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.

Thinking vs doing

It's not often that one sees a limo for sale, especially on someone's front lawn with a price tag of $2,500.  The limo wasn't new, it was a late 1980s model, but it was still a limo.  I used to drive past that limo weekly when I was in college.  I was intrigued, I had the money to buy it, and there were so many things I could do with a limo.  Eventually my daydreaming led me to what I thought was a brilliant idea.  I would buy the limo and start a late night taxi service.  Who wouldn't want to be picked up in a limo after a night in the bars and taken home in luxury?  I thought the idea was great, my friends thought it was great, everyone thought I was onto something.  The problem is I never bought the limo, I just talked about it.  Eventually the limo was sold and the dream died.

Everyone has ideas.  Almost everyone has a few innovative ideas.  Many have completely unique ideas.  Very few act on any of their ideas.  Most ideas are like my limo, they sound great, friends love them but they never move beyond a daydream.

I'm the firstborn of my brothers and I tend to be a perfectionist, or at least I desire perfection.  It's a firstborn trait (all firstborns are nodding in agreement right now.)  The problem is perfection can never be achieved.  My usual course of action would be to come up with an idea and then start to think about the implementation.  I either would get lost in the details or I'd begin to work on it and would stop when I realized I couldn't complete it perfectly.  My perfectionism was holding me back.

The problem is I'd never start on anything, or if I started I couldn't complete anything.  I had dozens of half started projects laying around to never be completed.  I could come up with incredible ideas, but execution and follow through were nonexistent.

Many of you are probably living the experience I did for years.  You have great ideas and poor execution.  Maybe you start to never finish, or you finish and are so disappointed with the results you never try again.

So what was my breakthrough?  There wasn't one specific moment in time, but a variety of small experiences.  The first was writing this blog.  I could take an investment idea, detail it for the future and act on it.  Each time I wrote up a company I took action on an idea.  Having written out my thoughts helped me take action and invest as well.

The bigger breakthrough was a home improvement project I undertook in 2011.  The basement was authentic to the 1940s, cinderblock walls and a cold uneven cement floor.  We decided we'd like a little more space and because I hate paying for things I can do myself I decided to build the basement myself.  Over the course of six months working an two to three hours at night after my wife and son went to bed I finished the basement into a very usable space.  I put up a ceiling, walls, wired outlets, lights, everything.  Complicating the project is the basement floor isn't flat, every 2x4 in the room  had to be custom measured and cut.  But slowly, night by night I made progress.  Some nights it was hard to tell I did anything.  Other nights I'd finish a wall or hit a significant milestone.  But regardless I kept pushing forward.  I created a habit by working on the project consistently, and completed the basement.

There were times during the build that I doubted what I was doing and worried about getting things just right.  But I kept reassuring myself that with construction any mistakes could be fixed.  Either by repairing, or destroying and rebuilding again.  Thankfully I didn't have to make any major changes, but just knowing in the back of my mind I could if I needed to helped me push forward and finish.

Finishing the basement gave me continued motivation to write on this blog, and start a business.  CompleteBankData started out as a germ of an idea, and through a continued habit of slow consistent work we produced a completed tool.  This past year I launched the Oddball Stocks Newsletter and built a new yet to be released iteration of CompleteBankData.  All of these projects loomed large and seemed impossible before they were started.  But by taking them a small step at a time I was able to accomplish things I never thought possible a few years ago.

By taking consistent steps forward towards a goal I was able to break through the fear of not finishing.  I'd like to think I've finally moved from never finishing to always finishing.

No matter what the task there is always ambiguity.  We never know ahead of time how things will work out.  But the only way to find out is to give it a try and move forward.  In trying new things we learn a lot about ourselves.  Over the past four years I've discovered strengths I never knew I had as well as discovered some areas where I need improvement.

There is probably an area in your life where you keep thinking about taking action but haven't yet.  Maybe it's fear of the unknown, or fear of not knowing all the details, or fear of not finishing.  Maybe it's time to stop researching an investment and finally invest.  Or maybe it's time to stop thinking about a new job and go find one.  Or time to start a business you've been thinking about for years.  I don't know what it is for you.  I know for myself I have an exciting set of projects that I'd like to complete in 2015.  I don't know how many will be successful, but I do know that everything I start I'll finish.

It's time to go out and get started...

HMG/Courtland Properties, a pile of cash, securities, and real estate for 52% of book value

All value investors are supposedly looking for the proverbial dollar trading for fifty cents.  How one defines a dollar and fifty cents differs greatly, but in theory we're all looking for the same thing, a discount.

