Strive for simplicity

Doing more with less, elegant engineering, concepts that are foreign to investing.  In seemingly every other professional discipline praise is bestowed on the one who can distill something complex down to a simple solution.  The investment world seems to work with different rules, simple investments are disdained, complex investments are glorified.  I want to push forward the idea that simplicity in investing produces higher results.

There is no one standard measure of simplicity, it's different for everyone.  The key is to "Know Thyself".  For some investors a simple portfolio is one with a half dozen holdings.  For others like myself a simple portfolio is dozens of simple companies.  I prefer the simplicity of small caps, but to others large caps are simple, with their venerable brands they can't help but make money.

The argument for simplicity is...well...simple; The easier something is, or the less assumptions one needs to make and the less room for error.  In my view the key to investing isn't having years where my portfolio is up 45% when the market's up 25%, it's not losing money, or losing very little when the market is down.  I believe maximizing gains comes through minimizing losses.  It's a lot easier to recover from a 10% loss verses a 40% loss.  It doesn't matter how hard anyone stares into the crystal ball, no one knows the future of the market, and anyone who thinks they do is a fool.  When I talk about avoiding losses I'm not talking about short term volatility, I'm talking about a permanent loss of capital.

If a company drops 30% on bad earnings but has a solid balance sheet and a history of higher earnings I can sit on my investment and wait for a recovery.  If a company is highly leveraged and falls 30% on the report of bad earnings they might trip debt covenants and etch a 30% (or more!) loss into stone as they enter the bankruptcy courts.  The company might ultimately recover, but it would be creditors who benefit.

The biggest gain from simplicity is a reduced set of assumptions.  The future never turns out as anyone expects.  As investors we build our portfolio around our model for the future.  Reducing the set of assumptions one needs to make for an investment to work out increases the chances that the future might work in our favor.

If my entire investment thesis rests on the idea that a company shouldn't trade for less than net cash I only have one working assumption.  I can spend all of my time proving or disproving my assumption.  I'm not worried about the growth in widget volume, or the executive compensation, all I care about is my one assumption that a particular company shouldn't sell below net cash.  I might be wrong on everything about the company, but if my assumption is correct the investment will work out.

A complex investment is the opposite of this, take JC Penny for example.  Turnarounds are not simple, they're like billiard balls, the second you move one  the rest shift, and it's impossible to know if they'll shift for or against you.  JCP eliminated coupons which led to a decrease in sales, yet simply re-introducing coupons won't bring their customers back, the billiard balls have shifted.  For an investment in JCP to work out well many things need to go right.

So what's the best way to introduce simplicity into an investing routine?  Start at the bottom, and start small.  As you research look at companies differently, try to determine if there are one or two data points that would make or break the investment and focus on those.  When researching ask the question if more information would help or hurt.  There is a minimum amount of information necessary for an investment decision, after that point the value of the data begins to experience diminishing returns.  I don't need to know how an airplane works to invest in an airline, and while I do find those things interesting, they aren't critical to an investment thesis.

After introducing simplicity at the company level introduce it at the portfolio level.  Do you have a portfolio that's maintainable if you take a break and go on vacation for a while?  Does the portfolio "make sense"?  Can you explain in three sentences or less to your mother-in-law why you own each position?  For some mother-in-laws you might only have a sentence to get the point across before she chimes in, can you do it?

The rewards for simplicity are reduced errors, and a maintainable portfolio.  It's a lot easier to stick with an investment, or an investment philosophy if you understand it well rather than second guessing it when the market hits a rough patch.

A banking primer, part 2

This is part two of a series exploring both the basics and finer details of bank investing from a value perspective.  My first post in this series was very well received, so well received that it has become the second most read post I've done.

In this post I want to explore the difference between a bank and a bank holding company, and why the distinction matters for investors.

What are holding companies?

When most people think of a bank they think of a local institution that gathers deposits and makes loans against them.  These banks are regulated by the FDIC, OCC, or state banking regulators.  The job of the regulators is to ensure that banks don't take undue risk with their deposits which might jeopardize their capital.

Bank holding companies are non-bank corporations that own one or more banks, and possibly other related bank or non-banking businesses.  Bank holding companies are regulated by the Federal Reserve.

The easiest way to tell the difference in the two is the name.  A bank will usually have the word "bank" in the name, non-banks aren't allowed to call themselves banks.  A holding company often has a name that's similar to "bank" such as "bancorp".  Most depositors and borrowers deal with banks, whereas most investors deal with holding companies.

