Christmas Eve Benzinga PreMarket Interview

I was on the Benzinga PreMarket show on Christmas Eve talking about banks and financials again.  You can find the video below.

Highlights from this discussion:

  • Everyone is on pins and needles for rates to finally rise.  I went against the crowd and speculated that interest rates won't significantly rise over the next year.
    • A related note on this.  My sister-in-law is a realtor and she said that this winter has been unusually busy.  Many buyers are afraid of rates going up and want to buy a house and lock in a low mortgage.  She swears rates will rise because the Realtor Association Chief Economist predicted so.  According to her he's never been wrong, although his statements from 2008 might disagree with that.  I find it interesting that talk of rising rates has translated into a rush to buy houses.
  • I discussed a small study I did on interest rates that was posted on the CompleteBankData Blog.
  • We had a short discussion about market making and HFT.
  • As always from each interview I'm asked about the big banks and how they're doing.  Bank valuations are unique, large banks and small banks are relatively undervalued.  Medium sized banks are fairly valued if not overvalued due to growth expectations.
  • I discussed a non-bank financial that I still like, Senvest (SVC.Canada)

Disclosure: Long Senvest

Preferred stock and how I messed up with SouthFirst

It's tough making a mistake, what's even worse is making a mistake in public.  We all want to be perfect, but unfortunately that's not the case.  For most readers if you make a mistake when evaluating a company the only person who knows is you, or maybe a boss if this is your job.  When I decided to write a blog I accepted that both good and bad decisions would be preserved online for all to see.  Of course at the time I never expected anyone to read what I wrote, so I never expected anyone to care what I was putting writing on here.  But success caught up with me and readership has grown like a weed, which makes publicly admitting a mistake worse for me, but also makes it more necessary for you.

When I wrote up SouthFirst last week I was in a rush to finish the post quickly on the morning of Christmas Eve and I pulled the numbers for the post from a data service (that will remain unnamed but was not that was incorrect.  In my haste I neglected to account for the bank's preferred stock, didn't double check the numbers I pulled and in the end reported incorrect figures.  I will get into the details below, but first I want to apologize for this mistake and any and all future mistakes I will make.  I would love to be perfect but I am not, and while I hope that this is the worst thing I'll ever do, I'm guessing it probably won't be.  I will probably write glowingly about some companies that turn out to be terrible investments.  And I'll probably write terribly about some companies that turn into incredible investments.  And I'm sure in the middle I'll inadvertently screw up some facts or figures about something important.  I do try my best and any error is never intentional.  Of course this error is reputationally worse for me because the error was simple and the stock is a bank, and I own a company focused on banks.  But these things happen, and I hope you can forgive me.  If not I hope you've enjoyed the run you've had here, all the best, and I mean that.  This blog isn't for everyone, it's not even for most people.  I've attracted a very unique group of readers that I'm thankful for, but they certainly do not represent the broader market or investors in general.

One question some of you insightful readers are probably asking is "why would a guy who has a bank data product not use his own product for a bank post?" This is a great question and one that deserves an answer.  I can't give a full answer yet, but I can say this.  We have been working to build a version of our software that runs on top of the unmentioned data provider above.  I pulled the graphs for my post from our software, but pulled the market related data from this provider itself because the window was up, it was easy and I was in a hurry.

If you're just interested in a quick correction then here it goes.  SouthFirst Bancshares has $2.8m in preferred stock outstanding and had $1m in short term borrowing as of June 30 2014 that reduces tangible common equity to $5.264m or $7.50 a share.  This means the bank is trading for 47% of tangible common equity, and 30% of book value, not the 25% I originally mentioned.  But it's important to note that while book value doesn't change, it's tangible common equity that matters to a stock investor.  Because my intention is to not mislead I'll be revising the original SouthFirst post.

If the topic of bank capital structure interests you at all, and maybe there are three of you for whom it does, I want to go into more detail.

