Wednesday, April 30, 2014

Gevelot's hidden value is exposed

Almost two years ago to the date I wrote about Gevelot (ALGEV.Paris), a small French industrial company.  I was attracted to the stock because they were a two-pillar stock, a company where earning power supported book value.  Two pillar stocks are especially attractive when the company is trading below book value.  In the past two years the company has slowly drifted higher until Monday when shares jumped 43%.  When I searched for a reason behind the jump in share prices I stumbled on Gevelot's hidden asset, a subsidiary's minority investment in an associate.

The company has three European subsidiaries that each have different areas of focus: extrusion, pumps, auto parts.  The company's extrusion division generates the most revenue at €109.7m, with pumps generating €89.4m and auto parts €14.1m.

The company reported their 2013 results in a press release, and released their annual report yesterday.  They recovered from a net loss in 2012 to earning a profit of €6.26 p/s in 2013.  The company is in great shape financially, they have little debt, and book value grew to €133m this year.  The company is still undervalued trading with an €86m market cap.  They also repurchased about 1,000 shares of their own stock, an extreme rarity in France.

If this were all there'd be nothing to post about.  It would be a cheap French company whose results are improving with a share price climbing towards fair value.  What makes Gevelot interesting is a paragraph included at the end of their 2013 results press release.  The company reported that their PCM subsidiary owned a 45% stake in a Canadian company named Kudu.  Kudu received a buyout offer for $250m, or €161m.  This offer valued Gevelot's stake at €72m, more than the market cap of the entire company at the time.

Instead of accepting the buyout offer the subsidiary rejected it and offered to purchase the 55% of the company they didn't already own for €94m giving them 100% control of Kudu.  The company continues in their release they once they own 100% of the company they intend to sell it to a third-party.  I find this last thing the most curious, why would Gevelot buy 55% of Kudu to flip it?

The Kudu stake was valued on Gevelot's balance sheet for €10m as an unconsolidated investment.  In 2012 Kudu generated €1m in net income, but in 2013 it generated €20m from €153m in sales.  Whatever Kudu is doing to sell pumps in Canada is apparently working, although Gevelot was about to be left out.  Kudu terminated their contract with Gevelot starting April 30th.  Gevelot noted in their annual report that they expect earnings to be much lower in 2014 as a result of this relationship.  It's no wonder that they decided to purchase the 55% of Kudu that they didn't own, it ensures that they have a distributor for their parts in the fast growing Canadian market.

When looking at the Kudu buyout with last years numbers it appeared like Gevelot overpaid.  When viewing the acquisition with the 2013 numbers it looks like they got a deal.  They paid €90m for €11m in earnings (55% * €20m, they already owned 45% of the earnings or €9m).  In total their cost for the Kudu investment will be about €100m, or 5x earnings.  If they can sell it for €160m they can flip this for a quick €60m.

My first inclination after the price jump was to sell my shares for a gain, making 100% in two years is an excellent investment.  But after digging into their press release and looking through the annual report I'm now inclined to sit still.  What looked like a foolish investment now looks savvy given how Kudu performed in 2013.  A criticism is that maybe the 2013 numbers are a cyclical high or a fluke and won't be repeated.  My response would be that Gevelot's management has a lot more insight into the situation compared to investors.  Investors only have financial statements to work from but the company can talk to Kudu's management and assess the viability of the market.

With the acquisition of Kudu complete Gevelot will be able to consolidate their financials.  If they were able to consolidate in 2013 the company would have earned €28.40 p/s.  Even with a 50% price increase the shares still appear cheap.

They aren't only cheap on an earnings basis, they're still cheap at the asset level as well.  The company has a book value of €133m, or €146 per share using Kudu's stated cost.  If we value the pre-transaction Kudu stake at the offer value then their book value increased to €226 p/s.  This is more than double today's price.  Fully consolidated it appears that Gevelot will continue to be a two pillar stock with €28 p/s in earnings and a book value around €226 p/s.  Earnings at 8-10x give credence to the company's book value.