The first question most readers are asking is "why does this exist?"  That's a great question, and the answer is somewhat complicated.  The biggest reason is that holding companies have a lot more flexibility with their operations compared to banks.  The biggest reason holding companies exist is the ease of raising capital for a holding company.  A bank is very restricted in how they can raise capital, it is usually limited to issuing equity.  A holding company on the other hand isn't restricted and can raise funding via the debt markets, equity markets or through other creative financing creations such as the Trust Preferred Security.

Let's take a very simple case, a bank needs to raise capital.  If no holding company is present they have very few options, the easiest option is to dilute current shareholders and do an equity offering.  Equity is the most expensive form of capital to raise, and something shareholders would prefer to avoid if possible.

To continue the example consider a bank with a holding company.  This bank decides to raise capital through the Trust Preferred structure.  The bank creates a trust (a special purpose entity) which issues non-voting preferred shares to investors.  Investors purchase the shares raising cash for the trust.  The holding company then issues a subordinated note to the trust on the same terms as the preferred.  At this point the holding company has the cash raised from investors on their balance sheet.  To then get that cash to the bank they issue equity at the bank level.  Investors in the holding company have not seen their stake diluted through the equity issuance.

Holding companies also offer other advantages, such as fewer restrictions on purchasing shares, ease of purchasing other holding companies, and ease of purchasing other non-bank subsidiaries.  The structure is so popular that 84% of commercial banks utilize the holding company structure.

Why does it matter?

Often investors get banks and holding companies mixed up which can have dire consequences.  A subsidiary bank could be very healthy, yet if the holding company is deeply indebted the company could be on the bring of collapse.

It's often easiest to learn by example, so I'm going to walk through a bank I looked at recently, First Menasha Bancshares Inc (ticker: FMBJ), a bank located in Wisconsin.  The bank has one bank subsidiary, the First National Bank - Fox Valley.  The bank has four branches, the first opened in 1887:

Here is a snapshot of the bank's balance sheet:

The bank's balance sheet is very simple and clean.  They have $265m in loans, $58m in cash and securities and $301m in liabilities, almost all deposits.  Drilling down into the balance sheet shows that the $17m in "other borrowed" consists of FHLB advances.

Unfortunately for investors the story doesn't stop here, the company's consolidated balance sheet looks a little different:

At the end of 2012 the holding company only had a book value of $30m, whereas their subsidiary had a book value of $37m for the same reporting period.  The level of assets are almost the exact same for the holding company and the subsidiary, this is because the holding company only has a few hundred thousand in cash and some unrelated goodwill.  The differences lies in the liabilities at the holding company:

There are three fields I want to focus on, Other liabilities, Balances due to subsidiaries, and perpetual preferred stock.

The holding company's other liabilities consist of a loan due to their ESOP.  Balances due to subsidiaries are subordinated debt issued from a subsidiary, a Trust Preferred that I described above.  The last item of note is the perpetual preferred stock.  When these items are put together investors in the holding company only have $30m in equity capital.

What we see when looking at First Menasha Bancshares is that while the subsidiary bank's capital structure is simple, the holding company's is a bit different.  Investors in FMBJ (the stock) are buying shares in the holding company, which has $30m in equity, not $37m.  Earnings are similar, the subsidiary bank earned $3.1m in 2012, but for investors in the holding company earnings were only $2.6m. 

This post might seem like a trivial item, but it's one that I feel is extremely important.  Consider the following search, I looked for bank holding companies with less than $500m in total assets where the holding company has negative equity (or almost zero), yet the subsidiary bank has positive equity:

There are 68 holding companies in the US where the underlying bank has positive equity capital, enough that regulators are satisfied, yet the holding company has negative equity.  Simply looking at the underlying bank gives investors an incomplete picture.  Unless an investor is looking directly at a bank they need to consider the bank's holding company as well.  In most cases investors in publicly traded banking stocks are purchasing shares of a holding company, not an underlying bank, which makes the distinction all the more important.

Interested in learning more about banks? Buy my book The Bank Investor's Handbook (Kindle and paperback available)

Disclosure: No positions

Special situation: The WP Stewart rights

Note: Before I begin I want to direct your attention to, the author has posted his big reveal recently.  Dave is stepping off the corporate treadmill to start his own asset management firm.   Dave has an eye for undiscovered investments, he loves the micro-cap stuff, but will invest in anything at an attractive valuation.  We try to get together fairly often and talk stocks over a coffee or a beer.  Every time we get together he's impressed me with his picks.  If you're looking for a manager it's worth a phone call or an email to see if the relationship would be a good fit.


