Monday, October 28, 2013

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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

Tuesday, October 22, 2013

Ameriserv, a bank with a not quite hidden asset

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

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

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

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

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

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

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


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

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

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

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

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

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


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

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

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

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

Disclosure: No position

Thursday, October 17, 2013

Value Investing 101 (how to value a company)

This post isn't for most readers, drop back in a day or two, there will be an interesting bank profiled.  I have had a number of emails recently from readers asking some basic value investing questions, and I thought I might put a simple resource out there for beginning investors to refer to.

What is value investing

Value investing is the concept of purchasing companies for less than their worth.  It's almost strange that this idea has its own title, because this is what all investors are endeavoring to do, whether it's titled value investing or not.

An investor needs to look at a stock as a piece of a real company.  A share of stock represents an ownership interest in a company that has real locations somewhere.  At their offices there are real people who go to work each day and work their hardest for you (the owner).  These people probably aren't thinking about the stock, they're thinking about the product, their upcoming vacation to Disney, and the day to day challenges they're facing.  The benefit they reap is a salary, what you reap as the owner is whatever value they generate that accrues to your ownership interest.

The idea of a value investment is to envision this real company and evaluate what it might be worth.  A great starting point is the company's balance sheet.  Their office, factories, desks, laptops, intellectual property all have some value.  Maybe the value is very small, or maybe it's significant, either way look at what the company owns.  Then look at what they owe, maybe they've mortgaged their entire future and what they own is actually owned by the bank, examining the asset and liability structure is important, after all, this is what you're purchasing a piece of.

You want to purchase this company for less than what you think they're worth.  If the company is worth $10m, then maybe a purchase a $6m is appropriate.  The key is to be a disciplined buyer.  If you decide something is worth $10m and you won't buy at more than 2/3 of their value don't cheat yourself and buy at 72%, unless you have a very good reason to violate your rule.  As a value investor you make money when you purchase a stock, you aren't hoping for the market multiple to expand, or for the company to grow into their valuation.  You are buying something worth a fixed value for less than that value.  Being sloppy on purchasing is one way to dilute your returns.

The question always comes up, what do you do when the stock price starts to fall?  The first thing to do is examine the reasons for the fall.  Maybe there are no reasons, maybe it's just moving with the market.   Think back to the actual business, think about the factories, the workers, the output; has something changed in their workday that makes them worth 2% less, or 4% less?  Most likely not, if the price continues to fall, and the actual value is unchanged consider purchasing more of the company.

How to value a company

I think people get hung up on valuation because it appears to be a financial dark science.  I have seen write-ups with complicated math and enormous tables that try to predict the future.  I'm not sure how well that stuff works, but I'd advise starting simple.  Often you never need to move beyond simple; simple valuation methods leave less room for error.

The best way to start is to screen for companies that are trading for less than book value, or for less than than a conservative earnings multiple (P/E 10, or EV/EBIT 7).  Work backwards, take a company you find in the list for less than book value and examine their book value.  Is this company's book value as strong as it looks initially?  Maybe they have a lot of goodwill, or are laden with expensive debt, discount those items.  Maybe their assets aren't as valuable as the company would like them to be, discount that as well.  Look at the adjusted book value compared to the market price, is the company still selling with a low valuation?  If so then consider buying it, when the company's value approaches your adjusted book valuation consider selling.

A similar method can be applied to earnings as well.  If the market is valuing all rubber hose manufacturers at 10x earnings and you find one selling at 6x earnings it's time to investigate.  Why is the company selling cheap, are their earnings depressed, or is there a reason they're discounted?  Determine what the reason for the discount might be, if it's a valid reason move on, if it's not a valid reason then maybe consider purchasing.

Summary

I believe the items in this post are great building blocks that any starting investor can begin to use now, and as they learn expand into more complicated item.  Don't become overwhelmed, focus on what's important, which is buying companies at a discount, and being disciplined in your process.  There is no need to jump from elementary investing to advanced investing.  A lot of the learning process happens over time with experience.  Investing takes patience and perseverance, you can't learn everything on day one!  My final piece of advice, if a company appears too hard to evaluate, move on, there are 60,000 traded companies world wide, there is no shortage of simple companies, start with those.

Tuesday, October 15, 2013

Federal Screw Works, engineering a turnaround?