Even if Gevelot isn't able to sell the company to a third-party for a quick gain this transaction is very accretive for shareholders.  Sometimes a company has a hidden asset shareholders don't even know existed as was the case with Kudu.

For those interested here is their press release
Here is the latest annual report
(Both in French)

Disclosure: Long ALGEV

Friday, April 25, 2014

Why you should attend annual meetings and talk to management

Investing can be as social, or as anti-social as one wants.  There are many investors who never speak to another soul and produce great results.  And then there are some investors who are talking to others so much it's a wonder they find time to research anything.  That's the beauty of investing, there is no one way to do anything, but a multitude of ways that can all lead to the same result; profits.  Investor opinion on talking to management ranges from believing it's vital, to a distraction, to actively decrying it.  I think there's a time and a place to talk to the management of companies we own, and even attend their annual meetings when possible.

I attended the annual meeting for a holding of mine this past week.  The company is local and I've owned shares for about three years, but I hadn't been able to attend until recently.  This isn't a large holding, I own about $150 worth (a placeholder amount), and my wife $1500.  The actual dollar amounts are important because many investors would consider it a waste of time to do anything beyond read a 10-K for a $1650 holding.

The annual meeting was held at the company's single location, in a small conference room above their offices.  I knew I was in the right room when I saw a box of cookies and coffee, staple fair for shareholders.  There were two rows of seats, maybe 20  total which were placed there to fill the room.  The company didn't really expect more than a person or two to attend.  The attendees were myself, the wife of the previous CEO, and the granddaughter of the company's founder.  Management was practically falling all over each other to introduce themselves to me, a new face.  The other two shareholders had been attending the meetings for decades.

The meeting itself was short, a few prepared remarks by management discussing the past years results.  I asked a flurry of questions about the business and their finances and then the meeting adjourned.  That's when the value of attending really began.  In a small setting management will usually stick around afterwards and answer questions.  The formal meeting lasted maybe 15 minutes at the most, but I talked with management and various Board members for another 45m.

For most investors board members are simply names on a proxy.  We don't know much about them, what they do, or how they're related to the company beyond the small one paragraph blurb the company provides.  The blurbs provided in proxies are near worthless.  It doesn't matter to me that a director was valedictorian of their college class in 1952, or that they hold awards in unrelated industries.  Investors have even less insight on what board members actually do.  We are at most presented with a detail of how many meetings they attended.  Even worse is that some directors don't even attend the board meetings, they just dial into a conference call.

I've been surprised, both positively and negatively at how much, or how little directors know when I've attended annual meetings.  Shareholders have the opportunity to question not just the management team, but the board, who run the company for them.  Some directors appear to be asleep at the switch, others actively engaged.  When a director defers all questions to management it's a red flag for me.  Likewise when a director tells me all about the product line, the evolution of their customers and breaks down who buys what, and how it's changed I'm encouraged.

Another advantage is often the largest shareholders attend the annual meeting.  For this company that was the case, I was able to find out details on shareholder purchases and sales that would never be known otherwise.

Annual reports, newspaper articles, and other written material can give a lot of information about a company.  Sometimes it's easiest to get a question answered by just picking up the phone, or attending the annual meeting.  The company whose meeting I attended has a pension plan that I'd been concerned about.  Their annual report had all of the standard pension disclosures which was helpful, but I still had concerns.  Two simple clarifying questions to the CFO eliminated any concerns I formerly had about the pension.  Without speaking I could have never had those questions answered, they just didn't exist in the filings.

I also spent a considerable time talking with the company's COO who walked me through various aspects to the business.  I wrote a post a few weeks ago about how even when we think we're experts on an industry we're really novices; my conversation confirmed that.  I was given an education on their that's common knowledge to employees and others in the industry, but can't be found easily online or in books.

