Thursday, February 28, 2013

Another oddball "investment", bitcoins

Investments come in all shapes and sizes, and only a fraction of investable items actually trade on an exchange.  I recently came across something a lot of people claim is an investment, but I view as more of a fascination, BitCoin, a digital currency.  This is probably the most oddball investable item I've ever ran across.  I stumbled on an article about bitcoins a week ago and have read a number since, the whole process is intriguing.

A bitcoin is nothing more than a tiny piece of data residing on a user's hard drive, but with that little bit of information people can purchase real goods.  The idea behind the currency was to create a digital payment system that was secure and not owned by any one country.  In theory a user in Mongolia could use bitcoins to purchase a laptop in North Carolina as easily as a user in North Carolina could use bitcoins to purchase an item from Amazon.  The problem with this is not many retailers actually accept bitcoins as payment for much of anything.

The problem with currencies and money is one of supply.  In most developed countries central banks are flooding the market with new money in the form of quantitative easing.  In the world of bitcoins money is created differently.  Money is digitally mined and created by users.  A user runs a mining program which runs some sort of creation algorithm to create new coins.  The system is built so that each new coin created costs more than the last when measured in processing time.  This means that in theory the supply is limited.

This is where things get interesting.  In the beginning of bitcoins users could run a CPU's all night long to create coins.  Eventually processing became hard enough that users would run rooms of computers, and then eventually whole networks of computers to mine coins.  As the cost to mine coins increased so did their value.  It was easier to purchase a new coin rather than create a new coin.

Besides processing power a driver to bitcoins value is the ease of obtaining the currency.  I've gleamed from threads on the subject that to link a bank account to a bitcoin account is fairly complicated.  Many of the companies involved don't exactly have glistening reputations, and they place limits on the amount of money that can be converted into bitcoins in a single day.  A few innovative students have created a bitcoin ATM where customers deposit cash and receive bitcoins in return.  The ATM seems like a dream device for a money launder, deposit cash and turn it into intractable currency.

In one article I read mentioned people buying specialzied asic processors for $1200 to mine coins.  The asic (whatever the heck that is) is specialized so that it can mine coins quickly and buyers can pay off the purchase price in a month or less.  Extrapolating this would mean that an asic buyer could potentially make $1k a month by just letting this asic run continuously.

Here is a chart showing the price of a bitcoin over the past few years:



The chart speaks volumes as to why people are interested in bitcoins as an investment, it appears to be a can't lose deal.  Buy some coins, sit and wait and the price will go up, or invest in the asic mining equipment, create coins and sell them at ever increasing prices.

As I read about bitcoins I couldn't help but draw a connection to them and gold.  In a way bitcoins are a digital version of gold.  There is a finite supply although marginal supply increases are happening at an increasingly slow rate.  Gold is still mined but it takes more time and energy to find smaller and smaller amounts.  Gone are the days when you could stumble on a gold nugget walking the California beach.  Bitcoins are the same, for the first users running a computer for a few hours could make them thousands of dollars, now specialized equipment and increasing amounts of time are required to create the same value.

The most interesting aspect of bitcoins for me is the speculation aspect.  In almost all of the articles I read about bitcoins a passing reference was made to what a bitcoin could buy, but most of the emphasis was on their investment value.  Users could supposedly buy all sorts of goods with the coins yet almost everyone buying coins is doing it because they continue to go up in value.  When buyers of an asset are all speculating the floor can fall out quickly.  Last year bitcoins reached a high of $30 per coin and quickly crashed 90%.  The price of coins has now recovered which has the market in a fervor, everyone suddenly wishes they would have purchased when the coins were at $3.  I saw a lot of comments about people buying now because they're afraid they'll miss the runup.

Ultimately with the bitcoin market composed mainly of speculators and not many users I can't imagine this digital currency gaining actual momentum.  The mark of a currency is stability, people want prices to be predictable and forcastable.

Watching bitcoins could be the modern equivalent of watching Dutch tulip prices. No matter how much market history exists humans still want to make a quick buck and let emotions rule their investment decisions.

Talk to Nate

Saturday, February 23, 2013

It's not a Fortune, but it's something..

Thanks to the efficient market we're presented with a $200 bill laying on the ground that most investors claim doesn't exist.  The $200 bill is in the form of the Fortune Industries going private offer.  My previous post on Fortune is in the top five for most read posts, which I find strange given this is a tiny penny stock.  Since July when I last posted on Fortune nothing has changed, and yet everything has changed.

