Tuesday, June 25, 2013

Book value follow up; earning power

My last post garnered quite a discussion in the comments, I'd encourage you to read them if you get a chance.  The main question that kept coming back again and again is whether it's possible to separate assets from earning power.

It seems a popular line of thinking is that assets without earnings are worthless.  This is clearly the market view as well, the market doesn't care about assets, only earnings.  It doesn't care about the quality of earnings, or cash flow, just that earnings, and hopefully high earnings exist.

I want to take a step back and think about assets and earnings with my "real world" glasses on.  Let's simplify things and consider a small business, a gas station in a prime location.  Presume this gas station is given to me by my grandfather (family business) and I don't have much interest in it.  I am happy with the small amount of earnings it throws off, but I don't keep up with it and I let the gas station fall into disrepair.  Eventually my gas station's earnings gravitate towards zero and possibly to a slight loss.  For me as a disinterested owner the gas station has become quite a drag, it's taking up my time and it's close to losing money.  I'd rather cut my losses and go do something I enjoy.

According to the market view this business is worthless.  I know that seems like a crazy statement, but it generates no earnings, and if assets that don't generate earnings are worthless, my gas station is worthless.  The problem is this simply isn't true, my gas station is ideally situated and at a minimum the real estate is valuable.  I already have tanks in the ground and working pumps.  A buyer can come along and for considerably less expense than starting new take over where I left off.  Maybe they reinvest and develop a car wash or mini-mart and earnings soar.  The base assets are the same, but in the hands of a capable manager they're used to generate earnings.

Earnings are great if they can be extracted from the business.  In the comments "red." pointed out that my example of a company with earnings that require constant re-investment is a business that doesn't earn their cost of capital.  This is true, a business that doesn't earn, or barely earns their cost of capital has to constantly reinvest to stay above water.  An investor wants to own a business that earns above their cost of capital; the excess cash can be used to pay out dividends, or grow the business.

I want to dispel another myth that appeared in the comments on the last post, that assets should be considered through the lens of reproduction value.  This line of thinking believes that a business should be worth what it would cost to start one new today.  I think this is clearly faulty for the following reasons.

Many businesses in heavy industry have locations and permits granted that enable them to do business in a way that a new business never could today.  In the Rust Belt there are numerous steel mills and heavy industrial companies (with considerable book value!) very close to urban areas.  Imagine trying to build a steel mill right next to the 'burbs in San Francisco, it would be impossible, not metaphorically impossible, literally impossible.  Even a city like Cleveland or Buffalo would shy away from such a development.  Yet existing businesses with ideal locations exist, they can be purchased instead of built from the ground up.

Many existing businesses have already occupied the ideal locations.  Think about trying to locate a car dealer in your local area, where would it go?  There's probably already a section of road packed end to end with dealers.  Areas like this are a destination for car shoppers, where would a budding dealer operator locate if the strip has no more room?  Maybe across town?  Why start fresh with a subprime location, when an ideal location with all of the existing infrastructure, and possibly a name brand exists?

In the White Sharks of Wall Street there is a section where the author discusses why Tom Evans engaged in takeovers instead of building divisions from scratch.  His line of thinking was why start fresh when a fully functioning company with clients already exists?  This is why I don't think reproduction value is worth calculating, why figure out how much it costs to build a business from scratch when one already exists.

Talk to Nate

Does book value even matter?

Book value is praised as the one true metric that matters to investing, and derided as an accounting fiction.  Book value is fascinating, on one hand it's an accounting creation, yet on the other hand it's a very rough estimate for the tangible value of the company.

At the most basic level book value is the sum of a company's assets minus all liabilities.  What's left over is termed equity, or a company's book value.  A company's book value isn't anything specific, it's just the remainder from subtracting two values, assets and liabilities.

Value investors place a lot of emphasis on book value, for most book value represents a tangible high water mark for an investment.  What's that you say, you are a value investor but don't care about book value and only growth?  My friend you are a value GARP investor, you're looking for cheap growth, you're in good company, many "value" investors are really trying to buy growth cheap.  Read on to discover how those of us with plaid sport coats and elbow pads view book value.

Book value is at best an estimate, an estimate of what equity holders tangibly own in a company.  In theory if a company were to pay off all liabilities and distribute the remaining assets investors would receive book value.  In reality this never happens, and when it does it's a messy affair, at times what's distributed is far in excess of book value, and other times far below.

Two companies could report $100m in equity, at the first company the value might be realistic, and at the second nothing more than a faint hope.  A company's book value is determined by the composition of its assets and liabilities.  I have a friend who runs a factoring business, he sent me an email recently discussing how many client receivables are hopelessly overstated and will most likely never be collected.  He brought up a good point, a point that Graham discussed in Security Analysis.  In all companies liabilities are real, whomever a liability is owed will ask for it to be settled at some point, but assets are never sure, cash is sure, but the value of receivables, inventory and property is often a best guess.  While inventory might be overstated, a debt on the balance sheet is never wrong.  I have yet to read a financial statement with the note "We borrowed $10m, but the lender decided they only wanted $9.5m back."

