Thursday, April 17, 2014

What's the worst case scenario?

Survival and end of the world scenarios seem to be en vogue.  From the preppers to the impending financial collapse of Japan/China/Europe/US there's a very vocal subset ready for a collapse of something.  Investors are preparing for another market crash, and it seems like journalists are writing about bubbles to capture page views.  I'm not sure if doomsday has always been so popular, but it's been something I've been thinking about recently.

Last week I drove up to Toronto to attend the Fairfax shareholder dinner on Tuesday night.  At the dinner we had a chance to listen to various Fairfax executives discuss their company and issues they felt were important.  One executive discussed her view that China is on the verge of an impending collapse.  Fairfax Financial in general is bearish on both the market and various countries, they predict that we'll experience deflation along with a Chinese implosion.  Their outlook is very dire, and it's not an uncommon view held by investors.

While I was listening to the Fairfax executives discuss China I started to think about a friend of mine.  He is a former survival instructor in the Air Force, he'd take students into the woods and show them how to kill game, find water and survive enemy tourture techniques.  I was always fascinated by his stories about eating goat eyeballs or being dumped in the desert without water, the training was intense.  Beyond his survival skills my friend also has a keen sense of business opportunity.  After leaving the Air Force he and his wife started one of the first drive through coffee shops in Pittsburgh.  It was no surprise when he wrote a book catering to the prepper movement based on his Air Force survival training.  For my foreign readers who need a little background; preppers are Americans who are scared about terrorists or a revolution, or nuclear attack who in response have fortified their house, stored food, and train to thwart attackers.  The prepper movement has spawned TV shows, books, and training courses to prepare for some terrible event.

My friend wrote a book about an EMP attack in the US.  I haven't read the book personally, but I'm familiar with it.  In the book civilization breaks down as a result of this attack and Americans are forced to fend for themselves.  The book is part survivalist manual, and part story.  From this launching pad my friend started a consulting business and is now in the business of writing other material for the prepper niche.  I doubt he ever thought he'd be making a career out of experiences from the Air Force, but he saw opportunity and took advantage.

I find the societial collapse scenarios and obsession fascinating.  There is a whole plethora of scenarios that could potentially take America from eating McDonalds and drinking Coke to fighting each other in the streets, growing food and living in some anarchist society.

Story lines for a societal collapse remind me of story lines for market collapses.  If A happens then it will lead to B, which in turn leads to C, which results in D, after which we're all living in huts with loin cloths and grass skirts.  The problem is outcomes are never as neat and tidy as the story lines we tell ourselves.

What's intriguing about all the collapse scenarios is that although we have a lot of stories and theories of collapse if one looks back in history there aren't that many examples of a total collapse.  There are examples of governmental breakdown and disorder in societies, but none that I know of have led to people living as they did in the stone age.  I'm astonished at the number of groups pushing for a total collapse.  From environmentalists preaching about our energy usage, to right-wing militias it seems like each of these groups has an agenda to push.  Each group is selling something, and if we don't adopt all of their changes we are led to believe we'll experience a worst-case scenario.

For some reason humans are attracted to the worst case scenarios.  We want to be worried about something remote and unlikely to happen.  We're worried about an EMP explosion (do they explode?) that knocks out the electricity grid, but we're not worried about unsafe drivers on the roads.  We're worried about China collapsing and destroying the market, but we aren't worried about buying into an over-levered company with a dying business model.  We over estimate remote risks, and under estimate reasonable risks.

Evidence to support this can be viewed in the comments on this blog.  Many commenters have posted very valid worst case scenarios about companies as a reason to avoid the investment.  The worst case scenario sounds attractive, and it's easy to buy into the story line, but is it relevant?  If you look back at a lot of those worst-case scenario comments you'd see that the scenarios never materialized, rather a much better scenario unfolded.

When a company is trading close to or above a fair value a lot of things need to go right, or continue to go well in order for the company to grow into their valuation.  Sometimes a company does everything right and a seeming overvalued turns into a missed buying opportunity for investors.  There really are companies out there that can grow sales 25-50% a year for stretches, I've worked at one in the past.  Growth like this doesn't last forever, but it lasts long enough that a high valuation can be deserved.  Just like there are star athletes, there are star companies that make all the right decisions for a period.

When a company trades for a low valuation not many things need to go well.  It's the opposite, as long as a company avoids failure or disaster they are often worth more than what the market is pricing them at.  Valuation trumps risk, at some point a valuation will be so depressed that even the most unpalatable prospects can be enticing.  I know investors will disagree on this point, but outside of purchasing nuclear waste or something toxic like that I'm guessing that most investors would take even the worst business in the world if offered for almost nothing.

A lower valuation protects an investor against terrible outcomes.  Competitive advantages, and concerns about a moat disappear as a stock's valuation drifts lower.  Below a certain point if the company continues to simply conduct business they are worth more than their valuation even if the market disagrees.  What seems to happen is the market latches onto worst-case scenarios and ignores more likely near term scenarios.

