The role of dividends

Happy New Year! As I write this 2013 is coming to an end and 2014 is right around the corner.  Hopefully 2013 was a great year, and wishing that 2014 is even better.

I don't talk much about dividends on the blog mostly because I haven't thought much of them myself.  For a brief period of time, around 2006 I had a slight interest in dividend stocks and the concept of dividend growth stocks.  The idea is that investors look for companies that have grown their dividends at a high double digit rates for years and then invest in those companies for the dividend.  In theory the investor's income stream will continue to grow 10-15%; the company's dividend growth rate.  Dividend growth investors don't seem concerned about price appreciation, only dividend growth.

A disciplined and patient dividend growth investor might start a small portfolio in their 20s and by the time they're in their mid-60s have a sizable growing income stream they can use in retirement.

The concept is alluring and works well when modeled in Excel.  It also worked well over the past thirty or forty years.  The concept broke down for myself because I had trouble paying up for companies that had growing dividends.  My concern was that while a company might not cut their dividend in a recession their price could take a sustained hit.  Dividend investors are supposed to ignore price movements and focus solely on dividends.

The dividend growth model just never stuck with me, especially after a number of dividend growth stocks such as financials ended up cratering and cutting their dividends in 2008/2009.  Many dividend growth investors experienced a double whammy, no more dividends, and a reduced principle.

Value investors often seem to ignore dividends entirely.  Many value investors in the Buffett mold disdain dividends preferring companies to reinvest at high rates of return, or to buy back shares.  If a company can profitably reinvest their profits to fuel more growth at high rates it makes sense for them to reinvest.  Similarly share buybacks make sense if managers are able to acquire shares at low valuations in quantities that are meaningful, and don't issue options that offset the buybacks.

Unfortunately many businesses don't have great reinvestment opportunities, and managers aren't the best investors, often buying back stock with the price is high and failing to do so when the price is low.  I have talked with a number of executives who tout reinvestment, but when asked how they measure if their investments are successful suddenly become silent before admitting they have no way of measuring results.

My own approach of buying average or below average businesses at extremely attractive prices has resulted in a portfolio of companies that often should not be reinvesting in their business.  Many times management at these companies isn't familiar or comfortable with share buybacks either.  This means I've had to become comfortable with companies that pay back some, or a lot of their earnings as dividends.

My own view on dividends has changed through the years.  I started like most value investors, completely ignoring them, to shifting to an approach that appreciates and looks for them in certain circumstances.  Specifically I look for a company to pay a dividend when it is foreign, or unlisted.  If a company it is neither foreign or unlisted I am content to invest at an attractive valuation and let the market do its work.

The reason I want a dividend in an unlisted or foreign company is because value realization can take longer in those circumstances, and I want to be "paid to wait."

I've found that unlisted companies, and foreign companies also tend to pay out a larger proportion of their net income as dividends.  When one looks only at the price action of a company they miss a valuable component of return.  In my 2013 year end review two companies mentioned showed lower than realized performance because I didn't factor in dividends, Argo Group and Carlo Gavazzi.  In the case of Carlo Gavazzi their dividends added an additional 7.7% to their yearly performance.

A common complaint I receive about companies I write about on this blog is that there are no catalysts and it's painful to wait for the price to appreciate on its own.  One antidote to this thinking is to invest in undervalued companies that pay out dividends.  The dividends provide a built in level of return without a catalyst, or market price action.  Investors can receive high returns (often upwards of 8-10% in Europe) while they wait for the market to realize the undervaluation.

In this manner dividends can be viewed as an essential tool for hitting a yearly performance target.  If one has a goal of earning 15% returns from their portfolio, and the portfolio yields 5% then the portfolio only needs to appreciate 10% to meet the goal.  All things considered a 10% portfolio appreciation is easier to achieve than a 15% portfolio appreciation.

I don't believe companies paying significant dividends should be specifically sought out, but I also don't believe dividends should be entirely ignored.  Somewhere in the middle is a happy medium, a place where dividends are appreciated as a component of return.  I've come to appreciate them more over the years, and as one who invests in average businesses I'd prefer management give earnings back to me to reinvest rather than squander the earnings themselves.

Looking back at 2013, how did my 13 picks do?

Last year about this time I suggested 13 stocks for 2013.  The stocks I picked were a subset of my overall portfolio, stocks that I felt at the time were still attractively priced.  The stocks typified the types of companies I like to invest in, somewhat dull, but often attractive on an asset basis.  Some of them are cheap earners, but first and foremost all had a margin of safety.

Here are the results:

I want to note that the performance isn't exact, I made the mistake last year of not recording the prices when I did my post.  It was hard to find historical prices for the foreign holdings, I used what appeared on my brokerage statement, or what had for the end of last year for many of the holdings.  I also didn't account for dividends, some stocks such as Argo paid significant dividends meaning the overall performance is understated maybe 1-3% or possibly more.

The picks did exceptionally well for a bunch of companies the market didn't have much faith in.  Many were priced below book value, and a few were net-nets.  For many of the companies their earnings didn't change dramatically in the past year, what changed was the market realized these companies were mis-priced and acted accordingly.

If you look at my post from last year you'll notice I excluded the category Japanese net-nets from my list above.  This is because I didn't specifically name any net-nets, and it's hard to find a way to track that pick.  I did a post on the performance of my Japanese net-nets at one point in the year that should give a good reference for how some of the category performed.

As of the post last year I held all of the stocks I had mentioned, throughout the year I ended up selling some of the positions.  I sold my stakes in Argo, Bank of the James, and Nexeya.

I don't advocate holding stocks for arbitrary time periods, rather I prefer to sell when they hit what I consider fair value whether that's in three months or three years.  An active investor in the above portfolio would have been able to do better if they sold throughout the year rather than holding onto the stocks.  At one point FRMO raced into the $8s, and Installux hit €200, both would have been sells at those points.

A question I'm sure to get in the comments if I don't answer here is "how did your personal portfolio do?"  As I mentioned above I owned all 13 stocks coming into 2013, but I also owned about 40 other stocks not mentioned in the post.  Overall my personal portfolio was up about 39%, which is something I'm very satisfied with.  The difference between the performance of my personal portfolio, and the 13 stocks in this post is that I hold a number of other companies in various stages of value creation that while I'm happy to hold I didn't consider them attractively enough priced to post on them.  Almost every stock I own in my portfolio has appeared on the blog at some point.

Here's to hoping 2014's returns are as great as 2013's!


The gravity of the market

The market is nothing more than millions of individuals making millions of decisions at the same time.  Yet through these millions of decisions consensus forms and stocks slowly rise or decline towards their fair value.  This idea that stocks are pulled towards their fair value is what I term the gravity of the market.

I view the stock market as a spectrum of value, from zero value on one side to outrageously valued (think snapchat) on the other side.  Every traded company falls on this spectrum somewhere, and often the company's position changes hourly, daily, and yearly.  I envision my spectrum in two ways.  The first is that there is a center of gravity to the spectrum, when there are a relatively equal number of undervalued and overvalued stocks the market is in balance.  When undervalued stocks prevail the market is out of balance and is due to tip higher.  Conversely when there are too many overvalued companies, and not as many undervalued companies the market is out of balance and is due to tip lower.

The second way I visualize my spectrum is I imagine it having a mass of gravity that is constantly working to pull companies towards the center.  The market doesn't like companies that are out of balance, it is always pulling towards the center.  The force of market gravity is much stronger at the edges.  A company hovering near the center might be slightly undervalued, but the pull of gravity near the center is so weak the stock might never be pulled the last little bit.  On the other hand a company at either edge of the spectrum feels the pull of the market's gravity very strongly.  A small improvement for an undervalued company could translate into a giant advance towards the center.  A small slip-up for an overvalued company could mark a quick retreat towards the center.