A company's book value is not precise.  The balance sheet is merely a snapshot in time, but thankfully most items captured on the balance sheet are slow to change.  A company's earnings might fluctuate quarter to quarter or year to year, sometimes slowly, and sometimes dramatically.  Book value rarely fluctuates quickly, the value it captures is slow moving and rarely changing.  Cash is valued the same five years ago as it is today and as it will be in twenty years.  A manufacturing company's building is probably worth the same today as it was ten years ago.  Until a company decides to sell their assets and determine what the market will pay book value is the best estimate we have.

Some items captured in book value are clearly understated.  Companies are required to depreciate property, plant and equipment and scheduled intervals.  This depreciation is supposed to capture the fact that property and machinery decline in value as they are used.  Depreciation is a rough metric, at times it's close, but with certain industries it clearly misses the mark.

My brother works for a manufacturing company whose machinery is from the 1930s and 1940s.  The company's needs are simple and the machinery is essentially bulletproof.  The machinery has long been depreciated, yet continues to have years of useful service left.  I have worked in a number of manufacturing facilities where I've seen similar things, although not to the same level.  Machinery manufactured in the 1960s and 1970s is commonplace in many American factories.

A company I own was an example of this recently, Bowl America announced that they had sold an underperforming facility for more than $2m.  They subsequently stated that the facility was held on the books for $230,000, quite a difference!

What I find very interesting is that while equity investors give book value a passing thought bond investors and bankers pay the utmost attention to book value.  A creditor has a lien on the company's income stream, but if for some reason a company can't pay they need to determine if they'll be able to collect on the money they lent.  In a bankruptcy or distressed situation a creditor might force a company to sell off some assets and return the cash to creditors.  An asset sale moves theoretical values to the tangible column.  A sale shows the world what the company thought a building was worth, and what others thought it was worth.

I like to see companies where book value is growing over the years.  When book value grows equity investors own more of something each year.  A high growth company could earn a lot of money, but need to re-invest all of it for continued growth.  If the company fails to invest growth slows, and often investors flee.  An investor in such a company is betting that growth will continue, but they don't own anything more than they did a year before.

When a company grows book value they show that they earn enough to cover costs, and have something left over.  Companies with growing book values selling at discounts are often incredible investments.

The one unstated item in this post is the quality of assets, I briefly mentioned it above, but it deserves further discussion.  Let me start with two examples.  Value investors are often afraid of banks, they seem complex and mysterious.  A claim I've heard is that bank investors don't actually have a claim on a bank's equity because it's held for regulatory purposes.

I would argue that banks are the ultimate liquid and commodity investment.  There are over 7000 banks in the US, banks routinely buy and sell loan portfolios to each other, as well as branches.  A bank with a good loan book and good branches could sell their loans and branches at par fairly quickly.  They could then take those proceeds and distribute them to depositors leaving equity holders owning the company's book value.  Due to regulation book value consists of cash and securities, highly liquid salable items.  Whereas on the surface a bank might be confusing, a bank's equity capital is very simple, and often very liquid.

The second example is a company floating around the blogosphere, Premier Exhibitions.  The company owns the Titanic artifacts, which a judge determined were worth $190m.  The company sells at a wide discount to the artifact values.  When looking at the book value of Premier it consists of the Titanic artifacts and not much else.  Clearly equity holders are betting that Premier will be able to sell their artifacts at close to their valuation.  They might be, but I am positive the market for $190m worth of Titanic artifacts is much smaller than the market for commodity items such as office buildings, or loan portfolios, or bank branches.

For book value investors the question to ask is what does book value consist of?  If a company is selling at a discount to book value is it because book value is a hard to value or a hard to sell asset?  Is it because the market doesn't understand how to value the assets?

Talk to Nate about book value

Disclosure: Don't own anything mentioned specifically, generically I own a number of bank stocks.

Tuesday, June 18, 2013

The Solitron Devices first [in decades] annual meeting..

"Thank you for coming here young man.." - Joseph Schlig

"It's not an us verses them…you treat shareholders like barnacles on a ship waiting to be scraped off.." - Nate Tobik

"..I think part of the problem is you've lived under a rock for the past 20 years.." - Jeff

"I'm actually surprised at how many people the company brought.." - Alex

A ying and a yang, frustrated and curt with shareholders, semi-friendly and willing to answer questions.  The Solitron Devices annual meeting was full of contrasts this morning, from grimy downtown Miami, to the nice boardroom, I could go on, let me start at the beginning.

The meeting was held in the SunTrust building in Miami.  I arrived with my proxy and was greeted by a number of lawyers at the door.  They took my ID and gave me the voting form, I voted on the spot.  I also received a set of "rules" for the meeting.

The rules of conduct set out the agenda, rules for voting, and then two contentious items.  The first states that shareholders are allowed two questions that are to be no longer than one minute long.  That's it, just two one minute questions or comments.

