Video: Opportunities in Banking; My talk at the Fairfax Shareholder Dinner

I recently had the opportunity to attend and speak at the Fairfax Holdings annual shareholder dinner in Toronto.  What started as a small group of Fairfax shareholders meeting in the back of a restaurant to talk about value investing has grown into a large charity dinner that this year hosted 180 investors and investment professionals.

My talk focused on opportunities in bank investments and specifically highlighted two ideas worth further consideration, Eastern Virginia Bankshares (EVBS), and Fifth Third Bancorp (FITB).

The video is on YouTube and can be watched below.  The slides are a little hard to see in the video so I've included a link to the PDF version below.


Thoughts on risk

I was 12 and the hill looked enormous.  I'd done it in the past with success, so much success that I could almost taste the thrill.  The thrill of riding a bike down a steep hill on a rutty dirt path and then flying through the woods.  The sense of completion from doing something dangerous, and the sensation of my stomach in my throat.  I went first and my friends watched.  Everything started well until my front tire hit a root.  Suddenly I was going faster than my bike, except I forgot to let go of the handlebars.  My bike and I were flying through the air before we finally landed in a jumbled mess on the ground.  The landing left a mark, a scar that took years to fade away.  My friends rode down without issue, they enjoyed the thrill.  At 12 I didn't want to look like a wuss, so I got on my bike and slowly followed through the woods.

The hill wasn't any bigger than it had been in the past, and others navigated it with ease on the day I crashed.  Risk is unfair.  That hill was too risky and I knew it, but I was too young and dumb at the time to not ride.  I took a risk and felt the literal pain of that decision for weeks.  Just because my friends made it down the hill without incident didn't mean the risk was nonexistent.  It just hadn't shown up yet.

The markets are full of risk.  Some might even content that the only thing that matters is risk.  Investors who are riskier earn more, investors who earn less took less risk.  Risk is the storyline academics use to explain market movements.

One thing markets do incredibly well is hide risk.  Millions of investors might buy and sell a company without issue before the company suddenly announces their largest product failed.  If you're the unlucky investor sitting in those shares on that day risk appears in a large way you could face a significant loss.  What was a safe company is suddenly risky with investors running to the exits.  Questions about the company's viability begin to appear.  Investors question themselves on whether they want to continue to hold.

I'm convinced that humans are terrible at assessing risk.  True risk, not the statistical likelihood of failure.  If there is a large enough sample size we can estimate failure.  But even then failure doesn't always happen the same way.  And an exogenous event might increase the failure rate in a way we never understood.

Many investors pride themselves on their ability to predict the future.  I read the recent interview with Stanley Druckenmiller and he calls this one of his greatest assets.  The ability to see a future event clearly and bet the farm on it.  If one has that ability, and judging by his returns he seems to, it would be foolish to not bet the farm.  But not only your farm, the neighbor's farm, the farms of relatives and anyone else's capital you can get a hold of.

I'm terrible at predicting the future.  I can do alright with softball predictions like "more people will use phones in the future compared to now."  But those aren't actionable insights.  Some macro trends are very predictable but impossible to act on.  Like the high school football player trumpeting their success 30 years later I have one prediction I made in college that was 100% spot-on.  I predicted in 2001 that in 10-15 years the internet will fill the air and we'd be able to connect everywhere.  I had imagined some sort of wifi system, but it was the phone system that filled the gap.  I was right, but there was no way to capitalize on it.  Most of the wireless companies at the time are gone now, and the technology has dramatically changed.

While I'm not good at predicting the future I am good at one thing; determining the worst case scenario.  I have a wild imagination and it's not too hard for me to start thinking about driving somewhere for a vacation and end up imagining a collapse of civilization and me sleeping in a tent on the side of the road.

I prefer to view risk in terms of the worst case scenario for a company.  Obviously the survivalist societal breakdown storyline might be entertaining, but it's not a true worst case for investors.  If we are reduced to drinking from streams and eating berries I don't think we'll care much about stocks.

For some companies a worst case scenario is a loss of confidence by their customers.  Business isn't build on the premise of the highest quality item for the lowest price.  It's built on relationships.  A company might work with a higher cost supplier because they like the sales rep, or the supplier is more flexible with some aspect of their process.  Another worse case for a company could be the loss of a critical supplier.  A piece so critical that without it production ceases.

Every business has one or more critical failure points.  Some companies need water, others types of metal, some reliable servers.  The list is endless.

Assessing risk means looking at the worst case scenario and then determining the likelihood that the company can overcome that issue.  If a brewery loses their water supply they can't make beer.  But do they have enough cash that they can pay to have it trucked in for a period?  If they are living paycheck to paycheck the loss of water for a week due to a water main break could be the difference between making interest payments and missing an interest payment.