WP Stewart (WPSL) is an asset management firm founded by Bill P. Stewart in 1974.  The fund manages a number of concentrated growth strategies across domestic and international markets.  The company notes they are a researched focused investment advisor.  They manage money for high net worth individuals and institutions, both through their own mutual funds and separate accounts.

The company hit an extremely rough patch starting in 2007 that continues to persist to the present. Assets under management fell from $9.3b in 2004 to a low of $1.4b in 2008, and have since recovered to $1.6b.  Along with falling assets the company's earnings have fallen as well.

The company went from earning $13.87 a share in 2004 to trading for $12 a share in 2013.

Asset management is a brand business.  Investors invest in an asset management firm, and a manager.  Managers with the absolute best performance don't always attract the most assets.  Managers and firms that can tell a convincing story attract assets.  To the investing public, who is mostly ignorant of how investing works they would rather hear that their fund manager is investing in exciting biotech startups in Taiwan, not told dryly that the fund beat the MSCI Asia-Pacific ex-Japan index by 200bps.

The influence of marketing and branding results in managers touting ideas on CNBC non-stop.  The financial press is happy to fill their pages with profiles of popular fund managers.  After all, it's much more profitable for a fund to manage $1b and match the index, rather than manage $100m and earn 20% a year.  

For the massive outflows that WP Stewart has experienced their funds haven't done all that bad.  The company's US Growth and Composite Growth have edged out the index, while their two other strategies have underperformed.

Compare the company's fund results with their AUM figures above.  While the funds have done anywhere between 3.8%-10.7% annual over the past five years AUM has barely budged, which means that clients have continued to withdrawal money since 2008, negating the performance of the funds.

The opportunity

In the midst of the company's AUM and earnings decline a press release was published recently announcing a sale of the company to AllianceBernstein, a well known asset manager with $444b in AUM.  For AllianceBernstein the WP Stewart transaction won't even add 1% to their AUM.

AllianceBernstein is purchasing WP Stewart for $12 a share in cash, plus a transferable contingent value right for each share owned.  The stock is currently trading at $12.07.  The right is a fascinating little security, if WP Stewart can grow AUM to $5b within three years of the sale close date right holders will receive $4 per right.  If the company's AUM fails to reach that point shareholders will receive nothing.

Based on the current price someone who buys today will receive their initial $12 in capital back within six months and receive a right effectively cost $.07.  The right is probably worth a little more if we estimate that the shares aren't worth $12 yet, with six months left in the deal maybe they're worth $11.80, in which case the right is being valued at $.27 apiece.

It's hard to know if the rights are cheap or expensive because they rely on a binary outcome from an event three years in the future.  But just because we don't know the future doesn't mean we can't take a stab at estimating if they'll pay out or not.  The entirety of this investment hinges on whether the company can more than double their assets in three years.

While I don't have any idea on where AUM will be in three years, I do have some general thoughts which might help lead to an answer.

The first is that at fiscal year end 2012 the company had $1.642b in AUM, and when they issued their press release on the sale they stated that they have $2b in AUM.  Maybe the PR department rounded up their AUM, but it seems strange that they'd do that.  Rather it's plausible that the company grew AUM by 20% in the first eight months of the year.  If they can continue this pace they will have no problem meeting their goal.

The second thought is the company has experience running large sums of money.  Some funds have problems scaling their strategy when assets rise which could lead to underperformance.  The fact that WP Stewart has managed $9b in the past is encouraging.

The final thought is that the AllianceBernstein brand might help them raise capital as well.  It's possible investors were worried about the viability of the fund, but with the AllianceBernstein name slapped on it their fears would disappear.  It's also possible that expanded distribution through AllianceBernstein's network could lead to an increase in assets as well.

The bottom line for me is I have no idea if the company's growth goal is realistic, maybe it's an easy target and the rights are free money.  Or maybe the rights are akin to a lottery ticket.  At worst for a buyer today the rights are a $.07 lottery ticket.  If they pay off at $4 investors would receive 57x their current value.

Disclosure: No position

Stephan Co., down 50%, now what?

In addition to this blog I write a monthly newsletter focused on net-nets for GuruFocus.  The first company I profiled for the newsletter, over a year ago was Stephan Company (SPCO).  Over the past year there have been a number of twists and turns that have accompanied a 50% decline in the stock price.  I spent some time this week re-evaluating the position, and instead of selling like seemingly most every other holder of this stock, I ended up purchasing more.

Stephan is a barber and hair styling supply company; I couldn't think of a less exciting business if I tried.  The company's products are mainstays of barber shops and hairstyling salons everywhere, and their products seemingly haven't changed in 60 or 70 years, clippers, barber chairs, bibs.  Up until recently the company's website was basking in the vintage Information Superhighway look of the early 1990s, which I felt reflected the pace of the company.