Before the meeting started I had the opportunity to introduce myself to most of the other shareholders present.  There were nine shareholders present, not including management.  Shareholders ranged from large holders such as Alex Toppan, and Ancora Advisors to smaller holders such as myself.  Universally everyone was excited the company had finally put something on the calendar, with the hope we'd be allowed to openly ask management a few questions.

The company came in with a posse of advisors, including the auditor, lawyers, and Board members.  As an aside, I had a chance to talk to the auditor before the meeting for a few minutes.  I asked what it was like working with Saraf, considering he is the CFO/COO/C-anything.  The auditor said he barely worked with him, instead he worked with the company's controller and accounting department, which he spoke highly of.  I think this is reassuring, Saraf isn't a one man band running the entire show, although his hands are clearly deep into all aspects of the company's operations.

The company read some prepared statements, then opened the floor for questions stating they expected to wrap up in 20 minutes, clearly not long enough to air 20 years worth of questions.

I will summarize some of the questions and answers below, but I want to point out two important points from the meeting.

The first was a short comment/question that Jeff, from Ancora stated.  Jeff stated that he'd interacted with the company multiple times, and each time became much more frustrating.  He said he felt the company had been in hiding for 20 years and suddenly they were found out.  They can't go back and hide, they need to deal with shareholders.  He gave the company a B+/A- for operations, but a D for corporate governance.  Jeff spoke for his firm, but in truth he spoke for all shareholders, he just vocalized the frustration we all have with the Board.  Jeff also asked if the company planned on keeping their auditor more than six months.  The auditor expected to stay around, but I'm sure all of their auditors had a similar expectation.

Jeff's main comment was that it was great the company was having a meeting in a nice office, but what will be different over the next year?  Will we all be sitting in the same room looking at the same numbers?  Unfortunately Saraf's answer didn't answer much of anything, instead he evaded the main question asked and answered with a non-answer.

The second item worth noting was what happened when the company tried to close the meeting down. Jeff Moore (ragnarisapirate.blogspot.com) asked if the Board would stick around for an informal conversation.  He was flatly rejected, I protested along with other shareholders.  Eventually the company's counsel asked if we could take a five minute break.  After the break the Board came back in, Saraf gave a mini speech about how he wasn't going to give out inside information, insinuating that somehow that's what we were there for, which of course wasn't true.

The informal question and answer session was the highlight of the meeting.  Management let their hair down and answered basic questions about the business, as well as a few questions regarding capital allocation.

I also had the chance to look through the shareholder register at the end of the meeting.  This was eye-opening.  The company has around 2000 record holders, 95% of them hold less than 1000 shares.  Most of the company's record holding shareholders appear to be remainder creditors from their bankruptcy, holders such as Florida Power and Light with 2,000 shares.  There were many South Florida supply companies listed on the register, along with many individuals with 100-200 shares or less.

Election Results

The company will be publishing an 8-k with the official election results, but this is what was announced at the meeting.  Shareholders voted 1,917,570 shares in total, and voted:


  • For Saraf
  • For Gerrity
  • For Kopperl
  • Against Davis
  • Against Schlig


  • For ratification of the CPA
  • For the Say on Pay
  • Voted to evaluate pay once a year


Questions/Answers

A wide variety of questions were asked, where I remember the question I have it noted, otherwise these are just general answers and notes I took.  Jeff, and Taylor (http://valueprax.wordpress.com/) might remember more, I'll let them fill in additional details.  The answers are mixed with some commentary, none of these are direct quotes as far as I can tell.


