Wednesday, March 26, 2014

You need an investing system

Investors seem to have an intrinsic drive to classify themselves.  People will say something like "I'm a mix of Graham and Buffett with a dash of Rockefeller and the temper of Carnegie."  Sometimes these classifications border on ridiculous, other times confusing.  Even still investors continue to classify themselves.  We use these heuristics because often it's easier to identify with an investor's system, rather than developing our own system for investing.

I finished reading two books recently, The Signal and Noise by Nate Silver, and  How To Fail At Almost Anything And Still Win Big by Scott Adams.  I think both books are worth reading for different reasons, but both have applications to investing.

Scott Adams outlines his belief that successful individuals use systems rather than goals to accomplish things in life.  With a goal you are in a state of perpetual failure until you achieve the goal, then you need another goal to move onto.  He believes we need systems, continual patterns that are sustainable and drive us towards our desired outcomes.  An example of this might be losing weight.  A goal might be that we want to lose 20lbs.  To achieve the goal we decide to not eat candy or have second helpings.  The weight starts to drop and eventually we hit our goal.  What happens then?  Do we continue to not eat candy and smaller portions?  Is it sustainable?  If we sneak a Snickers bar are we failures?

A system looks at the problem differently.  It might be that we can eat unlimited quantities of certain food groups, but keep others to a minimum.  This is a sustainable system.  Maybe I am free to eat as many vegetables as I want but keep candy to a minimum, such as special occasions.  If I'm hungry I can have carrots instead of denying myself anything to eat.  Being able to eat to satisfy hunger is fine as long as it's something healthy.  My own view on this is that I've never seen someone gain weight by eating too many fruits and vegetables.

Nate Silver's book is much different, he discusses how to view the world probabilistically.  He believes by applying Basyean statistics we can increase the accuracy of our forecasts and enhance our forecasting outcomes.  Silver discusses all sorts of forecasting problems from weather to earthquakes to the stock market and politics.  The book is long, but it was an enjoyable read.  There were two take-aways that I believe apply to investing, application of the power law, and thinking about investments probabilistically.

It might be helpful to read this post as a follow-on to my post on diversification.  I want to talk about systems first, and then how the power law and probability fits into the system.

I think it's critical that investors create a consistent system for their investments.  What I mean by this is I think we need to approach investments, measure investment success, and view investments in a consistent and repeatable manner.  Sometimes I'll encounter investors who say they do a little GARP investing, plus some dividend investing, plus some value stocks and a few moat companies.  To me that seems like they're throwing things at a wall and seeing what sticks.  It's hard to find investments if we don't have a structure to view things within.

We need to find styles that fit our personality.  It doesn't matter if it's investing in small cap growth companies, or distressed credits.  There is something out there that will make sense to you and will be almost second nature.  Don't invest in a manner because someone else does, or because someone famous has made a lot of money investing like that.  Invest in a manner that makes sense to you.

When I meet someone who wants to talk about investments, but isn't that knowledgable this is how I explain what I do in non-investing terms:

I like to go to the older part of town and look for businesses that look like time has passed them by.  I will buy them for some amount.  When I visit my new property I find that 80% of my purchase price is sitting in cash in the cash registers, and that I can sell the inventory for the other 20%.  I can also sell the building for a gain as well, along with the fixtures.  Sometimes I let the business run because the cash it generates pays me back in a year or two, but not always.

People understand this, it makes sense to them.  The second question is naturally "how do you find these places?" But there is no confusion as to my process.  They key is that my explanation is also the  system I use while investing.  I am looking for things at egregiously low valuations.  I'm not buying a Mercedes at 10% off sticker price.  I'm buying a Chevy Cavalier on Craigslist and reselling it a week later at double the price.