Investing in assets at a discount is akin to swimming in the baby pool of investing.  An investor identifies an asset, determines their value, invests at a discount and waits patiently.  You don't need to be an professional swimmer to be in the baby pool, and you don't need to be a professional investor to invest in asset mis-valuations.  Asset mis-valuations are simple to analyze and if an investor is correct with their valuation and buys at a discount they will do well given time.

Even though some investors are satisfied to spend their whole career investing in simple investments most aren't.  Professional investors don't want to stagnate, they challenge themselves to learn new industries and more advanced analytic techniques.  Retail investors tend to mimic professionals.  If professionals are investing in distressed debt, free cash flow yielders and companies with moats then when professionals talk about investing they'll discuss these types of investments leading retail investors to believe this is the only way to invest.

In many ways it's a shame that investors neglect simple and easy investments to chase the complicated and popular investments that are all over the financial media.  The company in this post is neither complicated or exciting, but it could offer investors an attractive return.

HMG/Courtland Properties (HMG.NYSE) is a publicly traded REIT.  The company consists of cash, investment securities, and various investment interests in real estate ventures.  Most importantly they have a market cap of $12m against a book value of $23m.  The company trades for 52% of book value.

The company doesn't have much in the way of earnings.  They have a very small stream of revenue related to an office building they own.  Their other income consists of gains from marketable securities, dividends from those same securities, and income from other real estate ventures.  Whereas income is volatile their expenses are not.  The REIT pays an advisor to 'manage' the investments, they also pay directors lavishly and have other real estate related operating expenses.  For being such a simple operation their expenses are not all that low.

What an investor is purchasing when they buy HMG/Courtland is essentially a managed real estate fund at a discount.  The key to an investment is the quality of the assets being purchased.

Starting from the company's most liquid asset to least they have $6.5m in cash and $11.6m in marketable securities.  The marketable securities consist of traded REIT stocks and traded REIT preferred shares.  No single REIT position is larger than $400k.  This means the company's portfolio owns about 28 individual positions.

The company also has a direct ownership interest in an office building worth $797k that generates roughly $85k in rental income.  Besides their office building they own stakes in various partnerships, affiliates and a note receivable.

In terms of liabilities HMG/Courtland Properties owes $2.4m to an affiliate and has $200k in accounts payable.  The market is valuing the company for $3m less than net cash and investments.  At this level an investor gets an office building and the investments in private real estate development for free.

The problem with the investment is that their operating income doesn't cover their operating expenses.  The company is reliant on gains from marketable securities, dividends from securities and dividends from joint ventures to meet expenses.  If any of those income sources drops for a period of time the company will be operating at a loss and be reliant on using their cash and securities to operate.  When companies survive off of their assets for an extended period of time the investment is affectionately known as a melting ice cube.  In a situation like this an investor is making a bet against time.  The bet being that the market will value the company higher before the company's asset value erodes to market value.

An investor's best bet at outrunning the melting ice cube scenario is the HMG/Courtland's investment into new real estate development.  At present the company has agreed to commit $1.8m for a one third ownership interest in a new joint venture.  The joint venture plans to build and develop 250 condos on 9.5 acres in the Orlando, FL area.  Each partner in the project will contribute $1.8m and the entity plans to raise an additional $27m in financing to complete the development.  When completed HMG/Courtland will either receive dividends as a result of rental income, or sell their stake.

The company has had success in the past developing properties and then selling them.  In 2013 they sold their interest in Grove Isle Yacht Club for $24.4m for a gain of $19m.  If they are able to do it again their investment in Florida condos might turn out to be just as lucrative.

An investment in HMG/Courtland is a bet on their ability to turn their real estate investment interests into considerable gains.  If they don't an investor is well protected by the company's cash and securities.  The big question is whether management can turn the condos into cash before they burn through their assets.

Disclosure: No position


Solitron and mis-management shenanigans

When you were a kid what would happen when your parent asked you to do something reasonable and instead of obeying you looked them in the eyes and said "No, you're worthless, I'm not listening to you, I'm doing my own thing"?  Maybe yelled at, scolded, spanked, or for the younger set given a 'time-out' or told to sit in a 'naughty seat'.  Those are expected outcomes.  Across societies respecting elders and parents is expected behavior.  Unfortunately in the real world when the elder is a shareholder, the legal owner of the company, management suddenly loses respect.