I first want to make a small note about these little tenders.  A lot of investors are dismissive about making a few hundred dollars on an odd lot tender.  They're considered the realm of pip-squeak investors.  Sure $200 isn't going to move the needle of any portfolio, but it is real money.  Step back and consider, where else can you make $200 for reading for a half hour and clicking a mouse a few times?  Think $200 isn't worth much?  You could buy 88 NYC Subway trips, 134 Fillet-o-fish sandwiches, or four cases of a craft beer with $200.

The basics of this deal are very simple.  Fortune is going dark again and they're cashing out shareholders who own less than 501 shares at $.61 a share.  Unfortunately given the company's history the unanswered questions are, who will be cashed out and will this deal actually complete?

To answer this we need to take a look at the developments over the past eight months.  Originally Fortune was going to cash out shareholders who held 500 shares or less at the end of March 2012.  Management who owned less than 1% of the outstanding stock engineered a deal where they would end up owning 71% of the company.  Shareholders who owned 39% of the company would own 8.6% after this deal.

The company claimed that shareholders would continue to hold a consistent 'economic interest' in the company even with the reduced ownership percentage.  To shareholders who just care about trading a piece of paper, the economic interest would indeed be the same.  If one were to place a multiple on the current earnings, and then place the same multiple on the earnings under the new structure the same economic interest is retained.  Unfortunately shareholding isn't just owning a piece of paper, it's actual ownership in a business.  Management is taking control of this company, throwing up smoke and mirrors and telling shareholders everything is alright.  Additionally I'm not sure how any shareholder can get comfortable with a management team that has worked so hard and creatively to outright steal the company from shareholders.

Last year everything looked like it was going according to plan for the going dark transaction until Carter Fortune's death in August of 2012.  Readers of the previous post will remember that Mr Fortuned owned perpetual preferred stock that the company was trying to rid themselves of.  As part of the transaction the preferred stock would be converted into shares that the current executives would control.  Mr Fortune would receive payment for his preferreds.

After Fortune's death the company entered into a merger agreement with Ide Management Group a nursing home operator.  In leu of the going dark the company was now planning on engaging in a reverse merger, and a divesture of the human resource company as a way to rid themselves of the preferred stock.  Small shareholders would no longer be cashed out, they'd now own a nursing home operator.  This transaction wasn't any better for shareholders, they would now own a different business than they originally set out to buy with different management.

The Ide deal was terminated this year for an unknown reason without consequence to the company.  This left Fortune with a problem, they no longer had an exit strategy to get rid of the preferred stock, a bank owned the preferred stock, and Carter Fortune the controlling person for those shares had passed away.

So the company did pulled out the going private agreement from last year, changed some dates and filed it with the SEC.  Herein lies the problem, while the filing date, and the date for the shareholder meeting to vote on the agreement have been changed nothing else has.  This means the company is still claiming they will only cash out shareholders who owned less than 500 shares on March 26th of 2012 and who continue to hold those shares.  A lot has changed in the past eight months, and it's likely the shareholder base has turned over a lot.  Will cashing out those holders from last year still be enough to get the company under the magic 300 limit to go dark?  It's unknown, and unfortunately the company's management is less than friendly when asked about this.

If after reading this you think the deal is going to close, and the current odd-lot holders will be cashed out it's worth picking up 500 shares.  On something like this I consider the gamble worth it, I own odd-lots in two accounts.  But keep in mind this isn't a slam dunk deal, there's a good chance the company could go dark and anyone purchasing after March 26th 2012 will still have their shares.  To that there's consolation that this company is cheap.  Right now they're on pace to earn about $.06 this year, and with shares at $.19 that's a P/E of 3x.  Not to mention they're trading below NCAV.

One other point, in the proxy it states that shareholders are allowed to request the full copy of the fairness opinion on the original deal.  I have a digital copy of the full fairness opinion if anyone's interested.

Talk to Nate about Fortune

Disclosure: Long some odd-lots of Fortune

Wednesday, February 20, 2013

A banking primer

Value investors come in two types, the ones who will look at financials, and the ones who won't.  If banking is your forte I would encourage you to read the paragraph on my approach then come back for my next post.  If banking is intimidating or difficult to understand hopefully this post will be educational and break bank investing down into easy to understand pieces.  The bank I use as an example is not a good investment, but I'll cover why.  I think readers will understand how to analyze a bank better by understanding what's bad about banks instead of showing a perfect banking investment.  If anyone thinks I'm long winded something to consider; this post is based off a presentation I gave to my company and I covered this material in under four minutes, I can condense when I need to.