I don't think many investors would dispute my theory of market gravity, it's essentially a different way of thinking about reversion to the mean.  I prefer the idea of gravity because it's a strong force, mean reversion doesn't carry as strong of a connotation.

The issue many investors have is they find the idea of market gravity mysterious, and mysterious unexplainable things are hard to accept.  I don't find the idea mysterious at all.  There are millions of investors trawling through securities worldwide.  No security is unknown, although many might only be known to a small group of people.  The process of investors looking for, talking about, and investing in stocks moves these companies towards the center of gravity.  At times it might seem like an investor buying 100 shares of a tiny pink sheet company is meaningless, but even small actions matter.  The 100 share investor might tell a friend, or email about a stock and 10,000 share investor might become interested and slightly move the price.

By nature investors can't hold back on talking about bargains they've found, they're inclined to share their ideas with friends.  Get more than two investors together and suddenly ideas will be flowing.  Likewise there is a jumpy or jittery nature to investors who invest in overvalued companies.  Many times investors will recognize they're playing with fire and are hoping to get out just before the bottom falls out of a hot stock.  Enough investors looking to avoid a dip might result in exaggerated moves with a high flying stock.

The force of the market's gravity is strong and I don't believe it's failed yet.  There is no list of stocks that have always traded at lofty valuations, and there is no list of stocks that have traded at 15% of book value forever.  Both situations are corrected eventually.

Many investors don't have the patience to wait for gravity to pull their holdings towards fair value.  Instead of believing in the force and being patient they seek out catalysts, investors who by sheer will attempt to overpower the market's gravity and push stocks to fair value themselves.  At times a catalyst can work, other times it's nothing more than a hope or a dream.

I have generally found that finding stocks on the far edge of the undervalued spectrum combined with a heavy dose of patience has resulted in satisfying returns.  Once I purchase I sit back and let the market's gravity do its work.  The question is do you believe in the force of the market's gravity?  And does your investing reflect this belief, or lack thereof?

Versailles Financial, almost too good to be true

Illiquid community bank stocks are possibly some of the most neglected securities in the market.  Many investors won't consider making a bank investment, and further, not many bank investors are willing to venture into the dark reaches of the unlisted and illiquid stock world.  It's at the junction of these criteria (unlisted, illiquid, bank) that some of the best deals of the market can be found, Versailles Financial (VERF) is a perfect example.

Community banks can be scary to some investors, a few bad loans and the whole ship is sunk, especially with a small bank.  A few bad loans at a larger bank and no one notices.  A few bad loans, years worth of bad decisions, and bad management and the country's citizens will bail you out at a large bank, unfortunately (or fortunately) there is no one backstopping community banks.  I would prefer a bank with management making intelligent lending decisions resulting in few if any losses.

Versailles Financial is the holding company of Versailles Saving and Loan, a single branch bank located in Vesailles Ohio founded in the 1800s.  The company shares its name with the royal and well known palace in France.  Versailles Financial is neither well known, or anything of note.  Versailles Ohio is a city with a population of 2,687 people.  I grew up in Northern Ohio, and we used to joke places like Versailles had more cows than people, the joke was funny because it was often true.  The bank's link to agriculture is most evident with that fact that 16% of its loan book is for farmland.

The investment case for the bank is fairly simple, the company's current market cap is $5.9m against a tangible book value of $9.8m.  In other words they're selling for 57% of TBV.  The bank is also profitable, and has been for the last nine years, sailing through the financial crisis without a loss.  They're over capitalized as well with an 35% tier one capital ratio.  The company's nine year earning summary is shown below:

The company isn't generating record earnings which can mostly be attributed to the lack of scale the bank has with only one branch.  A bank's branch network is what works to gather deposits and generate new loan volume for the bank.  With only one branch deposit and loan growth can both be constricted, which is the case for Versailles Financial.

One item worth noting on the income summary above is the lack of provision for loan losses.  A bank's safety is derived from its balance sheet.  A bank's value is also derived from its balance sheet.  If a bank has a history of dodgy loans then it's worth discounting their loan book when valuing them with the expectation that the future might look similar to the past.  Versailles Financial's lending history has been absolutely pristine with a very small amount of loan loss provisions, and an even smaller amount of charge-offs and non performing assets.  As of the most recent quarter the bank had zero non performing loans, no loans past due, and no OREO holdings.  Sit and consider that for just one minute, every single loan that Versailles has made is paying on time, the company has zero bad loans, not even one tiny mistake by a junior lending officer, none.  Granted this could change quickly, but given their lending history I'm fairly confident in their lending ability.

A cynic might read the above paragraph and think that they are cooking the books.  I would argue the opposite.  Recently bank regulators have been coming down hard on community banks in the area of charge-offs forcing them to realize them early.  Because of this the income statements of small banks have been prematurely depressed.  The large banks aren't dealing with this, regulators have allowed them to post-pone charging off loans that haven't paid in over six months; extend and pretend is alive and well at our largest banks.

An astute reader might wonder why this bank hasn't sold yet, they appear to be a prime candidate.  Single branch banks make perfect acquisition targets, there are many costs that can be removed quickly, such as the duplicate CEO and CFO, where the savings flow straight to the bottom line.  In the case of Versailles the retirement of the CEO and CFO alone would most likely double earnings.

The bank was founded as a mutual in the 1800s and IPO'ed in 2006.  Mutual conversions are restricted from selling themselves anytime before the three year anniversary of their IPO.  The timing for Versailles wasn't that good, their three year anniversary fell in the beginning of 2009, not an ideal time to sell a bank.  Since 2009 the bank M&A market has been soft, especially for many smaller banks like Versailles, it's hard to get a deal done for a $48m (assets) bank, there just isn't much interest in that market size.

While size is a potential negative I'm comfortable investing in a small bank with pristine credit quality at 57% of TBV.  When the bank IPO'ed a reasonable valuation would have been 1.2x TBV, at this point even if the bank traded up to TBV shareholders would be satisfied.  Until the market realizes what a deal Versailles is I will continue to hold the stock and let management do what they do best, make high quality loans and collect interest.

It's worth mentioning that this is an extremely illiquid stock, it trades by appointment on occasion.  It took a few months for my initial order to fill.  Patience is rewarded with a stock like this.

Disclosure: Long VERF

250 posts and counting, lessons learned

I recently crossed the 250 posts threshold, and while an arbitrary number I felt a small bit of introspection on the last three years of writing this blog might be warranted.  Many writers will start a blog with a post detailing their goals for the blog and why they blog.  I've never done such a thing, and I'm not sure it matters.  My goals for this blog are not your goals, if we have different goals but you still enjoy reading then I'd say I've been successful.  But to be honest I never stated my goals because I never had any.  I like to start things and see where they go instead of starting a project with a finish in mind.  For now I'm just riding the wave of Oddball Stocks, we'll see where it takes me.

1. Writing improves thinking

Arguably the biggest gain I've had from writing this blog has been that forcing myself to write out my thoughts and investment ideas has improved my thinking.  Writing clarifies thinking, often we think ideas are clear in our mind, yet when we try to explain them they're a jumbled mess.  Many times I will uncover something I need to research further, or realize information might be more or less valuable than initially thought when I'm putting my blog pieces together.

Beware though, we are our own worst critics.  I still feel like my English grammar hasn't progressed beyond 9th grade, which is incidentally when I had to take a grammar remediation class.  I appreciate everyone trudging through what I write even when it might not be as clear as possible.  Maybe once the blog generates more than zero in revenue I will work on hiring an editor.

2. Assumptions are often flawed, a margin of safety is key

One advantage of writing everything down is it can be reviewed later.  It's amazing to see how many things I thought would happen in the future never came to pass.  Likewise it's incredible the number of investment surprises that I've experienced as well, both good and bad.