Maybe this post has you thinking I've fallen in with the group of investors who believe talking to management is a requirement for any investment.  I don't think it is.  But I think we should also take advantage of every opportunity to attend annual meetings when they're close or convenient.  I don't think phoning management to ask simple clarifying questions or ask about the business is a terrible thing either.  As I mentioned above this is a small investment for us, so why did I attend?  I like the experience of going to these things, but I also received a great education in an hour that I couldn't have ever received by just reading.  Supposedly all knowledge is cumulative, and what was learned here is clearly applicable for other investments.  I also found out the company is now paying a 10% dividend, something they did without any announcement that could only be discovered by talking to the company.

Wednesday, April 23, 2014

A New Zealand oddball; Tenon Ltd

New Zealand is a bit of a hidden stock market far off the radar of most investors, let alone most travelers.  The tiny island nation's domestic market is limited forcing them to focus on export manufacturing.  What the country lacks in domestic industry they make up for in natural beauty.  The islands are renowned for their mountains and picturesque settings.  The country is sparsely populated with the majority of their population residing on the north island in Auckland.  This leaves much of the country sparsely populated, if populated at all, which is what Tenon Ltd needs to grow their product, trees.

Tenon Ltd (TEN.New Zealand) is a New Zealand listed specialty wood manufacturer.  The company runs a sawmill, a moulding plant, and a board plant in Northern New Zealand.  The company manufacturers a variety of wood products from locally sourced pine.  They claim their wood is appearance-grade timber, which is the finest quality.  The company packages their products into shipping cubes and sends them off to the US.  The US accounts for 90% of their sales, the company is heavily reliant on the US housing market.

I found this idea on a New Zealand investing blog I read and the author's summary intrigued me.  The thesis behind this company is that when housing recovers they will have the ability to generate up to $45m in EBITDA; significant considering their $84m market cap.  In the first six months of this year their EBITDA equaled what they generated for the entire fiscal 2013, an encouraging sign.  Other relevant points are that Third Avenue value owns 18%, and that the company intends to return capital to shareholders as soon as possible.  An insider's wife also purchased a large stake recently.

For a moment I want to venture down a short rabbit trail.  I've noticed that in non-US companies paying dividends and returning capital to shareholders is of the utmost importance.  Management at companies that cannot return capital lament as if they are failing shareholders by not paying a dividend or retiring shares.  I wish we had a similar culture in the US.  Instead we have managements who feel the need to horde cash for the possibility of future re-investment opportunity.  I don't know why American companies are so stingy about returning capital to its rightful owners.

The company's financial statements reveal the starkness of the company's situation.  They broke even the first half of this year, and lost money in 2013 and the prior year period.  They hold no cash on their balance sheet, and trade at 70% of book value.  Their book value is a soft number including $67m in goodwill, some inventory and receivables.  I wouldn't count on getting book value back in a distressed scenario.  While light on assets the company is well financed, they recently closed on a $70m financing deal with PNC bank.

The entire investment thesis rests on their leveraged exposure to the US housing market.  The way the company frames the situation once the housing market picks up they will be generating cash like it was 2005.  Except that's the problem, if this is a company that rode the housing wave why did they struggle to earn money during the epic housing boom in the early 2000s?

At the present moment the stock isn't cheap, they're selling for about 20x 2013 EBITDA, but should be selling for 10x EBITDA if results are inline this year.  If they are able to benefit from a housing recovery, and shipping costs remain low, and the exchange rate is favorable I think they can probably earn their target of $45m in EBITDA a few years out.  If they can hit their target an investor buying today is getting this company at 2x forward-EBITDA.

Unfortunately for myself this isn't my type of investment.  I have a terrible time predicting the future, and I hate leverage.  That said I know that a year or two from now I will be receiving a trickle of emails thanking me for posting about this as investors double or triple their money.  Leveraged investments work out fantastically when they work out.  Without any downside protection, and with a lot of leverage I'm going to leave this one to the experts.  That isn't to say that I didn't find it interesting enough to spend a few hours with their financials.

Disclosure: No position

Thursday, April 17, 2014

What's the worst case scenario?