Approach

My approach to bank investing is very similar to my approach to buying any other cheap stock.  I prefer to buy banks at 2/3 of tangible book value and sell when they approach 1x tangible book value.  There are many banks trading at or above tangible book value, and a bank that's profitable should be trading above it, yet many don't.  A lot of stocks trade below TBV due to management mis-deeds, or the inability of a company to earn their cost of capital.  I believe the reason for bank cheapness now is different, we just went through a banking crisis and banks are still considered toxic investments.  Beyond this the market has lost interest in smaller community banks conduct the boring business of gathering assets and re-loaning the money.  Many of these community banks emerged from the crisis unscathed, and in a lot of cases overcapitalized and trading at incredibly low valuations.  Unfortunately market psychology doesn't care much about this, the banks are still considered risky.

Banking basics

Banking is the ultimate commodity business, and at the same time the ultimate niche/moat business as well.  At the most basic level banks are all the same, they take in deposits and loan against those deposits making a spread.  Banks have the ability to work at the edges, but the fundamental business is the exact same for a bank in Peoria Illinois as it is for a bank in Sevilla Spain.

Banks are very simple, they gather money in the form of deposits then they loan that money back to those same people and collect interest on the loans.  Bank financial statements are a bit strange to look at because we think in terms of ourselves most often.  A person's asset might be cash, which deposited at a bank is a liability.  A liability to a person such as an auto loan is an asset to a bank.  The assets and liabilities are flipped from what you are used to seeing on a normal financial statement.  The good news is you only need to learn this once, all banks report in the same manner.

One thing that's interesting about banking is how sticky customers are.  For how commodity the bank industry is many banks have what might be considered a moat.  Bank switching costs are high, it's very difficult to open and close an account, and most customers don't consider it worth the hassle.  I opened an account at a bank a few months back and took my son with me thinking it would be a quick errand.  He's three years old, I could count the time it took to open the account by the number of Dum-Dums he ate while waiting, hint his mother will never know the true tally.  I think from start to finish it was about 45 minutes, that time alone is an impediment for customers to switch accounts, not to mention having to switch billpay and auto-draft numbers.

Introducing Atlantic Bancshares

The bank in this example is Atlantic Bancshares (ATBA), which is a tiny bank located in South Carolina.  The bank has some issues with bad loans which you'll see in a few minutes, but the valuation is attractive.  The bank has equity of $7.2m and is currently trading with a market value of $1.4m, or 19% of book value.  The bank publishes their annual reports on their website, with the most recent update from the summer.  I'm going to use last year's annual report for this example, it's a little outdated, but it doesn't matter much, the principles are universal.

The balance sheet

Assets

Here is the bank's balance sheet as it appears in the annual report:

The structure of any company's balance sheet is important, small differences on the balance sheet can mean the difference between profit and loss.

Starting at the top the first thing you'll notice is cash and cash due from other banks.  Banks hold cash and securities against their regulatory capital requirements.  An item worth noting with this bank is they have a lot of cash but not many marketable securities.  The cash is earning them nothing, where securities might be earning something.  Securities are counted against capital differently than cash, which can drive the composition, all things being equal interest bearing securities are better than cash.

The next important number is "Loans Receivable", in this case the bank has $64m in loans, or 69% of their assets are loans.  In the notes the bank breaks down their loans into the following categories:

Different investors have different opinions on what the best loan makeup is, but there are a few things to keep in mind.  Residential loans have the longest duration meaning a bank is locking in a residential loan rate for a longer term, usually 15 or 30 years.  On the other hand construction and development loans which might have a shorter maturity are much riskier.  Commercial loans carry higher rates than residential loans, but have risks as well.  Residential loans are usually made in smaller sizes, $100k, $300k etc.  Commercial lending is usually in larger amounts, if a commercial loan goes bad one loan could mean a few million dollars in losses, whereas a residential loan might only be a few hundred thousand dollars in losses.

The final lines under assets include bank owned real estate, and any assets related to branches they might own or lease.  The number under owned real estate is important to watch, banks are in the business of lending money, not managing properties.  A large number here might indicate the bank is a poor lender and underwrote a number of bad loans.

Liabilities

I like to scan a bank's liabilities first when initially looking at an investment.  A banks funding base is the first indication of profitability.  The ideal bank setup is one where the funding base is non-interest bearing deposits that can be re-loaned at much higher rates.  Commercial lending falls under this category, most businesses that borrow from banks are required to keep large deposits in order to secure a credit line.  To break this down a company might deposit $500k at a bank and receive no interest on their deposit.  The bank then lends the business $1,000,000 at 8% on a credit line.  In essence the bank is making the business pay 8% on their initial $500k to gain access to the second $500k.  