Banks are generally funding through four different means, deposits, equity capital, preferred stock, or debt.  This shouldn't be a surprise, it's similar to the way any company is funded minus the deposits.  Deposits are a very low cost funding source that non-financials don't have access to.  For many companies debt funding is the cheapest source of capital.

The majority of the banks in the US fund almost all of their loans with deposits.  In the most recent quarter 630 banks out of 6,598 had more loans than deposits.  Because banking is regulated and regulators are worried about losses you can't open a bank, attract $100m in deposits, make $100m in loans, earn a spread and call it a day.  A bank needs to be adequately capitalized in order to provide ready access to cash for depositors, have cash on hand to make new loans before others cycle off, and to protect against bad loans.

When it comes to capital not all capital is equal.  Banks capital consists of Tier 1 capital and Tier 2 capital.  These two measures together are considered total bank capital.  A bank's Tier 1 capital is its equity capital as a measure of risk-weighted assets.  Different assets require different capital levels set by regulators, but in general the idea is a certain amount of equity is required to back a certain asset level.  Tier 2 capital is supplemental capital and can consist of subordinated debt and other hybrid financial instruments.

The key is that regulators consider preferred stock to be equity capital that can count toward a bank's Tier 1 capital ratio.  This means that even though preferred stock is costlier on a CAPM basis compared to debt it's favored for banks due to their capital structure situation.  Once a bank meets their minimum capital requirements any additional capital can be used to fund growth.

Banking capital rules are why many banks have preferred stock.  Of the 308 holding companies with more than $500m in assets 255 of them have preferred stock outstanding or 82%.  The numbers are lower at smaller banks, but most small bank are not growing and don't need to fund growth.  For the majority of the smaller banks with preferred stock outstanding theirs is a result of the TARP program or various community development programs that provide capital to banks in exchange for preferred stock.

Hopefully the digression into bank capital helped clarify why banks choose preferred stock over debt when given the choice.

It works until it doesn't

Some investing strategies have stood the test of time, others do well in certain environments but can end badly.  Off the top of my head a few investing strategies stand out as having permanence, value investing, buying and holding growing companies, buying and holding market leaders.

There are many strategies that look brilliant for a while before ending in either a blowup, or fizzling out.  For years investing in real estate in California earned market beating returns and was extremely popular.  And for many investing in California real estate was a viable strategy, not just for a year or two, but for decades.  But for investors in the market in the mid-2000s the strategy ended badly.  Many investors were leveraged and those entering the market near the top, when enthusiasm was the highest were happy to walk away with anything more than a total loss.

California real estate isn't the only strategy that ended like this, there are many others.  Ranging from decimating outcomes like tech stocks in the 1990s to gently petering out and underperforming like the Dogs of the Dow.  The best outcome for a novel strategy investor is that the strategy simply starts to gracefully underperform rather than ending in a blowup.

The problem is investors never know what will happen next.  Even the smartest investors aren't immune to this.  Long Term Capital Management (LTCM) was a hedge fund staffed by some of the smartest investors in finance at the time.  They had designed what they considered a fool proof strategy that minted them money.  The problem was their fool proof strategy involved a lot of leverage and exposure to tail risk events, such as the Russian default.  LTCM went from being an esteemed hedge fund to being a fund in liquidation overnight.

The managers at LTCM didn't think they'd blow up.  They went to bed the night before the Russian default believing they had a strategy that would earn them livings for decades.  It worked until suddenly it didn't.

Recently I was reading a thread on the Corner of Berkshire and Fairfax message board (link here) that brought to mind some of the things I want to talk about in this post.  There are many investors who self-reported returns and strategies in that thread that seem to be working well, but I question how long they'll last.