My system is consistent and easy to apply.  I can apply it to stocks, or bonds, or real estate, or literally anything that can be bought or sold.  If I consistently apply my system I also know that I will consistently earn a satisfactory return.  I might not earn a return on every investment, I make mistakes, but over the long term I will earn a consistent return.  When I look at a new potential investment I view it through the lens of the system I'm using.  If someone is pitching me a product that will take over the world it just don't fit with how I view things.  That doesn't make it bad, or wrong, it's just not something I have experience with.

That brings me to one of the points from Nate Silver's book on thinking probabilistically.  One thing many investors struggle with is how do we know something is truly worth more than what it's selling for now?

Nate Silver's book flipped the lightbulb for me on this issue.  It helped me recognize that what I am doing when looking at companies is handicapping them, or thinking about the probability of them being worth more.  This is different than extrapolating the future.

Here's an example.  Barrons might profile a company and say they're trading at $20 and the paper thinks they're worth $22.  The reporter spends a page of text explaining why they think this.  The paper will probably make a great argument, but I ignore that and look at the gap between the two numbers.  They are saying that the stock has the potential to rise 10%, or put another way they're 90% of their fair price.

I look at a thesis like that and think that with a gap that small there must not be much uncertainty as to their real value, or the estimate needs to be right.  Is the probability of them being worth 10% more greater than the probability of them being worth less?  As the value gap closes between where a stock trades and what they're worth the amount of uncertainty needs to diminish for the investor to be right.

The opposite of this would be some of the investments I look at.  Take for example Conduril.  They were selling for 40% of NCAV and 2x earnings when I found them.  There is a larger probability that they're worth more, than worth less.  Maybe they're not worth 10x earnings or 5x earnings, but the probability of them being worth more than 2x is greater than them being worth less than 2x.  In a case like that it makes sense to invest.

This is why it's easier to invest in a much cheaper company compared to a company that's closer to full value.  If you think of two probabilities, one that it's worth more, and one that it's worth less, the probability that it's worth more decreases as the price goes up.  When comparing two companies side by side I will take the cheaper one in most cases.  The cases where I don't do this are times when there is more certainty that the more expensive one will rise.  An example of this might be two cheap companies, one with lousy self-dealing management, and one with honest management.  It's more likely that the company with honest management is worth more, there is less uncertainty.

I know a lot of fund managers use this thinking when looking at lottery ticket type of investments.  They look at the probability of something positive happening and the resultant gain, and then the probability of something negative happening and the resultant loss.  If the gain outweighs the loss then it's worth taking a position.  Over a single data point the probabilities don't mean much, but over a set of investments over a period of time the probabilities should hold true.  Referencing back to my diversification post, I could understand someone making five or ten investments like this at a time, but making one or two seems reckless.

The last thing I want to discuss is the power law.  Silver talks about this within the context of earthquakes.  People often misinterpret the probability of something greater happening because it hasn't happened in the past.  He uses the example of an area that's only experienced earthquakes measuring 5 or 6 on the richter scale.  Instead of thinking that nothing higher can happen because it hasn't happened in the past, the fact that any earthquakes have occurred at all should be taken as a warning that something greater can happen, and it's likely the magnitude will be greater.  That an earthquake measuring 5 on the richter scale happened is indication that an earthquake measuring a 7 can happen as well.  It's more likely that an area with prior earthquakes will experience a size 7 earthquake than it is for an area that's never had a earthquake to get one measuring a 2 or 3.

How does this translate to investing?  I believe the past is indicative of what might be possible in the future.  If a company has never been profitable is it likely that suddenly something will change and the company will make fantastic profits?  The lack of profits most likely indicates that it'll be harder for them to shift course and be profitable.  Likewise a company that's been profitable in the past, but is dealing with a temporary situation will likely be profitable again in the future.

We can't extrapolate the past mindless into the future, but we can look at the past as some indication of what could be possible in the future.  If a company has a management team that's done well previously then there's reason to believe they can be profitable again in the future.  If a company's management is experienced in losing money and constantly issuing shares what could prompt a change in the future?