In Atlantic Bancshares' case only 27% of their funding comes from non-interest bearing deposits.  As one walks down the categories of deposits the deposits become more costly.  An interest-bearing checking account might pay a small amount of interest whereas a CD pays a might higher interest rate.  You'll notice that most of Atlantic's funding comes from interest bearing sources, money market accounts, and CDs.  

The more interest the bank pays out to depositors the less money available for shareholders.  Finding banks with low cost funding structures is important.

The final item to look at on the balance sheet is the capital structure.  Atlantic Bancshares has a 7.37% equity ratio (equity/total assets), this means the bank is undercapitalized and will at some point require a further capital injection.  They did a recent preferred issue in 2011 which is seen under the Series AAA heading.  The bank raised $1.4m in 2011, mostly from directors and existing shareholders.

If anyone is trying to understand why this bank is a bad investment the capital structure coupled with the losses is the answer.  The bank is going to need to undertake costly dilutive preferred or equity offerings in order to meet their regulatory capital requirements.  As the bank continues to lose money the capital ratio will continue to deteriorate, until something changes the outlook is dire.

Income statement

Here is the bank's income statement:


The income statement is where we see the interest mechanics at work.  The bank took in $4.4m in gross interest from loans and interest paid on their marketable securities.  They paid out $1.08m to depositors holding CDs and money market accounts.  The bank then earmarked $1.86m as a provision for loan losses.  This means the bank is expecting to lose $1.86m or more on loans and they're saving this money ahead of time to deal with the problem.

After the bank pays out its depositors, and provisions for losses they are left with their net interest income.  After that is non-interest income, this is where things like overdrafts and one time investment gains are classified.  When you re-order checks and are surprised to learn they cost $24 that fee appears in this category on the bank's financial statement.

The net interest income plus other income is a sort of gross profit for banks.  Out of the remainder the bank pays for operations including salaries, rent, and other costs of doing business.  Following those expenses the bank pays taxes if they made a profit and records their profit or loss.

Some investors like to look at what is considered core banking earning power using pre-tax, pre-provision earnings.  For Atlantic Bancshares in 2011 their PTPP earnings would have been $503,843, meaning the shares are trading at ~3x PTPP.

Compared to the balance sheet a bank's income statement is very straightforward.  Expenses are itemized at a detail level that's unusual for a non-financial company.  What I like about the income statement is it clearly shows the drivers for a bank's profitability.  A few quick calculations can be made, take the interest from loans and divide it by the loans outstanding and you can see the interest rate on the bank's loans.  Take interest expense and divide it by deposits to see what the bank's paying on deposits.

Most of a bank's profitability hinges on two components, their expense management, and their interest margin.  If the net interest margin is too small because they have a high cost funding base they will struggle to maintain profitability.  Likewise if the bank's expenses are out of control there will be no profit left for shareholders.

Concluding thoughts

Astute readers will note I left out two things, a discussion of loan losses, and any discussion of a cash flow statement.  The cash flow statement isn't as useful when analyzing banks as it when analyzing a non-financial.  In a non-financial cash flows can be used to ferret out fraud, for banks other measures need to be used.  Banking fraud does happen, but it requires a bit more ingenuity because banks are so highly regulated.  The biggest risk to a bank investment isn't fraud but stupidity.  If a bank gets lazy and starts writing loose loans they will sink from lax lending standards quicker than anything else.

The second point is much more important, the banks loan losses and trend of losses is vital in determining the safety of an investment.  If the bank has too many non-performing loans they will either fail or be required to raise capital.  The level of NPA's is important, but the trend is just as important.  I didn't touch on this in too much detail because this isn't a comprehensive banking guide, different investors have different NPA preferences, I prefer lower and safer amounts, but some people do well riding momentum as losses start to moderate.

I hope this post has been helpful in explaining bank investing at an entry level.  There are a variety of resources to learn about each aspect of banking at a deeper level, but there is no substitute for practice.  The best way to learn how to value banks is to get out there and start valuing.

Talk to Nate about bank investing

Disclosure: No position in Atlantic Bancshares

Friday, February 15, 2013

Moats aren't forever

Most investors seem attracted to growing companies with large competitive advantages (a moat).  Who wouldn't want to own Apple as it went on to dominate the world.  Companies with moats are the types of stocks people talk about at parties when they say things like "I purchased Proctor and Gamble in 1988 and it paid for my retirement."