Humans are incredibly creative and able to react in unpredictable ways to situations.  Investing in companies with extremely low valuations is akin to betting that we will witness human ingenuity.  When a company is facing dire circumstances often management will do uncharacteristic things in order to both save their jobs and save the company.  Sometimes those actions work, not always, but enough.  Othertimes conservative management can be forced out of their comfort zone when competition is at their doorstep.  A previously sleepy company catches the growth bug and both management and investors are rewarded.

Human ingenuity and creativity are part of the reason I don't buy into worst-case scenarios.  When we start heading down a bad path few sit by and let events run their course.  Our normal response is to do something and try to fix the situation.  When a country heads towards collapse a group of citizens will step up and attempt to fix the situation, altering the course of events.  Companies are no different, few management teams sit by idly as a company falls apart.  It's the action that people take that creates unpredictability in our story lines.  Suddenly the A->B->C->D story line is disrupted because between B and C people stepped in to do something.  Sometimes a fix works, othertimes it doesn't, but it always alters the storyline.

When we buy into companies or countries at high valuations we are implicitly betting that a best case scenario will unfold.  If it doesn't then we are at risk of losing money.  When we invest in a company or a country with a low absolute valuation we are betting that human ingenuity will attempt to do something, and that we'll avoid the worst case scenario.

I look at a lot of companies that the market and investors have written off as worthless.  Many are worthless, they have management teams working to extract all of the value for themselves while the company coasts to zero.  But some aren't worthless, investors might have fears about them, but at a low enough valuation these fears can be overcome.  Absolute valuation is critical, keep that in mind and risk will fall into place.  Items that are risky at 2x BV and 30x earnings are non-issues at 50% of BV and 3x earnings.  Focus on what's likely, not the unlikely worst-case scenario.  And lastly when buying something at a depressed valuation realize that you're making a bet on human creativity and ingenuity to do something to resolve the situation.  The response might not be perfect, but nothing in life ever is.  A reaction doesn't need to be perfect, it just needs to be good enough to avoid the worst.

Friday, April 11, 2014

Determining intrinsic value for a bank; why discounts to book shouldn't persist

My last post generated quite a response.  Between investors thanking me for the idea and others accusing me of pumping and dumping the stock the most interesting response was an article posted on Seeking Alpha.  The author goes to great lengths to explain why at 40% of TBV M&F Bancorp is fairly valued.

I don't have any interest in getting involved in online debates, if I did I would have posted a comment.  Instead I want to further explain my thinking on banks and show that even an unprofitable or marginal bank has a lot of value.  I don't expect everyone to agree with me, that's what makes a market.  I'm also happy that there are investors who will pass over what I consider obviously cheap stocks, if there weren't I might not have an opportunity to buy them.

In Security Analysis the concept of intrinsic value is defined as the value a well informed private market buyer might pay for a business.  A company's intrinsic value is the amount that both the buyer and the seller would consider fair after extensive due diligence were performed.

Public market and private market transactions differ greatly with the private market being much more efficient.  Private companies are often sold at or near their intrinsic value.  This is because both the buyer and the seller come together and determine a mutually agreeable price.  Outside of unusual circumstances prices paid are reasonable for all parties.  The dynamics of a private market purchase are different than a public market purchase.  In the private market an acquirer sees a company that they believe they have the operational wherewithal to improve.  The acquirer doesn't mind paying a fair value because they believe their expertise, or existing systems will allow them to generate better returns with the company they purchase.  Explained another way private transactions are operationally focused whereas public transactions are financially focused.

The intrinsic value of a bank is no different than the intrinsic value of an industrial, or insurance company.  A bank's intrinsic value is what a well informed buyer and well informed seller would mutually agree on as a fair price.  The question is then, how do we get that value?

One of the reasons I love banks and banking is because they're very easy to compare.  Consider two banks in the same town across the street from each other.  Their business is the same, they both take in deposits and make loans.  If the banks aren't making the same returns it's interesting to consider why.  Why are two companies located across the street from each other generating different returns from the exact same business model?  Maybe it's marketing, or the culture of the employees, or the color of the toasters they're giving away.  It isn't as if one bank can make better loans than the other, often their rates are the exact same.

In this scenario what's even more fascinating is that when the outperforming bank purchases the underperforming bank the underperforming bank becomes outperforming.  This suggests that performance has nothing to do with the location or the product, but the culture and how the bank is managed.  This is true across banking and other industries as well.  A friend related a story recently about how their company purchased an underperforming location and after instituted some of their cultural practices saw a remarkable change in profitability at the new location.  The new location contained the same employees doing the same job as before, but with different motivation and new management they were able to execute at a higher level.

I met for coffee with a local former bank executive back in the fall and he walked me through how a banker views a bank acquisition.  I made a reference to the methodology in my Versailles Financial post.  Incidentally PL Capital, a well regarded bank financial-focused hedge fund walked through a similar valuation methodology during their recent Value Investing Conference presentation.