An example application of this might be biotech investing.  It's more likely that a company with previous drug approval experience will get a new drug approved over a company with no experience in getting drugs approved.  That's not to say it's impossible, just not as probable.  If a company has experience with radical transformations and has come through successfully then we might expect that when faced with a radical transformation it will be possible for them to succeed.  If a company has never done anything transformative and then they attempt it we should view their chances of success with skepticism.

None of these concepts were entirely new to me, long time readers will recognize that I've been applying these concepts for years.  But what is new is having a name for them, and being able to identify exactly what I'm doing.  Sometimes we do things without being able to label it, I've now been able to label a portion of my process.

Disclosure: I receive a small commission if you purchase something from Amazon.com through the links provided.  The price you pay is not marked up, Amazon builds this commission into the cost of all of their items.

Friday, March 21, 2014

Diversification..again..

I often get asked the question "what are your thoughts on diversification?"  Someone asked me recently and I thought that newer readers might appreciate my thoughts on it as well.  I wrote about this a year and a half ago, the post generated some lively comments, and I expect this one will as well.

Before I begin in I want to set out a few points accommodate those who are too lazy to read the post, but will post comments anyways.  I have heard that Warren Buffett says that only the ignorant diversify.  I have heard that I'm diluting my returns by investing in anything beyond my ten best ideas.  I've heard that what I do is just mechanically investing based on math, or formulas.  I'm already well aware of all these things, no need to refresh me.

It's surprising but I actually believe in concentrating one's resources into a single investment if the circumstances are appropriate.  If an investor has control over the investment, and can make decisions about the company's strategy, future direction, and capital allocation I think it makes sense to concentrate resources on that investment.  I think it makes so much sense that if you're in this position it might make sense to focus all of your money, time and effort on the particular investment.  I think concentrating in a position also makes sense for hedge funds and mutual funds in similar positions.  If they have the ability to control or influence the outcome of an investment it makes sense to concentrate their capital where they are spending a lot of time and energy.

There's a story floating out there where Charlie Munger talks about owning a small town restaurant, hardware store, gas station, and hotel.  He says he'd feel adequately diversified with that portfolio.  I would as well, the reason being that in the analogy I would own and control those properties.  How would the story change if I owned a tiny little sliver of each and a faceless manager 800 miles away who I couldn't get on the phone was making the decisions?  Would I still feel diversified?

There's a famous Buffett quote that's often used to bludgeon investors who concentrate their portfolios: "Diversification is nothing more than protection against ignorance."  This quote describes me and my investing perfectly.  When I look deep inside, no matter how much research I do I am still ignorant of the companies I'm investing in as an outsider.  I laid out my thoughts for that in this post, one that many of you skipped.

As outside investors we can't know everything about what's happening at a company.  If we think we do we're deluding ourselves.  I worked at a startup out of college that was in many ways run on a shoestring and a lot of hope.  We had outside investors who were blissfully unaware of what was actually taking place day to day.  At one point we had a massive system crash that destroyed all of the company's data, intellectual property and software.  Our core system had died suddenly without a backup.  Thankfully a coworker was able to engineer a solution and numerous hours later business continued as usual.  Customers knew there was a massive disruption, and employees knew without our co-worker's creativity unemployment would have been our future, but investors receiving quarterly statements they never knew they were hours away from losing everything.  Unfortunately many companies are run in the same haphazard way, and we as investors never have any idea.

I diversify my portfolio to avoid disaster, but that isn't the only reason, or the main reason.  The theory for concentrating is that no one is bothering with investments that will only return 50%, rather many only invest in companies that double, triple or quadruple in two or three years.  Why settle for a measly 50% return when you can search harder and find the 400% return?