Growth investing will always be popular with a large segment of the market.  I know many co-workers have invested in "growth" funds because they want their money to grow, a fund with value in the name just sounds cheap, like a value meal at a fast food joint.  It doesn't help the image that many value investors are actually cheap themselves, some even fall beyond the cheap realm into the miser category.  Investors have a choice between a growth fund run by a slick looking guy wearing fancy clothes and driving a nice car and some value fund manager who's sport coat has elbow pads and drives a gremlin.  

Many readers know that I don't seek out companies with moats or competitive advantages as the market sees them, but I pick through the market's dustbin.  I don't think I've ever articulated why I don't seek out moat-ish companies, so I want to use this post to lay out my thoughts.

This idea came to me recently as I was reading an article about the recent Carnival Cruise Lines incident.  For readers who were unaware a Carnival ship had a fire which left it disabled in the water for a week.  Passengers were trapped without food, water or toilets.  The biggest story seems to be that passengers had to sleep on the decks and that raw sewage was running through the halls.  As I was reading the article I started to think about a series of posts Geoff Gannon and Quan Hoang wrote here about Carnival and the company's moat.

I wondered how badly Carnival's reputation would be harmed from the incident, some customers might shrug it off and say it wasn't the cruise line's fault, but for many others the name would be connected with a terrible experience.  No matter how many free vouchers Carnival gives to customers the brand damage has been done.

I thought about this in a broader context, the difference between investing in a cheap stock, and investing in a company with a moat.  A company with a moat needs to always be innovating and leading the pack to ensure their moat is safe.  One or two missteps could destroy their advantage entirely.  Maybe Carnival's advantage is their economy of scale, but scale doesn't matter if customers don't book cruises.  A company with a moat cannot sit back and rest on their success, the second they do they lose the lead.  Value investors are familiar with a number of companies that lost their moat such as Blackberry, Radio Shack, Best Buy and others.

On the other hand a cheap deep value stock is just the opposite.  The market has priced these stocks as if they are worse then dead.  I sometimes think of deep value investing like this, it's as if everyone predicts a city will be utterly destroyed by a nuclear bomb but instead most of the city just catches on fire.  When expecting a nuclear bomb a city-wide fire is a relief, complete destruction didn't happen.  Deep value investors need to be ready for bad news, it will happen, it will happen often and frequently.  But sometimes the bad news isn't as bad as the market expects causing the stock to rise.  The corporate corpse is found to have a faint pulse and investors rejoice, certain death was avoided and the company is repriced.

There's a completely different mindset required for investing in value companies verses moat companies.  To invest in a value situation all one needs to be sure of is that death isn't certain.  If a company isn't terminal, and has value then it could be worth an investment.  There is no glamour in buying these stocks.  No one recognizes the names in my portfolio, but that doesn't bother me, returns don't come from popularity.

I'm convinced buying companies with a competitive advantage and concentrating a portfolio is the path to riches.  There isn't anyone on the Forbes 500 list who constantly churned a portfolio of net-nets, they all founded companies with competitive advantages and put their entire net worth, and often their entire life into the company, the epitome of concentrating an investment.  If one wants to be rich I think they need to be an entrepreneur, they need to find an unserved niche and serve it and pour everything they have into that company.

If one can't start a company themselves the second best thing they could do is to invest in a company that has those characteristics.  Many more people made money investing in Starbucks or Microsoft when they were startups than investing in mature companies with leading competitive positions.  Buying into a small company with a defensible niche is probably the second quickest path to riches.

The problem is most investors really don't know what they're looking for when they're looking for a moat.  I was on a flight recently and started talking to my seat-mate.  Maybe this sounds weird, but I can't help myself from talking to people.  If I'm standing next to you for more than a minute we'll be in a conversation.  It turns out he owns a large trucking company familiar to almost any American who has ever driven on a US highway.  We talked about the trucking business and some of the challenges he faces along with the Ravens, skiing, and kids.  He made a comment that was interesting when he said "just like all businesses you need to figure out what you can do a little bit different that causes customers to use you."  His business specializes in certain types of loads, and runs their network in a unique way.

What struck me about his comment was that he's correct, and that our view as investors isn't the same as the people who run the businesses we invest in.  In an finance textbook trucking would be considered a commodity business.  One truck is equivalent to any other truck, they can haul loads the same, and it's doubtful anyone would claim a trucking company could have a competitive advantage.  The thing is in the real world every business that's in existence has a competitive advantage, if they didn't they would be gone.  Each company has something that's a little different that causes customers to do business with them.  

Investors without in depth industry experience, or a deep network of contacts can sometimes mistake a normal competitive advantage with a durable lasting one.  They are deluded into thinking a given company has a moat, when in reality every company has some advantage.  An investor who can correctly identify moats at small and growing companies will do well for themselves over the long run.  