When I researched and initially invested in the company the thesis was simple, it could be boiled down to this:
  • A discounted NCAV of $2.26
  • NCAV of $3.48 and tangible BV of $3.78
  • The Board of Directors contained an activist investor who emphasized book value as fair value, and had pushed for a sale in the past.
  • The company was consistently profitable.
  • They had $7m in cash, and a $10m market cap.
The bullet points provide a nice overview from an investment perspective, but miss a rich backstory.

Stephan was a family controlled company, Frank Ferola, the CEO and largest shareholder ran the company for 30 years, until he passed away suddenly last summer.  An interim-CEO, Michael Smith, was elected by the Board and began his tenure.

In 2004 Stephan attempted to go private at $4.60 per share.  Ancora Advisors submitted a 13-D stating that they believed that the $4.60 offer was a low-ball bid that undervalued the company, and that the company was worth at least book value.  The 13-D also called out the CEO for an egregious employment contract, and excessive compensation.  The going private bid failed, and a contested proxy battle ensued and resulted in Ancora winning a spot on the Board.

When I researched Stephan the investment thesis hinged on the question "was this company really worth NCAV or more?"  My hope was they were worth at least NCAV, if not book value, the target that Ancora had painted on them during the proxy fight.

Fast Forward

The past year has been a whirlwind for Stephan, they hired a new CEO, re-wrote their website, took a big bath inventory write-down, have been party to two lawsuits, and are now dealing with two lagging brands.  The stock has subsequently fallen 50%, and I've held the whole way down.

I generally like family controlled companies because shareholder interests are aligned with the controlling family.  A controlling family wants the company to last a long time and continually provide income, two goals shareholders strive for as well.  I mis-read Stephan, Ferola wasn't running the company with shareholders in mind, he was picking their pockets and lining his.  I knew this was the case based on the proxy fight, but I foolishly believed that his death would be a catalyst for a sale, and shareholders would finally be rewarded.  I thought the CEO malfeasance started and stopped with his compensation package, and once he was gone this negative bullet point would be as well.

What I missed is that when a CEO runs a company with himself in mind and then passes away suddenly there are a lot of loose ends that need to be tied before the company is salable.  Ferola was running Stephan on a wing and a prayer.  When he passed the company's new management unearthed all of the skeletons in the closet.

At this point most sane readers are thinking I'm insane, I increased my position in a clearly melting ice cube.  In hindsight shareholders should have taken the going private deal from 2004, heck if someone offered me $4.60 for my shares today I'd hand them all over as quick as possible.

The company today is not the same company I initially invested in a over a year ago.  A year ago they hadn't cleaned out the closets yet, and there were still cobwebs coating their inventory.  The new management team has been aggressive at sizing up the situation and taking write-downs where necessary.  The company is worth much less now than it was a year ago, although if I'm honest with myself they were worth the current amount a year ago, it's just that I overestimated their value.

Here is what that company looks like now:

  • Book value: $2.45, NCAV: $1.42
  • $3m in cash on the balance sheet, plus $3m in inventory that was recently re-valued
  • $3.50 a share in NOLs
  • Of the two lawsuits the company is facing, they won one (in appeal) while the other is pending.  They have repaid all but $85k of their long term debt, if they lose the second lawsuit they could take on debt to pay a settlement if necessary.
  • The company re-located from Illinois to Florida to consolidate operations and save expenses.
  • Legacy brands that have turned a profit until this past year when one time expenses and a corporate upheaval resulted in a loss.

I realize that Stephan isn't the best investment out there, this is a company with a foot in the grave and the other on a banana peel.  Even with the market's imminent death sentence I believe this is an attractive investment.  The stock is trading as if they will lose the lawsuit and they will continue to have problems.  The company is in the midst of a turnaround, and management has been quick to realize losses in inventory and goodwill.  I believe at this point we've seen all the bad news we're going to see, now the hard work begins of reviving sales and turning a profit.  When that happens I believe that management is going to work to sell the company.

I hate to see investment positions work out like this, I'd rather have everything I own travel on a smooth straight line up and to the right, but that doesn't happen often.  It's also worth keeping in mind that I don't practice concentrated investing, Stephan is a 1% position in my portfolio.  I'd be happy to own 100 companies where the risk of permanent capital loss is low, but the opportunity for a 50-100% gain is high.  As a note, I don't actually have 100 positions, I have slightly over 50 positions.

I'm going to be patient and see what happens for Stephan in the next year..

Disclosure: Long Stephan

Why are you investing?