If I could find five stocks that I knew would all quadruple in three years I'd bet the farm on them as well.  The concept sounds great.  The question I have is where are all the funds and investors doing 100% compounded?  Compound capital at 20% for a decade or more and suddenly you will be a 'guru'.  Why is there such a gap between what investors are looking for and what happens?  Many shoot for the stars investments fall flat.  A few do make it to space, but their gains needs to be spectacular to negate the losses for the rest of the investments that blew up.

The problem is consistency.  It's hard to consistently invest in companies that return 200%+.  To understand why think of baseball.  It's easier to consistently hit singles verses consistently hitting home runs or grand slams.  A grand slam is possible under the correct circumstances, but a single is possible every time the batter steps to the plate.  In theory a hit is a hit, but that's not true.  A pitch needs to be thrown just right, and the bat needs to hit the ball with enough power at the right place for a home run to occur.  Players who can consistently get on base are more valuable than the power hitter who makes a great highlight on ESPN, but mostly strikes out.  I think of Walter Schloss, an investor enthroned in value investor lore who consistently hit investing singles.

If a company meets my minimum criteria for an investment I'm likely to take a position.  It might be a small position, but it will be added to the portfolio.  It's important to note that not every position gets some pre-set mechanical sizing.  If a company is unusually cheap, or there's some other special characteristic I will size the holding larger.  Sometimes I'll increase a position if the company becomes cheaper, or if I become more convinced about their potential.  I have averaged down on holdings, but I've also averaged up.

Whereas sometimes I'll take a larger positions, I've also taken many small positions.  My holdings in community banks are a great example of this.  I have a general profile for a cheap bank that I look for.  If a bank meets my criteria I will take a small position.  There have been a few of these banks that after researching I end up liking and take a larger position.  In general most are tiny positions.  In the aggregate my exposure to small community banks is greater than 10% of my portfolio.

A great criticism might be to ask why I don't just invest in an index of banks.  The problem is there is no index that does what I want.  There are no indexes that invest in banks with $9m market caps, or $150m in assets.  I don't know of an index that has criteria that says if a Chairman and CEO are in their 70s it will buy more.  If there were an index that did some of these things I'd probably consider purchasing it.  I enjoy investing, but it isn't like I couldn't find something else to do with my time either.

I know my approach isn't for everyone.  It's probably not for anyone.  It works for me though, it's something I'm comfortable with and lets me sleep well at night.  I'm going to continue to hit singles and doubles and let the rest of you hit the home runs.

Monday, March 17, 2014

Calling all risk takers, a Ukrainian investment at 2x earnings and 45% of book value

"The time to buy is when there's blood in the streets." - Baron Rothschild

Investors who venture into risky markets can realize either fantastic returns, or encounter losses to be written off at tax time.  Right now feels like one of those times where a fortune could be made or lost by investing in the Ukraine or Russia.

I haven't spent any time looking at Russian companies, but I have seen a Ukrainian company written up on a number of blogs that I felt merited a further look.  The company is Avangardco (AVGR.London), an egg producer.  They are the number one egg producer in the Ukraine and in Eurasia.  If you're reading this and live in Europe you've probably consumed Avangardco eggs.

The company is compelling due to their extremely low valuation.  They trade for slightly over 2x earnings, and about 45% of book value.  This is a really low valuation for a company with a considerable market position.  Usually a valuation this low can be attributed to one time earnings, or another non-repeatable event.  That's not the case for Avangardco, the company's earnings appear relatively stable.  The company's book value is well supported by earning power.  Book value is close to five times net income.  This is clearly a two pillar stock.

When a stock is trading for such a low multiple an investor doesn't need to spent a lot of time considering whether it's good business, or if they have a moat, or if can earn acceptable returns on equity.  If you are interested in exploring those issues I'd recommend you read Dave Waters' writeup of the company from January.

In my view there are only two questions that need to be answered about the company, and if both can be answered conclusively then this is an incredible investment.  The first is will the company's business going forward resemble business the past, secondly is there a risk of permanent capital loss from some event or incident?