When we make assumptions it's easy to forget ones that don't work and remember ones that do.  By having everything recorded we preserve a record of our decision making that can be reviewed and studied later.

When reviewing my past investments and write-ups on the blog the concept of margin of safety has been re-enforced.  No one knows the future, if we buy a security at a large enough discount we in theory are protected against a multitude of bad surprises, and are opening ourselves to the potential for a good surprise.

3. There are no points for ideological purity

Since writing this blog I've come across a number of investing purists, maybe something isn't 'value' enough, or it isn't something Buffett would ever buy.  These investors are attached to a dogma, they invest with that dogma and are zealous about protecting the dogma.

I have no investing dogma, and most of the successful investors I've met don't either.  I'm not even sure Buffett has one, if he can turn a dime it seems he's a willing participant.  At the end of the year I want my portfolio's value to be greater than at the start of the year.  If I had to invest in net-nets, or low P/B stocks, or cash boxes, or whatever to get there it doesn't matter as long as the goal is hit and my risk is kept in check.

Investors aren't rewarded based on what school of investing they follow, they're rewarded when they buy something mis-priced, whether it's growth, or assets, or cash flow, or exotic artwork.

4. You are not the first to ever find an idea, no matter how obscure

I don't agree that a justification for a low valuation is that a stock is undiscovered.  There are always others who are aware of any potential investment either at the same time as you, or before you.  This might sound strange coming from someone who digs up what seem like many original ideas.  But I've found that in almost all investments, no matter how obscure I end up connecting with a number of readers who already knew of the company, or were aware of the situation.

The comments you see on this blog are a small snapshot of the correspondence I have with readers.  I probably have a 20:1 ratio of emails to comments, for each comment you see on this blog I have about 20 emails discussing various investments or asking questions.  I've found that there are passionate followers of even the most obscure stocks I have dug up.  It turns out the more obscure and strange something is the more responses I get in private about the company.

Given a function of how many global investors exist, the inter-connected nature of the Internet, and how easy it is to communicate and find ideas I don't think there are many hidden markets left in the world.  On the other hand there are plenty of ideas hiding in plain sight.

5. Some stocks are fun to write about, but not necessarily good investments 

This is the hardest lesson that I've learned on the blog, many stocks which are a challenge to unravel, and generate heated discussions aren't necessarily great investments.  Sometimes the best investment is a simple one like PD-Rx, or REO Plastics.  These companies were straightforward at the time of investment, undervalued assets with earnings.  But there isn't much to write about for a company like that.  Whereas some of the most interesting and complicated investments don't offer as attractive of a return.

It's difficult writing to find a balance between posts readers might enjoy, and posts that provide potential profitable investments.  I clearly enjoy unravelling a good mystery, but if I filled my portfolio with mystery stocks I would probably have sub-par returns.

I've purchased a number of small companies where an hour of research is all I need to make an extremely educated investment.  That includes reading all of the news and multiple years worth of annual reports.  These simple companies also have generated substantial returns for my portfolio as well.

In the past year I've tried to increase the mix of topics I post about, great ideas, ideas I passed on, general investment thoughts, and investment mysteries.  With a greater mix it's harder to get stuck on one topic for too long, which hopefully lessons any potential for boredom from reading the site.

Final thoughts

I've enjoyed writing this blog, it's helped me develop as an investor, helped me meet many great people, and hopefully made a little money for many readers.  Here's to the next 250 posts!

CIBL, a discounted pile of cash with high optionality

An oft-written about investment on this blog, CIBL (ticker CIBY) has finally come full circle.  What started as a complicated mess of wireless partnerships and TV stations has finally been unwound into a pile of cash and two new investments.

If you have the time I'd recommend reading the full series on CIBL, part 1, part 2, part 3.

For the rest of you I'll provide a quick recap.  CIBL was spun off from telecommunications company LICT in 2008.  CIBL as originally spun off was simply a collection of ownership interests in various joint ventures: two wireless towers in New Mexico, and interests in two TV stations in Iowa.  In my initial post I speculated that the company could be worth between $1249 and $3314 if they were to sell out of their ownership interests.

The company had stated in their financial reports that they had received an offer to buy their wireless ownership interests for a value that was materially higher than the current share price.  Even with a clear message from management regarding their undervaluation the market didn't seem to care.  The Board, which includes Mario Gabelli, a famed value investor with a 27% ownership stake seems very shareholder focused, both on realizing value, and undertaking shareholder friendly actions.

Fast forward close to two years later, CIBL has followed through and sold out of their wireless towers and TV station ownership interests for a value that is slightly higher than my low end estimate.  It's fascinating to read over my previous posts, and especially the comments with the lens of knowing how things worked out.  My estimate of value for the TV stations was low, my highest estimate of value was $13.8m, and they sold the stations for $14.5m.  On the other hand my wireless tower valuation was too aggressive, the final sale was for $31m, whereas I estimated they could be worth anywhere between $25m and $68m.

Amazingly even with management's value unlocking actions CIBL still looks cheap.  Here is a breakdown of their current assets:

The company has a large amount of cash from the sell off of their wireless towers, as well as from distributions from past operations.  They also have $352 per share receivable net of taxes from the sale of their TV stations.  Once the sale closes, which could be a while due to regulatory issues, the company will have close to $1400 per share in cash.

Along with their cash the company holds two other investments, a 1.26% stake in Solix, and a 51% ownership interest in ICTC, a rural telecom company.

The company's Solix stake is non-traded, but Dave Waters found they did $91m in revenue in 2012 when he wrote about CIBL, I am valuing the stake at 1x of sales.

When evaluating the latest price against the sum of the parts detailed about CIBL is about 20% undervalued.  The stock would need to rise about 25% to trade at the value of its assets, which would be a nice appreciation for shareholders, but nothing to write home about.

There are two factors that I believe make CIBL more attractive than the numbers initially suggest, potential hidden value at CIBL, and Gabelli's capital allocation skills.

As mentioned above Mario Gabelli owns 27% of the company and serves as a Director.  Gabelli is a well known value investor who runs GAMCO Investors a $30b asset management firm that runs a number of highly rated mutual funds.  While the CIBL stake is nothing more than a speck to his overall fortune he does seem to be actively involved in pushing for value creation.  The real kicker for CIBL is that Gabelli and his associates will have a pile of cash to invest.  Given how well they've done in the past I don't mind letting them invest some of this cash for me.

The second factor is potential hidden value at ICTC itself.  CIBL has worked over the past year to increase their stake in ICTC at $22 a share to a 50% ownership stake.  When I initially looked at the ICTC financial statements I couldn't understand why CIBL was interested in buying shares.  After thoughtfully reconsidering the statements I began to see shades of hidden value, much like CIBL looked like when I initially researched them.

ICTC is a holding company for a rural telecom company as well as a CLEC and a few other assorted investments.  The company is selling for slightly more than stated book value and a reasonable earnings multiple of 12.6.

Gabelli & Co did well unwinding the complicated ownership interests and joint ventures of CIBL and turning them into cash.  My suspicion is that they're intending to do the same thing with ICTC.

ICTC has a few sources of value, the first is the telecommunications operating company.  The company has 3200 customers that are generating $1274 in revenue per customer.  This is compared to Frontier Communications who's customers are generating $1385 in revenue per customer.  I will take ICTC's market value as their fair value; let's assume the telecommunications company is worth $8.2m or 12x earnings.  Then the company has $2.9m in cash, and a slightly smaller amount of debt.  There are two ways to look at this cash and debt.  The first is that it might travel with the telecom company in an acquisition.  The debt might be attached to communications facilities or equipment, and since it's easily serviceable it wouldn't need to be paid off.  The second way is to net the cash and debt effectively canceling them out, I think this is probably appropriate.

