner, children's soccer teams don't even keep score anymore.  Likewise it seems that most value investors have convinced themselves that everything they invest in is a 'wonderful business' (a growing company with a sustainable advantage).  And of course Warren Buffett prefers these wonderful businesses himself, so why shouldn't everyone else?  How does a business become wonderful?  In Buffett's case a wonderful business is self-referencing.  But how do the rest of us find these mythical high growth companies that will generate fabulous shareholder returns for years?

Many investors think of growth in terms of high returns on invested capital (ROIC), or high returns on equity (ROE).  The problem is both of those figures are backwards looking.  An ROE metric, or ROIC metric will tell you what a company did in the past, not what they'll do in the future.  ROE's are not predictive, think of a pager company in the late 1990s.  They were posting fantastic ROEs, now their products are being sold in slummy parts of town next to check cashing stores.  A more contemporary example is Blackberry.  A company who posted excellent results year after year, but those results didn't predict the quagmire they're in now as their products fell out of favor.

In some ways it's simple to discover if a business will be successful.  Successful businesses offer products and solutions to clients that provide clients more value compared to the value they give up to purchase the product.  If that last sentence confuses you re-read it and think it through.  A buyer gives up something of value (often money) to purchase something of greater perceived value.  This is the essence of a sale.  If a buyer doesn't perceive value from a product or service greater than what they're giving up they won't purchase, no matter how many steak dinners a salesperson takes them to, or how cool the commercials for the product are.

The first step to finding a growth company is finding a company with a product that satisfies an essential need.  This sounds easier than it is.  There are many products that seem essential, which under the magnifying glass are just 'nice to haves'.  Consider the context of the product.  Users don't need a Macbook to exist, but a graphic design studio might not survive without one.  Often the most successful products fill very specific needs, that if left unfilled would leave the purchaser in a very vulnerable position.

It's easy to see how a company selling products to another business fills this role  Think about a company selling conveyor belts in an assembly plant.  Conveyor belts seem like a commodity item, yet to the purchaser without them their assembly plant would be at a standstill.  They need conveyor belts that are so reliable that they don't need to think about them.  The best products are ones whose users never think of them when they're working well.  The worst products are ones where users are constantly thinking about them.

Maybe it's hard to see where a consumer product fits into this mix.  Why does a person need Under Armor, or Starbucks?  The answer to this is found in Ca$hvertising (I'm currently reading it, and so far would recommend it to those interested in marketing).  The author states that there are eight life forces that we are biologically programmed with the desire to satisfy.  These forces are: survival and enjoyment of life, enjoyment of food and beverages, freedom from fear, pain and danger, sexual companionship, comfortable living conditions, to be superior and win, care and protection of loved ones, and social approval.  Products that serve these life forces satisfy a consumer's biological desire. Consider Starbucks, they fit enjoyment of food, and social approval, two life forces.  Under Armor fits comfortable living conditions and survival, we need clothes to protect us from the elements.

Create a product that meets a life force, effectively make potential customers aware of the product and a company has a success on their hands.

Creating awareness and product marketing is often misunderstood.  Posting quotes on Twitter, or creative ads isn't great marketing.  Marketing is using a medium to sell a product.  As Claude Hopkins said in Scientific Advertising (the Security Analysis of marketing):
"The only purpose of advertising is to make sales.  It is profitable or unprofitable according to its actual sales.  It is not for general effect.  It is not to keep your name before the people... Treat it like a salesman.  Force it to justify itself.  Compare it to other salesmen.  Figure its cost and result."  
Marketing is a different type of sales.  Marketing that can sell products is powerful and valuable.  A great example of this type of marketing is Proctor and Gamble.  They product a variety of products, each is too small for a salesperson to sell to the end consumer.  So the company sells through their marketing.  They treat marketing like a science.  They sell to consumers through their ads in magazines, on the radio and on TV.

For a company to develop the correct product, target its market, and then market and sell effectively takes the correct set of people.  A successful company needs capable management that listens to their employees.  Take this quote from the creator of Crystal Pepsi for example:
"It was a tremendous learning experience. I still think it's the best idea I ever had, and the worst executed. A lot of times as a leader you think, "They don't get it; they don't see my vision." People were saying we should stop and address some issues along the way, and they were right. It would have been nice if I'd made sure the product tasted good. Once you have a great idea and you blow it, you don't get a chance to resurrect it."  
The executive thought the idea was brilliant and charged forward without stopping to consider if the drink ever even tasted good.  The executives reports were telling him to stop and reconsider, he didn't listen, he just marched forward.  As a result Crystal Pepsi was a failure, something that many in the company knew before it launched.