On my last post someone suggested in the comments that I check out Federal Screw Works, a name I'd seen bouncing around the internet over the past few months.  I am familiar with the company, I came across them as I evaluated hundreds of pink sheet companies over a year ago. With the a reader's prompting it was time to look at the company again.

Federal Screw Works (FSCR) is a Michigan company engaged in the manufacture and production of machined parts.  An incredible 97% of their sales is to the automotive industry.  A sampling of their products is shown below:

Companies like Federal Screw have a tendency to scare me, these are companies with long histories of losing money that suddenly become profitable.  When the perennial money losers start to make money it's often a sign that we're in the late stages of a recovery or worse, in a market that's topping out.

Most often asset value plays are considered cigar butt investments, companies with a little juice left in them, but not much more.  I believe the analogy could be extended, there is a whole category of earnings based cigar butt investments as well, of which Federal Screw Works is potentially one of them.

When an investment thesis is based around a company's assets the investor is betting that the company isn't worth less than either liquidation value, or book value, and eventually the market will agree with their point of view.  An earning based cigar butt is a little different.  The market already values companies on the basis of earnings, companies with good earnings are rewarded with high multiples, and low earnings with low multiples, mostly regardless of asset value.  A company that suddenly has a few great quarters can be caught up with investor enthusiasm and be priced accordingly.  Often the stock price rise for a mediocre company with a few great quarters can be an exciting ride, as long as you know when to get out.

The key to cigar butt investing is knowing when to get out, most deep value investments are not buy and hold investments.  Because of this many people have this impression of asset based value investors as glorified traders, swapping in and out of these stocks creating a tax nightmare.  The truth is much more subdued, the market is often slow to appreciate their value.  An investor might purchase a stake then have to wait a few years before something happens and the share price appreciates.  But when it does appreciate sell out at what you consider fair value, and be quick about it, often the price will appreciate quickly, and then rapidly decline right back to where it was prior to its ascent.

Federal Screw Works is levered to the auto industry, with most of their sales directly related to autos they do well if car sales are up, and they struggle if car sales are down.  What's impressive is the company found a way to lose money from 2005 until this past year.  They blame their most recent losses on the recession and reduced demand, but their losses from 2005, 2006, and 2007 can't be blamed on a poor economy.  The oldest annual report I could see was 2007, where they were blaming their difficulties on outsourcing and reduced light truck demand from high gas prices.

The company's continued losses since 2005 have resulted in an incredible display of shareholder destruction.  Book value declined from $59m in 2004 to -$4m in 2012, and has since recovered to a positive $2m.  During this period the company has been working to change their operations, they've dramatically reduced head count, and were able to turn a profit on $57m of sales, whereas in 2005 they lost money on $85m worth of sales.

In the company's defense they are a survivor, despite the continued losses they have been able to hang on and fight long enough to see a small profit.  The question is whether their profits are fleeting, or something sustainable?

Besides the company's poor earning history they have sizable liabilities that could become problematic at some point in the future.  The company has a sizable pension that's partially unfunded, and retirement health benefits that are sizable.  The company has steadily increased their debt, keeping them afloat as losses mounted.

Here's a five year financial history from their annual report:


It's unclear whether Federal Screw Works is cheap at the current level.  The company is expensive based on every asset based metric, and even most conventional earnings metrics.  The company has significant operating leverage, and it wouldn't take much of an increase in sales before profits start to flow to the bottom line in a significant way.  Maybe this is best considered as a speculative value investment.  The chance to buy into a turnaround right before it turns, but not having to be a shareholder for the almost decade of losses.

I don't see a margin of safety with this holding at all, and turnarounds of this type are hard to manage, but for an investor wiser than myself it might prove to be profitable.

Disclosure: No position

Friday, October 11, 2013

Webco: cheap, but is it safe?

My last post was on the topic of niches, so it's only appropriate that the company that's the subject of this post operates in a niche.  I actually didn't plan for this sequence of posts to happen, I was turning over rocks today and stumbled on Webco Industries (WEBC) selling at close to 50% of BV.  The discount to book value along caught my attention, and their history of significant past earnings encouraged me to continue researching them.

Webco Industries is a metal tube manufacturer.  The company really is that simple, they manufacture a variety of metal tubes to specifications for different industry applications.  One thing I spotted on their website is they are the only supplier of full line welded boiler tube in the United States.  Maybe this is a big deal, or maybe it's the equivalent of someone being the best athlete in a town of 200, I don't know enough about the industry to know the difference.