The foundation of a strategy that's lasting is that it can withstand significant events and multiple market cycles.  Often this is accomplished by keeping portfolio leverage limited.  Leverage isn't necessarily a bad thing, levered returns are how many wealthy individuals became rich.  But risk is piled on when leverage gets too high.  A company leveraged 10% is most likely no more risky than one without leverage.  But a bank leveraged 40 to 1 such as Lehman Brothers was simply a bug in search of a windshield.  Even worse is an investor who levers their personal portfolio to invest in a highly levered company.  Doing so is like running through a dynamite factor with a flame thrower, it's possible one could make it through without incident, but it's also likely there'll be a free fireworks show.

Almost all investors have some form of leverage imbedded in their portfolio, either operational leverage or financial leverage through the companies they own.  One of the benefits of being an outside investor is having the ability to take advantage of an investment's leverage without that leverage being recourse to the investor.  The only thing we put at risk when we invest in a leveraged company is our initial investment.  The key is using this embedded leverage wisely.  I don't leverage up my personal portfolio, but some do with options or warrants.  Others go a step further and invest on margin.  A step further is to invest on margin in options on a levered company.  It's possible someone who undertakes this will never experience any financial harm whatsoever and might speak of a strategy in glowing terms.  But the danger is we never know when something will change overnight, and investors with high leverage run the risk of an unexpected margin call, or drawdown.

One of the investors on the Corner of Berkshire and Fairfax message board posted that they had a return that had generated 65% annually since 2008 whereby they invested in a single stock they felt would double each year.  While this might sound like a new strategy I believe Will Rogers created it in 1929 when he said "Buy stocks that go up; if they don't go up, don't buy them."  When someone claims to only purchase a single stock that appreciates on average 65% each year for six years the strategy starts to sound like the Will Rogers quote.  The investor is either extraordinary luckily, a liar, or has the oft sought after working crystal ball.

Is an investor who bets their entire portfolio successfully on a handful of stocks any different from the gambler at the roulette table who has a hot streak?  The difference is the gambler realizes they're lucky, the danger is the investor with a wild run starts to believe they're something special and have above average market insight.  Overconfidence is a return destroyer.

It's not to say that an expert can't navigate a niche area of returns successfully for a period and exit the strategy before experiencing a failure.  Joel Greenblatt, an extremely accomplished special situations investor did just this.  For years he earned 50% returns with his fund and then suddenly exited, wrote a book and switched his strategy.  A variety of explanations have been given for his strategy shift from one that earned incredible returns to one with more stable but lower returns.  I read an interview he gave where the interviewer asked why he switched his strategy. Greenblatt exclaimed that the environment in which they made their returns changed and they realized the results wouldn't be replicable going forward, they were happy with that they achieved and moved to something persistent.

What separates a novice from an expert is that an expert knows they're investing in a temporary strategy and they have the ability to exit before the bottom falls out.  Usually when experts get caught in a strategy washout it's because they've become too greedy.  The returns are too good, they want more and they can't imagine moving to something lower returning.

There is a common market expression that higher returns equal higher risk.  This is definitely true in some cases.  I believe it's possible to earn market beating returns with lower risk through a value strategy.  But as returns deviate from the market my personal view is that risk also increases.  There are no risk free strategies that generate 50%+ returns a year, and as returns rise the tail risk increases as well.  Like LTCM, you can only pick up free nickels in front of a steamroller for a while before getting squished.

My view probably isn't very popular, but it's well known that time in the market is a bigger predictor for ultimate wealth creation.  The best investors have survived multiple recessions and market cycles, and in the mean time beat the market by a few percent.  To me the superior investment strategy is one that survives any market cycle, and while it doesn't provide eye-popping returns in any given year it doesn't implode during downturns either.  A few percentage points of outperformance can result in a large gains when compounded over a significant period of time.

It's in bull markets where all sorts of new strategies appear that make investors fantastic returns.  There are many people who get rich doing crazy things.  Investors seem to ignore the role of luck in markets.  A gambler on a hot streak realizes they're lucky, if an investor makes money they were smart, if they lose the market went against them.  There are many investors who are just as lucky in the market as gamblers at the roulette table.  And maybe skill doesn't matter.  If the point is to create wealth then does it matter if it was luck or skill that generated the result?