ICTC has three investment holdings, an ownership stake in a North Dakota telecommunications carrier, a few miscellaneous investments and a partnership interest in a rural wireless tower.  Their investments are starting to sound like CIBL's investments.  ICTC carries their tower interests for $144k, which is understated considering it paid them over $250k in distributions last year.  If the company were to sell the wireless tower interest at a similar multiple that CIBL received for their New Mexico towers it's presume that they might receive $1.7m for their interest.  My guess is that their North Dakota ownership interest is similarly undervalued, although without more details it's impossible to know by how much.  If ICTC were to unwind in a piecemeal fashion I don't think it's a stretch to think they might be able to realize another $150 p/s in value for CIBL bringing CIBL's total asset value to about $1800.

Overall CIBL isn't a slam dunk investment, but it's the type of asymmetric investment I like, buying safety at a discount with the possibility of an upside surprise.  What makes the upside even more attractive is that the company has a history of profitably unwinding complicated investments, and a savvy investor is helping to take part in the process.

Disclosure: Long CIBL

Valuation thoughts: Terminal Value

An oft repeated mantra is that something is worth more than it's selling for now, but it's exact full value is unknown.  It's as Benjamin Graham said, you don't need to know a man's exact weight to know that he's fat.  Along these lines I've been thinking a lot about a concept I will call terminal value.  I believe each company has a maximum, or terminal value that is the most it could be worth.

A company's terminal value is what they would be worth if their assets could be put to their highest and most productive use.  Another way to define terminal value is what a company might be worth if the world's best capital allocator with expertise in a company's given sector were in control of the company and made perfect decisions.

I came to think about the concept of terminal value after thinking about valuing companies at a micro level.  As an example think about a bank branch.  Bank branches are everywhere, on some street corners all four corners are inhabited by branches of different banks.  The location of all four branches is the same yet each might have different levels of profitability, why?  Why can one branch across the street from another one differ so much in profitability?  Why is it that an underperforming branch can suddenly become profitable when the bank is acquired, a new logo hung outside, and new processes and procedures implemented?

At a micro level it should be possible to model the perfect bank branch.  We could take the best processes and procedures from any bank in the US and apply those theoretically to our example branch.  Then we could take into account location and geographic details.  All of these inputs would give us the maximum a perfect branch could produce given a certain level of deposits.  If this exercise were extended to all of a bank's branches in theory we could create the maximum value of a bank.

The sum of these maximum branch values, plus an ideal lending program could be considered a bank's terminal value.  Our model creates the most this bank could possibly be worth in an ideal environment.  If an investor is expecting a bank to be worth more than a terminal value their expectations are too lofty.  Conversely if a non-perfect management team, or non-ideal environment exist then the bank's intrinsic value should be much less than its terminal value.

I used the example of a bank and bank branches because branches are easy to understand, and somewhat fungible.  But the concept of terminal value isn't limited to banks, I would say in many ways it's more applicable to other business types.

Take an example of a real estate company that owns an apartment building.  If the company were to attempt to rent their apartments for double the rent of any nearby building they'd have a vacant building.  So it's reasonable to assume that there is some value of rent that minimizes vacancies and maximizes revenue at the building.  If the company were to keep the building in this ideal state forever that cash flow might represent terminal value.  For this real estate company they can't be worth more than this value unless something unusual happens.

It seems like many investors build investment thesis on the premise that something unusual needs to happen for an investment to work out.  A company with an entrenched management team needs a change of heart.  A previously unsalable asset suddenly becomes liquid, an underperforming division suddenly wildly profitable.  Something unusual is different than a reversion to the mean.  A company can't underperform, or outperform forever, eventually competitive dynamics will either hurt or help the company and push them towards the middle (the mean).  The something unusual thesis is expecting that something external to the company, which is unpredictable, and unknowable will unlock value for investors.

Unusual things to happen to companies, they are nice surprises that everyone can celebrate.  Maybe the real estate company owns a property in a depressed area that suddenly experiences revitalization.  While it's nice to experience an external event that unlocks value, it is speculative to base an investment thesis on something unknown and unknowable.

What's the practical application of the terminal value concept?  I don't expect any investor to build a giant model of the highest and best use for each property a company owns.  I think terminal value is a great framework that provides a double check on investment assumptions.  If a thesis assumes Warren Buffett's expertise, but instead has Barney Fife as management it's time to scale back expectations of intrinsic value.  This framework can also help clarify where we think ultimate value will be derived from.  Will it be better utilization of current assets, or something external to the company?

West View Savings..a sleepy bank ripe for an activist

I have a confession to make, when I see a cheap bank I have a hard time not purchasing shares, when the bank is local the shares become irresistible, which is how I ended up owning a position in WVS Financial (WVFC), the holding company of West View Savings Bank.

There's something to be said about investing in local companies.  It's easier to conduct research beyond filings.  I used to live behind West View Bank's headquarters, my evening run used to take me past their building and parking lot.  One might argue this is meaningless to an investment, but I'd argue otherwise.  After running past their branch daily I had a sense for how busy the bank became on certain days, and could see how well the company maintained their facilities.  The biggest advantage though is that their annual meetings are local, in West View's case they hold them at a church about 15m away from where I live.

The annual meeting was a great opportunity to meet other like minded investors in Pittsburgh, it also gave me a chance to talk to senior management at WVS Financial and question the board.  Unlike my experience at Solitron, the WVS Financial team was open to questions and glad to have shareholders interested in the company.

West View Savings Bank was a Pennsylvania chartered mutual savings bank up until the early 1990s.  A mutual savings bank is owned by their depositors.  When a mutual bank IPO's the depositors are given the option of subscribing to the IPO, in effect they're doubling down on their stake in the company.  The bank raises capital in the IPO and shareholders receive the cash they put in, along with the existing equity they had previously owned.  It became apparent to me at the meeting that many of the shareholders in attendance were original participants in the IPO.  One even going as far as asking the CEO if it was even possible to dispose of shares, to which the CEO told him that he could go down the street to the local Fidelity office and open an account to sell them for $8.

The bank is listed on the NASDAQ, but their listing hasn't attracted much investor attention, shares trade infrequently and were selling at 50% of BV in the past year and a half.

The investment case for WVS Financial is fairly simple and can be summarized in a few bullet points:

  • The bank is selling for 72% of tangible common equity.
  • They are profitable, and remained so during the financial crisis.
  • The CEO is fanatical about managing risk, NPA's are almost nonexistent, charge-offs are low, lending is extremely conservative.
  • The bank's balance sheet is conservative, most of their assets are in cash and securities, lending is very low.
  • Due to the balance sheet mix if the bank were to grow their lending, or rates were to rise earnings would rise significantly.
Here is a snapshot of the holding company's statistics from :

Two numbers from the above stats are probably sticking out to anyone who invests in banks, the 5.87% ROE, and the 1.63% NIM.  You're inclined to stop reading, please bear with me, those figures are low, but there is hope.

The reason for the bank's below average net interest margin can be easily spotted by looking at their balance sheet:

The bank's loan book has been in decline over the past decade from $61m down to $33m.  Couple the lending decline with a decline in interest rates over the same period and it's not a surprise that their NIM has been trending downward.  The bank has never been a strong earner due to their conservatism, but even if lending had stayed flat at 2011 levels earnings would be much higher than now.

At the annual meeting the company was questioned regarding their lending and their conservatism.  Management says they're waiting until rates jump 100bps before they increase lending.  Unfortunately there's no telling when this might be, in the next year, or in five years or more.  The conclusion I took away from the meeting is that the company has a lackluster lending operation.  In a low rate environment they should have been originating loans and earning the servicing revenue where possible.

Compared to the lackluster lending operations the company's deposit base is strong:

Most of their deposits are interest bearing, but from what management explained at the annual meeting the majority of the interest bearing deposits are in 1-year or shorter CD's paying a nominal amount of interest.