  • Is there a succession plan in place?
    • There is a layer of management under the CEO, including the Controller, but otherwise all of the titles mentioned have no place in replacing the CEO.  The answer was essentially no.
  • What does the company plan on doing with their excess cash?
    • The company likes to keep money in reserve.
    • There are 72 (or 30 or 60, this number changed each time it was mentioned) before the EPA liability is completely eliminated.  Saraf discussed how difficult it is to work with the EPA, he said it took 10 years to negotiate the initial payment plan, this was not for lack of trying.  He said he has trouble getting them to return his calls, and hasn't been able to get a final date for satisfaction of the liability.  Somewhere between 30 days, the number a director mentioned, and 72 the number Saraf mentioned.
  • Much of the PP&E has been mostly depreciated or fully depreciated, does the equipment have years of service left?
    • Yes, much of the fully depreciated equipment is very useful.
    • Also worth noting the company is only operating at 50% capacity.
    • The company also has a lot of empty warehouse space available.
  • Sequestration has provided business opportunities, any conflict including a Middle East conflict would be a boom for business.
  • The company would consider future buybacks.
  • Why did auditors change?
    • The company is required to change auditors every five years due to SEC regulations, that precipitated the switch.  
    • The most recent change was due to their former auditor merging with an auditing company that specialized in insurance instead of manufacturing.
    • I didn't really buy the explanation of the change, especially considering most of the company's auditor changes were glossed over without any explanation.
    • The company stated unequivocally that they will remain with this auditor, my view is this remains to be seen.
  • Someone asked if the company could be more transparent, the company gave an evasive answer.
  • The company stated that shareholders are allowed to contact directors directly, this is a change from the past where Saraf wanted all communication to go through him.
Informal meeting questions
  • What type of marketing does the company employ?
    • Word of mouth, no one attends industry events, the industry knows Solitron.
  • The company is known as a niche supplier, they do their niche very well.
  • The company's niche is a sunset technology, this was a strange answer.  To a later question the company stated their product is unique and unlikely to ever go away.
  • Jeff Moore asked what directors look for when they buy a stock for their own account.  One director spoke and said he looks for a stock to go up, and at times looks for short term investments, and other times long term investments.  Some shareholders joked that he should have said "I invested in the Barrons stock of the week."
  • The military is willing to spend more on quality parts that meet qualifications.
  • The military expects companies to earn a profit, Solitron charges for everything.
  • DNA marking is a new requirement, each transistor is required to be stamped with a DNA stamp so a transistor can be uniquely identified, Solitron is stamping their chips and charges extra for it.
  • The company might be required to test chips in some special gas chamber, the chamber is expensive, in the $500k range.
  • The company's products are used in power supplies, there is no digital replacement, this answer is in contrast to the answer that the company's technology is a sunset technology.
  • The company's packaging is unique, not sure what the point of this was.
  • Some products are used to steer missiles.
  • 90% of the company's products are customer designed, meaning the company employs no R&D.
    • Of general note, a shareholder Doug explained afterward to me that the company doesn't sell anything unless the item has been ordered on contract yet.  This means 100% of the company's inventory has been ordered on contract, the company builds nothing on spec.  The company's inventory will all flow through to revenue.
  • Gold is a significant factor in cost, copper a larger component.  The management seemed worried about the cost, which is confusing because a few minutes later they stated they pass on all commodity costs.
  • The company would consider an acquisition, possibly an upstream acquisition of a larger company to use all the NOLs.
  • The company doesn't believe a buyback or dividend would have any effect on the stock price.
  • Saraf doesn't appear to care much that the share price doesn't move.
  • The company will only consider people for the Board who have industry experience.
  • Foreign sales are through US certified partners, I was somewhat unclear on this aspect.  It seemed that foreign sales aren't targeted to foreign buyers, but rather parts are sold to an American defense company, who then sends them to a foreign buyers.
  • The company had a large and growing market in some part, but Chinese suppliers flooded the market cheaper.
  • The company is facing an issue with wafer sizes, they currently use 3in wafers for production.  The supply of 3in wafers is dwindling worldwide.  Silicon manufacturers have moved to 5in and 8in wafers.  Moving to larger wafers would require a $5-10m investment to completely re-tool the business.
    • A note here, this was thrown up as a reason why the company doesn't want to distribute any cash, they "might" need it to re-tool.  I talked to a shareholder after the meeting who pointed out that for how penny tight Saraf is it's unlikely he's going to dump all of their hard earned cash into re-tooling.  This was most likely a red herring.
Conclusion

I enjoyed looking management in the eye and asking them questions.  I think all shareholders were glad the company finally held a meeting.  The problem is that management looked us in the eyes, nodded their heads, but in the end nothing will change.  It's easy for them to entertain us for an hour and a half, but taking action is much different.

My biggest fear after the meeting is that the company could enter into a costly acquisition that's above what they can manage.  My second biggest fear is that management will continue to have an us verses them mentality regarding shareholders, this isn't good for anyone, especially when management only owns around 10% of the shares outstanding.


Disclosure: Long Solitron

Monday, June 17, 2013

Questions for the Solitron Board of Directors

I am in Palm Beach mentally preparing myself for the Solitron annual meeting tomorrow.  This means I've been sitting on the beach, enjoying the sun, relaxing and eating fresh seafood.  I wanted to post the questions I intend to ask at the meeting tomorrow, and solicit other questions from shareholders.  I'm not sure how many questions I will get to ask, but I will try to get in as many as I can.

I'm expecting to post again tomorrow with a summary of how the meeting goes, so stay tuned. For anyone new to the Solitron situation I have a short summary below.  For everyone else skip straight to the questions.

Solitron Recap

In 2010 I discovered a tiny profitable net-net, with a slug of cash on their balance sheet.  The company had a number of liabilities stemming from their bankruptcy in the 1990s.  I wrote a number of posts detailing the investment case for the company, and ultimately waited for something to happen.

I eventually wrote a letter to the Board, urging a stock buyback and encouraged them to hold an annual meeting.  After hearing an outcry from investors (including one filing a lawsuit) the company acquiesced .

In the meantime the company paid off all of their known environmental liabilities stemming from their bankruptcy.  The company is now a pile of Treasury bonds with a profitable electronics manufacturing company attached.  It's worth noting they are still undervalued, according to some measures significantly so.