Sometimes I feel like a broken record saying investors should be aware of the risk in their portfolios. But when I read message board threads where posters are saying they are disgusted by a 10% return I start to wonder what sort of environment we're in.  Others have done 25% annually and speak like they're just average and feel they can do better.  There are not many investors who've compounded capital at 25%+ or higher for decades, a small handful, but not the masses.

My final point is to do a gut check.  Are you investing in a strategy that has the potential to end badly?  Do you hold the equivalent of a number of leveraged house investments in the Inland Empire in 2003?  If so maybe recognize that it's time to take the gains and walk away lucky.

SouthFirst Bancshares, small, simple and cheap at 47% of tangible common equity.

Sometimes we make investing too hard.  Value investing can be described as picking up the proverbial dollar for $.50.  That sounds simple, but if you read enough about value investing it starts to become complicated.  Investing guru's discuss investing in companies undergoing complicated financial maneuvers, finding competitive advantages and sizing up management all before committing a dime to an investment.  While many of these types of transactions can be profitable, and many have a place in our portfolios it also is worth stepping back and doing the simple things well.  Additional complexity opens an investor up to the possibility of making mistakes or errors of omission.

In the simplest case take a company worth $100 that's in liquidation and selling for $50 in the market.  This type of investment is a true $1 for $.50, it's simple and barring an extended liquidation time frame is a reasonable investment.  Not many errors can be made in this situation, some are possible, but not many.  Now consider the type of investment many blog and articles write about, a company with a sustained advantage.  The investment case rests on the ability of the company to keep their advantage for the next five, ten or 15 years.  Predicting what anything will do in 10 or 15 years is difficult.  As an example consider the iPhone.  I saw a headline yesterday that to purchase the exact same computing power available in the iPhone 5S in 1991 would have taken $3.56m.  In 1991 it would have been absurd to suggest that ~$3.5m worth of computing power would be in everyone's pockets with a touch screen, instantly connected to the Internet and only cost $199 (plus monthly payments).  We have trouble understanding what the future would look like.  We have incredible computing power at our finger tips, but no flying cars and have to prepare our own meals and clean our own bathrooms, a strange irony.

I talked with someone recently and he asked a very insightful question regarding my investment process for small banks.  He asked whether I am able to size up a bank quickly given how many I've looked at.  This has been something I've been thinking about extensively since our conversation.  I've come to the conclusion that yes, when looking at a simple bank I can determine whether or not I want to invest fairly quickly.

Banking is the ultimate commodity business.  From the smallest bank in the US to the largest, they are all doing the same thing, connecting people with money to those who want money.  Borrowers don't care about the brand name on their loan.  I have never heard of anyone say "I only borrow from Wells Fargo because their loans are more reliable."  Being a commodity business the only thing banks can do to set themselves apart is offer differentiated service, niche products, or high touch customer service.  These are the elements that win over consumers when they're considering which bank to keep their savings or a bank to borrow from.

It's within this context that I want to take a look at SouthFirst Bancshares (SZBI) an extremely small bank located in Alabama.  I want to re-iterate that this is a small illiquid bank, it took me weeks to fill a small share order.

The attraction of SouthFirst is readily apparent, they are trading for $3.55 when their tangible common equity is $7.50 per share.  They are selling for 30% of book value and 47% of tangible common equity value.  But not only that, the bank is profitable as well.

As mentioned earlier the bank is small, they have slightly less than $100m in assets and $9.4m in equity.  Given that they're trading for 47% of TCE they have a market cap of $2.5m.  As I mentioned, this is a small bank only for only the most patient investors or those who are willing to have exposure to such a small bank.

The bank isn't perfect, they hit a very rough patch during the financial crisis, net income slipped from $642k in 2006 to a loss of $2.9m in 2011.  Income has since recovered and the bank earned almost 10% on their equity in 2013.