This is a philosophical post, not for myself, but for you.  This question was inspired by something I read on a blog where the author stated they hoped to get rich through investing.  This quip isn't an isolated case, I've heard this from others as well, they invest to get rich, that's their goal.

If you want to get rich I have one piece of advice.  Sell all your stocks, walk away from the market and go start a business.  With the exception of Warren Buffett there are very few rich people who became rich through investing in publicly traded companies.  But what about all those famous investors?  Look closely and you'll find they're all rich from starting a business, an asset management businesses.

It's not unusual to hear of entrepreneurs growing companies at 20-50-200% a year or more.  There is a startup blog I follow where they claim anyone not growing at 10% a month is failing.  Madoff's investors thought they had found the holy grail of investing at 12% a year.  It's not uncommon to hear of people starting successful service businesses from a few thousand dollars in initial capital and growing them into companies that generate hundreds of thousands of dollars a year.  Whereas it's unusual to hear of someone who starts with a $5,000 brokerage account and turns it unto something throwing off $150,000 a year in dividends within three to five years.

I believe investors with a purpose outperform investors without a purpose.  It's like getting in a car to go drive somewhere without knowing the destination.  I imagine drivers (investors) who want to get rich are trying to drive to "someplace better" without knowing where that is.  Drivers who have a destination in mind can be focused on it, and their focus helps them from driving aimlessly.

My own goal is twofold.  I'm first investing a portion of our savings for purchases far in the future.  It sounds strange to say that the money we save now is for purchases in the future, but it is.  I would rather spend the money I invest at some point rather than hand my kids a pile of cash I never touched.  If I spend it, or my kids spend it, or the government spends it, it will eventually be spent by someone at some time.

The second goal of my investing is to maximize the returns possible by taking the least amount of risk.  I do that by buying assets and earnings at discounts that are only available in public equities.  It seems like a paradox, but private markets for companies are much more efficient than the public market.  Outside of extremely unusual situations it would be rare for a private company to sell for less than their property and plant, or less than NCAV, or even for a few times earnings.  Yet these conditions are occur with regularity in the public markets.

Staying focused on your purpose helps to ignore investments that don't "fit".  An investing purpose could be confused with Buffett's circle of competence.  I think they're different, I hear people throw ideas out because it's out of their circle of competence.  To me the circle of competence is a phrase meaning that someone intimately understands the topic at hand.  There are many ideas that I understand well, but they don't fit my investing purpose.  The worst abuse of the phrase is when investors use it as an excuse to not investigate an investment.  "Oh banks, that's outside my circle, I'm happy with a tiny circle so I'd rather not learn something new.."

The benefit of having a purpose is that it helps an investor keep focus.  I know the types of stocks I do well investing in.  There are plenty of other styles of investing that work well for other investors, but they don't work for me.  When someone pitches something that doesn't fit in my purpose I can listen and appreciate the idea, but it's not something I need to act on.  Having an investing purpose also keeps me from speculating too.  I'm focused on long term results, and want to stay aware of risk, by keeping my purpose in mind I don't buy stocks hoping they'll pop on an earnings surprise, or trade short term on rumors.

There are probably very successful investors who had no purpose, maybe it's not even necessary.  I know for myself having a purpose to my investments has helped tremendously.  I'm not thrown to and fro by the market's waves, I can react quickly when I see an opportunity, and it helps me recognize investments that are good, but not a good fit for myself.

Is it time to dump George Risk?

George Risk, a favorite of value bloggers, and value investors.  The company's investment thesis was so simple to understand, yet they seemed to sidestep all of the attributes that a net-net would normally have.

George Risk is a small company based in Kimball Nebraska that manufactures safety switches for pools, electronics components and outdated computer peripherals.  They have two locations, and are run by the Risk family.  Their CEO, Ken Risk passed away recently, which meant that his daughter, Stephanie Risk the CFO was promoted to CEO.

When I purchased the company in early 2010 they were selling for less than NCAV, and most of NCAV was comprised of cash and a securities portfolio.  The business itself was profitable, earning $.10 p/s in 2009, and $.30 p/s in 2010.  An investor could buy the cash and securities at a discount and get a profitable business for free.

As the economy has recovered from the recession the company's sales have grown considerably, they earned $.52 p/s in 2012 and $.40 p/s in 2011.  Earnings have grown 73% since 2010.  The company's portfolio of mutual funds has grown with the market increasing their NCAV roughly in line with the market.

If there ever was a stock to sell investors on a style of deep value investing, George Risk was it.  They had the safety and simplicity of being available for purchase below net cash and securities, and they had a profitable and growing business attached.  George Risk was really the perfect child of net-net investments, at least on the surface.