Back before Putin began to reassemble the Soviet Union the biggest risks outlined for an Avangardco investment were related to its billionaire majority owner.  A noted but not emphasized risk was that the company operates out of a politically unstable country.  That previously minor risk has come to the forefront lately.

To consider Avangardco as an investment we need to rule out two potential outcomes: that the company will disappear, and that their business is permanently impaired.  If both of these risks can be eliminated buying a company at 2x earnings and 45% of book value has a great chance of generating a return.

Let's tackle the first issue, that they will completely disappear.  I can see this happening under two or three circumstances.  The first is that Russia launches an all out war against the Ukraine and either destroys all of Avangardco's facilities, or re-collectivizes them.  I think this is the most remote possibility, I'd assign a very small probability of this happening.  There's a chance Russia might invade the Ukraine, but given how Ukraine resisted in Crimea I'm not sure there would be much fighting.

Hens are going to continue to lay eggs regardless of whoever is in control of the country.  As long as the eggs can get to a customer, and the customer as the ability to pay the company should continue to make money.

The second potential risk is that even if the company can conduct operations going forward it will be at a reduced level.  I'd consider this the best argument for the low valuation.  Some of Avangardco's facilities are in Crimea, maybe those will have to be abandoned.  If Russia invades Eastern Ukraine then maybe the company will lose half of their facilities or critical infrastructure.

If the company were to lose half of their earning power they would still be trading at a very low valuation of 4x earnings.

I think there's another alternative that investors should consider as well.  Prior to Ukraine's recent unrest they weren't known for having the most transparent or honest government.  Even in those conditions Avangardco was able to flourish under the control of their billionaire owner.  My thought is that the owner knows how to grease the political wheels to get favorable treatment.  Considering that the Russian economic system seems to be run by in a similar manner it's likely that Avangardco's owner will find a way to work in whatever new political system emerges.

The question to ask regarding Avangardco is if the worst case doesn't happen then what does the future look like?  If their facilities aren't destroyed in a war or collectivized in a communist revival, and the hens continue to lay eggs is it worth more than the current valuation?

If you think the worst case is a likely outcome then this is an investment to avoid at all costs.  If you don't think the worst case is likely then the company could return multiples once the political environment begins to settle.

I think Avangardco illustrates a few things about buying cheap companies and margin of safety concept.  If an investor is buying companies without much room for error their assumptions and estimations need to be very accurate to realize a return.  The cheaper a company gets the less accurate assumptions or estimations need to be.  At a certain point, as in Avangardco's case, as long as the company survives and is able to find a way to make money investors will most likely realize a return.

Disclosure: No position

Friday, March 14, 2014

Detroit Legal News, a recession hedge

Sometimes being in the right place at the right time is all that's needed for success.  The Detroit Legal News can certainly take credit for making the best of a bad situation.  The company owns legal newspapers and a magazine in Michigan.  For years the company minted money as they profited by publishing mandatory foreclosure filings in their publications.  As the Michigan housing market recovers from a once in a century downturn the company is faced with what to do next.

I enjoy reading and researching companies like Detroit Legal News (DTRL).  Their Chairman's letters are usually entertaining to read, and the annual reports are short and to the point.  Becoming familiar with this company and their business didn't take much time.

The company experienced extraordinary earnings throughout the recession.  Now that Michigan is returning to normal their earnings have declined to a level last seen in 2001.  This past year the company earned $26 per share, down from $198 a share in 2008.

Here are the company's financial details from 2008 forward:



It's hard to say where the value lies with this company.  They seem to have traded in line with earnings in the past.  But as earnings fell the stock hasn't declined as much.  

The company's book value has declined since 2008, which is usually a cause for concern.  The majority of the decline can be traced to paying out a substantial portion of their earnings and excess cash as dividends.  In the latest shareholder letter the Chairman stated that they had averaged a 94% earnings payout in the form of a dividend.  The company's idle cash has halved since 2008, all of it paid out as dividends.