I've discussed Solitron Devices (SODI) at length on this blog in the past.  A Google search reveals 101 references, see here for yourself.  The back of the napkin summary is they are a small electronics manufacturing company selling at a discount to almost anything with stubborn management.  I first discovered them as a net-net.  I ended up getting somewhat engaged with the company talking to management and trying to convince them to pay a dividend.  I also helped rally shareholders into forcing the company to hold a legally required annual meeting in 2013.

Solitron is like many public companies, they have a very valuable asset and then something either masking it or blocking that asset from realizing its full potential.  Solitron has a slightly valuable operating business and a pile of cash stuffed into Treasury notes.  The company could easily pay out the majority of their market cap as a dividend without having any effect on their day-to-day operations.  Yet the company won't.

Even though shareholders legally own a company there is a problem in America with publicly held companies.  Common men and women when promoted to the highest office of a company suddenly forget shareholders exist and start to believe the company is theirs.  Just because someone holds a given title doesn't mean they can usurp the legal rights of shareholders.

Tim Eriksen of Eriksen Capital Management wrote a letter to Solitron management that was filed with the SEC today.  The letter summarizes how many shareholders feel.  Shareholders voted out directors only to see company management reinstate them.  The directors that shareholders (the owners) deemed unsatisfactory by a large margin are somehow acceptable to management.  To me this speaks volumes about the quality of Solitron's management.  The truth is Solitron doesn't really have management in a plural term, they have a sort of dictator leader named Shevach Saraf.  He claims almost all important titles to himself and appears to be a one man show running the place.  It's Saraf's way or the highway.

I am clearly frustrated with the company and in some ways disgusted.  The fact that Saraf has the audacity to completely ignore shareholders shows his opinion of us.  What Saraf doesn't realize is that while he's a kid bragging about the size of his castle on shareholder beach the shareholders are the ones with the bulldozer.  And it's time to fire that thing up and use it.

In the past I've advocated voting out Board members but keeping Saraf.  I'm changing my position, Saraf needs to go.  He needs to go peacefully or forcefully.  He only owns 30% of the company, and most of the other 70% is well represented among my readers.  It's time to vote him out and when he fails to leave force him out through the courts if necessary.

If shareholders acted as childishly as Saraf we'd be booking flights to Florida to TP and egg the company's headquarters.  But shareholders are respectful, unlike Saraf.  We've tried to assert our control through legal means only to be ignored.  I think it's time to step up the pressure.

I want to end this post with some quotes from Tim's letter to the company:

"As a reminder, the company had improperly, and as far as I can tell illegally, neglected to hold an annual meeting for over ten years. Finally a shareholder filed suit, which led to the board holding an annual meeting in 2013. At that meeting, shareholders rejected two of the company’s four board nominees. Management responded by reappointing one of those nominees anyway. At the 2014 annual meeting, shareholders rejected the board’s sole nominee. How often does a board lose uncontested elections? After the 2014 meeting some of Solitron’s larger shareholders reached out to the company and submitted potential candidates. The board ignored them all."

"To add further insult to injury, on November 26, 2014 CEO/President/CFO/Treasurer/Board Chairman Shevach Saraf certified an inaccurate filing with OTC Markets. In that filing he neglected to include Eriksen Capital Management among the list of 5% shareholders. Eriksen Capital Management had filed a 13D with the SEC more than three months prior, on August 7, 2014. How was Mr. Saraf unaware of who the owners of the company were? It takes less than a minute to find the information on the SEC Edgar website."

"What is obvious is that there is a board problem and a management problem at Solitron. Instead of using your time and energy to try and entrench yourself, we think management and the Board should meet with large shareholders and work to improve the company’s future. To that end we intend to submit proposals for the 2015 annual meeting to:

1. approve an amendment to declassify the board of directors, 
2. to nominate two directors in opposition to Solitron’s two nominees, 
3. to increase the board size to seven directors, 
4. to elect additional directors to fill the newly created directorships, and 
5. to repeal any and all changes to the bylaws subsequent to the date of this letter, up through the time of the annual meeting."

Disclosure: Long SODI

Investing consistency

I enjoy running, maybe something inside me is mis-wired, but I truly enjoy running outside, even in the cold.  I'm competitive and enjoy pushing myself and will occasionally entering a race.  It's fun to compete in a race and try to set a personal best.  I've had races where my times were abnormally good.  Everything was perfect that day, the weather was crisp, the course flat, competition a good match, and I was feeling good.  The race went perfectly and I achieved a time that was unrepeatable, at least until events line up perfectly again.  If you race enough you'll have more than one perfect day, maybe a handful, maybe a few dozen.

Anytime I ran a perfect race I knew it.  I could feel that what I had just accomplished was unlikely to be repeated soon.  I would enjoy my personal best, but in my mind it was always hedged with the thought that I couldn't really do it again, or maybe I didn't quite earn it.