The idea is that the value in a bank lies in the ability to remove costs post transaction and better utilize the assets.  A perfect example of this might be some of the small banks that are making $10-15k in net income a year.  Most if not all investors look at banks like that and throw up their hands claiming that anything a 2-3% ROE is worthless and should trade at 50% of book value, or at the very least passed over.  Fortunately that's not how bank acquirers see a bank like this.  They see a bank where if the CEO were gone ($250k salary), the CFO were gone ($150k salary), and the CLO were gone ($150k salary) salary that $550k in operating income would almost magically appear on the income statement.  This doesn't even begin to factor in the integration of a better core system, or branch efficiencies, or culture changes that can lead to growth.

The problem with small banks is they don't have the scale to outrun their costs.  But larger banks, or the combination of two or three smaller banks do have that scale.  Once those cost hurdles are removed the acquiring bank can reap near-instant profits by simply removing top executives and putting into place simple cost saving measures.

I put together a small table from showing the average efficiency ratio of all banks broken out into different asset ranges.  All of the ranges are in thousands, so for banks from $0 in assets to $100m in assets the average efficiency ratio is 153%.  An efficiency ratio this high means that the bank's expenses are 153% of their revenue.  You can see that as banks attract more assets their efficiency ratio drops dramatically.  Simply moving from below $100m in assets to above brings enough efficiencies that most banks in that category have the chance of being profitable.

When I invest in banks my goal is to find banks where I can look past their current situation and see something more valuable.  I try to see valuable deposits, or an under utilized assets that can be re-allocated to a higher purpose under a different management team.

The major criticism I'll receive on this post is that my line of thinking relies on a bank merger or catalyst to unlock value.  Many investors don't want to invest in a company that needs a merger or dramatic corporate action to unlock value.  My response to them is that there are many companies earning 10-15% returns on equity that are trading at fair prices worth purchasing.  I prefer to purchase undervalued companies without knowing how or when value might be unlocked, but I am confident that it will eventually.

I remember in 2010 a few investors were talking about idea of permanent net-nets; companies that seemed like they'd been in the results of net-net screens forever.  I'll point out that none of those companies are net-nets anymore, they have all appreciated significantly.  I am proposing the same thing for undervalued banks.  With a terrible crisis in our rearview mirror some investors are making the claim that 40% of TBV is a fair value and that many banks are so terribly run they will never be worth book value.  That's crisis thinking, a bank like M&F Bancorp has a lot of value to an acquirer, and ultimately the fair value that I base my investment decisions on is what I think a private acquirer might pay.

My investment philosophy doesn't rest on the theory that every company I own needs to be acquired. Rather I believe that if something is fundamentally cheap eventually an acquirer, or other investors will take notice and the price will rise accordingly.

If you're interested in seeing how can simplify your bank research, or help you find profitable bank investments sign up for a trial and see for yourself.

Disclosure: Long M&F Bancorp.  I receive a small commission for items purchased through the Amazon link above.  Prices through the link are the same as if you went to directly.

Monday, April 7, 2014

M&F Bancorp at 30% of TBV what's not to like?

I know myself; in my pursuit of perfect I miss what's good.  This happened to me when I looked at Japanese net-nets.  I wanted to find the best net-nets.  The net-nets that were the greatest companies, yet also the absolute cheapest.  What happened?  As I pushed numbers around in a spreadsheet the market rose and I didn't participate as much as I would have liked.  There were many good net-nets that I wish I would have owned.  The good net-nets did as well as the great net-nets.

It seems like there is always a country that's selling at a low multiple, or a sector of the market selling with depressed valuations.  The areas of concentrated low valuations are what I consider pockets of value.  These pockets of value need to be mined quickly before they disappear.  There can be issues with this approach.  Critics always have a myriad of reasons to avoid these pockets, many of the reasons are compelling if not convincing.  Second mining pockets of value can result in a portfolio that's heavily concentrated in a hated area of the market.  It's a tough sell for clients when all they see on CNBC are dire predictions about a portion of the market you're concentrating their portfolio in.

Financials were one such pocket of value coming out of the financial crisis.  Most of the surviving financials are much better capitalized, and should do well going forward.  Some of the larger financials are still cheap, but that pool of opportunity is quickly shrinking.  As larger financials have drifted higher they've pulled small bank stocks up with them.  It's almost as if investors cycle out of larger stocks into smaller and cheaper stocks.  Then when those small bank stocks rise investors go even cheaper.  What we're left with is around 100 or so banks selling below book value.

M&F Bancorp (MFBP) is one of those banks selling for less than book value, quite a bit less.  The letters in the bank's name stand for Mechanics and Farmers, which is also the name of their bank subsidiary.  The bank is located in North Carolina and has seven branches located in the major metropolitan areas of Charlotte, Raleigh, Durham and Winston-Salem.

On the bank's website they have a page describing their corporate mission.  The bank's mission contains 13 things they are focused on, the last bullet point is profits.  This is a fitting placement, the bank is profitable, but they clearly aren't working to squeeze profits from anything possible.  The bank is profitable and trades for about 8x earnings, and while that's nice what's even better is their discount to book value.

The bank has a market cap of $7.6m against tangible common equity of $24m and a book value of $36m.  They bank is selling for 30% of their TCE which is low, especially for a profitable bank.