The last ingredient a company needs for growth is a large addressable market.  A company selling barber shop poles is going to struggle to grow as there are only so many barbers, and the number is shrinking.  A growth company needs to be in a growth industry.  There are plenty of niche profits in servicing obsolete markets, but these are long tail declining profits.  Growing profits come from growing markets.

If we put it all together the ingredients for success for a growth company are: product that serves a vital need, excellent marketing and sales, and employees/management that can pull all aspects together.  A company needs all of these elements to become a successful growth company.  It's like a three legged stool, if any leg is missing the stool falls over.

The difficulty a public market investor faces is that much of the vital information needed to make a decision about growth companies isn't in a 10-K or 10-Q.  So how does one go about finding these companies?  Get out and talk!  The best place to start is a company with high margins, and revenue growth.  Spend time talking to the company's customers.  Ask why they purchase from the company under investigation verses a competitor.  Talk to suppliers and former employees.  Then finally talk to management.  Understand where they see the future and how the company plans on getting there.  Good management is key to navigating a company through growth.  Companies hit plateau's that need to be carefully approached.  Often the best leader is one who's been through growth challenges in the past.  A good leader is also one who is willing to listen.  A know-it-all executive is a red flag.

If a company has a great product, and a way to get it to the market then it's the people that make or break the company's success.  Great people will take a great product a very long way.  Lousy people will find a way to destroy products with incredible potential.

Maybe all of this sounds very hard, and like a lot of work.  That's because it is.  The rewards of investing in a growing company compensate for the work required.  It's not uncommon for a growing company to rise 5x, 10x or more over a number of years.  Likewise a growth hopeful won't just sit flat, it'll fall like a rock if expected growth isn't achieved.

In my view growth investing is best left to professionals and individuals who have a lot of time on their hands to do intense feet on the ground research.  Finding good growing companies is a lot of hard work, but hard work alone doesn't ensure success.

One problem with finding growing companies is that there aren't many of them.  There are a lot of companies that are growing, but not a lot of companies that have all of the attributes necessary to take their business from $10m a year to $500m a year.  Most growing companies will stall out, or will encounter culture problems as they hit certain levels.  Very few companies that look good remain that way for decades, or even years.  A big risk with investing in growing companies is paying a growth price for a company whose growth isn't sustainable.

Finding good growing companies that are wonderful businesses is difficult.  You might be wondering if there's an easier strategy?  There is a much simpler way to invest in growth businesses, but the simplicity eliminates a lot of the outsized returns associated with this strategy.  The simple way is to buy the leading company in a growth industry during a temporary downturn.  When industries go through crises it's usually the top company in the industry that comes out stronger.  The top company in an industry is often the most efficient and growing the fastest.  There is a reason they are at the top of their industry.  Buying during a market dip ensures an investor doesn't overpay for this marque company.  While this approach might beat the market, it pales in comparison to the returns of the investor who can correctly identify great growing companies.

Interview on the Benzinga PreMarket show

I was asked to be a guest on the Benzinga PreMarket show again, to which I happily agreed.  You can find my segment below.  I discussed the Citizens Bank (CFG) IPO, along with merger activity in small banks, and a European bank idea.


Portfolio Strategies: Liquidity

Liquidity for most investors can be measured in seconds, the amount of time it takes to open a portfolio and click 'sell'.  The speed at which investors can change their minds has created a distorted environment where frantic buying and selling is the norm, and patience is old fashioned.

I want to examine what liquidity is, why you need it, and also reframe the discussion.  I think sometimes discussions about liquidity are really discussions about symptoms, not the root cause.

What is liquidity?  Liquidity is a measure that represents the ease at which something can be bought or sold in a market.

Almost all purchase or sale decisions outside the stock market involve friction in both buying and selling.  Almost everything anyone buys is illiquid, yet this doesn't seem to bother consumers.  For example consider a house purchase.  A family decides they want a new house, they hire a realtor, tour houses and eventually find one they like.  Then they place an offer and haggle back and forth with the seller.  Once an agreement is reached financing needs to be arranged, documents need to be signed and a closing date is set.  Often the closing date is a month or more in the future.  If the buyers move in and decide they don't like the neighborhood they have to endure the same lengthly sales process they just went through before they can be rid of their purchase.

Consider another example of a smaller purchase, a dress shirt.  To purchase a dress shirt you need to drive to the store, pick it out, then stand in line to purchase it.  If you get home and decide you don't like it you need to make another trip to the store, stand in line again, and conduct the return.