To me a deep value investor is like a doctor who can walk into a room and identify quickly that the patient is going to live.  A moat investor is a doctor who can walk into a room and tell that the patient is the next Frank Sinatra.

Monday, February 11, 2013

What's the upside?

If anyone was dying to see a long winded analysis of a really attractive company this post isn't it.  I'm out skiing in Utah for a few days, and while I am not planning on researching any companies while I'm out here over the past two days I've been thinking about the following topic.

The topic of this post stems from a conversation I had with someone recently with regards to the time value of research.  As I was riding a lift today I was thinking about what percentage of undervaluation would be attractive as an entry point.  I was thinking about this in the context of the Ben Graham quote where he said you don't need to know a man's exact weight to know he's fat.  Likewise you don't need to know exactly how undervalued a company is to know they're cheap.

When I look for a company I want to add to my portfolio I look for what I call silly cheap companies.  These are the net-nets, the low book value, the hidden asset, hidden earning companies.  Because I invest mostly in small caps I have the ability to only buy companies that are extremely cheap.  A manager of a fund of any respectible size couldn't possibly buy shares in some of the companies I own.  As one travels up the market cap ladder the size of potential undervaluation decreases.  Whereas it wouldn't be surprising if some $10m company grew 100x it's unlikely a $1b company will do the same.  This leads to what I call the Barron's effect.  Most of the companies recommended in Barrons will have a line in the article saying something like "We believe this company could return 18% in the next year."  When I read something like that I wonder how few estimates have to be slighly wrong for that 18% to disappear and the stock be flat.  The problem is most Barrons readers want to purchase large cap stocks, or are in the industry buying larger stocks.  If Barrons came out and recommended some $30m company and said they could triple, their article alone would probably get the stock 40% of the way there on Monday morning.

The percentage of undervaluation is another way of stating a margin of safety.  The margin of safety is just a place holder for error and unknowns.  If I think something is worth $1000, but there are some unknowns I might not invest unless the price were $667 or below.

I believe most if not all value investors understand the concept of margin of safety.  What I think a lot of smaller value investors miss is the time value of research.  One of the advantages of looking at small companies is it doesn't take much time to read all of the annual and quarterly reports.  For some of the unlisted companies I own it might take 20 minutes a year to read all of their financial reports.

The time value of research takes into account the amount of research required for a given return.  For example, take two companies with the same expected outcome, a 50% return on a $10,000 investment.  If the first company is a simple net-net that takes 10 hours to research the hourly return per research time is $500 per hour.  If the second company is very complex and requires 50 hours of research the return per research time drops to $100 per hour.  Given this example it's obviously better to invest in the net-net with 10 hours of research verses the complex company at 50 hours.  What's odd to me is most value investors are attracted to the complex situations and shun the simple investments.  I believe most of this is due to a pride factor, there is a lot more pride in being able to understand AIG or some complex balance sheet verses Logan Clay Products.  Ultimately for myself I don't care about pride, I want the highest returns for the least amount of time.

The obvious conclusion from this is to look for simple investments with large return potentials.  If someone recommends I look at a company that has a 100+ page annual report I will skim a bit before looking at something else unless the recommender states that this company could go up some incredible amount.  In the time it takes to read 100 pages on a single company I could read the annual report of five different small cap firms.  My belief is that better investments are found with the more ground I cover.  That's not to say I'm opposited to reading 100+ page annual reports, it's just that I would prefer the simple companies.

I strongly believe the biggest efficiency gain possible in investing is understanding banking.  There are 7600 banks in the US, I don't know how many are publicly traded, but a lot are.  Banking is unique in that if you understand how to value one bank you understand how to value them all, banking is a commodity industry.  So for the effort it takes to understand how to value banks initally an enormous range of potential investments is opened up.

My concluding thought on this post is when looking at a given opportunity consider the time value of your research.



























Wednesday, February 6, 2013

Workforce Holdings, lots of sales but no cash.

To some people who stumble across this blog the companies I write about are some of the strangest and most obscure things in the market.  For most readers who are familiar with these markets the names are common and there's nothing odd about the companies at all.  I often write about stocks foreign to Americans, but they're domestic to many readers, maybe unsurprisingly half of the readership for this blog comes from outside the US.  One place not many readers come from is Africa, an area I've wanted some exposure to for a while.  I've written about Africa in the past, a book review here, and about a Portuguese construction company with a lot of African exposure.