I mentioned in a previous post that I try to break an investment thesis down to a few simple pivot points.  We first need to ascertain whether M&F Bancorp is on the edge of extinction, if they aren't then we can proceed to establish a value for them.

There are two interrelated things that can kill a bank quickly, bad lending and too much leverage.  A bank can operate through good years with a lot of leverage if they don't engage in reckless lending.  Bad lending will destroy any bank, and it'll destroy banks with a low capital cushion much quicker.  A bank with a higher capital cushion can weather a bigger storm, but if enough of their loans are bad the bank will eventually be taken over by the FDIC.

In the case of M&F Bancorp much of their depressed valuation can be traced to their lending quality.

The above picture shows the holding company's asset quality statistics for the last six semesters.  Non-performing assets as a percentage of total assets were at the elevated level of 6.22% in 2011.  In general I try to avoid investing in banks with NPA/Assets much higher than 3%.  Although exceptions can be made, especially when the bank's portfolio is moving from troubled to normalized.

Here's another more extended view of their non-performing loans going back nine years:

The company's problem loans peaked at 8.09% of total loans in 2010.  I dug further into the bank's loan portfolio to determine where they struggled with lending.  It's not uncommon for a bank's non-performing assets to spike if one or two of their large commercial loans run into issues.  Commercial loans are riskier than residential loans, and if business conditions are difficult it's not unusual for a company to default or defer interest on a loan.  Business loans are larger than residential loans as well.  A business might need to finance a million dollars for expansion, whereas a million dollar residential loan is rare.

M&F Bancorp's lending issues weren't related to commercial lending, they were with real estate loans unrelated to individual borrowers.  The details of their actual issues aren't public, but it looks like they might have done a lot of lending for multi-family residences which ended up facing issues.  The loans never went bad, they were eventually restructured and the loans are now performing.

The bank has been continuously profitable for the past nine years, and coupled with the sizable capital cushion of 10% core capital, and 15% Tier 1 I think we can safely establish that the bank isn't going out of business any time soon.  And with their loan portfolio under control they aren't heading for a capital injecting anytime soon either.

With that we've established the first pivot point for this investment, that they are a viable company and should continue as a going concern.  The second task is figuring out what they're worth.  This is a much simpler task.

My general rule of thumb is that a profitable bank with an average loan portfolio should be worth at least book value.  When I first started writing about banks I was taken to task over this presumption.  I received comments and emails justifying why 50% of book value is a fair value for a profitable bank. I still disagree with that assessment, and the market does as well.  As I mentioned above the pool of banks selling for less than 1x book value is quickly shrinking.  Secondly the bank M&A market seems to be firmly established around the 1.5x TBV metric for acquisitions.

The great news is that M&F Bancorp is selling at such a depressed valuation that even if it were only worth 50% of TBV that would mean a 50% gain for investors buying at current levels.  I suspect that this bank is worth much more than 50% of TBV, but to get the numbers to work we don't need an optimistic scenario.

If you're interested in seeing how can simplify your bank research, or help you find profitable bank investments sign up for a trial and see for yourself.

Disclosure: Long MFBP

Tuesday, April 1, 2014

How I manage my portfolio and keep track of 50+ stocks

I never set out to create a series of posts outlining the basics of my investing philosophy, but it appears to have happened.  This post joins the past two and fills in some gaps on how I implement my investment style.  I also wanted to take some time to answer a question I get asked a lot, how do I actually manage a portfolio with more than 50 stocks.

I've heard it said that a typical NFL game's outcome can be broken down to three pivotal plays.  What this means is you can go back and review a game and there are usually three plays where if they went the other way the losing team would have won.  Sometimes a game can hinge on less than that.  The outcome of one play can change a game from a loss to a win, or a win to a loss.

It's my belief that most successful investments are similar, their outcome and success can be distilled down to a few important factors.  If I can't simplify an investment to a small number of pivot points I will pass on the investment, because monitoring the company and estimating an outcome is too difficult.

Let me explain with a few examples.  The easiest example is a net-net, or a company trading below book value.  There are a lot of different things investors can research about the given companies, their margins, their competitors or their management.  The first question I ask is whether the company is worth NCAV or BV?  If it is then why isn't it trading there?  If a company is worth their asset value then the next question is what will it take for the company to trade there?  Most of it time it's just that the market needs to recognize value.  After I've determined the company is undervalued and I need to be patient all I need to monitor is that business continues as usual at the company.

Distilling an investment down to a few pivotal facts makes following a company easier and also simplifies the selling decision.  If I determine a company has an undervalued piece of real estate and suddenly the real estate is sold then it's time to sell.  If I think a CEO is holding the company back and they're replaced and nothing changes then I need to sell.

My goal is to reduce an investment idea to a set of factors that if true would validate the thesis and result in a gain, and if false would invalidate the idea.  Keeping an investment simple isn't just a matter of simplifying the investment idea, it also includes investing in simple companies.