The riskiest investments are ones where if the worst case scenario were to take place the company could end up in bankruptcy court or in liquidation.  A loss of a critical supplier when no replacement is available, or the loss of consumer confidence due to a fatal error can cripple a company forever.

Companies have the ability to rebound from a variety of problems.  When I was looking at Japanese net-nets there were companies that could last for 20-30 years without another cent of revenue.  Outside of a Japanese Yen devaluation or outright fraud those companies were almost risk-proof.

When looking at risk from a portfolio perspective it's important to dig into the worst case scenario of each holding.  But a potential danger for investors is that they will become too pessimistic and never invest in anything.  I temper my worst case evaluation with my optimistic belief that humans are creative, inventive and resourceful, and when put in a tough situation usually find a way to get out with the least pain.

When considering a new investment I like to think about potential worst case scenarios and their implications for the stock.  Am I comfortable with the downside in each of those scenarios?  If I am and the stock is undervalued then it's very likely I'll buy a position.  Is my risk analysis as precise as mathematical models?  Absolutely not, but I also believe it captures a lot of situations models fail to catch too.  One of the keys to making money in small undervalued stocks is avoiding losses.  While my risk assessment methods might be unorthodox they do seem to work with avoiding losses.

A banking survey of Alaska

What often classifies as an "oddball stock" is simply a company that not many investors have an interest in truly investigating.  Typically these are stocks that are too small for most investors or companies where information is hard to obtain.  Another situation where stocks could be classified as oddballs is when they operate far off the beaten path.  In the US there is one place about as far off the beaten path as possible, Alaska.

Alaska is an enormous state filled with plenty of wildlife, mountains, oil, cold weather and hardy individuals.  The state is more than double the size of Texas.  If the state were a country it would be 33rd in terms of total size, or roughly double the size of Sweden.  The state is disconnected from the rest of the continental US.  An American needs to drive through Canada to access Alaska by land.

The exposure most Americans have to Alaska is a series of shows in the Discovery channel featuring "crazy" individuals who live off the land, drive trucks on ice, or mine for gold.  Alaska in many ways is still considered the frontier and isn't generally thought of as a business destination unless you're working in oil & gas, mining or something related to wildlife.

Even though Alaska isn't  a hot bed of business there are still people who live and work there who need loans and have money to deposit.  In general the state is overlooked, and I imagined their banks would be even more overlooked.  It turns out I was right.

The state has five bank headquartered there and three are publicly traded.  The banks headquartered in Alaska are shown below:

Outside of the five banks headquartered in the state Wells Fargo and KeyBank also branches in the state.  Statewide there are only 130 total bank branches with Wells Fargo claiming the most at 50.  Runner up in the branch count is First National Bank Alaska with 30 braches.  The other six alaskian banks all have 16 or less branches.

The easiest way to look at all of the banks in Alaska is to divide them up between the non-traded and traded banks and look at each.

Traded Banks

Here is a simple comparison showing the historical returns on equity for all three traded Alaskan banks from CompleteBankData.com (Bloomberg Terminal: APPS BANKS <GO>):


Alaska is set apart from the US and their banks appear to be as well.  All three are very healthy and avoided problems during the financial crisis.  Both Northrim and Denali Bancorporation are earning returns on equity above the national average.  All three banks are profitable as well.  And lastly all three have more than 10% equity to assets with low to non-existent non-performing assets.

These are safe and profitable banks.  Is it any surprise that once an investor leaves the mainstream opportunities suddenly present themselves?

Northrim Bancorp (NRIM)

Northrim is a $1.4b bank headquartered in Anchorage, AK founded in 1990.  The bank recently purchase and integrated Alaska Pacific Bankshares (formerly AKPB).

The bank has $966m in loans with the majority of them lent to residential borrowers.  The bank has been profitable since 2003 and sailed through the financial crisis without any issues.  Their Tier 1 capital has remained above 10% since 2004 and non-current loans to loans peaked at 3.66% in 2008.

The bank trades for 1.11x TBV and 12.25 times earnings with a $167m market cap.  Shares are fairly liquid with about 15,000 trading daily.

Our CompleteBankData valuation model (available on the Bloomberg Terminal version) has the bank's estimated intrinsic value at $30.81 compared to the most recent close of $24.44.  The valuation model is shown below:


If Northrim were to be acquired, or to trade in line with the bank index multiples shares should trade higher.  Even without multiple expansion the bank looks attractive.  They are conservative but have been growing steadily over the past decade.  The bank's equity has more than doubled in a decade.

First National Bank Alaska (FBAK)

There is a stigma attached to companies whose stock price is over $100 a share.  An even greater stigma exists for companies with share prices higher than $1,000 per share.  First National Bank Alaska takes it a notch further with their $1,550 share price.