The effect of dividends on this stock shouldn't be understated.  As mentioned above the company is back to their 2001 earning level of $26 per share.  The difference is that in 2001 the company's shares were trading for $125, they're $930 now.  A shareholder since 2001 would have experienced a seven fold increase in the share price alone.  Since 2008 they would have received an additional $753 per share in dividends.  Dividends paid since 2001 eclipsed the stock's appreciation.

For those investors who don't believe buying cheap companies works they should look at the results of a Detroit Legal News investment in 2001.  At that time the company was trading with a P/E of 5.6 and a P/B of 54%. The investors who made money were the ones who held on, rather than the ones who flipped it for a quick 100% profit.

The company's shares don't appear to be a great value at this price if business conditions don't change.  That's not to say that value doesn't exist here, it does, it's mostly hidden value.  In the company's 2012 annual report there is a note detailing their operating leases.  The beginning of the note is unusual, it discusses a transaction where the company owns a property which is on their books for $100k that is generating $119k per year in lease revenue.  Additionally they had an agreement with the lessee where they property could be purchased for $2m if the lessee decided to exercise the option.  It becomes even more interesting because after this the company notes they're exploring the sale of this property.

There is also a parking lot property mentioned in the leases section of the notes that might be understated too.  The property generates $53k a year in lease revenue.  These two properties combined might be valued at $3m or more than their carrying value.  If that were true it would increase the company's book value by 14%.

Even if there is a little more value on the balance sheet it doesn't solve the company's biggest issue, their declining revenue.

Detroit Legal News' record earnings were the result of a regulatory actions.  A regulation was published concerning the publication of foreclosure notices in 2008/2009.  The company benefitted from this until it had run its course.  The regulation for publication became optional in 2012 whereas it was mandatory prior.  This leaves the company with two options, they can invest in their Inland Press subsidiary, or wait for another recession to hit Michigan.

The company seems to be taking the first approach.  They used some of their record earnings to upgrade the Inland Press printing presses.  Management expects the new machines to reduce operating costs going forward.  They've also increased sales at Inland Press slightly, but not enough to make up for the foreclosure notice loss.

If the economy hits a rough patch again then it's plausible that Michigan could slip again into a depression.  If that's the case shareholders of Detroit Legal News could sail through the storm unharmed.  But as the economy recovers management is going to need to figure out act two quickly.  The company has no debt and appears to be run by very capable managers, I have no doubt they will survive.  The issue is will shareholders profit if they were to buy at this level?  Personally I'd be a buyer at less than book value, but probably that won't be happening soon.

Disclosure: No position

Monday, March 10, 2014

Avalon Correctional, an unlisted information arbitrage

Gaining an edge in small unlisted companies isn't uncommon, and done timely can be lucrative.  I want to talk about an investment I made that symbolizes everything that's great about unlisted stocks.  Opportunities like this don't come often, but when they do investors need to have the foresight and ability to act quickly.  For those of you who scan for a ticker and purchase without reading further I'd urge you to not act.  This investment has already run its course, this is a post-mortem writeup.

At the end of 2012 I was working my way through a list of stocks that no longer file financials with the SEC or OTCMarkets.  At the time I had a habit of checking companies who's OTCMarket filing status had changed to "No Information".  I would then Google the company and see if I could find any morsel of information that might prove valuable.

I came across Avalon Correctional (CITY) and a press release filed the same day announcing a tender offer in response to a lawsuit ruling.

Company tender offers can be a great source of value for investors.  An investor might buy shares at $10 and then tender them to the company for $10.50 picking up a 5% gain in the process.  When a company announces a tender arbiters bid up the shares and the spread between the market price and tender price tightens.  If you listen to financial academics the spread between the tender price and the market price reflects the risk of the tender not happening.  Of course the market isn't always right.