Readers are aware that most of the time I invest in small companies, usually because that's where opportunities exist, but also because they're easy to understand.  I have two annual reports on my desk from small unlisted companies, both are 15 pages or less.  I can read and analyze the companies in a half hour at the most.  One of them sends only an annual report, the other sends an informative letter quarterly plus the annual report.  The time commitment for both of those companies is about an hour a year at the most.  I can spend an hour a year and keep up with two companies that I'd like to own at a lower price, right now I own single shares of each to stay on their mailing list.  I have a few dozen companies like these two.  They send out short annual reports and it doesn't take many hours to keep up with them.  I also like to scan through the OTC Markets financial reports page.  I will open and read or scan the filings for any company that's filing within the past few weeks.  I can usually read and keep up on dozens of companies without much time spent.

Finding easy to understand, easy to follow companies whose investments hinge on a few factors is one thing, fitting them into a portfolio is another.

Just as investors like to classify themselves as certain types, readers seem to classify me as well.  I'm often thought of as a net-net investor, or maybe a low P/B investor, or a bank investor.  I certainly invest in those types of stocks, but I don't limit myself either.  I manage my portfolio in a somewhat unique fashion.  It's hard to build a portfolio around one specific type of investment idea.  What does a spin-off investor do when there are no spin-offs?  What does a net-net investor do when there are no net-nets?  I guess they'd sit on cash until those opportunities arose again.

What I have done is to divide my portfolio up into a number of different styles.  Low P/B stocks, cash box stocks, net-nets, banks, quality companies I'd hold etc.  My goal is to never let any of these specific strategies overwhelm the entire portfolio.

Dividing my portfolio allows me to diversify across strategies, and it also allows for new investments when one strategy starts to top out.  Right now in the US there aren't many net-nets left, but that's fine, I have been finding cash boxes, some special situations and a few attractive banks.  I'm still able to buy cheap companies even though there aren't net-nets abounding.

The last thing investing like this does is it allows me to compare and fit new investments into a framework of existing investments.  If I'm looking at a bank stock I can compare the bank's relative value to the other banks I own.  If the bank is more expensive than my current holdings I need to either know why it's worth holding or reconsider the position and add to an existing position.  I do the same with all of the other types of investments I own.

To end this post I distilled my approach into a few simple bullet points:

  • Follow companies that are simple to understand.
  • Follow companies that publish short annual reports that are quick to read and easy to understand.
  • Invest in multiple strategies, never let one overwhelm the portfolio.
  • Compare new ideas to existing ones

With the above guidelines I'm able to manage my portfolio without spending a lot of time keeping track of what I own.  I can dedicate most of my time finding new companies I'd like to buy.

Wednesday, March 26, 2014

You need an investing system

Investors seem to have an intrinsic drive to classify themselves.  People will say something like "I'm a mix of Graham and Buffett with a dash of Rockefeller and the temper of Carnegie."  Sometimes these classifications border on ridiculous, other times confusing.  Even still investors continue to classify themselves.  We use these heuristics because often it's easier to identify with an investor's system, rather than developing our own system for investing.

I finished reading two books recently, The Signal and Noise by Nate Silver, and  How To Fail At Almost Anything And Still Win Big by Scott Adams.  I think both books are worth reading for different reasons, but both have applications to investing.

Scott Adams outlines his belief that successful individuals use systems rather than goals to accomplish things in life.  With a goal you are in a state of perpetual failure until you achieve the goal, then you need another goal to move onto.  He believes we need systems, continual patterns that are sustainable and drive us towards our desired outcomes.  An example of this might be losing weight.  A goal might be that we want to lose 20lbs.  To achieve the goal we decide to not eat candy or have second helpings.  The weight starts to drop and eventually we hit our goal.  What happens then?  Do we continue to not eat candy and smaller portions?  Is it sustainable?  If we sneak a Snickers bar are we failures?

A system looks at the problem differently.  It might be that we can eat unlimited quantities of certain food groups, but keep others to a minimum.  This is a sustainable system.  Maybe I am free to eat as many vegetables as I want but keep candy to a minimum, such as special occasions.  If I'm hungry I can have carrots instead of denying myself anything to eat.  Being able to eat to satisfy hunger is fine as long as it's something healthy.  My own view on this is that I've never seen someone gain weight by eating too many fruits and vegetables.

Nate Silver's book is much different, he discusses how to view the world probabilistically.  He believes by applying Basyean statistics we can increase the accuracy of our forecasts and enhance our forecasting outcomes.  Silver discusses all sorts of forecasting problems from weather to earthquakes to the stock market and politics.  The book is long, but it was an enjoyable read.  There were two take-aways that I believe apply to investing, application of the power law, and thinking about investments probabilistically.

It might be helpful to read this post as a follow-on to my post on diversification.  I want to talk about systems first, and then how the power law and probability fits into the system.

I think it's critical that investors create a consistent system for their investments.  What I mean by this is I think we need to approach investments, measure investment success, and view investments in a consistent and repeatable manner.  Sometimes I'll encounter investors who say they do a little GARP investing, plus some dividend investing, plus some value stocks and a few moat companies.  To me that seems like they're throwing things at a wall and seeing what sticks.  It's hard to find investments if we don't have a structure to view things within.