Survival and end of the world scenarios seem to be en vogue.  From the preppers to the impending financial collapse of Japan/China/Europe/US there's a very vocal subset ready for a collapse of something.  Investors are preparing for another market crash, and it seems like journalists are writing about bubbles to capture page views.  I'm not sure if doomsday has always been so popular, but it's been something I've been thinking about recently.

Last week I drove up to Toronto to attend the Fairfax shareholder dinner on Tuesday night.  At the dinner we had a chance to listen to various Fairfax executives discuss their company and issues they felt were important.  One executive discussed her view that China is on the verge of an impending collapse.  Fairfax Financial in general is bearish on both the market and various countries, they predict that we'll experience deflation along with a Chinese implosion.  Their outlook is very dire, and it's not an uncommon view held by investors.

While I was listening to the Fairfax executives discuss China I started to think about a friend of mine.  He is a former survival instructor in the Air Force, he'd take students into the woods and show them how to kill game, find water and survive enemy tourture techniques.  I was always fascinated by his stories about eating goat eyeballs or being dumped in the desert without water, the training was intense.  Beyond his survival skills my friend also has a keen sense of business opportunity.  After leaving the Air Force he and his wife started one of the first drive through coffee shops in Pittsburgh.  It was no surprise when he wrote a book catering to the prepper movement based on his Air Force survival training.  For my foreign readers who need a little background; preppers are Americans who are scared about terrorists or a revolution, or nuclear attack who in response have fortified their house, stored food, and train to thwart attackers.  The prepper movement has spawned TV shows, books, and training courses to prepare for some terrible event.

My friend wrote a book about an EMP attack in the US.  I haven't read the book personally, but I'm familiar with it.  In the book civilization breaks down as a result of this attack and Americans are forced to fend for themselves.  The book is part survivalist manual, and part story.  From this launching pad my friend started a consulting business and is now in the business of writing other material for the prepper niche.  I doubt he ever thought he'd be making a career out of experiences from the Air Force, but he saw opportunity and took advantage.

I find the societial collapse scenarios and obsession fascinating.  There is a whole plethora of scenarios that could potentially take America from eating McDonalds and drinking Coke to fighting each other in the streets, growing food and living in some anarchist society.

Story lines for a societal collapse remind me of story lines for market collapses.  If A happens then it will lead to B, which in turn leads to C, which results in D, after which we're all living in huts with loin cloths and grass skirts.  The problem is outcomes are never as neat and tidy as the story lines we tell ourselves.

What's intriguing about all the collapse scenarios is that although we have a lot of stories and theories of collapse if one looks back in history there aren't that many examples of a total collapse.  There are examples of governmental breakdown and disorder in societies, but none that I know of have led to people living as they did in the stone age.  I'm astonished at the number of groups pushing for a total collapse.  From environmentalists preaching about our energy usage, to right-wing militias it seems like each of these groups has an agenda to push.  Each group is selling something, and if we don't adopt all of their changes we are led to believe we'll experience a worst-case scenario.

For some reason humans are attracted to the worst case scenarios.  We want to be worried about something remote and unlikely to happen.  We're worried about an EMP explosion (do they explode?) that knocks out the electricity grid, but we're not worried about unsafe drivers on the roads.  We're worried about China collapsing and destroying the market, but we aren't worried about buying into an over-levered company with a dying business model.  We over estimate remote risks, and under estimate reasonable risks.

Evidence to support this can be viewed in the comments on this blog.  Many commenters have posted very valid worst case scenarios about companies as a reason to avoid the investment.  The worst case scenario sounds attractive, and it's easy to buy into the story line, but is it relevant?  If you look back at a lot of those worst-case scenario comments you'd see that the scenarios never materialized, rather a much better scenario unfolded.

When a company is trading close to or above a fair value a lot of things need to go right, or continue to go well in order for the company to grow into their valuation.  Sometimes a company does everything right and a seeming overvalued turns into a missed buying opportunity for investors.  There really are companies out there that can grow sales 25-50% a year for stretches, I've worked at one in the past.  Growth like this doesn't last forever, but it lasts long enough that a high valuation can be deserved.  Just like there are star athletes, there are star companies that make all the right decisions for a period.