I know a number of bloggers and investors made a stink about Ken Risk, the 60% owner of the company expensing $14k worth of airplane incidentals and lease payments a year.  That never bothered me, what bothered me was their product catalog.  Outside of their pool safety switches the company sells higher priced electronics components, and computer peripherals that are outdated.  The company mentions the keyboards they manufacture ten times in their annual report.  Let's just say it would be very hard to buy a computer old enough that would allow the keyboard to work without a frankenstein mess of adapters.

Beyond the products, I worried about leadership and personnel.  It's hard to find good talent in a medium sized city, let alone in a small town (Kimball pop 2500) in the middle of Nebraska.  It would be very hard for the company to attract talent, and while I'm sure there are some very talented individuals who already reside in Kimball, the talent pool is small.  Based on Wikipedia pictures Kimball has a classic American small town look.

Even with the worries the stock was undeniably cheap a few years ago.  It's since risen 87% since my purchase, and it's now trading close to $10, which is the value I had mentally pegged as "fair value", which is a signal that I needed to look into the company again.

I feel that selling stocks is a weakness for most investors, if not all investors.  It's easy to spot a bargain and buy it, but it's hard to tell when the music is over and it's time to sell.  In general I try to keep a few things in mind when I look to sell a stock.  The first is whether the company has a margin of safety at the current level.  For most investments this means an asset backed margin of safety.  I do own one moat stock, Mastercard, and the margin of safety for that stock is the brand.  If there is still a margin of safety at the current price, and nothing else has changed with the business I will continue to hold.

The best investments are ones where the company's NCAV grows with the stock price, and a year or two after purchasing an investor owns an appreciated stock with the same safety they held when they first purchased.  That's unfortunately rare, although it appeared true for George Risk.

Beyond looking for a margin of safety I look to see if anything has changed in the business.  If a business that was once strong is now stumbling, and the stock is getting pricy it's time to sell.  There might be gains left, but why try to sell at the top, it's a fools errand.

If a margin of safety still exists, and it's business as usual I do nothing.  Doing nothing is the most underrated investment activity.  Most often the best investment decision is no decision.

Back to George Risk, a second issue came to light that caused me to re-evaluate the company's role in my portfolio.  The company filed a 10-K NT recently, the 10-K should be out soon, but this is a potential warning flag.  The company hasn't filed a NT since 2009, this one comes on the back of Stephanie Risk's father passing.  A narrative could be constructed that Risk has her plate full both running the company and trying to manage the financials and the company missed filing their annual report.  I have no idea if this is true, but that was my first thought when I saw the 10-K NT filing.

Along with the 10-K NT filing I'm starting to feel uncomfortable with the company's current valuation.
The company has a book value of approximately $30m, and they are on track to have about $2m in FCF during 2013.  Their cash and securities are worth $26m, so the company has a EV/FCF of 9.5.  The company isn't cheap on an asset basis anymore, and for a small family controlled micro-cap they're heading into richly valued territory for their earnings as well.

I'm going to do nothing with the position until after the 10-K is out.  My guess is the company earns $.50 a share, or similar again, and book value will have grown slightly.  I'm also going to continue thinking about selling the position.  I love this at $6, but at $9 not as much.  I'm sure there are some readers out there who have a bull case for the company, if so I'd love to read it, toss it in the comments.

Disclosure: Long George Risk

Something's rotten at Fortune Industries

Markets are built on trust, when trust disappears markets begin to fall apart.  The default behavior of markets is to trust unless evidence says otherwise.  At times even when there is an overwhelming amount of evidence to the contrary investors still trust, such as with Enron, or Worldcom.  Shareholders at Fortune Industries trusted management to do the right thing for them, unfortunately their trust was misplaced.

I'm going to cut straight to the chase and fill in the details later:  Fortune Industries management negotiated the going dark/private deal in bad faith, took advantage of shareholders, and took actions that were highly unethical if not blatantly illegal.

I have written about Fortune previously (and here), I'd recommend reading the past posts, but I want to provide a quick summary.  Fortune, an HR outsourcing company, when faced with the sickness of their founder created a financial transaction that would eliminate small shareholders (under 500 shares), while restructuring the balance sheet.  The company would be redeem the founder's perpetual preferred shares and replacing them with debt.  Unaffiliated shareholders would own 8.9% of the company after the transaction down from 39% before the transaction.  In the transaction ownership interest transferred from Carter Fortune and minority shareholders to CEO Tena Mayberry and CFO Randy Butler.  Two members of management who held an insignificant interest in the company suddenly came to own 91% of the company through financial engineering.