We need to find styles that fit our personality.  It doesn't matter if it's investing in small cap growth companies, or distressed credits.  There is something out there that will make sense to you and will be almost second nature.  Don't invest in a manner because someone else does, or because someone famous has made a lot of money investing like that.  Invest in a manner that makes sense to you.

When I meet someone who wants to talk about investments, but isn't that knowledgable this is how I explain what I do in non-investing terms:

I like to go to the older part of town and look for businesses that look like time has passed them by.  I will buy them for some amount.  When I visit my new property I find that 80% of my purchase price is sitting in cash in the cash registers, and that I can sell the inventory for the other 20%.  I can also sell the building for a gain as well, along with the fixtures.  Sometimes I let the business run because the cash it generates pays me back in a year or two, but not always.

People understand this, it makes sense to them.  The second question is naturally "how do you find these places?" But there is no confusion as to my process.  They key is that my explanation is also the  system I use while investing.  I am looking for things at egregiously low valuations.  I'm not buying a Mercedes at 10% off sticker price.  I'm buying a Chevy Cavalier on Craigslist and reselling it a week later at double the price.

My system is consistent and easy to apply.  I can apply it to stocks, or bonds, or real estate, or literally anything that can be bought or sold.  If I consistently apply my system I also know that I will consistently earn a satisfactory return.  I might not earn a return on every investment, I make mistakes, but over the long term I will earn a consistent return.  When I look at a new potential investment I view it through the lens of the system I'm using.  If someone is pitching me a product that will take over the world it just don't fit with how I view things.  That doesn't make it bad, or wrong, it's just not something I have experience with.

That brings me to one of the points from Nate Silver's book on thinking probabilistically.  One thing many investors struggle with is how do we know something is truly worth more than what it's selling for now?

Nate Silver's book flipped the lightbulb for me on this issue.  It helped me recognize that what I am doing when looking at companies is handicapping them, or thinking about the probability of them being worth more.  This is different than extrapolating the future.

Here's an example.  Barrons might profile a company and say they're trading at $20 and the paper thinks they're worth $22.  The reporter spends a page of text explaining why they think this.  The paper will probably make a great argument, but I ignore that and look at the gap between the two numbers.  They are saying that the stock has the potential to rise 10%, or put another way they're 90% of their fair price.

I look at a thesis like that and think that with a gap that small there must not be much uncertainty as to their real value, or the estimate needs to be right.  Is the probability of them being worth 10% more greater than the probability of them being worth less?  As the value gap closes between where a stock trades and what they're worth the amount of uncertainty needs to diminish for the investor to be right.

The opposite of this would be some of the investments I look at.  Take for example Conduril.  They were selling for 40% of NCAV and 2x earnings when I found them.  There is a larger probability that they're worth more, than worth less.  Maybe they're not worth 10x earnings or 5x earnings, but the probability of them being worth more than 2x is greater than them being worth less than 2x.  In a case like that it makes sense to invest.

This is why it's easier to invest in a much cheaper company compared to a company that's closer to full value.  If you think of two probabilities, one that it's worth more, and one that it's worth less, the probability that it's worth more decreases as the price goes up.  When comparing two companies side by side I will take the cheaper one in most cases.  The cases where I don't do this are times when there is more certainty that the more expensive one will rise.  An example of this might be two cheap companies, one with lousy self-dealing management, and one with honest management.  It's more likely that the company with honest management is worth more, there is less uncertainty.

I know a lot of fund managers use this thinking when looking at lottery ticket type of investments.  They look at the probability of something positive happening and the resultant gain, and then the probability of something negative happening and the resultant loss.  If the gain outweighs the loss then it's worth taking a position.  Over a single data point the probabilities don't mean much, but over a set of investments over a period of time the probabilities should hold true.  Referencing back to my diversification post, I could understand someone making five or ten investments like this at a time, but making one or two seems reckless.

The last thing I want to discuss is the power law.  Silver talks about this within the context of earthquakes.  People often misinterpret the probability of something greater happening because it hasn't happened in the past.  He uses the example of an area that's only experienced earthquakes measuring 5 or 6 on the richter scale.  Instead of thinking that nothing higher can happen because it hasn't happened in the past, the fact that any earthquakes have occurred at all should be taken as a warning that something greater can happen, and it's likely the magnitude will be greater.  That an earthquake measuring 5 on the richter scale happened is indication that an earthquake measuring a 7 can happen as well.  It's more likely that an area with prior earthquakes will experience a size 7 earthquake than it is for an area that's never had a earthquake to get one measuring a 2 or 3.

How does this translate to investing?  I believe the past is indicative of what might be possible in the future.  If a company has never been profitable is it likely that suddenly something will change and the company will make fantastic profits?  The lack of profits most likely indicates that it'll be harder for them to shift course and be profitable.  Likewise a company that's been profitable in the past, but is dealing with a temporary situation will likely be profitable again in the future.

We can't extrapolate the past mindless into the future, but we can look at the past as some indication of what could be possible in the future.  If a company has a management team that's done well previously then there's reason to believe they can be profitable again in the future.  If a company's management is experienced in losing money and constantly issuing shares what could prompt a change in the future?