The annual meeting is tomorrow at 9am at the firm's law offices in central Miami.  I was disappointed by the location considering their facility and headquarters are than 10 miles from where I traditionally stay when in Florida.  I would have been nice to see their facility from the inside as well.

I have written too many posts on Solitron to link to each, so here is the Google link for all of them.

Solitron Board Questions


  • Are there any residual liabilities from the bankruptcy that are off balance sheet or haven't been noted?
  • Why hasn't the company grown in the last decade?  Especially in light of the extraordinary defense spending and growth rich environment.
  • What is your approach to target new markets?
  • Has your customer list changed much in the last decade?  Have you gained new customers?
  • How has the sequester affected your business?
  • What accounted for the $190k increase in SG&A this past year?
  • How do you measure the business?
  • What is your standard of success?
  • Do you consider Solitron successful?
  • Why haven't you hired a CFO?
  • [Statement] As a shareholder I, and others would be happy if the company paid more per year for an audit if the auditor would remain the same year over year. 
  • Have you considered taking the company private?
  • Is the company more likely to execute a dividend or buyback with the excess cash?
  • What is holding the company back from distributing excess cash to shareholders?
  • If the company pays a dividend or buys back shares, and shareholders become less vocal will you discontinue annual meetings and stop listening to shareholders again?
  • Have you considered an acquisition?
  • What would you look for in a potential acquisition?
  • Would you consider using debt to finance an acquisition?
  • How would you evaluate a potential acquisition target?
  • [Statement] As a shareholder, seeing how the business has failed to grow in the past decade I would prefer the company give cash back to shareholders, instead of attempting to grow the business through an acquisition.

If anyone has anything they wish to add to this list leave a comment.  Fair warning, I might be slower to approve comments, I will have my phone at the beach, but won't be checking it as often, please be patient!


Disclosure: Long Solitron

Friday, June 14, 2013

Purchasing Bexil at a discount through Winmill

I've never had a reader email me asking what I consider an oddball stock.  Maybe my posts do the talking for themselves.  I find most of the companies I research and write about are not all that odd, they're just not mainstream mid/large cap names that most investors are familiar with.  

Many investors appear to be drawn to complexity.  There is a certain intellectual challenge to a complex situation.  Complexity doesn't interest me that much, I prefer simplicity, but what I really enjoy are things that are hidden.  Complexity is good for experts, hidden things are good for individuals, professionals (most) can't be bothered to look.  I enjoy researching stocks where information is very hard to find.  The research process is like a treasure hunt, each piece of knowledge I pick up is either discarded as useless, or exceedingly valuable.  Anyone can go on these treasure hunts, but most would rather not waste their time.  Some of my favorite stocks are very simple investments, but very hidden.  For many outside investors this process appears complex, it's not complex, just different.

The stocks I want to talk about in this post might appear complex, but keep in mind the above paragraph.  The investment story is very simple, it's unraveling the details that's difficult.  Winmill (WNMLA) and Bexil (BXLA) are hidden, but not complex, what they are is utterly fascinating.  This post might seem complicated, but I would encourage you to read to the end, I think the reward is ample.

I was alerted to Winmill & Co almost exactly one year ago by a reader.  I read their website, and eventually ended up on the Bexil website.  Recently another reader suggested I take a look at them.  I look at a lot of stocks, but if I find myself drawn into a story, and spending an inordinate amount of time reading and researching an idea, I will usually write it up.

Winmill & Company is an investment advisor to a number of mutual funds, both open and closed end.  The company's funds pursue very narrow strategies, such as gold funds.  Of the Midas Funds, one invests in the Harry Browne perpetual portfolio.  A second one, the Midas Magic held 25% of its assets in Berkshire Hathaway, and 20% of its assets in Mastercard.  Incredibly 45% of the funds assets are in two stocks, which by the way are both holdings of mine as well, although I'd never recommend anyone make 45% of their portfolio out of those stocks.

When visiting Winmill's website, one might get the impression the company focuses on asset management.  This might actually be the second impression a visitor might get, the first is the feeling that they were transported back to the information superhighway circa 1996.  The only thing missing from Winmill's site was some blinking text and little animated gifs of spinning dollar bills.  This is a complete total digression, but I'd love it if some finance researcher did a study on the stock performance of companies that have dumpy websites vs companies with slick websites.  My gut says that the dumpy website companies would come out ahead.

The value of Winmill's asset management business is unknown, but what is known is their stakes in two much larger companies, Bexil and Tuxis Corporation.  All three companies are controlled to various degrees by members of the Winmill family.

Tuxis is a self-storage and real estate company located in Connecticut.  They are non-reporting, but as of 2007 they had an equity value of $7m.  As of 2007 Winmill owned 25% of Tuxis, I haven't been able to find further details, but given the Winmill family's tight reign on this operation I would presume the stake hasn't shrunk.

The much more interesting Winmill holding is Bexil Corporation.  Bexil is a holding company that is engaged in securities trading, investment management, and mortgage banking.  Winmill owns 222,644 shares of Bexil.