If I could summarize my post to this point it would be: West View Savings is a very conservative bank with a poor lending program, solid deposits, and a great branch network selling at a cheap price.

The issue all investors ask is whether the price is justified, and what might happen to unlock value.  If West View were to never change, then it's possible that 72% of book value is a reasonable valuation.  I don't believe it's reasonable because I believe cheap sleepy banks eventually catch the eye of an activist or acquirer.  One bank activist who has a small toehold position in the stock is Joseph Stilwell, he owns about 1.5% of the common, not much more than a book mark position.

While a stock activist might not be waiting in the wings I think West View is extremely attractive to a potential acquirer.  I've spoken to some knowledgable individuals in the bank industry and there are rumors floating that a few regional banks are looking to buy into Pittsburgh.  Wesbanco did this recently with Fidelity Bancorp.  Fidelity had a similar profile as West View, a great deposit network, but poor lending.  Wesbanco purchased their deposits and placed their own lending program in the branches, the formerly poorly producing branches should be churning out profits for Wesbanco soon. It's possible Wesbanco would be interested in acquiring West View to further expand their presence, or another bank looking to enter the market.

An acquiring bank would see a valuable branch network, valuable deposits, a clean loan book, and inefficient assets.  Turning West View's mortgage backed securities portfolio into a valuable loan portfolio is a much easier task than turning around failed assets, or trying to build a brand in a new market.

I'm hoping that either West View's current management will be prompted to develop their lending, an activist will get involved, or an acquirer will see value in the bank.  I believe in the maxim, but something cheap and maybe something good will happen.  I'm also not opposed to working to unlock value myself through discussions with other investors/funds/potential banks/management.

Disclosure: Long WVS Financial, open to acquiring more.

All screenshots are from, stop hunting down call reports, FFEIC reports and building massive spreadsheets, let us do the work for you.

Costar, a missed opportunity in review

Back in January I wrote a small post about a company named Costar (CSTI), the post was fairly concise and to the point.  I researched the company and found some things that made me uneasy, the sum of the uneasy items led me to pass on investing.  That was when the stock was at $2.02 a share, it trades today at $8.25, and hit $10 two days ago.

I wanted to review the investment with the benefit of hindsight, the most cruel type of review possible.  Decisions that look sound at the time appear foolish in hindsight, and decisions that were foolish and reckless can appear to be genius in hindsight.  The purpose of looking at Costar again is a examine my initial reasoning.  If my initial conclusions were made on a sound basis, and because I can't know the future I will be satisfied that even with a missed investment gain that I made the right decision.

The reasons I passed on the company were fairly simple, I was worried their profits weren't sustainable, I didn't like that it took them five years to turn the business around, and I didn't like their debt and cash situation.  All of those items combined led me to pass on investing in the company at 46% of NCAV.

When I wrote Costar up they had a book value of $8m, $203k in cash and $1.4m on their credit line, trailing earnings (9mo) were $.45 p/s.  Fast forward to today, they have $2.5m in cash, $10m in equity, no debt, and trailing 9mo earnings are $1.43 p/s.

I made a bold claim at the end of my previous post on Costar, I believed they were fairly valued at $2, because I felt their inventory might be overstated, and I was concerned their profitability was a mirage.  I had good reason to believe that as well, the company had earned $.45 in the first three quarters of 2012, but in Q3 they were essentially break-even earning $2,000.

With the benefit of hindsight I look like a moron, I was worried about earnings disappearing, and instead they more than tripled.  There was no way to know earnings would suddenly explode, when I looked at the company they had their first reported profit in years, and then suddenly a quarter later they were operating at break-even again.  It appeared at the time that their earnings were temporary, and were back onto a normal declining trajectory.  On the earnings front I feel like my decision at the time was the right one.

When reviewing my decisions regarding the balance sheet I'm much more mixed on whether I made the right decision.  The company reported in 2012 that they had trouble securing a credit line, they were able to secure one from a lender with a high rate, and low underwriting standards.  This was a concern, I felt that going to a lender like this was an indicator of the quality of the company.

I've had a number of conversations with bankers and small business owners recently that casts doubt on my conclusion over Costar's debt.  I've come to find that financing for a small company with the income history of Costar is almost nonexistent at a traditional bank right now.  Banks are only interested in loaning a million dollars to a guy with two million in his account.  Large banks are lending to large companies, and large companies have no problems issuing debt, but the financing market is still difficult for small companies, especially ones that aren't pristine.

My myopia on their lender prevented me from seeing that the company had aggressively paid down debt.  Management was serious about eliminating debt and finally did so in the past few months.  The cash the company was using to pay off their debt has now started to pile up on the balance sheet.

Overall I'm mixed on Costar, if I were to look at them again today as they were in January it's possible I'd make the same decision.  If I had known more about the small business financing market I might have cut them more slack.  With a net-net the balance sheet is the starting point for an investment, if confidence in the balance sheet is lost the investment is lost.  I didn't have confidence in Costar's balance sheet, and while earnings recovered nicely there was simply no way of knowing it would happen.

What does the future hold for Costar?  I don't know, they earned $.72 p/s this past quarter, annualized that's $2.80 in earnings for the year, for a whopping 40% ROE.  Unfortunately one of my key questions remain, are these earnings sustainable?  If so then Costar is probably a bargain at these prices, if not then look out below.

Disclosure: None

Why go Buffett?

There seems to be an unspoken (but often implied) mantra in value investing that beginner investors start with asset investments and then once they learn the ropes and grow they graduate to real investment, buying great companies based on earnings or free cash flow.  A special few graduate to the highest honors of value investing, special situations, catalysts and bankruptcies.

I was attracted to the idea of value investing because it appeared so simple, purchase something for less than it's worth.  When I first encountered this it was so obvious, I couldn't believe that everyone in the market wasn't investing like this.  Purchasing something tangible for less than it's appraised value is something most of the population can grasp.  People will brag about the great deal they got on a pair of pants, or how they purchased a house out of foreclosure and saved a lot of money.  Buying an item at a discount to salable value is not a foreign concept to anyone, except participants in the public markets.  Market participants will bend over backwards to explain all the reasons a company should sell for less than book, or NCAV.  

Fortunes are made and lost in the market on a whim.  To make a fortune outside of the market you need to either marry the right person, be born in the right family, or most often work hard for sweat equity.  I've never heard of a young intelligent person starting a business, and within months turning the little local Carpet Barn into a billion dollar fortune through their raw intelligence, yet these sorts of stories percolate around Wall Street often.  A young fund manager can become famous from a single year of outperformance, or a single great trade.

For many it appears easy to make money in the market, do some reading, invest and profit.  The market's greatest spokesman, and one of the world's richest men doesn't help, Warren Buffett's folksy explanations of value investing are simple, but I feel miss the point.  I don't talk much about Buffett on this blog because I'm not sure if there's much to learn from him.  This might sound strange to say, but I put Buffett in a class of his own.  Buffett is a superstar investor, he is the Ussain Bolt, or Michael Jordan of investing.  Are Ussain Bolt's tips on running going to help me run any faster for my Thanksgiving race?  Probably not, no matter how simple they are, Ussain Bolt is naturally more gifted than I am.  I enjoyed reading The Snowball and Buffett's annual letters, but I don't believe he can be replicated, he's naturally a great investor, I don't have that same gift.

Given Buffett's success it's no surprise that there are legions of investors attempting to follow in his footsteps.  The problem is his footsteps are unclear, is it cheap stocks like he did in the 1950s, is it his concentration, is it his ability to discern great management teams, or his ability to take advantage of opportunity?  Everyone seems to have a slightly different take on what made him successful, and there is no consistent pattern to follow.