The company operates out of Oklahoma, but also has manufacturing locations in Pennsylvania and Illinois.  They have a market cap of $81m, and their shares trade for $103.  I like when companies have high share prices, it seems to discourage investor interest, a high share price often indicates a higher likelihood of an undervaluation.

Here is a spreadsheet I put together with the company's results over the past eight years:


Long time readers will probably notice that I usually don't post large spreadsheets on the blog.  If anyone's curious as to why I don't, it's often because I don't create them for many of my investments.  I know the stereotype for Graham investors is that we buy anything that's cheap, but that's not the case for myself.  I don't have an unlimited amount of capital, and I'd be killed by trading costs if I was trying to pick up everything trading for less than book value, I'd have a bunch of $4 positions scattered around my portfolio.  Rather I start by looking at cheap companies and then I become picky, a company needs to fit certain criteria before I'll invest in it.  If a company meets most of my criteria, but not all I will pass.  While I'm not a concentrated investor by any means, I also don't just swing wildly at any pitch that's coming somewhat near the strike zone.

When I buy a company I want them to be brain dead cheap, and an obvious slam dunk.  Many of the companies profiled on this blog fit that description.  Take for example Conduril, they were trading at 40% of NCAV, and at 2x earnings, after some investigation I determined a margin of safety existed and confirmed they were cheap.  With something like that I don't care what their results were five years ago, or what their ROE is, if they even start to revert to the mean at all my position will do well, which is incidentally what has happened.  Even more amazingly Conduril's results have been outstanding and even with the move up the company is still cheap.

How does this tie into Webco?  As I was reading their annual reports I didn't get an obvious cheap feeling about the company, instead I started to feel a desire to accumulate more and more data points with the hope that somehow the data would give me an answer as to whether I should invest.  In essence it did, because when I feel the need to accumulate more data it's a sign that I'm not looking at something obviously cheap, possibly only marginally cheap.

I discuss the exact reasons on why I passed on Webco below, but first I want to discuss a few positive aspects of the company.  The company clearly has a history of profitability, and at times tremendous profitability.  They have also shown the ability to turn their earnings into cash flow.  Over the past eight years operating cash flow has outpaced earnings by $10m.

The company's earning history is volatile, but when they are able to push through higher margin products at high volumes the company has significant operating leverage as seen by them earning anywhere from $18 to $31.98 a share in their good years.

And lastly the most attractive aspect of Webco is their valuation, they are trading at a 51% of book value, which is mostly equipment and inventory.  Second to this is their ability to compound book value at 8% a year, during very difficult economic conditions.

There are a number of issues that could potentially scuttle an investment in Webco, but I want to focus on the two that turned me away from them.  The first is their debt.  The company carries a significant debt load, yes they have ample earnings coverage, and yes they seem to operate just fine with it, but it could be a ticking time bomb.

What you don't see in my spreadsheet is the current/non-current breakdown of the company's debt each year.  The company doesn't have much long term debt, it's been steadily declining and was $12m at the end of their latest fiscal year.  This means the company has $78m in short term debt that is coming due this year.  If one looks at their financial statements through the years there isn't a significant capital expenditure use, the cash just appears to mysteriously vanish.  Of course it doesn't really, but where it goes is very unclear.  The bottom line is the company appears to roll forward a large amount of short term debt year to year, most likely on a line of credit.

Before you think I'm an idiot I want to discuss the second point, which is tightly tied to my first concern.  The company is very forthright in providing an income statement and balance sheet, yet they only provide three line items regarding their cash flow, operating cash flow, depreciation, and capex, nothing more.  The problem with this is that seeing the company's cash flow statement is vital to understanding how the other two financial statements work together.  I recognize that I could construct a cash flow statement from the balance sheet and income statement; I haven't spent the time.  I'm not sure it's necessary either, it's very strange to me that a company would intentionally neglect to provide information on the flow of cash in their business and at the same time provide abundant information on their balance sheet and income statement, including a lengthly writeup describing them.

The amount of short term debt, and the company's lack of a cash flow statement didn't put my fears over their debt to rest.  Instead it did the opposite, it fanned the flames and encouraged me to move on.  When the market is high and good ideas are hard to find the last thing I want to do is lower my standards and invest in marginal companies because there is nothing else out there.  Companies that look great, and appear safe at the top of the cycle can often lead to portfolio disasters in a downturn.

I'm glad I spent time investigating Webco, but this won't be a name that finds its way into my portfolio.