Anything that's purchased out in the 'real world' involves friction in both buying and selling.  Once something is purchased there's a hassle factor to returning the item and receiving your money back.  I can't think of any purchases where one can buy something, immediately change their mind and within a few seconds have reversed the entire transaction.  It's fair to say that illiquidity is part of any transaction when something is purchased.

Even cash, the golden standard of liquidity, is sometimes illiquid.  When someone wants to move cash from a savings account to a checking account it takes three days for the money to post.  Say the person changes their mind on the transaction and wants the money back in their savings account, another three days to transfer back.  A full six days for cash to make a round trip between one account to another.

When consumers understand that a transaction has considerable friction or is hard to reverse they spend a lot of time up front to ensure they're making the right decision.  I've heard people joke that many investors will spend dozens of hours researching which washing machine to buy and then spend 15m researching a stock purchase.  On the face of it this is absurd, an investment is many times the value of the washing machine, so why the time differential?  It's because the cost of making the wrong decision on the washing machine is much greater than the cost of making a poor investment decision.  If one purchases the wrong washing machine it's not an easy task to return it.  Whereas if the investment purchase is wrong it's just a few mouse clicks from a sale.

When an investor is considering either an extremely large purchase of a business, or purchasing a private business they spend a lot of time researching their decision.  Large minority, or majority investors don't have the luxury of selling off their position anytime they want.  Their sale could be interpreted as a signal to the market with the share price negatively reflecting this information.  An investor buying a stake in a private business has to consider their decision carefully because they can't easily reverse it either.

Larger holders, and private company investors also have different investment objectives compared to the majority of private market buyers.  They aren't looking to flip their shares quickly for a small gain, rather they're in the investment for the long term.  They are looking for capital appreciation, or for the company to return a portion of their profits to them as dividends.

Dividends are under-rated, they provide liquidity in even the most illiquid situations.  If a company is profitable and investors are paid out a portion of earnings as a dividend not many investors can be found complaining about the inability to sell shares.  In fact the opposite is true.  I know of a number of very illiquid unlisted stocks paying very high dividends and it's impossible to buy shares because no current holders are willing to sell!

The drive to own a liquid stock stems from two underlying reasons, the near term need for the cash, and for the optionality to change ones mind quickly after a purchase has been made.

In order to purchase more illiquid assets a strategy needs to be put in place.  Here is how I structure my portfolio in a manner that allows me to own very illiquid assets.  Money I need for near term events, which I define as five years or less I hold in a savings account.  I never invest this money, and my liquidity on it is three days.  Beyond my initial cash I own a number of stocks that are either very liquid, or moderately liquid.  A moderately liquid stock is one where I could sell out of my position in a day or two, a very liquid one is where I could sell out of my position instantly.

The bulk of my portfolio consists of moderately liquid holdings.  Some of these holdings pay dividends, but not all do.  If the market provides an opportunity for an exit then I'm willing to forgo a dividend, although I prefer one if possible.

The last portion of my portfolio I invest in illiquid stocks.  I view these in the same way I'd view purchasing a stake in a local business.  I expect to be in these holdings for a very long time.  Because of the time commitment I will only invest when these stocks trade at a significant discount, and I always want them to pay me a dividend.  I have made one exception to the dividend rule, it was for a stock trading at 10-15% of BV and a few times earnings.

When I first realized the potential to dedicating a portion of my assets to illiquid securities I came across an article with a quote from Jack Norberg, the unlisted stock king.  He suggested to the journalist that no more than 15-20% of one's portfolio be dedicated to illiquid securities.  This seems like an accurate number to me as well, I personally have 18% of my portfolio in illiquid securities.

One question I haven't addressed that some readers might be asking is "what's the point of buying any illiquid stocks at all?"  Let me answer the question this way.  If a local businessperson approached you with the opportunity to buy shares in their successful business for 4x earnings and at 50% of book value that paid a 10% dividend would you consider that investment?  I think many investors would, and investors don't need to find local businesses to invest in.  There are many opportunities like that in the current market place found in stocks that don't attract a quote daily (or at times weekly).  Its in these stocks that some of the most incredible bargains can be found.

Reliance Bancshares, a turnaround that's actually turned around

A big secret in investing is that turnarounds usually don’t turn around.  Companies in the midst of a seismic business change often don’t make it through to the other side.  The reasons for this are numerous but one of the most important factors is management.  The management of a company that falls into a mess is usually the wrong team to get a company out of a messy situation.