When a company trades for a low valuation not many things need to go well.  It's the opposite, as long as a company avoids failure or disaster they are often worth more than what the market is pricing them at.  Valuation trumps risk, at some point a valuation will be so depressed that even the most unpalatable prospects can be enticing.  I know investors will disagree on this point, but outside of purchasing nuclear waste or something toxic like that I'm guessing that most investors would take even the worst business in the world if offered for almost nothing.

A lower valuation protects an investor against terrible outcomes.  Competitive advantages, and concerns about a moat disappear as a stock's valuation drifts lower.  Below a certain point if the company continues to simply conduct business they are worth more than their valuation even if the market disagrees.  What seems to happen is the market latches onto worst-case scenarios and ignores more likely near term scenarios.

Humans are incredibly creative and able to react in unpredictable ways to situations.  Investing in companies with extremely low valuations is akin to betting that we will witness human ingenuity.  When a company is facing dire circumstances often management will do uncharacteristic things in order to both save their jobs and save the company.  Sometimes those actions work, not always, but enough.  Othertimes conservative management can be forced out of their comfort zone when competition is at their doorstep.  A previously sleepy company catches the growth bug and both management and investors are rewarded.

Human ingenuity and creativity are part of the reason I don't buy into worst-case scenarios.  When we start heading down a bad path few sit by and let events run their course.  Our normal response is to do something and try to fix the situation.  When a country heads towards collapse a group of citizens will step up and attempt to fix the situation, altering the course of events.  Companies are no different, few management teams sit by idly as a company falls apart.  It's the action that people take that creates unpredictability in our story lines.  Suddenly the A->B->C->D story line is disrupted because between B and C people stepped in to do something.  Sometimes a fix works, othertimes it doesn't, but it always alters the storyline.

When we buy into companies or countries at high valuations we are implicitly betting that a best case scenario will unfold.  If it doesn't then we are at risk of losing money.  When we invest in a company or a country with a low absolute valuation we are betting that human ingenuity will attempt to do something, and that we'll avoid the worst case scenario.

I look at a lot of companies that the market and investors have written off as worthless.  Many are worthless, they have management teams working to extract all of the value for themselves while the company coasts to zero.  But some aren't worthless, investors might have fears about them, but at a low enough valuation these fears can be overcome.  Absolute valuation is critical, keep that in mind and risk will fall into place.  Items that are risky at 2x BV and 30x earnings are non-issues at 50% of BV and 3x earnings.  Focus on what's likely, not the unlikely worst-case scenario.  And lastly when buying something at a depressed valuation realize that you're making a bet on human creativity and ingenuity to do something to resolve the situation.  The response might not be perfect, but nothing in life ever is.  A reaction doesn't need to be perfect, it just needs to be good enough to avoid the worst.

Friday, April 11, 2014

Determining intrinsic value for a bank; why discounts to book shouldn't persist

My last post generated quite a response.  Between investors thanking me for the idea and others accusing me of pumping and dumping the stock the most interesting response was an article posted on Seeking Alpha.  The author goes to great lengths to explain why at 40% of TBV M&F Bancorp is fairly valued.

I don't have any interest in getting involved in online debates, if I did I would have posted a comment.  Instead I want to further explain my thinking on banks and show that even an unprofitable or marginal bank has a lot of value.  I don't expect everyone to agree with me, that's what makes a market.  I'm also happy that there are investors who will pass over what I consider obviously cheap stocks, if there weren't I might not have an opportunity to buy them.

In Security Analysis the concept of intrinsic value is defined as the value a well informed private market buyer might pay for a business.  A company's intrinsic value is the amount that both the buyer and the seller would consider fair after extensive due diligence were performed.