To understand this transaction you need to understand Avalon Correctional and how they ended up at this forced tender.  The company operates halfway houses across Oklahoma, Texas and Wyoming.  States contract with them to provide services that the state would normally otherwise provide.  Private prisons are supposed to be cheaper for taxpayers.

Up to 2005 the company was SEC reporting and exchange listed.  They decided to go dark suspend regular reporting.  Around the same time the company changed their corporate registration from Oklahoma to Nevada.  When a company goes dark sometimes investors will allege that management simply wants to loot the company while remaining out of sight from investors.  That accusation was leveled against Avalon Correctional by Ravenswood Management, a fund with a large holding.

Ravenswood Management is run by Robert Robotti, a one time protege of Mario Gabelli.  Robotti has had a history of investing in smaller companies with value traits such as Avalon Correctional.  Robotti's firm issued a large records release request via lawsuit soon after the company went dark.  The two parties fought back and forth in court for years.  The company claiming that due to their new Nevada domicile they weren't required to release any information to investors.  Robotti claimed the company was paying above market rates to lease equipment from a management owned entity, insider dealing and other disturbing practices.  The company fought back against Ravenswood every step of the way, which for me only served to validate his claims.  Ravenswood was seeking a $10m payment to shareholders.

The years of lawsuits ended with a ruling that Avalon Correctional was to tender to purchase any and all remaining shares.  Additionally Ravenswood was to sell their stake back and agree to not sue any further.

The company was offering to repurchase shares at $4.05 a share, which was a full dollar higher than the last trade price.  In some versions of the press release it also mentioned that shareholders who tender would receive preferred shares with a par value of $1.60 that pay a 7% dividend.

Stocks on the OTCMarket are famously inefficient and I ventured that most investors in Avalon Correctional hadn't seen the news.  I placed an order for shares at $3.01, and unsurprisingly a portion of my order filled.  It was at this point that I made a big mistake.  I noticed that more shares were available at $3.25 and $3.50, but I decided I'd rather be patient and wait for more to fill at $3.01 rather than follow the price up.  I was greedy and stupid, as a result my position wasn't as large as I wanted it to be.  I should have purchased as much as I could at any price under $3.50.

The press release I had relied on for my purchase decision didn't have any of the finer details of the transaction.  I thought that maybe the gap between the share price and the offer price was due to some investor ignorance, but also the risk of the deal not closing.  Soon after I had my shares I started to receive massive legal briefs in the mail regarding the position.  The transaction between Ravenswood, Avalon Correction and shareholders was a result of a ruling, and was being enforced by the courts.  I reasoned that since the transaction resulted from a legal ruling there was almost no chance of it failing.

I continued to receive briefs updating me over the months on what was taking place.  I sat tight with my extremely illiquid shares and attempted to buy more when possible.  Eight months after the deal was announced I received my cash of $4.05 per share and the preferred shares, which have already paid dividends.

There are a number of take aways from the investment.  The first is that small and unlisted stocks are often not efficient, or even close to efficient.  I was able to buy shares for $1.04 less than the tender price, and receive preferred shares for 'free'.

The second take away is when investing in these companies and situations you need to be confident in your conclusions.  When I called Fidelity to tender my shares I found out they had bad information on the deal.  The investment rep said there'd be no preferred shares to accompany the tender.  As he explained what he thought the deal was I had my massive notice from the District Courts in Oklahoma detailing that if I tendered I would in fact receive shares.  I went with the information I knew and trusted my conclusions.

The last lesson is that while these deals aren't often they do exist, and when they happen investors need to act in size and act quickly.  I tried to act in size, but due to a foolish mis-calculation on my this was a small portfolio position instead of a larger one.

Disclosure: Long Avalon Correctional preferred shares

Monday, March 3, 2014

LICT, any meat left on the bone?

Over two years ago I wrote a post about a company trading at 50% of book value and 5 times earnings.  I mostly liked what I saw.  I liked the valuation, and liked who was at the helm, but hated the industry.  I saw a value trap in LICT, not a great investment.  I was wrong.