An example application of this might be biotech investing.  It's more likely that a company with previous drug approval experience will get a new drug approved over a company with no experience in getting drugs approved.  That's not to say it's impossible, just not as probable.  If a company has experience with radical transformations and has come through successfully then we might expect that when faced with a radical transformation it will be possible for them to succeed.  If a company has never done anything transformative and then they attempt it we should view their chances of success with skepticism.

None of these concepts were entirely new to me, long time readers will recognize that I've been applying these concepts for years.  But what is new is having a name for them, and being able to identify exactly what I'm doing.  Sometimes we do things without being able to label it, I've now been able to label a portion of my process.

Disclosure: I receive a small commission if you purchase something from through the links provided.  The price you pay is not marked up, Amazon builds this commission into the cost of all of their items.

Friday, March 21, 2014


I often get asked the question "what are your thoughts on diversification?"  Someone asked me recently and I thought that newer readers might appreciate my thoughts on it as well.  I wrote about this a year and a half ago, the post generated some lively comments, and I expect this one will as well.

Before I begin in I want to set out a few points accommodate those who are too lazy to read the post, but will post comments anyways.  I have heard that Warren Buffett says that only the ignorant diversify.  I have heard that I'm diluting my returns by investing in anything beyond my ten best ideas.  I've heard that what I do is just mechanically investing based on math, or formulas.  I'm already well aware of all these things, no need to refresh me.

It's surprising but I actually believe in concentrating one's resources into a single investment if the circumstances are appropriate.  If an investor has control over the investment, and can make decisions about the company's strategy, future direction, and capital allocation I think it makes sense to concentrate resources on that investment.  I think it makes so much sense that if you're in this position it might make sense to focus all of your money, time and effort on the particular investment.  I think concentrating in a position also makes sense for hedge funds and mutual funds in similar positions.  If they have the ability to control or influence the outcome of an investment it makes sense to concentrate their capital where they are spending a lot of time and energy.

There's a story floating out there where Charlie Munger talks about owning a small town restaurant, hardware store, gas station, and hotel.  He says he'd feel adequately diversified with that portfolio.  I would as well, the reason being that in the analogy I would own and control those properties.  How would the story change if I owned a tiny little sliver of each and a faceless manager 800 miles away who I couldn't get on the phone was making the decisions?  Would I still feel diversified?

There's a famous Buffett quote that's often used to bludgeon investors who concentrate their portfolios: "Diversification is nothing more than protection against ignorance."  This quote describes me and my investing perfectly.  When I look deep inside, no matter how much research I do I am still ignorant of the companies I'm investing in as an outsider.  I laid out my thoughts for that in this post, one that many of you skipped.

As outside investors we can't know everything about what's happening at a company.  If we think we do we're deluding ourselves.  I worked at a startup out of college that was in many ways run on a shoestring and a lot of hope.  We had outside investors who were blissfully unaware of what was actually taking place day to day.  At one point we had a massive system crash that destroyed all of the company's data, intellectual property and software.  Our core system had died suddenly without a backup.  Thankfully a coworker was able to engineer a solution and numerous hours later business continued as usual.  Customers knew there was a massive disruption, and employees knew without our co-worker's creativity unemployment would have been our future, but investors receiving quarterly statements they never knew they were hours away from losing everything.  Unfortunately many companies are run in the same haphazard way, and we as investors never have any idea.

I diversify my portfolio to avoid disaster, but that isn't the only reason, or the main reason.  The theory for concentrating is that no one is bothering with investments that will only return 50%, rather many only invest in companies that double, triple or quadruple in two or three years.  Why settle for a measly 50% return when you can search harder and find the 400% return?

If I could find five stocks that I knew would all quadruple in three years I'd bet the farm on them as well.  The concept sounds great.  The question I have is where are all the funds and investors doing 100% compounded?  Compound capital at 20% for a decade or more and suddenly you will be a 'guru'.  Why is there such a gap between what investors are looking for and what happens?  Many shoot for the stars investments fall flat.  A few do make it to space, but their gains needs to be spectacular to negate the losses for the rest of the investments that blew up.

The problem is consistency.  It's hard to consistently invest in companies that return 200%+.  To understand why think of baseball.  It's easier to consistently hit singles verses consistently hitting home runs or grand slams.  A grand slam is possible under the correct circumstances, but a single is possible every time the batter steps to the plate.  In theory a hit is a hit, but that's not true.  A pitch needs to be thrown just right, and the bat needs to hit the ball with enough power at the right place for a home run to occur.  Players who can consistently get on base are more valuable than the power hitter who makes a great highlight on ESPN, but mostly strikes out.  I think of Walter Schloss, an investor enthroned in value investor lore who consistently hit investing singles.

If a company meets my minimum criteria for an investment I'm likely to take a position.  It might be a small position, but it will be added to the portfolio.  It's important to note that not every position gets some pre-set mechanical sizing.  If a company is unusually cheap, or there's some other special characteristic I will size the holding larger.  Sometimes I'll increase a position if the company becomes cheaper, or if I become more convinced about their potential.  I have averaged down on holdings, but I've also averaged up.