Disclosure: No position

Monday, October 7, 2013

What ponds are you fishing in?

"There are riches in niches."

What's your specialty, do you have one?  I've started to come to the conclusion that people who are successful find a niche and exploit it.  No one has made a name for themselves as a generalist, "Oh talk to Bob, he knows a little about a lot.."  

There is a common American (is this universal? I don't know) expression that asks "would you rather be a big fish in a small pond, or a small fish in a big pond."  The implication is if you find a small pond it could be rather easy to become an expert, rather than trying to be the biggest fish in a very big pond.

Niches fascinate me, most investors would agree that almost all successful businesses have a niche that they actively exploit.  Some companies grow to the point where they have economies of scale either in their branding or in their network where a niche is no longer needed.  Wal-Mart doesn't need a niche, they have the scale to crush any local competitor.  But a local grocery story that wants to compete with Wal-Mart needs to differentiate themselves.  A local store might play up their local-ness, or carry high end organic brands, or offer superior customer support, or even locate themselves in a better location.  But they have to do something different, if they advertise that they will beat any of Wal-Mart's prices they won't last much longer than their Grand Opening.

The concept of a business having a niche is well accepted amongst investors.  The concept of having an investment niche doesn't receive as much attention.  I've had a number of conversations with successful investors recently and this idea of investment niches really struck a chord.  It might seem strange for me to say that because my blog is the epitome of a niche, I mostly write about net-nets and other tiny deep value stocks.

The investors I talked to all know their strengths, whether it is unlisted stocks or small banks.  They work on knowing a small area better than almost any one else, and with that they end up with an investment edge.  That's one way to exploit a niche, find one and become the expert of it.

Another way to exploit an investment niche is to find an area of the market that others don't care much about.  This is how I approach my international investments, in many foreign markets there simply aren't enough investors who care about the smaller stocks.  An example of this would be French small caps, most investors in France care about the larger stocks and foreign markets leaving their small caps under followed and neglected.  Another example is Japanese small cap net-nets, a neglected market, a neglected segment, and net-nets, a niche unto themselves.  I don't face much competition when investing in a Japanese net-net.  Conversely most investors worldwide are looking at US stocks, so when looking at US stocks I bury myself into tiny holes most avoid, small companies, often very small.

Buffett's circle of competence comment gets a lot of use, people will say things like "oh fast casual restaurants in the Mid-Atlantic aren't in my circle of competence, I only know fast casual in California, know of any good books to get up to speed?"  I believe niche thinking is more valuable, I'd rather be the person who knows everything there is to know about unlisted stocks, or contingent value rights, or something, rather than building up a circle of competence that's the same as many others.

I want to extend this post beyond investing because I think it's very applicable in life.  The way to provide value to an organization or clients is to do something very specific very well.  I remember early in my career receiving some bad career advice.  A boss told me I shouldn't focus on any specific practice area because my skills could become outdated and I'd be pigeonholing myself in a very narrow area.  A few years later after leaving and working at a number of other companies I realized that advice was wrong.  Experts are paid handsomely and are sought after, no matter how esoteric.  Companies don't only run, they thrive on ancient tools and processes.  There is an enormous skill shortage for people who know things very well, instead we have multitudes of employees who all know the same basic knowledge, and not much beyond it.  Even stranger a person who is an expert in a niche can be terrible in every other aspect of their job.  I have worked with many people who are hands down experts in one very critical irreplaceable aspect of their job, and barely function otherwise.  Yet I've seen executives fall all over themselves to keep these people in place.  I'm not saying this is good behavior, but I'm saying you don't need to be a top performer in all aspects of your job, find an expertise, excel at it, and if you can perform at an average level for everything else you will do well.

It's possible to find a niche by examining what you do daily, or the things you're interested in, but that's the tough route. I think a niche often finds you.  When I decided to start this blog over three years ago I had no idea where it would be today.  I set out to record my thoughts on various investments I was researching.  I loved investing in net-nets and low P/B stocks, and was intrigued by special situations, there was a lack of that sort of investment writing on the internet, so I started filling the void.  Over the past three years I've solidified my niche, there are very clear categories of stocks that I feel I understand very well, and others I punt on because I know nothing more than what a new graduate might.