I initially posted about Fortune over a year ago, but the deal only closed recently.  Shortly after the deal closed I received some fascinating comments on the original post.  I've since been in touch with that commenter and the story I heard about Fortune appalled me.  As a side note, if you leave an anonymous comment I cannot see your email, if you want to get in touch with me you need to reach out as this person did.

I will refer to my source as Person A in this post, I've decided to keep their name anonymous out of respect for their privacy.  If you are interested in talking to them email me and I'll get you in touch.  They are very willing to talk and share the information they have, which is a lot.

To understand where Person A is coming from a little background is in order.  They approached Fortune after the deal was initially announced with a letter of intent to purchase the company outright.  They offered $1.5m more than what the company's management was offering.  Additionally the money from their offer was guaranteed.

Person A initiated contact with the attorney for the Board of Directors, the attorney refused to pass the offer onto the Board, and Person A ended up contacting the Board members individually with the proposal.

After contacting the Board Person A setup a meeting with the company to discuss the proposal.  Management and members of the Board were to be present at the meeting, when the meeting happened no one from the Board was present, just Jeff Bailey, and the inside attorney Carrie Hill.  This is a very important point, the board of directors are to represent shareholders, they run the company and employ management for day to day operations.  A Board can fire all management, management cannot fire the board unless they become shareholders.  shareholders can fire board members.  So at this meeting, when a superior deal was presented the shareholder representatives were absent, the very people who are supposed to evaluate the deal and decide whether to present it to shareholders.

During the meeting Person A asked for a 30 day quiet period where due diligence could be conducted. This is a typical request, Fortune denied it saying there wasn't enough time and they had to get the deal done now.  The irony of this statement is that it took Fortune over a year to complete the deal, an extra 30 days shouldn't be an issue, especially if the deal is superior.  Clearly management didn't even want to entertain the offer and threw out a limited time excuse.

One aspect of the deal that never sat well with me was that it appeared to be a sweetheart deal for management, and it as negotiated with Carter Fortune on his deathbed.  In talking to Person A I came to find out that Carter Fortune had a reputation around Indianapolis for being an honest businessman who cut favors for no one.  He believed in engaging in arms-length transactions even with family members.  It strikes me as odd that suddenly a man would go against his life's character and sign a blatantly favoritist deal in his last days.  Further bolstering this view is the fact that a very prominent family member, who was very familiar with Carter Fortune did not like the deal.

Why would management refuse to look at a materially higher offer?  They stood to gain 92% of the company if their deal went through, whereas if the company were sold they would gain almost nothing outside of a side pocket fee buried deep in the proxy.  The company's lawyer stood to gain $500k from the deal, and their CPA $300k from the deal as well.  The company's management and its advisors stood to gain so much financially it's no surprise they were incentivized to do everything possible to shoot down other offers.

This inherent conflict of interest is why companies have boards of directors.  The board is supposed to be independent and objectively evaluate deals for shareholders.  Except in the case of Fortune the Board of Directors was kept out of the loop, and possibly mislead about the nature and terms of the deal.

What's in this post is the tip of the iceberg with regards to the malfeasance related to the transaction.  The information above directly relates to how shareholders were taken advantage of, but some of the other things I heard could potentially be securities fraud or criminal in nature.

Now that the transaction is done it seems like all hope is lost, but that's not the case.  Shareholders have a VERY strong case against management, and the company's advisors.

Action items:

1.  If you are a current Fortune shareholder, or were one and are interested in joining a class action lawsuit against the company please contact me at the link below.  There's a possibility this transaction could be reversed and shareholders receive a far more fair compensation for the deal.  You would not be paying legal fees out of pocket.

2.  If someone has a contact at the SEC, a real contact, someone who can actually move something forward please contact me as well.  The SEC's mission is to supposedly protect shareholders, but unless a story gets in the news, or the company is large shareholders are neglected.  Some of the stories I heard strongly lead me to believe that the SEC needs to open an investigation into Fortune's management.  I filed an initial SEC complaint months ago, it disappeared into the void, I want my next complaint to land somewhere important.

3. Spread this story!

Lastly you might wonder why I even care about this.  I didn't hold a significant position in Fortune, but it bothers me to see management take advantage of shareholders.  The shareholders are the owners of the company, and the fact that they were denied the ability to vote on a superior deal is frustrating, as well as other aspects related to this deal.  I feel that often management at smaller public companies thinks that they can get away with more because the SEC doesn't care about small companies.  If the government won't do their job then individuals need to step in and fill the gap.  If small companies knew their shareholders cared and were watching them, then some might be less inclined to behave unethically.