Whereas sometimes I'll take a larger positions, I've also taken many small positions.  My holdings in community banks are a great example of this.  I have a general profile for a cheap bank that I look for.  If a bank meets my criteria I will take a small position.  There have been a few of these banks that after researching I end up liking and take a larger position.  In general most are tiny positions.  In the aggregate my exposure to small community banks is greater than 10% of my portfolio.

A great criticism might be to ask why I don't just invest in an index of banks.  The problem is there is no index that does what I want.  There are no indexes that invest in banks with $9m market caps, or $150m in assets.  I don't know of an index that has criteria that says if a Chairman and CEO are in their 70s it will buy more.  If there were an index that did some of these things I'd probably consider purchasing it.  I enjoy investing, but it isn't like I couldn't find something else to do with my time either.

I know my approach isn't for everyone.  It's probably not for anyone.  It works for me though, it's something I'm comfortable with and lets me sleep well at night.  I'm going to continue to hit singles and doubles and let the rest of you hit the home runs.

Monday, March 17, 2014

Calling all risk takers, a Ukrainian investment at 2x earnings and 45% of book value

"The time to buy is when there's blood in the streets." - Baron Rothschild

Investors who venture into risky markets can realize either fantastic returns, or encounter losses to be written off at tax time.  Right now feels like one of those times where a fortune could be made or lost by investing in the Ukraine or Russia.

I haven't spent any time looking at Russian companies, but I have seen a Ukrainian company written up on a number of blogs that I felt merited a further look.  The company is Avangardco (AVGR.London), an egg producer.  They are the number one egg producer in the Ukraine and in Eurasia.  If you're reading this and live in Europe you've probably consumed Avangardco eggs.

The company is compelling due to their extremely low valuation.  They trade for slightly over 2x earnings, and about 45% of book value.  This is a really low valuation for a company with a considerable market position.  Usually a valuation this low can be attributed to one time earnings, or another non-repeatable event.  That's not the case for Avangardco, the company's earnings appear relatively stable.  The company's book value is well supported by earning power.  Book value is close to five times net income.  This is clearly a two pillar stock.

When a stock is trading for such a low multiple an investor doesn't need to spent a lot of time considering whether it's good business, or if they have a moat, or if can earn acceptable returns on equity.  If you are interested in exploring those issues I'd recommend you read Dave Waters' writeup of the company from January.

In my view there are only two questions that need to be answered about the company, and if both can be answered conclusively then this is an incredible investment.  The first is will the company's business going forward resemble business the past, secondly is there a risk of permanent capital loss from some event or incident?

Back before Putin began to reassemble the Soviet Union the biggest risks outlined for an Avangardco investment were related to its billionaire majority owner.  A noted but not emphasized risk was that the company operates out of a politically unstable country.  That previously minor risk has come to the forefront lately.

To consider Avangardco as an investment we need to rule out two potential outcomes: that the company will disappear, and that their business is permanently impaired.  If both of these risks can be eliminated buying a company at 2x earnings and 45% of book value has a great chance of generating a return.

Let's tackle the first issue, that they will completely disappear.  I can see this happening under two or three circumstances.  The first is that Russia launches an all out war against the Ukraine and either destroys all of Avangardco's facilities, or re-collectivizes them.  I think this is the most remote possibility, I'd assign a very small probability of this happening.  There's a chance Russia might invade the Ukraine, but given how Ukraine resisted in Crimea I'm not sure there would be much fighting.

Hens are going to continue to lay eggs regardless of whoever is in control of the country.  As long as the eggs can get to a customer, and the customer as the ability to pay the company should continue to make money.

The second potential risk is that even if the company can conduct operations going forward it will be at a reduced level.  I'd consider this the best argument for the low valuation.  Some of Avangardco's facilities are in Crimea, maybe those will have to be abandoned.  If Russia invades Eastern Ukraine then maybe the company will lose half of their facilities or critical infrastructure.

If the company were to lose half of their earning power they would still be trading at a very low valuation of 4x earnings.

I think there's another alternative that investors should consider as well.  Prior to Ukraine's recent unrest they weren't known for having the most transparent or honest government.  Even in those conditions Avangardco was able to flourish under the control of their billionaire owner.  My thought is that the owner knows how to grease the political wheels to get favorable treatment.  Considering that the Russian economic system seems to be run by in a similar manner it's likely that Avangardco's owner will find a way to work in whatever new political system emerges.

The question to ask regarding Avangardco is if the worst case doesn't happen then what does the future look like?  If their facilities aren't destroyed in a war or collectivized in a communist revival, and the hens continue to lay eggs is it worth more than the current valuation?

If you think the worst case is a likely outcome then this is an investment to avoid at all costs.  If you don't think the worst case is likely then the company could return multiples once the political environment begins to settle.

I think Avangardco illustrates a few things about buying cheap companies and margin of safety concept.  If an investor is buying companies without much room for error their assumptions and estimations need to be very accurate to realize a return.  The cheaper a company gets the less accurate assumptions or estimations need to be.  At a certain point, as in Avangardco's case, as long as the company survives and is able to find a way to make money investors will most likely realize a return.

Disclosure: No position