Buffett most recently has been preaching that investors should be buying great companies at good prices and let them compound.  Math is in his favor with a statement like this, it's impossible to argue against buying a company that continually compounds at 15-20% forever at a good or cheap price.  The issue is these companies don't sell at low prices often, and when they're priced low it's usually due to an issue or problem they're facing.  In my view claiming that the company will come out unscathed and continue on their unrelenting compounding journey is hubris that's often reinforced with hindsight bias.  No one knows the future, at best one is making an educated gamble that the future will resemble the past, with the twist that an investor is hoping any issue is resolved without incident.  We've lived in an unprecedented age of prosperity in America since the 1940s which has provided a nice tailwind for this style of investing, momentum is hard to change.

The mere fact that the world's most successful investor preaches a particular philosophy is reason enough for most investors follow after him prowling around for great businesses at good prices.  My view is that just because Buffett does something doesn't mean that everyone else can do the same as him no matter how easy he makes it seem.

What I don't understand is the general disdain for asset investing compared to Buffett's growth value investing.  The research bears out that simple value strategies like net-nets, or low P/B stocks outperform the market significantly.  In the book Quantitative Value the authors make note of a study that showed that if one were to take all stocks at less than 1x book value, short the ones with a low F_Score and purchase the ones with a high F_Score they would outperform the market by a whopping 20% a year.  The problem is doing something like this is too simple for most investors.  They want a challenge and buying and churning through cheap stocks isn't enough for them.

I like to think of value investors who follow in the footsteps of Graham are the antique collectors of the market.  We are digging through flea markets looking at old baseball cards hoping to luck on a mint condition Mickey Mantle rookie card.  We never quite find that Mickey Mantle card, but we do find a lot of Wade Boggs and Jose Canseco cards which if purchased cheap enough can be flipped for a nice profit.  The Buffett school of investing continually visits flea markets until the Mickey Mantle is found.  The problem is if one might not know exactly what mint condition constitutes, or how to tell the difference between an authentic and fraud card, and eventually overpay for their Mickey Mantle rookie card.

For me investing is a means to an end, it's a way to prudently manage extra savings and grow it at a rate above inflation.  When I need the money at some future date I hope to have more, I don't think I'll care much about how I got there, either by net-nets, low P/B stocks, or growing a business.

I'm not sure if this post has much of a point, maybe it's really a rant against an attitude I see a lot.  My question to you is: "Why so much disdain against a proven investment methodology, that while simple has historically consistently high results?"

Who are you talking to?

There is this stereotype image of a value investor being a lone wolf figure, holed up in some library poring over annual reports feverishly looking for investments.  Said investor simply reads and generates profits for themselves or their fund.  If all it took was a quiet location and lots of reading to be a successful investor the world would be overrun by rich librarians.  Fortunately, or unfortunately if you're a librarian, that's not the case.

I went to a local company's annual meeting recently, and the number of connections I made coming out of that meeting have had me thinking about the role networking plays in investing.

There's an interesting evolution in life, the young think they have everything figured out and have no need to listen to experience of the older generation.  They then repeat the same mistakes, learn the same lessons and then try to pass them down to the next generation with the same results.  It seems futile, but it's the course of life.  I remember being in college and receiving advice from mentors and bosses saying that networking and building connections is what mattered, not necessarily book knowledge.  I of course ignored the advice until I learned it on my own.  Now I'm sharing the same advice with younger people who ask, and I would imagine they're ignoring it much like I did.

Think about any given topic in investing, there are probably thousands of investors with experience investing in that space, maybe a few dozen will write blog posts about it, and maybe one will write a book.  Of the thousands of varied experiences the only remembered in a decade will be the ones in the book, or potentially a few blog posts.  Yet the experiences not recorded didn't vanish, and in many cases they might be better examples, and better explain the pitfalls and potential than what is recorded.  The verbal history isn't visible while the literary history is, what is visible is what's remembered.

I feel like there are certain foundational books to creating an investment style, the books explain important foundational concepts, but beyond that for an investor to grow they need to start talking to other investors.  It isn't enough to just read a few books, sit in a room reading 10-Ks and invest.  The investor who does this repeats the mistakes of earlier generations.

When an author writes a book they write it for a wide audience, they write generically.  When I talk to someone on the phone (or email) and ask for advice I can share my situation and the person giving advice can give specific advice tailored to my exact situation.  Additionally a conversation takes much less time than reading a book or a blog post, and can yield much more information.

So how does networking with other investors help?  First and foremost you get to meet interesting people.  If you put yourself out there as someone who wants to learn and meet new people you will start to make a number of connections quickly.  Secondly you might learn a lot about something that you can't learn anywhere else, especially online.  There is so much history that's stored up within people and will never be published to the world.  If you can make the connections with these people these stories can be unlocked.  Don't discount verbal history simply because it's unseen.

Another value investor stereotype that needs to be shattered is that all management is promotional and slimy.  If you're investing in junior miners in Canada, or Nevada development stage companies this might be true, but I've found otherwise.  Of course management is going to talk their book, I'm sure you'd talk your book about your portfolio if given the chance as well.  But most likely you're not an expert in the field that the CEO works in.  I've had short conversations with executives where I've quickly learned the important drivers and a number of considerations from a management perspective that I'd never seen anywhere else.

In the more than three years I've been writing this blog I've probably made about $150 in consideration directly from the blog.  What I have made is a great network of friends and investors I can talk to about potential investments, business opportunities, and general career and life advice.  If it weren't for reaching out and being willing to talk I would never have the network I have today.

The bottom line is that to grow as an investor you need to be talking to other investors, other business people, and people who work at companies you research and invest in.  These people will teach you, encourage you, and challenge you in a way that you can't get yourself.  In turn you might teach them, challenge them, and encourage them.  In the spirit of this post I leave you with a small excerpt of prose:

"No man is an island,
Entire of itself,
Every man is a piece of the continent,
A part of the main."

-John Donne


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Screen using relative metrics and market data, find holding companies and banks below or above specific thresholds easily.

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Sunlink: liquidating their way to profits

A common term associated with net-net investing is liquidation value.  In theory a company's current assets minus their liabilities approximates liquidation value, what the company might receive if it were to decide to close down and distribute the proceeds to shareholders.  Often a company's accounting liquidation value is not accurate except in cases where a company's assets are mostly cash, they have no liabilities, and management is determined to return the proceeds with as little friction as possible (read: lawyer/advisor fees).  A liquidation is where accounting value meets real world value, and a company's balance sheet gets a gut check.  Are the values on the balance sheet accurate?

In the public markets companies don't liquidate often, principally due to an incentive mis-alignment.  In many public companies management does not own a majority stake, and the company's ownership interest is divided among many diverse parties, that have never had, or will ever have contact.  A company's management is incented to keep their job, after all that's usually their only source of income. The company's owners usually don't have enough power individually to force a liquidation, and when they do have enough power management can often work against them eroding value.

Sunlink Health Systems (SSY) is in a unique position not unlike many companies on the brink of failure.  The company's management needs to work hard to liquidate balance sheet assets to stave off potential failure.  As management fights to keep their jobs shareholders are rewarded as potentially undervalued assets are sold for market value.

I was first introduced to Sunklink Health Systems through Whopper Investments, he wrote them up as a potential odd-lot tender opportunity.  I received their annual report in the mail, and even though I only own a tiny position for a tender I was compelled to browse their financials.  Browsing their financials led me to read most of the report as I became hooked on their story.

Sunlink Health Systems purchased five hospitals in 2001 with leasehold rights to a sixth hospital.  The company subsequently purchased another two hospitals and three home health businesses.  The company also operates nursing homes and a pharmacy business.  The company currently operates 232 hospital beds and 166 nursing home beds throughout their facilities.  The company's hospitals are primarily in rural locations.