In the intro I mentioned that I can size up a bank quickly, what I'm looking for is the following.  A discount to either book, or relative value.  Non-performing assets that are 3% or lower and either some sort of earnings, or the potential for earnings.  And lastly a large gap between what an acquirer might pay and the market value of the bank.

At first glance one might think I could automate this criteria and invest in a bank like this in a quantitative manner.  This might be true, but not every bank that matches what I'm looking for receives an investment.  I like to buy banks that I think will either be bought out, are extremely cheap, or are showing some forward momentum.  And lastly I'm very cautious regarding asset quality.  A stretch of bad loans or reckless lending can sink a bank quickly.  Some of these attributes can only be evaluated by a human, they need a small bit of intuition.

SouthFirst is both cheap and has forward momentum.  Here is a chart of their ROE and ROA for the past few quarters:

As you can see the bank's earnings were marginal before the financial crisis, terrible during the crisis and have recovered since.  Viewed in isolation the bank's ROA of .83 is quite respectable and their return on equity is approaching 10%, a seemingly magical number for bank investors.  The question is whether the bank's earnings are sustainable at this level.

Profitability is important with a small company.  If a company or bank is profitable it becomes easier to hold a very small stock because value isn't being destroyed quarter after quarter.  When holding shares in a small company generating losses the investment becomes a race against the clock.  When holding a small undervalued company earning money the investment becomes a test of patience.

With a bank the biggest indicator or danger to earnings is poor quality loans.  The following graph shows the bank's equity to assets as well as two asset quality measures:

There are a few items of note from this chart.  The first is that the bank's capital has been increasing over the past few years.  Increased capital gives the bank a bigger buffer against potential losses.  The second is that non-current loans to loans are slightly trending up, which the bank's loan loss allowance has remained steady.

The bank's non-performing loan increase is a result of an uptick in non-performing home equity loans and 1-4 family loans.  The majority of these loans are considered non-accrual if the borrower doesn't pay will eventually migrate to foreclosure and other real estate owned (OREO):

The question when looking at loans is what's the worst case scenario?  Let's presume that SouthFirst has to charge-off all of their non-current loans.  This would be equal to a charge-off of $1.8m, except that 65% of those non-current loans have a reserve against them meaning their total exposure is $630k.  In this total charge-off worst cast their equity would take a hit of $630k dropping it below $9m.  Considering their market cap of $2.5m this worst case isn't catastrophic to the investment.

Banks selling for such large discounts afford large margins of safety for investors if one can actually get shares.  A bank like SouthFirst is fairly simple, they are a dollar for $.50 or so.  Like anything cheap maybe the bank isn't worth a full dollar, but even if they mark down their loans and only sell for half of book value an investor would do well to own shares at this level.

What one needs to realize when looking at a bank like SouthFirst is that they belong in a well diversified portfolio of a patient investor.  This bank is unlikely to go on an acquisition spree, or grow earnings at 25% going forward.  But it's very likely that they are worth more than their current valuation, potentially upwards of 1x book value in an acquisition.  All an investor needs to do is purchase a small position and wait.

It's worth noting that I didn't conduct any complex analysis about the housing market that they serve, or dig into the details of management.  The numbers tell the story, and at the price they're selling for some of those details are irrelevant.

Simple banks like this are a bedrock position in my portfolio.  It took me longer to write this post than it did to research the company.  I don't own a large position, but in aggregate a number of small positions at valuations such as this have done well over the years and make up a large part of my portfolio.

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

Disclosure: Long SZBI

Investing gap between theory and practice

Google the phrase "gap between theory and practice" and you'll end up with dozens of links to scholarly articles attempting to explain why things in practice don't always match an academic theoretical version.  I find it somewhat ironic that academics are attempting to explain why practitioners aren't following their theories with more theories.  I've been confronted with the gap between academic finance theory and the actual practice of investing recently.