At times a company might realize that they are outside of their capacity regarding a turnaround and they bring in outside management.  It’s in situations like this where things get very interesting, such as with Reliance Bancshares.

Reliance Bancshares (RLBS) is a holding company for Reliance Bank located in St. Louis, Missouri with two branches in Ft Meyers, Florida.  They have a market cap of $154m, and have slightly over $1b in assets.

The financial crisis was not kind to Reliance Bancshares, the company’s results from 2009-2011 were horrible.  The bank lost $21m, $31m, and $29m in 2009, 2010 and 2011 respectively.  Non-current loans to loans rose from a pre-crisis .81% to a high of 15.33% in 2010.  In 2011 they charged off 3.5% of their loans as they worked to clear out their troubled loan book.

As a result of their operational problems the bank was given a Cease and Desist order from the Office of Thrift Supervision (OTS), and later a Consent Order by the FDIC, the successor to the OTS.  The orders directed the bank to cease dividend payments, cease share buybacks and improve their capital position.

The bank's management at the time realized that they were out of their element and brought in an outside banking consultant.  The consultant was Thomas Brouster, a banking entrepreneur who had previously turned around 14 banks.  The company's management eventually promoted Brouster to the position of CEO.

The Consent Order from the FDIC directed the bank to raise capital, which they did.  They raised $31m in an equity offering led by Brouster.  Brouster came away with a majority ownership position in the bank, and the bank ended up with $24m in capital, raising their Tier 1 ratio above 10%.  The rest of the capital was held at the holding company.

Brouster did what he was known to do, he stemmed losses at the bank and returned it to profitability.  He did this by reducing costs, lowering deposit costs and growing the bank's loan book.

The biggest drag on the bank's earnings has been their cost of deposits, the picture below show how much they were paying historically:



In 2010 the bank was paying 1.84% for their funding, a value that's dropped to .77% in the most recent quarter.  High funding like this is a sign of a bank that uses costly brokered deposits.  Reliance Bancshares was a pig at the trough with hot money going into the financial crisis.  In 2008 they had $168m in brokered deposits and $808m in time deposits.  As of the most recent quarter the bank has $8m in brokered deposits and $324m in time deposits.

Fast forward to the most recent quarter, the bank earned $2.08m pre-tax and $38m in net income.  A difference like this merits further investigation.  Their large one time gain was a result of a reversal of a valuation reserve against their deferred tax asset.  As banks generate losses they book those losses into something called a deferred tax asset to be used at a future point to offset future gains.  If it seems unlikely that a bank will be able to utilize this asset the auditors require the bank mark down this asset.  The reversed valuation allowance amounted to $36m.

Along with expense reductions, and lowered deposit costs Brouster has also been at work growing the bank.  In the second quarter loans grew 11%, and deposits grew 2.4%.  Additionally the bank's non performing assets have continued to drop, and they've now had 28 months without a loan more than 30 days past due.

Reliance Bank is not only working on expanding their loan book, they're expanding their physical presence too.  They recently closed on a piece of property in St. Louis proper, and are working on constructing another branch in the St. Louis suburbs.  Both of these branches should result in increased deposits and lending.

The bank is clearly on the mend, they earned more this past quarter verses all of last year.  If they can continue to decrease expenses and lower their deposit cost earnings will grow, even without loan growth.

The obvious question is what is this bank worth?  That's where things get interesting.  The bank isn't cheap on any classic valuation metrics.  Their book value is $1.78 per share, and tangible book value is $1.22 per share.  This past quarter they earned $.02 per share.  Let's assume they can earn a similar amount over a year for $.08, they'd be trading with a P/E of 25.

A better way to model the bank is to look at what their ultimate earning potential is given their assets and work from there.  If the bank can continue to reduce their expenses and deposit cost maybe they can earn 1% on their assets.  Under that scenario they'd be earning $10m per year, or $.13 per share.  A 10% reduction in expenses could lead to $2.1m in savings, a 25% reduction in expenses could lead to another $5m in savings.  With the bank's substantial tax loss carry-forwards these savings would fall straight to the bottom line.

It's possible the bank will grow into their valuation.  Maybe they can dramatically reduce expenses beyond my 10% estimate as well as increase lending with their new branches.  Regardless, Reliance Bancshares isn't a typical value investment, but I can imagine a number of scenarios where if this bank can execute on their growth plans that one might consider this price cheap.

In the end this isn't an investment for me, but I'm sure this is something a few readers will be able to benefit from.

Disclosure: No position