The company trades securities on their own account, and manages a dividend and income closed end fund.  Close to 50% of the company's revenue is attributed to their trading and investment management activities.  

Bexil's annual report will be a familiar read for investors who have read the Berkshire Hathaway annual report.  Bexil considers themselves successful if they are able to grow book value per share over the long term.  Because so much of the company's results are due to trading gains, and the sale of subsidiary companies, management feels that book value is a justifiable measure.  I agree with a few caveats, the first is that while book value has been growing the share count has been growing almost as fast.  The second caveat is there appears to be some wiggle room as to what the company's exact book value is due to the nature of their operations.  This isn't necessarily a bad thing, but just something to watch out for.

The story with Bexil became much more interesting late in 2012.  The company decided that they wanted to enter the mortgage origination business.  Mortgage origination is a business where a company finds a borrower, lends them the money for their mortgage, then sells the mortgage to the government.  The originator can service the mortgage and make a profit on servicing.  Bexil wanted to enter this market, but didn't have the resources to do it on their own.  They formed a subsidiary Bexil American Mortgage and funded it partially themselves, and partially with outside investor money.  The outside investor is Alex B. Rozek, a name that probably isn't familiar to most.  Alex is Warren Buffett's great nephew, the B in his name stands for Buffett.  Alex manages a hedge fund in Massachusetts called Boulderado Partners LLC.  A side note is that Alex proposed to his then girlfriend at the end of a Berkshire shareholders meeting a few years ago.  Alex not only provided seed capital for the mortgage origination business, but he's also a significant shareholder in Bexil.

Attached to Bexil's 2012 annual report is a two page discussion by Alex explaining why he believes mortgage servicing and mortgage origination are the perfect businesses to be entering right now.  The short summary is there are few companies qualified to do this business, and government barriers to entry are so high it takes years to complete an application to compete.  Bexil American already has all of the required certifications and approvals to operate.

Bexil's balance sheet is hard to parse due to the consolidation with their mortgage origination business, the CEO even states this in his annual letter.  The important parts worth noting are that Bexil has $30.7m in equity, and $15m in cash and securities.  They have a lot of debt, but it's warehouse borrowing related to the mortgages they originate.  A balance sheet is a snapshot in time, and the mortgage subsidiary's books are always fluid with loans moving in and out quickly.  So the snapshot preserved for the annual report most likely bears no resemblance to their current balance sheet.

Bexil American isn't profitable yet, but if an investor believes the story that Alex and management are promoting it should be profitable soon, and when it is the company will be gushing money.  Alex states that a mortgage originator can expect 100% returns on their capital if they do things right.

When examining Bexil through the filter of their latest results, they don't look that cheap at current prices.  The company has a market value of $49m against a book value of $30.7m.  The company has consistently lost money, and until recently was steadily growing book value per share.

The twist in this investment comes with Winmill, they own 222,644 shares of Bexil which at current prices is worth $11.187m.  They also own 25% of Tuxis, which is worth about $400k.  An interesting side note, Tuxis might be worth a look, they are trading at 18% of their 2007 book value.  Both of Winmill's public subsidiaries are worth $11.5m in total.  Winmill's own market cap is $3.045m, meaning they are trading for less than the value of their subsidiary stakes alone.  The market is valuing their investment management business at less than zero.  Winmill also historically had some cash and securities on their balance sheet, let's call it $2m.  Their historic liabilities were close to zero.

When you add all of the holdings up, and toss back in Winmill's presumed cash and securities the investment starts to look like a dollar selling for $.22.  Investors are able to purchase Bexil at a steep discount by purchasing Winmill.  Additionally if the Bexil mortgage origination business does as well as management thinks it will both Bexil and Winmill will benefit.


Disclosure: Long Mastercard, Berkshire Hathaway

Monday, June 10, 2013

The importance of expectations

I've had a post on a Greek net-net bouncing in the back of my head for a few weeks now.  As I've thought about writing that post I kept reading articles and blog posts where either readers or authors had unreasonable expectations.  It occurred to me that I've never clearly talked about my expectations for investments, and why they are important to the investing process.

This post probably crosses into the life advice category as well, but I've found that most life advice that's good advice is applicable to investing, good advice is universal.

Nothing can demotivate as quickly as unreasonable expectations.  This is just as true in finance as it is in marriage, or in a career.  Twenty-two year old's who expect to be sitting behind the mahogany desk on the top floor in three years are in for a rude awakening.  Individuals who expect marriage to be all bliss will be disappointed.  Investors who dig deep and do a lot of work on ideas and expect them to all go up will be disappointed.

There are two sets of expectations when it comes to investing, the investor's own expectations, and other investor expectations.  I want to talk about both.

Other investors

This is the easiest set to talk about; the expectations of others.  When the expectations of the market don't align with reality an opportunity exists.  Generally expectations are either overwhelmingly negative, or overwhelmingly positive.