A month or two back I purchased a book on bank valuation.  There are a lot of dauntingly large books that with excruciating verbosity explain one small slice of the banking industry.  While there are a lot of books focused on a banking specialty there are not many general books, so I was excited to find one that I thought would be more general.  I was further encouraged when in the introduction the author stated that they intended to lay out a simple comprehensive framework for bank valuation.  My enthusiasm ended when within the first few pages I was confronted with a mathematical proofs showing that a bank with a higher ROE should be worth more than one with a lower ROE.  The proofs didn't end there, the book is anything but simple, and is extremely academic in nature.

I've taken a break from the book for now when I came across the chapter detailing how the author believes bankers make decisions.  The author laid out a very complicated formula for determining if a given loan or deposit would create value for a bank.  It included modeling out a number of future values for everything from rates to risk over the duration of both asset and liability side.  The formula took up most of a page.  I can assure you that most bankers do not use this formula to determine whether an action should be taken or not.  If so the models are faulty at best because no one knows what the bank will be paying on deposits ten years in the future.

I appreciate the input of academics on issues, they look at a problem in a very different and systematic way.  But I've derived the most value from practitioners.  One of the greatest books about value investing, Security Analysis was written by an investing practitioner.  If one were to take a look at the 'best' recommended investment books almost all of them were written by professionals detailing their experiences.  This is valuable because what experience provides an insight to and math misses is the human element.

Why do stores sometimes sell products for below cost?  They do it because they know that people can't resist a good deal, and often enough a good deal gets people in the door to buy more higher priced items.  I'm sure there's a paper out there discussing loss leaders, but selling something for less than cost is not rational, and no academic paper would tell you to do so, unless the paper were explaining why something that works in the real world works on paper.

It seems to be the difference between the way academics see the world verses how practitioners see the world is one of perspective.  Practitioners are forward looking, the academic is working to explain the past.  They want to know why something happen whereas a practitioner wants to know the future.  An academic might apply research on a historical event and attempt to apply it to the future, but it's always the past that's directing their outlook.

The two approaches are so fundamentally different I'm not sure they can be reconciled.  What academic studies miss is the human element, you can't model behavior easily.

Many value investors consider technical analysis as the voodoo science of investing.  It's purported to be this mystical system of trading not grounded in anything but professes to make millionaires out of chart squiggle readers.  I will admit it seems somewhat spacey, but doesn't fundamental investing seem crazy as well?  There are these imaginary values, intrinsic values that fundamental investors claim a business is worth.  Yet companies never trade at these values, and by some mystical mechanism market value will eventually reach intrinsic value and investors will know to sell.  Further these intrinsic values are supposedly easy to calculate, but everyone except the buyer is wrong on what they are.

Often reality is different.  Investors, both value investors or traders purchase a stock because they believe it's either undervalued or some market action/reaction will take place.  In many cases investors with years of experience have a sense about these this and "know" that something will happen.  Sure enough the stock reacts, either with the market, or due to a one-off event, shares run up and the investor sells taking a profit.  All the while patting themselves on the back because they were right about what happened.

The problem is no one knows exactly why stocks appreciate or decline.  We tell ourselves narratives about why something happened, but many times no one truly knows.  There are so many factors and participants at work in a single company's shares that it's impossible to determine what or who caused a price change.

I was at an event recently and was talking to someone who manages a multi-billion dollar mutual fund.  He clearly represents the practitioner of this story.  He could construct a brilliant narrative about almost anything economic happening in the world.  Want to know why Japan's debt was increasing but they didn't have inflation?  He had an answer that sounded great.  He was very skilled at constructing narratives.  But what I found interesting is that didn't seem to drive how he invested.  We discussed the types of stocks I purchase, to which he conceded that they will most likely clobber the market, but without professional participation because they're too small.  He said at the end of the day he's simply a handicapper, not much different from someone at a casino.  He looks at a company and assesses if the likelihood of something good happening is higher than the likelihood of something bad happening.  He buys companies with stable balance sheets at low multiples of cash flow, with the theory that it's unlikely these companies will go out of business, but it's likely that eventually the market will give them a higher valuation.  It seems simple and it is, and he's paid very well to do this.