Find a void and work to fill it.  One more parting thought on this.  Many people work to become experts at something but do it privately.  I don't know of any private experts, but I know of plenty of public experts.  Some are afraid to speak out about their knowledge because they're afraid someone else will steal it or will surpass them.  The truth is most people aren't passionate about the same things you are, but they can learn a lot from what you're passionate about.  Secondly I'd be honored if someone learned from me and then far surpassed what I accomplish.  Teachers teach to impart their knowledge on others, if they wanted to remain smarter than their students they'd stay quiet.

Wednesday, October 2, 2013

Assorted investment musings

Oftentimes I'll have some market or investing observation that I'll be able to grow into a post.  Often though I just have some fragments of thought that don't really merit a post on their own, but are worth considering.  This post is a collection of things I've been thinking about recently as they relate to the markets, investing, and business.

Patience

If investing types were like restaurants value investing would be the long drawn out four course meal.  Trading and momentum trading would be hitting up the most popular fast food joint for a quick fill up, at the end of the day the diner's stomach is full from both, but supposedly more satisfied from the longer meal.  The reality is many value investors are eating at Chipotle and calling it fine dining.

The giants of value investing preach that value will eventually be realized somewhere between three and five years.  Yet I read posts where people aren't willing to invest unless there is a catalyst on the horizon that will unlock value in the next six to twelve months.  What ever happened to buying cheap things and waiting five years?

I don't think most investors are patient enough to hold a stock for five years, or the majority of their stocks for five years.  Granted I would love everything I purchase to jump 100% the day after I buy it as well, but I realize that's not going to happen.  Waiting has a nice built in side effect, it slows down portfolio turnover.  I own slightly over 50 stocks, somewhere between five and ten appreciate to fair value in a year on average.  This means I have a portfolio turnover of about 20% which keeps taxes at bay and keeps the workload for finding new ideas to a reasonable amount.

I couldn't imagine turning my entire portfolio in a year, I couldn't find 50 new investment ideas, I'm not even sure I could find 10.  But I am reasonably confident I can fine one or two a month which is all I need.

Simplicity

I've spoken before about simplicity but I believe it's always something that needs to be at the forefront for me.  I appreciate a complicated investment story as much as anyone else, but it's important to be able to effectively communicate a thesis in just a few words.  I was talking to my brother-in-law's brother-in-law this weekend about advertising.  He works in advertising and conducts focus groups to determine the effectiveness of labels and ads for some major national brands.  He said universally people will give five seconds of attention to something new, if you can't grab their attention in five seconds their interest moves on.  This is why simple and straightforward ads work better than walls of text.  I think the same thing relates to investing.  When I see an investment thesis and it requires that I understand 15 years of backstory I lose interest, unless right up front there is a killer attention grabber.

Some of my best investments could be summed up in about four bullet points.  When those points stop being relevant it's time to sell.

Retail

I generally avoid retailers as investments, they're difficult and take a certain type of investor.  Many retailers become legitimately cheap because their general popularity has waned.  Retailers sell popularity, popular fashions or popular dining.  Once the freshness fades sales often move on, but there are always exceptions, Red Lobster and Olive Garden come to mind.  There is no freshness there, I'm honestly amazed that anyone eats at Olive Garden considering the much better, and more authentic Italian dining in our area, yet there is always a wait.

The lifecycle of retail is interesting, my wife and I recently had a conversation about this.  We drove past a JC Penny and my wife commented how it was dying, but it made sense because so many newer stores had taken its place.  Her point was that in the US there are only so many consumers, a number that's roughly growing with population and immigration growth.  Unless consumers start to spend more of their income there is a fixed amount of money that can be allocated to retail consumption.  This means if a store is experiencing wild growth it's coming at the expense of another store.

If a retail turnaround is going to happen it means that a once dying store needs to steal back their customers from another more popular store.

Another thought along these lines is often that a popular retailer is in a newer area considered a good location.  I love comments about older stores where someone will say they wonder why they're located in such a bad spot.  At one point that bad spot was the good spot, but time took its toll.  Eventually those new spots could become bad spots and the lifecycle continues.

A related thought to this is that while I do a lot of international investing I generally try to avoid foreign retailers.  I also avoid retailers that I can't visit.  There is a certain pulse to a company that one can gather by visiting.  I don't mean foot traffic, but how goods are displayed, how the stores are laid out etc.  These things play into the culture.  Shopping is such a cultural thing I can't imagine getting it right being thousands of miles away.  How do I know if the cheap retailer in Thailand hit a temporary bump, or if they aren't popular anymore?  I have this general sense in the US, but overseas it's impossible to know without going there.