The health care industry landscape has changed dramatically since the company acquired their facilities in 2001.  They went from earning operating profits from their hospitals to sustained losses most recently.  Compounding their losses is the fact that the company took on debt to finance their acquisitions, and it's coming due quickly.  The company doesn't have the means to raise capital, and with their operating subsidiaries generating losses management has been placed in a tough spot.  As a result the company has started to sell off hospitals.

Most recently the company sold two hospitals.  The first was a 50 bed facility in Southeast Missouri for net proceeds of $7.4m.  The company used $5.2m of the sale proceeds to pay down their debt.  The company also sold the Memorial Hospital of Adel, located in Georgia for $8.35m last year.  They used the net proceeds of $7.5m to pay down debt further.

In 2011 the company sold the lease to the Chilton Medical Center to Carraway Medical Systems for a monthly rent of $37,000, and the option to purchase the facility for $3.7m.  Carraway Medical Systems operating license for the hospital was revoked by the Alabama Department of Public Health due to their inability to meet financial obligations.  Carraway defaulted on their lease to Sunlink.  Sunlink tried to re-lease the facility but failed, their lease reverted to the original owner.  This property will be a total loss for Sunlink.

In 2004 the company sold a medical center in Georgia for $40m in consideration.

As of the most recent annual report, the company owned and operated three hospitals, one nursing home, and one joint hospital/nursing home, as well as their pharmacy business.

As mentioned above the company is facing two issues forcing them to monetize their assets, they are losing incentive payments for electronic health record conversion, and they are facing a debt maturity date in the next year.  As such the company expects to sell three of their hospitals within the next year if possible, and apply those funds to their debt, and use the remainder as working capital.  In theory the facilities they are keeping are expected to be profitable in the near future.

It's significant that I haven't mentioned anything related to the company's valuation yet, understanding the background is important to Sunlink.  The company trades with a market cap of $7.5m, but a better measure of value would be enterprise value, which is $23.3m.  The company's book value is $33m, of which $30m is their physical plant, which has an original cost of $64m.  The company has $9.5m of debt due in the next year, with $8.7m due shortly thereafter.

An investment thesis for Sunlink is fairly simple to construct after building out this story.  Are the three hospitals the company plans on selling worth more than $18m?  The two hospitals sold in the past few years sold for about $7.5m apiece (net).  If that figure holds true for the three latest hospitals the company would be able to pay back their debt and have cash left over to finance working capital.  The company is attempting to hold onto their best assets, the profitable pharmacy operations, nursing homes with profit potential, and land that is being redeveloped into a multi-use office park.

A simple scenario for what might happen is as follows: the company sells the three hospitals for $7.5m each net of taxes and fees for a total of $22.5m.  They pay back $18m in debt and then have $6m available as cash and a greatly reduced liability structure.  The company retains their pharmacy segment which is currently profitable, although barely, and the nursing home/hospital that they believe has the best profit potential.

An investment in Sunlink works out if the company is able to sell their hospitals for $7.5m or more each.  If they can do that then this is a much slimmer company, with no interest payments, and a remaining collection of assets that are profitable, or will be soon.  If the company can't sell their hospitals for $7.5m it's possible they will enter receivership.  A bankruptcy receiver might sell the company's hospitals, but it's likely shareholder recovery would be much smaller.

Investors seem to love lottery ticket investments, and Sunlink qualifies as such.  Investors have an additional factor on their side, the company's management is highly incentivized to sell the three hospitals, if they don't they will likely lose their jobs.  If they do they will keep their jobs, but also reap the benefits as the share price rises, and their stock options vest.

Disclosure: Long an odd-lot.

Hanover, still cheap; do changes signal a possible acquisition?

In a market that isn't bursting at the seams with cheap companies it's often worth revisiting older holdings that might still be attractively priced.  One such company is Hanover Foods (HNFSA, HNFSB), I previously posted on them over a year ago in a series of two posts (post 1, post 2).  In the ensuing year the company has continued to perform as expected yet the stock price has barely budged.  Additionally one of the largest items holding potential shareholders back from investing has been resolved.

Hanover Foods is a vertically integrated food manufacturing company.  They grow vegetables in Central America, ship them to the US, process them, package them and ship them to grocery stores.  Hanover's brands are distributed mainly in the Eastern US.  Readers who live in the East would probably recognize their frozen food packaging with a little dutch boy next to the logo.

The company's business hasn't changed since I last posted about them, they are still producing frozen vegetables, snack food, and frozen meals.

The company is clearly cheap, here are a few relevant metrics (most recent price $109.89):

  • Book value $285 p/s
  • NCAV $130 p/s
  • P/E 6.82
  • EV/EBIT 7.97
As seen above the company is clearly cheap, I would consider them one of the cheapest companies I'm familiar with in the market right now.  Of course with cheap companies, there is always a reason they're trading at a low valuation.

Hanover's Board and executives were involved in a messy legal battle before the company delisted in 2004.  The founder's grandchildren inherited the business, but couldn't agree on how the company should be run after their father passed away.  John Warehime, the oldest son took the reigns of the company by controlling the family voting trust.  John tried to vote himself excessive pay packages and perks, which his siblings vehemently disagreed with.  The ensuing legal battles left the family shattered, the siblings haven't spoken in years.

Through the family voting trust John Warehime had a complete lock on the company.  The voting trust was a strange creation, the trust 'owned' a number of B shares, which are the shares with voting rights, yet according to the company's auditors the trust B shares held zero economic value.  That is if the company were to merge with another company the trust shares would essentially disappear.  The voting trust also ensured that no activist shareholder could ever gain control, or significantly influence the company, a major hurdle for value realization.

A company is eligible to delist when they have fewer than 300 (potentially 1500 with the JOBS ACT) shareholders.  The company is considered 'private' in the eyes of the SEC, even though shares continue to trade on the over the counter market.  Reporting requirements for dark companies vary and are determined by the state of incorporation.  Some companies continue to send quarterly releases and annual reports, other companies shut down all reporting whatsoever.  Hanover was in the habit of mailing quarterly financials and an annual report, although this year they skipped a quarter.  The financials they send are functional, but they don't contain any management commentary about the business, any business changes are to be inferred from the notes, or other subtle clues.

This year's annual report contained two giant surprises for shareholders, the first was that John Warehime stepped down as CEO and his son took his place.  The second change was included in the notes, the company wound down their ESOP and voting trust.  Additionally for the first time since going dark the company reported the number of shares authorized and outstanding in the annual report.  If you go back to my previous posts I spent a lot of mental energy trying to calculate the number of shares outstanding, this is no longer necessary.

I can't overstate how significant these changes are.  Neither is more important than the other, but together, with the addition of additional disclosure in their annual report I get the sense something is changing at Hanover.

The elimination of the voting trust potentially removes the voting lock that John Warehime had on the company.  It's anyone's guess who the largest shareholders are at this point since the last proxy for the company came out in 2004.  I have heard through sources that Michael Warehime, John's brother, has been selling down his stake over the years.  Until someone sues the company in Pennsylvania for a shareholder register this item might remain a mystery.

The problem with Hanover is almost every investor who looks at the company recognizes there is value, but most believe the value will never be unlocked so the investment isn't worth a spot in their portfolio.  I believe that value is always realized given a long enough time frame, and I hold out that hope for Hanover, and the hope the time frame isn't too long.  Fortunately the recent changes have simplified the ownership structure, and opened the door for a potential activist, or acquisition.

What might an acquirer see in Hanover?  They would see a brand name food company selling at a very depressed valuation.  An acquisition at book value might seem like a stretch to some readers when compared to the company's earning power.  What they're missing is that the company's earnings are artificially depressed due to a transfer of wealth from Hanover's customers to their executives.  Executive compensation isn't broken out explicitly, but based on the note detailing the company's golden parachute it's reasonable to estimate that numerous executives are earning at least a million dollars a year or more.  If a company were to acquire Hanover and pay the golden parachute they could instantly unlock a 20-30% earnings gain on the back of reduced executive compensation alone.  Add in synergies and suddenly an acquisition at book value starts to look like a bargain.