Public market and private market transactions differ greatly with the private market being much more efficient.  Private companies are often sold at or near their intrinsic value.  This is because both the buyer and the seller come together and determine a mutually agreeable price.  Outside of unusual circumstances prices paid are reasonable for all parties.  The dynamics of a private market purchase are different than a public market purchase.  In the private market an acquirer sees a company that they believe they have the operational wherewithal to improve.  The acquirer doesn't mind paying a fair value because they believe their expertise, or existing systems will allow them to generate better returns with the company they purchase.  Explained another way private transactions are operationally focused whereas public transactions are financially focused.

The intrinsic value of a bank is no different than the intrinsic value of an industrial, or insurance company.  A bank's intrinsic value is what a well informed buyer and well informed seller would mutually agree on as a fair price.  The question is then, how do we get that value?

One of the reasons I love banks and banking is because they're very easy to compare.  Consider two banks in the same town across the street from each other.  Their business is the same, they both take in deposits and make loans.  If the banks aren't making the same returns it's interesting to consider why.  Why are two companies located across the street from each other generating different returns from the exact same business model?  Maybe it's marketing, or the culture of the employees, or the color of the toasters they're giving away.  It isn't as if one bank can make better loans than the other, often their rates are the exact same.

In this scenario what's even more fascinating is that when the outperforming bank purchases the underperforming bank the underperforming bank becomes outperforming.  This suggests that performance has nothing to do with the location or the product, but the culture and how the bank is managed.  This is true across banking and other industries as well.  A friend related a story recently about how their company purchased an underperforming location and after instituted some of their cultural practices saw a remarkable change in profitability at the new location.  The new location contained the same employees doing the same job as before, but with different motivation and new management they were able to execute at a higher level.

I met for coffee with a local former bank executive back in the fall and he walked me through how a banker views a bank acquisition.  I made a reference to the methodology in my Versailles Financial post.  Incidentally PL Capital, a well regarded bank financial-focused hedge fund walked through a similar valuation methodology during their recent Value Investing Conference presentation.

The idea is that the value in a bank lies in the ability to remove costs post transaction and better utilize the assets.  A perfect example of this might be some of the small banks that are making $10-15k in net income a year.  Most if not all investors look at banks like that and throw up their hands claiming that anything a 2-3% ROE is worthless and should trade at 50% of book value, or at the very least passed over.  Fortunately that's not how bank acquirers see a bank like this.  They see a bank where if the CEO were gone ($250k salary), the CFO were gone ($150k salary), and the CLO were gone ($150k salary) salary that $550k in operating income would almost magically appear on the income statement.  This doesn't even begin to factor in the integration of a better core system, or branch efficiencies, or culture changes that can lead to growth.

The problem with small banks is they don't have the scale to outrun their costs.  But larger banks, or the combination of two or three smaller banks do have that scale.  Once those cost hurdles are removed the acquiring bank can reap near-instant profits by simply removing top executives and putting into place simple cost saving measures.

I put together a small table from CompleteBankData.com showing the average efficiency ratio of all banks broken out into different asset ranges.  All of the ranges are in thousands, so for banks from $0 in assets to $100m in assets the average efficiency ratio is 153%.  An efficiency ratio this high means that the bank's expenses are 153% of their revenue.  You can see that as banks attract more assets their efficiency ratio drops dramatically.  Simply moving from below $100m in assets to above brings enough efficiencies that most banks in that category have the chance of being profitable.


When I invest in banks my goal is to find banks where I can look past their current situation and see something more valuable.  I try to see valuable deposits, or an under utilized assets that can be re-allocated to a higher purpose under a different management team.

The major criticism I'll receive on this post is that my line of thinking relies on a bank merger or catalyst to unlock value.  Many investors don't want to invest in a company that needs a merger or dramatic corporate action to unlock value.  My response to them is that there are many companies earning 10-15% returns on equity that are trading at fair prices worth purchasing.  I prefer to purchase undervalued companies without knowing how or when value might be unlocked, but I am confident that it will eventually.