The idea of handicapping stocks can be extended much further, and at a certain level is the essence of investing.  I prefer to buy extremely cheap stocks with strong balance sheets.  Many of these companies are smaller, but that's only because of what's available.  But what I'm doing is finding companies where the likelihood of something bad happening is small, whereas they are so cheap that I'm betting something better will eventually take place.  I'm not always right, but one doesn't have to be correct 100% of the time.

Investing for many is no different than trawling garage sales for collectables and antiques.  Some garage sale buyers purchase large quantities of small items that they unload at flea markets for a tiny profit.  These are the traders of the garage sale world.  Others will visit sale after sale looking for an extremely mis-priced antique.  When one finds a mis-priced antique they usually don't know what it's blue book value is, but they know that something rare shouldn't be selling for $35, or a similarly low value.  These antique buyers are the value investors of the garage sale world.  There are other garage salers who are hunting for a lost Monet that they plan on hanging in the living room and cherishing forever, these are the Buffett investors.  The academic of the garage sale world is the auctioneer who is trying to piece together the garage sale action from a glass tower in Boston.  They see the sales prices and see the inventory and are trying to construct a narrative about the market.  Even though the auctioneer has all of the market's data it's truly the participants who know what's going on.  They have the 'feel' of the market whereas the auctioneer only knows the results.

The problem is the motivation of a buyer (garage saler or investor) is never clear, it's a human nature problem.  Traders identify patterns in charts that signal a market move.  Technical analysis feeds off itself, if enough traders participate then a signal becomes 'true' because enough people act on it.  Trading rewards those with superior tools and information who can act quicker.  Value investing is for slow traders.  But like in trading value investing incorporates a heavy notion of human judgement.  I have purchase companies that I knew were cheap and I had a sense something might happen.  It was from how management wrote their letters, and how they spoke of the company.  My sense was developed with experience, but it isn't something that can be modeled.

Both parties can benefit from each other.  Academics need to recognize that the market is fueled by human behavior.  Sometimes investors do things that are completely non-rational in an effort to impress someone, to gain a promotion, or just because.  These things don't fit nicely into models.  But practitioners don't get off easily here either.  They need to recognize the limits of models and studies instead of blindly following them.  If one looks hard enough any relationship can be forged out of stats.  It's relationships built on reason that have the highest chance of being true.  There are some investors who are such slaves to the models that they've failed to recognize the world isn't populated by computers.

The one thing I know is that successful investing requires a practitioner mindset.  You will never find the next best investment studying what Buffett was buying in 1952.  Even Buffett himself isn't tied to the past like that.  He like most investors is handicapping the future.  Evaluating stocks and determining that it's more likely that something good will happen verses something bad.  Then buying and waiting.

Aztec Land and Cattle revisited, still as cheap as ever

Many of the stocks I write about make the term 'sleepy' seem exciting.  If only some of these oddball companies would become sleepy, it would be a step up.  Even with companies that appear to be dormant it's helpful to look at them every few years to keep up with developments.  I last wrote about Aztec Land and Cattle (AZLCZ) in 2012, and it's finally time for an update.

If you're an investor dying to buy cheap real estate than Aztec Land and Cattle is a company you need to look at.  When I first took a look at the company their 228,000 acres of land were effectively selling for $49 an acre.  This is land they originally purchased for $.50 an acre in the 1860s.

The company's land is mostly Arizona pasture land.  In 2012 the company submitted a master development plan detailing to the county how they expected to slowly shift land usage from pure pasture to both commercial and residential uses.  