In running like most sports the path to success is consistent practice over a period of time.  You don't train for a race by running haphazard varying speeds during practice.  You build up both time and distance with practice.  Consistently hitting goals in practice results in predictable race times.  If I could run five or six miles daily at a seven minute a mile pace I knew I could run a 5k at a 6-6:30 pace (note I said above I like to run, not that I'm fast.)  My race outcomes were predictable because I had a repeatable practice process, and in practice I ran consistently.

When I think of investment returns the parallel to my running experience comes to mind.  It's possible to have a few fluke races (abnormal years), but if you don't have a consistent process or a repeatable process you won't have any assurance that you'll consistently outperform the market.

Wall Street loves high flying managers and highly successful individual investors.  The financial media complex loves volatility.  A manager who beats the market by 30% one year then trails by 10% sells lots of articles.  Investors love these stories too.  They either evoke envy and a desire to do better, or feeling of accomplishment for not doing as poorly.  The problem is that as investors constantly read read articles like this they begin to think this is what normal investing looks like.  A few great years followed by a minor blow up with a spectacular recovery and then another year or two of underperformance for a record that barely beats the benchmark.  A strategy like this will get you on the front cover of magazines, but it won't build wealth over the long term without either a lot of antacid, or resilience.

I sometimes wonder about Bernie Madoff's investors.  Madoff's ploy was brilliant, a fund that returns 12% annually forever.  A lot of investors, especially recently would scoffing at Madoff's measly 12%.  But this was 12% forever without down years compounding into eternity.  Of course it was a fraud, but the return is what fascinates me.  I'd think it'd be easier to deceive investors by having a few big up years followed by a down year that gives the paper gains and more back.  That way you could just adjust performance for how much investor money remains after most of it is spent.  Yet that's not how it worked.  Madoff's investors were usually successful individuals who understood the magic of compounding.  To these investors consistent results were highly valued, valued above any other strategy.

One of the secrets of investing is that avoiding losses and slightly above average returns beats a volatile return profile with both high highs and low lows.  I consider this a secret because most investors forget the market can fall fast.  The majority of the time stocks are in a bull market with brief downturns, but if one isn't prepared a downturn can take away years of gains or more.

Over the past two years I've heard a number of investors say they are searching for stocks that double or triple in three years.  I believe this was first popularized by Mohnish Pabrai, a value investor who looks for the same thing.  Many of these investors have done well for themselves, but not consistently.  Some stocks do return 2-3x or more in a short period of time, while others fail to do so. Often the large gains from a few stocks are enough to counteract the losses and the portfolio beats the market.  While many of these investors are looking for 2x-3x gains their portfolios are only appreciating at 20-30%.

Long time readers are aware that my goal isn't to set individual year records with my portfolio performance.  Instead I strive for investing consistency like I do with my running.

To achieve consistency in investing one needs to first know what they're looking for.  I look for undervalued stocks by either assets or earnings.  I will buy a growing company if there is a true undervaluation present.  Secondly an investor needs to know how well they've done in the past.  If I say that I like to buy stocks at 50% of private market value implying a 100% return then I should check my statements to see what my success rate at picking these stocks is.  And lastly if I have been successful with this in the past I need to develop a repeatable process that I can use again in the future.  The success and repeatability of a strategy is measured through market cycles.  I haven't been investing through many cycles myself, but the style I use has been tested since the 1930s.

When I find a new stock I ask myself "how is this undervalued?"  If I can't answer it in a way that fits my investment style then I usually take a pass.  That doesn't mean it's a bad investment.  It just means it doesn't fit into my process, my path to generating consistent results.

For me the key is that I believe it's much easier to consistently find stocks at a 50% discount to private market value rather than finding stocks blast off like a rocket and appreciate 2-3-5-10-100 times.  It's not to say that I don't stumble on those gems, I have, and plan to in the future as well.  It's that it's easier to consistently find simpler mis-valuations.  And if I can build a portfolio of simple mis-valuations I can somewhat estimate my future returns.  Just like in running where my practice determines my race times in investing our process and the consistent application of it generates our returns.

The problem with a strategy like this is it doesn't get a face on a magazine cover, and it isn't attention grabbing.  For many years it's boring and it really only pays off after years of compounding.

I don't believe my 'brand' of value investing is what's right for everyone, but I strongly believe in the theme of this post.  Everyone needs to find the style of investment that they're good at, and instead of shooting for the stars look for places where consistent returns can be earned with a small potential for loss.