I remember in 2010 a few investors were talking about idea of permanent net-nets; companies that seemed like they'd been in the results of net-net screens forever.  I'll point out that none of those companies are net-nets anymore, they have all appreciated significantly.  I am proposing the same thing for undervalued banks.  With a terrible crisis in our rearview mirror some investors are making the claim that 40% of TBV is a fair value and that many banks are so terribly run they will never be worth book value.  That's crisis thinking, a bank like M&F Bancorp has a lot of value to an acquirer, and ultimately the fair value that I base my investment decisions on is what I think a private acquirer might pay.

My investment philosophy doesn't rest on the theory that every company I own needs to be acquired. Rather I believe that if something is fundamentally cheap eventually an acquirer, or other investors will take notice and the price will rise accordingly.

If you're interested in seeing how CompleteBankData.com can simplify your bank research, or help you find profitable bank investments sign up for a trial and see for yourself.

Disclosure: Long M&F Bancorp.  I receive a small commission for items purchased through the Amazon link above.  Prices through the link are the same as if you went to Amazon.com directly.

Monday, April 7, 2014

M&F Bancorp at 30% of TBV what's not to like?

I know myself; in my pursuit of perfect I miss what's good.  This happened to me when I looked at Japanese net-nets.  I wanted to find the best net-nets.  The net-nets that were the greatest companies, yet also the absolute cheapest.  What happened?  As I pushed numbers around in a spreadsheet the market rose and I didn't participate as much as I would have liked.  There were many good net-nets that I wish I would have owned.  The good net-nets did as well as the great net-nets.

It seems like there is always a country that's selling at a low multiple, or a sector of the market selling with depressed valuations.  The areas of concentrated low valuations are what I consider pockets of value.  These pockets of value need to be mined quickly before they disappear.  There can be issues with this approach.  Critics always have a myriad of reasons to avoid these pockets, many of the reasons are compelling if not convincing.  Second mining pockets of value can result in a portfolio that's heavily concentrated in a hated area of the market.  It's a tough sell for clients when all they see on CNBC are dire predictions about a portion of the market you're concentrating their portfolio in.

Financials were one such pocket of value coming out of the financial crisis.  Most of the surviving financials are much better capitalized, and should do well going forward.  Some of the larger financials are still cheap, but that pool of opportunity is quickly shrinking.  As larger financials have drifted higher they've pulled small bank stocks up with them.  It's almost as if investors cycle out of larger stocks into smaller and cheaper stocks.  Then when those small bank stocks rise investors go even cheaper.  What we're left with is around 100 or so banks selling below book value.

M&F Bancorp (MFBP) is one of those banks selling for less than book value, quite a bit less.  The letters in the bank's name stand for Mechanics and Farmers, which is also the name of their bank subsidiary.  The bank is located in North Carolina and has seven branches located in the major metropolitan areas of Charlotte, Raleigh, Durham and Winston-Salem.

On the bank's website they have a page describing their corporate mission.  The bank's mission contains 13 things they are focused on, the last bullet point is profits.  This is a fitting placement, the bank is profitable, but they clearly aren't working to squeeze profits from anything possible.  The bank is profitable and trades for about 8x earnings, and while that's nice what's even better is their discount to book value.

The bank has a market cap of $7.6m against tangible common equity of $24m and a book value of $36m.  They bank is selling for 30% of their TCE which is low, especially for a profitable bank.

I mentioned in a previous post that I try to break an investment thesis down to a few simple pivot points.  We first need to ascertain whether M&F Bancorp is on the edge of extinction, if they aren't then we can proceed to establish a value for them.

There are two interrelated things that can kill a bank quickly, bad lending and too much leverage.  A bank can operate through good years with a lot of leverage if they don't engage in reckless lending.  Bad lending will destroy any bank, and it'll destroy banks with a low capital cushion much quicker.  A bank with a higher capital cushion can weather a bigger storm, but if enough of their loans are bad the bank will eventually be taken over by the FDIC.

In the case of M&F Bancorp much of their depressed valuation can be traced to their lending quality.