I ran a screen for South Africa looking for net-nets on a whim, one came back, Workforce Holdings (WKF.South Africa).  It shouldn't surprise anyone that the company is small with a market cap of roughly $14m USD or 122.4m ZAR.  After taking a cursory look I was smitten with Workforce, they had so many things going for them including:

  • NCAV of 128.4m against a market cap of 122.4m
  • Book value of 206m (91.4 ZAX (essentially cents, 100ths of the South African Rand ZAR))
  • Trading with a P/E of 4.6x
  • Revenue, operating profit, earnings and equity have all been consistently growing.
Note: The company can be traded through Fidelity after enabling their International Trading platform.

The company is a staffing company, they fill temporary employment needs for clients.  For example a company might have a period of time that's much busier and they need extra factory help, along with the extra factory help they might also need some accountants on a temporary basis, and HR individuals to temporarily hire all of the above.  Workforce can provide temporary employees to most industries and most positions within those industries across South Africa and in neighboring countries.  The majority of their staffing is outsourced industrial support.

One question to ask when looking at a cheap company is "why are they trading so low?"  I find this is the question most investors fail to ask, and it's usually the answer to this question that leads to the fulcrum of the investment.  Most investments rest on a few hinges, fulcrums, turning points.  For growth investors the fulcrum might be the release of a new product, or a new service.  If the product is successful the stock takes off.  Those of us digging in the mud of the market are looking at things a little different.  The fulcrum for distressed investors might be if a stock doesn't breach a covenant then it will result in gains.  With most of the cheap stocks I look at the fulcrum is finding out the bad thing the market expects and determining if that bad thing will happen, or if the market has overshot.  It's rare to find a net-net that's debt free, loaded down with cash, has shareholder friendly management, high margins and gushing cash.  If it does exist, and a few might they probably trades less than 100 shares a year, in that case illiquidity is the fulcrum.

The issue for Workforce Holdings is the South African labor laws have changed in a way that could harm Workforce's business model.  The latest annual report asserts this won't be the case, but the company's actions speak louder than the CEO's letter.  The company has expanded into other markets including financial and lifestyle products.  This division has a fancy name for payday and student loans.  The telling line in the annual report is when the company states they believe the financial and lifestyle products division will be the growth driver in the future.

After building up a preliminary thesis I set out to find reasons why I should never invest in this company.  I try to work in reverse when I research, instead of reading ten years worth of annual reports and writing a competitive analysis on an industry before performing a valuation I want to make sure something is cheap first.  Once I've determined it's cheap I set out to find a reason why I shouldn't invest.  If I can't overcome all of the negatives on a stock I move on, sometimes there aren't many negatives, or at the price the company's trading the negatives might not matter much.  If I were to buy UPS at 35x earnings I might be worried about how gas pricesaffect earnings, at 5x earnings and below book value gas prices aren't an issue anymore.

It actually took me a while before I found the fatal flaw with Workforce Holdings, I made it through their latest annual report, and all the notes before I had my lightbulb moment.  I put together a spreadsheet showing the last six years worth of results with the flaw highlighted:


I lied, there isn't one flaw, there are a few.  The first is that while the company has great earnings they have a lot of trouble converting their earnings into cash flow.  To compensate for this the company continues to accumulate more and more debt.

The second problem are the company's receivables.  For long term construction projects it might not be unusual to have a receivable entry that continues to grow for years before a project is completed.  Staffing is different, client companies are billed weekly or monthly for the services provided.  There isn't a long runout with staffing, a person works, they bill hours and Workforce is paid.  The problem is Workforce doesn't seem to be getting paid that often.

The company reported 130m in earnings over the past six and a half years yet had operating cash flows of -117m over that same period of time.

If the company is having a lot of trouble converting their earnings into cash I started to wonder about the quality of the receivables.  If the company can't convert the receivables into cash then are the receivables worth their stated value?  Applying a significant haircut to them destroys any margin of safety on this investment, especially at this price.

Another way to look at the balance sheet is from a lender perspective.  I considered that if I had millions of rands would I lend them to Workforce Holdings if they asked?  The company has already borrowed against their receivables, which means the only thing left to loan against is property and plant, or their earnings stream.  Book value appears high, the company highlights that book value is double the share price.  Book value starts to fall apart when reading the notes, property and plant is made up of software licenses, computers and office equipment.  These items all have value in generating earnings, but their book value is an accounting fiction.  I wouldn't loan against the earnings stream because as I mentioned above the earnings are mostly an accounting fiction as well, there is no cash to back those earnings.