Talk to Nate

DynTek and the problem with earnings

Investors in public markets love certainty, steady earnings, steady dividends, steady interest, steady growth, a market darling.  When something fits on a nice linear path the market goes nuts, a company that earns a steady $1 per year is valued higher than a company that earns $.50 one year and $1.50 the next.

Certainty is an interesting thing, of course no one knows the future, yet most market participants act like they have a hint as to what the future might be.  My favorite are CEO's who announce that they will earn some amount per share, and it will grow steadily at 15-20% forever.  Unless the company's customers have signed contracts locking themselves into those numbers it's foolish for anyone to announce something so uncertain with certainty.  Unfortunately the market's reward for certainty gives rise to the temptation for management to game earnings, which in the short term makes everyone happy, but ends in a trail of tears for investors and potentially (but not often enough) a visit to Club Fed for management.

I have written in the past how I prefer to value companies based on assets, because I believe the certainty of assets is greater than the certainty of earnings.  A company's book value rarely fluctuates dramatically from year to year, and the value of what they own is usually drifting upwards or downwards on a nice glide path.  Earnings on the other hand rarely are steady.  They might be down due to a recession, and then come back strongly during the recovery.  An investor who uses the trough earnings undervalues the company, whereas an investor who uses recovery earnings might overvalue them.  Many investors go through a complex ritual where they adjust and tweak all sorts of numbers and term their ending creation "normalized earnings".  If I decide to normalize earnings I will average a company's last seven years worth of earnings to create my value.  Unfortunately normalized earnings don't mean much if the companies earnings are highly irregular.  When a company's earnings are extremely volatile the market places a low multiple on their shares, one such company is DynTek (DYNE).

DynTek is a IT services and vendor business.  The company offers IT consulting services, and resells software from Microsoft, among other names.  For readers who are unaware of how the IT consulting industry works there are two types of tech consulting firms, software solutions, and implementation solutions.

A company that specializes in software solutions would visit a client, understand their needs and build a solution from the ground up using Java, C#, or the language du jour.  Accenture, and Ernst & Young are two large names that come to mind when I think of this space.

The second type of company is an implementation company, which is what DynTek is.  DynTek will install a Microsoft Sharepoint site at a client, configure a data center, or offer help desk services.  They install and configure software and hardware created by others, whereas a software solutions company will build a custom solution tailored to the client's needs.

The difference is material, it's the difference between hiring a plumber and an architect.  You don't hire a plumber to design the piping for a new building.  The architect designs the plumbing, while the plumber installs it.  The difference in roles appears in the rates they charge, implementation services charges much lower rates.

DynTek has had a few different corporate iterations, the company started in 1989 as Universal Self Care Inc.  They then changed to Tadeo Holdings, followed by TekInsight, and finally DynTek in 2001.  The company began life distributing diabetes drugs and related medical devices.  Then in the heat of the dot-com boom the company decided they wanted to become a tech company, sold their existing assets and purchased a software design company.

I bring up the company's history to show that their path to the present has been anything but predictable.  I could have done a post entirely on their history I dug up in old SEC filings.  As shown in the chart below, DynTek has never performed consistently:

As I mentioned above, for most companies, their book value is slowly changing, not for DynTek.  They found a way to destroy enough shareholder value to go from having $13m in equity to a negative $8.3m in equity.  Then almost as suddenly, they doubled book value from negative $5m to a positive $6.4m

Earnings have taken a similar roller coaster ride, from $.10 in 2010 to $2.92 in 2011, and back to $1.17 in 2012.  The company appears to be having another year like 2011, but given their track record it's impossible to predict anything.

I was initially attracted to the company due to their low P/E, they're trading with a P/E of 5x or so.  They're selling for roughly 2x book value, but given how quickly they're growing book this might not be much of a problem in the future.  But an alternate scenario exists as well, the company begins to falter again and earnings decline to a new lower permanent state along with book value.

The issue is there's almost no way to know by reading the financial statements.  Almost 50% of the company's revenue comes from government contracts, maybe that's good steady work set to grow.  Or maybe it is about to fall off a cliff.

DynTek seems like an interesting company, their growth is fascinating, and their business is simple to understand.  If they can continue to execute as they have in the past this might be an incredibly cheap stock.  Yet this isn't really knowable just from the financial statements, a little scuttlebutt is required on this company.

At this price I don't see a margin of safety, this company is another added to the discard pile.  I know that I have many readers who are looking for cheap growers, or successful turnarounds, and this company surly qualifies for a further look.

Disclosure: No position