An example of positive expectations can be seen when looking at any media darling growth stock.  The stock is modeled to have 15-20% earnings growth from now until eternity.  Simple models like this fail the Peter Lynch test.  Lynch talks about thinking of real world implications.  He mentions in his book reading a growth forecast and realizing that every person in the US would need to buy the product for the forecast to come true.  An expectation like that is unrealistic, and thus the stock is selling with too rich of a valuation.  Think about how many units would need to be sold to make estimates reasonable as a way to test the market.

Where I spend most of my time is evaluating negative expectations.  Many companies I decide to invest in have been left for dead by other investors.  Investors either expect the company to remain dead money, or to always trade in some tight range that's perennially low.

The key to being a successful value investor is determining the expectations the market or other investors are making regarding a stock, and then comparing those expectations to the facts, or the truth.

Sometimes investors have bad expectations because they don't have all of the information needed to make a correct decision.  Missing information leads to an informational advantage for investors with the information.  The better information also allows better estimates for what an investor might expect to happen in the future for a company.

I think too many investors get hung up on getting an information advantage.  Instead investors should aim for creating a patience advantage.  In many value stocks the selling owners are shareholders who've owned the stock since it was a high flyer.  The stock has fallen, the company has deteriorated, and they are finally throwing in the towel.  These are ideal sellers.  I get nervous when I see that most of a stock's ownership basis is value investors, or the only people talking about a stock are value investors.

Our own expectations

Here is a simple life lesson, people will talk endlessly about things that don't affect them.  People will talk about things that affect them if action isn't required.  If there is an issue that affects someone, and it requires the person to act it will be met with silence.

To become better investors we need to face our own expectations.  I've received emails from readers who tell me they're only interested in stocks that will triple, or go up 5x in three years.  Sure, I'm interested in those stocks as well.  If someone can email me where to find only those stocks I will sell everything I have for them.  I've had readers tell me they only want 20% returns, or they only want high quality net-nets.  A high quality net-net is an oxymoron, they don't exist, if a company is trading below NCAV there is a problem, guaranteed.

Why are our expectations regarding returns so incorrect?  I think some can be traced to Buffett, he famously quipped that he could guarantee 50% returns on $1m invested.  This is like Michael Jordan guaranteeing that he could single handedly beat any high school team in game of pick up ball.  With sports we recognize that superstars are naturally talented, and no matter how many hours we practice, 10,000, 20,000, we will never be able to perform at their level.

Yet Buffett seems so simple, he has this folksy wisdom, and he talks about how he just buys these good businesses and somehow he'd do 50% a year.  The sale pitch is enticing, and we start to believe if he could do 50% why can't we?  Just like we're not Michael Jordan, we're not Buffett either.  Knowing ourselves sets the basis for creating reasonable expectations.

Setting reasonable return expectations should lead to better investing decisions.  If my bogey is 25% a year and I'm only able to do 18% I might start to take on extra risks in an effort to juice returns to meet my goal.  I remember seeing a quote that 40% of investments fail, it's keeping the number of failures to a minimum that drives returns, not a few 30-baggers.  It's fairly easy for a company to go to zero, all they need to do is stop selling and spend down all of their cash, default on their debt and setup an appointment with the bankruptcy court.  It's very difficult for a company to double their sales, or triple earnings.

The second area of personal expectation setting is the time frame required for an acceptable return.  A friend of mine sent me a note months back stating that he set up a test portfolio in Yahoo with a number of stocks he had given up on.  He went back and looked at it and they were all trading higher, many at or above his original estimate of IV.  My friend is extremely patient, but no one is patient forever.  The longer we're willing to wait the better chance we have of an investment idea working out well.

I want to take a journey down a tiny rabbit trail for a second here.  I've had a few comments asking why I prefer to invest in profitable net-nets when research shows that the unprofitable ones end up doing better return-wise over the long term.  The reason I prefer profitable net-nets, or profitable low BV companies is because the profit gives me time for the investment to work out.  I can sleep well at night knowing a company isn't frantically spending down their cash pile.  Impending doom can be a motivator, but impending doom is also a stressor.  I prefer investments that might return less, but the tradeoff is I am willing to hold on to them over a long period and be patient.

I've come to appreciate that investments always take much longer than I expected to work out.  This is why investors seek out catalysts, it's an effort to reduce patience.  I'd rather work on my patience skills, because there are a lot more investments without catalysts out there, than with them.

Another pet peeve expectation is liquidity.  I realize that I probably have some readers who are tossing around serious money in the market, this isn't for you.  This is for everyone else who wishes they had a Ferrari, but really only has a Corolla.  It's possible to build, and liquidate positions in illiquid stocks with smaller amounts of money.  The key is patience and having a reasonable expectation.  In the past selling a stock used to involve going to the bank, taking the certificate out of the safe deposit box, driving to the post office, mailing it, and waiting.  Now we click a button on the computer and complain how illiquid a stock is when we don't have a fill in 15m.