The company is publicly traded, but is closely held.  The bank is the largest of the Alaska banks with $3.3b in assets.  They trade for slightly more than book value and 15x earnings.  The bank has experienced loan and deposit growth in the past three years as shown below (deposits in red, loans in blue):

According to our model the bank is considered fairly valued to slightly overvalued for both our acquisition valuation model and the dividend discount model.  If the bank is valued relative to banking index multiples they are undervalued by 13%.



The advantage that First National Bank Alaska has is that they are the largest bank in the state and they're growing.  Scale in banking matters a lot and First National Bank Alaska has built scale and a brand in their region.  They are consistently growing and pay a nice dividend.  If one wished to have some exposure to Alaska in general a single share of First National Bank Alaska might fit the bill.

Denali Bancorporation (DENI)

Denali Bancorporation is much smaller than the other two, but equally attractive.  The bank trades for slightly more than TBV and 13x earnings.

The bank has $266m in assets and $133m in net loans.  They earned $1.86m this past year, or about $.68 per share.  They have an above average net interest margin and a 16% Tier 1 ratio.

The bank's assets appear to be in check outside of a curious line item in their last two financials.  The bank recorded 44% of 2014 Q3 and 68% of 2014 Q4 US Government guaranteed loans as non-current.  The bank doesn't have any government loans on their books.  This would indicate that the non-current government loans are most likely government backed bonds that have stopped paying interest.

Besides the small size of Denali Bancorporation and their inefficient operations (85% efficiency ratio) there isn't much to not like.  As you can see below they have never earned less than $1.2m in the past 11 years.


The bank has grown strongly over the past decade much like Northrim has.  The bank's size makes it an attractive acquisition target for a larger Alaska bank, or a bank that would like to enter the Alaska market.  Absent an acquisition investors own a nicely growing bank with an attractive dividend yield at 3.45%

Non-traded Banks

The state has two non-traded banks, First Bank, and Mt. McKinley Bank.  Both of these banks are less profitable compared to their public peers.  The reason for the lower profitability is both of these banks are overcapitalized with Mt. McKinley Bank coming in on top with a 39% Tier 1 ratio.

There isn't much to say about either of these banks.  Both are solid performers currently and have been historically.  Neither of these banks lost money during the financial crisis.

Mt McKinley Bank

The bank has $344m in assets and earned a 5.37% return on equity in the last year.  They've remained profitable since their start.  While they've been profitable they haven't experienced much growth.  Their equity has grown from $43m in 2006 to $73m today.  Total loans have fallen from $151m to $130m.  As loans have decreased security holdings have increased.  The bank owned $80m in securities in 2006 and owned $179m in securities at the end of 2014.

First Bank (First Bancorp)

The bank was founded in 1924 and prides itself on being locally owned and operated.  Their branches are located in Ketchikan and around Juneau.

They have $486m in assets and $215m in loans.  First Bank earned 7.34% on their equity.  The difference between Mt. McKinley's ROE and First Bank's ROE is that First Bank only has a 16% Tier 1 ratio compared to the monster 39% Tier 1 ratio that Mt. McKinley Bank has.

The bank could improve their operations some, their efficiency ratio stands at 82%.  Non-current loans to loans are under control at 1.24%.

Summary

A dive into Alaskan banks didn't turn up any banks trading for 25% of book value, which is unfortunate.  But what this exercise did turn up was a set of conservative and growing banks that avoided the housing crisis.  Investors might worry about the energy production drop harming Alaskan banks, or maybe a mining drop.  These are valid concerns, and there will always be dark clouds lurking on any investment horizon.  Alaska is physically separated from the rest of the US and their banks appear to be separated as well.  On a relative basis all are undervalued and all have experienced growth in a flat no growth environment.  Alaskan bank shares might be the perfect investment to make and tuck away in a drawer for a few years.

Want to find more information on how to find and research bank equities on your Bloomberg Terminal with APPS BANKS <GO>?  We recently put together a short video with a walk through and posted it to YouTube here.

Disclosure: Long DENI

Latest interview on Benzinga PreMarket show

This past Friday I had the pleasure of being a guest on the Benzinga PreMarket show again.  I enjoy discussing banks and bank investing with the Benzinga listeners.  A link to the video is below.


I discussed a few items that I intend to post about in-depth in the future.

  • Recently I spent some time reviewing the Q4 numbers for the US banking industry.  Specifically I investigated the narrative that this low rate environment was causing margin compression and making it hard for banks to make money.  What we found was that the majority of US banks have experienced expanding net interest margins over the past year.
  • One area of the banking market I've spent some time looking at recently are the regional banks. These are discussed in the show.  Two regional banks stand out as more attractively valued: FITB and STI.  

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.