If anyone invested in LICT based on my initial post they wouldn't have been cheering their good luck before last week.  In the two years since I posted about LICT the stock rose 20%, and trailing the market.  Long suffering investors were rewarded with a strangely worded press release on February 19th.  The company stated that they received an unsolicited proposal to purchase the company from a third party at a significant premium to their most recent share price.  Management responded that the offer didn't accurately reflect the company's private market value and rejected the offer.

The company's press release would have been great if that's all it contained.  Fortunately it had one more line of good news.  The company stated right before their legal disclaimers that they were currently in negotiation for a management led buy-out of one of their operating units.  The company provided no further detail and emphasized that they won't provide updates except as required by law.

I can understand investor disinterest at this point.  A company in a dying industry with a flat share price released PR saying an unnamed company offered an unnamed buyout price that was rejected.  It's not uncommon for less respected pink sheet companies to release statements like this to pump up their stock price.
"I've seen this movie, and I know how it ends."

For the uninitiated LICT is a Mario Gabelli controlled collection of telecom assets in markets that the majors would rather forget about.  If this is starting to sound familiar it is, it's following the playbook of CIBL (CIBY), another bundle of telecom assets Gabelli controls.

When CIBL traded near $300 p/s the company issued a press release stating that they had an offer for their wireless assets at a price that exceeded the current price.  It took a while for the deal to be consummated, about two years, but it happened at $900, three times the price at the time.  CIBL's management team then went on to sell the company's remaining assets for another impressive number.  The company's shares are now trading at $1450, potentially what management saw as private market value initially.

 LICT's announcement boosted their shares by $1,000 per share, they now trade at $3,300 a share.  It's impossible to know whether $3,300 is too high or too low unless we have a reasonable estimate of LICT's private market value.  In the case of CIBL their private market value exceeded their book value and was based on a multiple of earnings and replacement cost.

LICT has a book value of $88m, and a market cap of $74m.  They spent $300m building their telecom network, although I'd caution that it's doubtful they'll get anything close to replacement value.

The company is trading for about 10x trailing twelve month earnings.  Their EV/EBIT is 9, which seems reasonable given the industry and where they operate.  If we consider their earnings in isolation the company appears fairly valued at the current price if nothing changes in the future.

Given that LICT paid $300m for their telecom infrastructure I don't think it's a stretch to say that it could be worth book value of $88m.  What is disappointing is that $300m worth of cables and routers is only generating a roughly 2% return on their initial cost.

As I've worked my way through this post I've probably reinforced the thinking that LICT has the potential to be a value trap.  While they might have valuable assets it's also possible that the assets aren't as valuable as we'd want them to be.  The company is in a tough competitive position as well because they are landlocked into rural markets where running new cable is costly, and incomes aren't has high.  I've found myself thinking "who would want to buy this, and why?" as I've been writing.  I think a strong case could be made that LICT is worth at least book value, but to get any value higher requires some creative thinking.

The truth is most companies that acquire don't do it for a one time financial gain, they expect to pay a fair price and add value through their expertise.  Viewed through this lens it's easy to see what an acquirer might gain.  An acquirer might have more efficient operations, or operate in a similar geographic area.  If that were the case they might save significantly by consolidating operations.  Or maybe the acquirer plans on moving all the customers to a cheaper VOIP installation.  It's even possible the acquirer plans on attempting to upsell LICT's customers with more services or raising prices.

What if the potential acquirer doesn't come back with a counter offer?  Shareholders will probably get a glimpse at how the Board values the company when the management buy-out takes place at one of the subsidiaries.  Beyond that owning LICT doesn't seem like a terrible investment.  The company has considerable asset value, and their earnings have stabilized.  They service an important niche that isn't going away anytime soon, and they have responsible management at the helm.  You could do worse than owning LICT, and for the patient investor you will probably do quite well over time.

Disclosure: Long CIBL