The obvious question someone might ask after reading this far is: "what are the downsides?"  The company has a significant amount of debt as of the annual report, mostly related to inventory financing.  There is also a single line in the notes that states that the company tripped a covenant, but the bank waived it.  It's hard to imagine how such a strong company could trip a debt covenant.  My guess is one of their subsidiaries tripped the covenant, and any trouble at a subsidiary is masked once consolidated with much stronger subsidiaries for reporting.

What to do next?  If any of this post, or the previous two whet your appetite for Hanover shares the next step is to probably get a copy of their annual report.  I do not have a digital copy of Hanover's annual report, and I do not plan on scanning in my paper copy, please don't ask.  The easiest way to obtain an annual report is to purchase a single share or more and call the company as a shareholder and ask for the annual report.  Be forewarned the woman you will need to talk to will probably be "on vacation" each time you call...  

I'm still bullish on Hanover, and just as exited as I was when I first found them over a year ago.  Except with the recent changes at the company it appears gears might be in motion that could potentially unlock value sooner rather than later.  I always have my eyes out for shares of Hanover when they come on the market at the right price.  Shares can be hard to obtain, but patience is rewarded.

Disclosure: Long Hanover, actively buying if the price is right.

Ameriserv, a bank with a not quite hidden asset

One of the great things about being a bank investor is that banks are all very similar.  They all make money by participating in the same activities, and they fund those activities by similar methods of funding.  The advantage for investors is that once you understand how to analyze one bank there are suddenly over 1,200 traded banks that can be compared.  The disadvantage is that since most of these banks are similar there are few rarities, and often rare situations can be bastions of value.

Ameriserv Financial (ASRV) is a bank holding company located in Johnstown Pennsylvania.  Johnstown is about an hour east of Pittsburgh, where I live.  The common stereotype of Pittsburgh is that it's a dirty, smoggy, industrial city laden with manufacturing.  The reality is that manufacturing left Pittsburgh in the mid-1980s and since then the city has cleaned up.  The main industry here now is finance (PNC), education (Pitt & Carnegie Mellon), and health care (UPMC & Highmark).  While the industrial stereotype has moved on from Pittsburgh it still fits Johnstown.  Johnstown has a legacy of steel manufacturing, railroading, and other heavy industry.  A lot of the area's steel mills shuttered around the same time they shuttered in Pittsburgh, but Johnstown unfortunately never recovered.

It's in this setting that Ameriserv is located, they are headquartered in Johnstown, and have branches throughout the area.  The bank is fairly unique in the sense that their workforce is unionized.  Out of their 374 employees 188 belong to the Steelworkers Union.  According to the company there are only ten unionized banks in the country.  A unionized staff comes with collective bargaining, the current contract expires this month, although that's worrying the bank hasn't had a work stoppage since 1979.

The bank takes advantage of their union connection with information on their website decrying Wall Street and other large banks.  They consider themselves a Main Street bank that's helping to create union employment in their area.  As a result of their strong union connections the bank's trust subsidiary has specialty union services, and manages $1.5b of Steelworkers money.

While it's always nice to learn about interesting companies that's not the ultimate purpose of this post.  There are a few aspects of Ameriserv that make it a potentially compelling investment.

  • The bank is trading for 78% of TCE (tangible common equity)
  • Troubled assets are a very small percentage of total assets; the bank is safe
  • Relatively high equity to assets ratio, they are well capitalized.
  • Two strong subsidiaries that provide ballast to earnings in this low rate environment.
  • A valuable asset management firm that could be worth up to 50% of the current market cap.
Here is highlight of the bank's metrics:

The bank itself is a fairly standard bank, I compared them to 13 other banks that are all traded that are all very close to the same size:

The first thing I noticed is that Ameriserv is in the middle of the pack regarding the yield they generate from their earning assets.  This means they have a fairly average loan portfolio, and considering the low rate of non-performing assets this is good.  What is not good is their funding cost, they have a high funding cost.

The majority of the bank's deposits are retail non-demand deposit accounts which is why their cost is so high.  Of the bank's $840m in deposits $680m is interest-bearing.  The bank doesn't have any brokered deposits which is good, brokered deposits are one of the costliest types of deposits.

The second item that caught my eye in the comparison is Ameriserv's high efficiency ratio.  A bank's efficiency ratio is a measure of their non-interest expenses to revenue.  It's calculated by dividing a bank's non-interest expenses by their total income, both interest and non-interest.  A lower efficiency ratio is better, an easy way to think of the efficiency ratio is an inverse gross margin.  If you subtract the efficiency ratio from one you have a gross margin for the bank.

The largest non-interest expense for Ameriserv is salaries, which is not surprising, banking is an asset-lite service business.  Instead of reducing costs many banks try to outgrow a low efficiency ratio by growing deposits and lending.  In the current low rate environment that's difficult and often banks are resorting to cost-cutting as a way to increase profits.  In Ameriserv's case cost-cutting will be hard because of their union employees.

In general Ameriserv's bank is nothing more than an average Mid-Atlantic bank.  They have a healthy loan portfolio and a low level of non-performing assets.  The bank doesn't hold excessive OREO (Other real estate owned), and they're profitable.  Overall there isn't much of a reason for Ameriserv's bank to be valued at less than their tangible common equity, which is $76m.

Before discussing the company's asset management operations I want to take a quick detour and talk about why I'm using tangible common equity and not book value, or tangible book value.  Ameriserv participated in the Small Business Lending Fund and took on $21m worth of preferred stock from the fund.  The goal of the fund was to increase lending in small banking institutions.  This preferred stock is counted as equity capital for regulatory purposes, but to investors it's better viewed as a loan.  If the bank were to sell the preferred would need to be paid off at par, which is $21m.  Equity holders would have a claim on what's left.  Book value includes preferred stock, whereas tangible common equity removes preferred stock, goodwill and intangible items.  In most cases tangible common equity is the number equity investors should be interested in.  The following picture shows their capital structure:

The holding company owns three subsidiaries, Ameriserv Bank, Ameriserv Trust & Financial, and a life insurance subsidiary that I couldn't find the name of.  The asset management subsidiary has $1.5b in AUM that generated $7m in revenue and $840k in profit last year for the holding company.  As mentioned above the company is deeply affiliated with unions, and their asset management company is no different.  Most of the firm's AUM is union pension funds, which is somewhat of a niche business.

The asset management subsidiary's earnings are passed through to the holding company, meaning there is no hidden value with their earnings stream.  The value lies in what the firm might be worth apart from Ameriserv.  Based on their revenue and assets last year they are charging .47% of assets in fees.  Typically asset management firms are valued as a multiple of AUM.  I spent a long time searching for the number, but was only able to find a range from 2% of AUM to 7% of AUM as a valuation guideline.  If we use a conservative range of 1%-3% of AUM the asset management subsidiary alone could be worth $15m-45m.  Given that the company's market cap is only $59.7m, this is significant!

The trouble with a sum of the parts for Ameriserv is figuring out how the value could be unlocked.  It's unlikely the bank would sell, integrating a union with a non-union workforce would be problematic, especially because Ameriserv derives so much of their identity from their union roots.  Separating off the asset management firm would be much easier.  The company could spin it off as a separate company, or could sell it to a larger asset manager.  The company's asset managers have expertise with union assets, but that expertise could travel, along with the relationships to a company like Vanguard, which is similarly priced, and also located in Pennsylvania.

Ameriserv is a unique niche bank, and while their banking operations are pedestrian they have a valuable asset with their asset management subsidiary.  If the market were to recognize the true value of both of these companies Ameriserv's market cap could be anywhere between 58%-108% higher than it currently is.

Disclosure: No position