We could all use a deep peer into our souls and examine our expectations.  Are we expecting too much, are we expecting too little?  Are our expectations causing us to make bad decisions?  The secondly look at the expectations others in the market have for companies we own.  Are there opportunities to take advantage?

Talk to Nate


Monday, June 3, 2013

Solitron proxy voting guide

I have written about Solitron Devices extensively on this blog.  I write about the company, not because I have a large position in them, but rather because the story is so interesting.  For readers who don't wish to spend their morning trolling the archives I will give a very quick summary below.

Solitron is a Delaware corporation that makes electronic diodes and components for the aviation and defense industries.  The company went through a bankruptcy in the early 1990s and recently settled their remaining outstanding liabilities related to the bankruptcy.  For years the company traded below NCAV, where most of their NCAV consisted of Treasury bonds, and cash.  The company's operations are small, but efficient, and most importantly profitable.

After owning the stock for a while I became fed up, I was off-put by the brash CEO, and the lack of shareholder focus.  I eventually wrote the company a letter asking for a share buyback and the instatement of an annual meeting.  My letter got the ball rolling, other shareholders began to contact Solitron and push company into action.  One small fund sued the company as a means to force them to establish a date for the annual meeting (June 18th, 9am in Miami FL.)  I have felt that my letter, and subsequent posting of it on this blog got the snowball rolling.  I can't take credit for anything subsequent my letter, but I do feel that I got the process moving.

I have a lot more thoughts on this topic in general, and with regards to the shareholder/management relationship problem, but I want to keep this post focused.  I will save those thoughts for some point in the future.

I received my annual report and proxy in the mail recently:


Both are available online through EDGAR as well.

I thought it might be helpful to walk through a few issues in the proxy that are up for a vote, and voice my opinions on them.  It would be much easier to say "Vote Yes on a,b,c.. No on d,e,f.." but instead of spoon feeding my views I'd rather share my opinion on these issues.

Director Election - Up until recently the Board of Solitron could be summed up as follows: a CEO and two empty leisure suits.  Of the three members of the Board, two seemed to be missing in action, they will not be getting my vote.  One of my goals in establishing an annual meeting was so the company would allow shareholders to vote on the Board.  We need fresh faces on the Board, removing Jacob A. Davis, and Joseph Schlig is essential.

The company recently nominated two other new directors for a short term, they are also up for re-election at the annual meeting.  I voted against the two new candidates as well.  I don't wholly trust the current Board's judgement, and since the new nominees were nominated by the current Board by proxy I don't like them either.

Another reason to vote against Joseph Gerrity and Sidney Kopperl is that the company changed their bylaws so that director elections are staggered.  It would take three years for the full Board to be replaced.  The last thing I want are two more potential bad Board members voted in for three years.

I voted for Saraf to remain on the Board, I voted against the other four nominees.

Ratification of Accountants - This is often the easiest item to vote on a proxy.  Most companies keep the same accounting firm year to year and the vote is more of a formality.

Solitron is different, they have a habit of firing their accounting firm yearly and bringing in someone new as a way to save costs.  This is a practice I'd like to see discontinued, and an item that's hopefully raised at the annual meeting.  If no one else raises it, I plan to.  I voted for the ratification, but intend to question the Board as to why they think this is a good practice to save a few thousand dollars, but alienate themselves from the investor community.

Say on Pay vote - Shareholders are allowed a non-binding vote on executive compensation.  The company doesn't have to listen to shareholders, but this is a way for the company's owners to loudly voice their view on what management takes out of the company each year.  Smart companies listen to their shareholders, and if shareholders vote against pay they revise it.

I voted against this item.  The only executive is Shevach Saraf, the CEO, who made $403k last year.  This was up from $380k the year before.  I recognize that in the grand scheme of things $403k isn't an egregious salary for the CEO of a company that does $8m in sales.  On the other hand Soliton has been treading water for almost two decades in terms of profitability.  I don't see why shareholders should regard a CEO who is essentially babysitting a company with a paycheck for $403k.  If the company were growing, or shareholder friendly I would reconsider in the future.

Frequency of pay advisory vote - With the passage of Say on Pay shareholders have the choice on how often they want to voice their view of management compensation.  The choices are 1 year, 2 years, or 3 years.  Naturally management doesn't want the owners meddling in their affairs, Solitron has suggested that every three years is an appropriate time for shareholders to vote.

I disagree with this and firmly believe shareholders should be voting on compensation yearly.

Conclusion

I am interesting in any differing thoughts or views on the proxy that shareholders, or any readers have.

I will be attending the annual meeting in person, the meeting is on June 18th at 9am at the offices of Akerman Senterfitt in Miami Florida.  I have informally talked to a few other shareholders and we are planning on grabbing something to eat after the meeting.  If anyone is planning on being there you're invited to join us and talk about Solitron, micro-cap stocks, value investor, or really anything afterwards.  If anyone has any suggestions on where to eat within walking distance of the SunTrust building in Miami they would be helpful too.

Talk to Nate

Disclosure: Long Solitron