I really wanted to like this investment, the initial thesis was tempting, plus the potential to be able to participate in the growing African labor market was compelling.  Unfortunately the company's inability to turn sales into cash flow turned me away from Workforce Holdings.  Unless they cleaned up their balance sheet and started to generate cash, I couldn't imagine being a buyer.


Disclosure: No Position

Friday, February 1, 2013

Value momentum, speculating on recovering net-nets

This might be a strange post, maybe a sign of the times for the market we're in, I'm not sure.  I've been seeing something happen that I can't fully wrap my head around, and I'm not sure what to make of it, yet it exists.  I'll call the phenomenon value momentum.

Let me back up first, valuing a net-net is easy, calculate NCAV and buy below that price.  At times the company might have substantial unrealized business value, if that's the case the company should be valued on an earnings basis.  Another type of stock I like to buy is a two pillar stock, this is one that's selling below book value, and has earning power that supports book value.

I rarely buy stocks with poor earnings simply trading below book value, unless book value is something tangible or has strategic value.  I almost never buy a stock selling below book value when book value consists almost entirely of goodwill, unless that stock falls into the next category.

A third type of cheap stock I like to buy are discounted earners.  These are companies that have high returns on equity or invested capital.  Sometimes these companies are heavily laden with cash, and the true business value is hidden.  They might have low multiples like an EV/EBIT of 4x, or a P/E below 8x.

In this post I want to talk about net-nets which are trading at or very close to NCAV with recovering operations.  The current market has a lot of net-nets where book value isn't much higher than NCAV, and if it is higher then most of book value is pure accounting fiction.  An investment at a considerable discount to NCAV would be prudent and well justified.  An investment at NCAV is made on shakier grounds if what lies above it is speculation.  The theory behind buying net-nets is that the companies are priced for extinction, so when they don't go extinct the market will reward the stock because expectations were too pessimistic.  Another word for this is mean reversion.

Try going to the local hardware store and asking the owner to buy the store for less than the cash in the registers, and have him throw in the building, inventory, and client contracts as well.  It's ridiculous to even consider asking for that, yet the market gives us valuations like that all the time.  People will even go out of their way to justify the valuation, with things such as: "Hardware stores are outdated", "I can buy a circular saw on Amazon, or at Home Depot cheaper", "The building was built in the 1800s, it's probably worthless", "It's located in an old part of town".  Even if all of those sayings were true about the hardware store most reasonable people would agree that it should sell for something more than the cash in the register.

Some investors get caught up trying to find the competitive advantage of a net-net, my advice, stop looking, they don't have one.  Others work out DCF calculations, my advice is don't waste your time.  This is not to say that a good business can't sell below NCAV from time to time, it does happen, but not as often as many investors think.  When it does happen question why the seemingly good company is selling so cheap.  If you can understand why and the valuation is unwarranted back up the truck.  A lot of net-nets are average businesses with below average valuations.  You'll find companies such as, a cleaning supply store, a glove manufacturer, a barber shop product supplier, a metal stamping company, and some electronics manufacturers.  Nothing exciting in terms of business potential, yet the valuations the market gives these companies is clearly wrong.

Given that most net-nets are average or poor businesses, and most should be valued on an asset basis the question arises, what to do about the near net-nets?  Here's what I've observed, a company will be selling for 90% or 95% of NCAV and suddenly the company will report a great quarter, earnings go from $.10 a share to $.30 a share.  The only problem is the stock is selling at $19, earning power doesn't support the valuation.  Further the company's earning power will probably never support a valuation beyond NCAV.  What happens in the market is vastly different though, these companies gain momentum and start to fly.  I owned one that went from $6 to $13 in about six months.  Unsurprisingly outlook turned negative for this company and the price fell back to $7, then they had a good quarter again and it was right back up at $11.

What I'm talking about aren't isolated incidents, I've seen a number of companies fly past NCAV into no mans land in terms of valuation.  The company's valuation has become unhinged from its asset value, and earning power, yet the stock continues to rise.

My question is what should we do if anything with these value momentum stocks?  This is something observable that continues to repeat, but how does one invest prudently in these companies.  Once they float past NCAV and book value there is no margin of safety anymore, the price is bouncing on the whims of the market.  Yet clearly there is a lot of money to be made harvesting even some of the gains as expectations shift on the company.

What's frustrating to me is there are a lot of companies selling close to NCAV, but they're too close to NCAV for me to make a comfortable investment.  These companies also don't have much of a book value beyond NCAV or earning power.  Yet I also know that once they have a few good quarters their price is going to rocket forward for a while before results disappoint again.  I see these gains over and over, yet I can't bring myself to invest, or should I say speculate.

Has anyone else observed this?

Talk to Nate