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.


  1. Appreciate the update Nate. Keep up the good work.


  2. Awesome post Nate, anyone with have a brain knows to trust people who admit mistakes way more than to trust those who don't. Keep up your great work!

    I also feel honored to be one of the three people interested in bank capital ratios :)

  3. Takes guts to write this post.
    but increases confidence. congrats.
    It's just another line to add to the checklist

  4. I saw your updated SouthFirst post. Very honest and upfront of you admitting your error.

    I thought I'd mention IBWC as it is cheaper than SouthFirst at current levels. At the $16.10 bid it is cheaper, with Price to Book of 31%!!!

    At June 30, 2014, IBWC had common equity of $31,513,000 ($37,984,000 - $6,471,000). This included $1,405,000 of DTAs, so the common equity excluding DTAs is $30,108,000. There are 602,886 shares outstanding, book value including DTAs is $52.27 and excluding DTAs is $49.94. At the current $16.10 share price, PB including DTAs is 31% and PB ex DTAs is 32%.

    Don't beat yourself up about the SouthFirst post. Even Warren Buffett makes mistakes!

  5. I wish my biggest investing mistake this year was buying a bank at half of book value ;)

  6. Just wanted to join the others and encourage you to not beat yourself up Nate.

    I follow about a dozen other value guys between blogs and Twitter, and you're one of the best when it comes to putting your money where your mouth is and publishing ideas. Keep it up, you're not about to lose me as a reader over a little mistake.

  7. Dear Nate,

    I have been reading your blog now for last 2 weeks . It has been pretty enriching .

    The point I want to ask you is when do you think it is right time for a person to be full time investor ??.

    Why are you not decided to take up investing as full time career yet ??