Since my last post on Aztec the stock has appreciated about 50%, which is significant for a company most investors expect to go nowhere for years.  What prompted me to look at Aztec again is a new report by Andrew Slusser of Seven Pines Capital.  Andrew initially emailed me his report, then we talked on the phone about the idea.  What Andrew put together highlights how a small to medium amount of research on some of these oddball companies can give an investor an incredible informational advantage.  Andrew highlighted a few aspects to Aztec Land and Cattle that I hadn't appreciated when I first evaluated the company.

In the past two years the company has been very active.  For the past few years the company has considered leasing out a portion of their land to a windmill farm.  Two years ago this was just a concept, but today 14,000 acres are leased generating $140k in rent income.  There are plans to increase the amount of land for additional wind power, although the timing for that is unknown.

A bigger development in my mind is the purchase of the Catalyst Paper Company and Apache Railroad Company by Aztec.  Both Catalyst Paper and the Apache Railroad fell into financial difficulties recently prompting bankruptcy filings.  Aztec's Chairman led a group of investors that purchased a number of assets out of bankruptcy, including the railroad and 19,000 acres of land.  Control of the railroad could serve as a catalyst for commercial development on Aztec's land.  My suggestion on viewing the railroad is to view it not as a source of potential earnings, but as a reason for potential development.  The company is marketing the commercial land by the railroad as the West Snowflake Railpark development.  The area already has power, natural gas, road and railroad connections.

Even with a wind farm and railroad commercial park the main thesis for Aztec rests on the value of their land.  Their operations are essentially break-even and pay for the carry on their land holdings.

Arizona is unique in that 16% of the state's land is deeded to private citizens and corporations. Arizona essentially has a 16% public float on their land.  This is much less than surrounding states, and is partly the reason that pasture land averages $940 an acre in Arizona vs $360 an acre in New Mexico.  The average price for pasture land in the US is $1,200 an acre.  Also unique to Aztec is that their 228,000 acres are a single continuous segment, in a state little available land a single usable segment of contiguous land is significant.  Pasture land in the US has steadily appreciated over the last decade.

Sometimes a company gives investors insight into how they view their own assets.  In the case of Aztec the company completed several inter-company transactions where land was swapped between subsidiaries.  In these transactions the company valued their own acreage at $137 an acre, or double what the market values the company at.

I think a very simple and compelling argument could be made that Aztec's land is worth more than the current market value of $77 an acre.  The question I had when I first looked at the company was how long would investors need to wait for value to be realized?  If the land is truly worth a few hundred dollars an acre, but an investor needs to wait 30 years for value to be realized this isn't a great return.  A lot can happen in 30 years, and taking a gamble on something that far out is risky.  Either the land needs to be worth significant more, or a change in value needs to happen relatively quickly, say in the next ten years or so.

In Andrew's report he put together a matrix showing a NPV analysis of land values to years to value realization.  The chart is shown below:

At current prices investors are saying the land is either worth little, or there is very little certainty as to when this thesis might play out.  But an undervalued asset is undervalued regardless of whether it's land in Arizona or New York.  Patience is not a skill that many investors have, which is probably why Aztec is trading for such a low valuation.

If the company were to simply sell themselves as a ranch at today's New Mexico land prices they would receive $529/sh in proceeds.  Let's consider that maybe it takes 20 years before the company decides to sell themselves as a ranch at today's prices, even still the shares would fetch $200, which is higher than the current share price.

Granted no one ever knows what something is worth until it's sold, but there is a considerable margin of safety at these prices.  With the current margin of safety investors also get the optionality of something good coming from the company's recent actions.  Maybe the railroad will spur development, or maybe an additional wind farm will be built.  We don't know, but even if this is 'just' a pasture and never progresses from being a pasture it should at least be priced like similar pastures throughout the state or country.  

My only qualm about the company is that they don't pay a dividend.  When I invest in oddball stocks that are dark and my expected holding period is long I like to be paid something for waiting.  Unfortunately shareholders of Aztec simply need to wait. 

If you're interested in Andrew's report drop me an email.

Disclosure: No position