The above picture shows the holding company's asset quality statistics for the last six semesters.  Non-performing assets as a percentage of total assets were at the elevated level of 6.22% in 2011.  In general I try to avoid investing in banks with NPA/Assets much higher than 3%.  Although exceptions can be made, especially when the bank's portfolio is moving from troubled to normalized.

Here's another more extended view of their non-performing loans going back nine years:

The company's problem loans peaked at 8.09% of total loans in 2010.  I dug further into the bank's loan portfolio to determine where they struggled with lending.  It's not uncommon for a bank's non-performing assets to spike if one or two of their large commercial loans run into issues.  Commercial loans are riskier than residential loans, and if business conditions are difficult it's not unusual for a company to default or defer interest on a loan.  Business loans are larger than residential loans as well.  A business might need to finance a million dollars for expansion, whereas a million dollar residential loan is rare.

M&F Bancorp's lending issues weren't related to commercial lending, they were with real estate loans unrelated to individual borrowers.  The details of their actual issues aren't public, but it looks like they might have done a lot of lending for multi-family residences which ended up facing issues.  The loans never went bad, they were eventually restructured and the loans are now performing.

The bank has been continuously profitable for the past nine years, and coupled with the sizable capital cushion of 10% core capital, and 15% Tier 1 I think we can safely establish that the bank isn't going out of business any time soon.  And with their loan portfolio under control they aren't heading for a capital injecting anytime soon either.

With that we've established the first pivot point for this investment, that they are a viable company and should continue as a going concern.  The second task is figuring out what they're worth.  This is a much simpler task.

My general rule of thumb is that a profitable bank with an average loan portfolio should be worth at least book value.  When I first started writing about banks I was taken to task over this presumption.  I received comments and emails justifying why 50% of book value is a fair value for a profitable bank. I still disagree with that assessment, and the market does as well.  As I mentioned above the pool of banks selling for less than 1x book value is quickly shrinking.  Secondly the bank M&A market seems to be firmly established around the 1.5x TBV metric for acquisitions.

The great news is that M&F Bancorp is selling at such a depressed valuation that even if it were only worth 50% of TBV that would mean a 50% gain for investors buying at current levels.  I suspect that this bank is worth much more than 50% of TBV, but to get the numbers to work we don't need an optimistic scenario.

If you're interested in seeing how CompleteBankData.com can simplify your bank research, or help you find profitable bank investments sign up for a trial and see for yourself.

Disclosure: Long MFBP

Tuesday, April 1, 2014

How I manage my portfolio and keep track of 50+ stocks

I never set out to create a series of posts outlining the basics of my investing philosophy, but it appears to have happened.  This post joins the past two and fills in some gaps on how I implement my investment style.  I also wanted to take some time to answer a question I get asked a lot, how do I actually manage a portfolio with more than 50 stocks.

I've heard it said that a typical NFL game's outcome can be broken down to three pivotal plays.  What this means is you can go back and review a game and there are usually three plays where if they went the other way the losing team would have won.  Sometimes a game can hinge on less than that.  The outcome of one play can change a game from a loss to a win, or a win to a loss.

It's my belief that most successful investments are similar, their outcome and success can be distilled down to a few important factors.  If I can't simplify an investment to a small number of pivot points I will pass on the investment, because monitoring the company and estimating an outcome is too difficult.

Let me explain with a few examples.  The easiest example is a net-net, or a company trading below book value.  There are a lot of different things investors can research about the given companies, their margins, their competitors or their management.  The first question I ask is whether the company is worth NCAV or BV?  If it is then why isn't it trading there?  If a company is worth their asset value then the next question is what will it take for the company to trade there?  Most of it time it's just that the market needs to recognize value.  After I've determined the company is undervalued and I need to be patient all I need to monitor is that business continues as usual at the company.

Distilling an investment down to a few pivotal facts makes following a company easier and also simplifies the selling decision.  If I determine a company has an undervalued piece of real estate and suddenly the real estate is sold then it's time to sell.  If I think a CEO is holding the company back and they're replaced and nothing changes then I need to sell.

My goal is to reduce an investment idea to a set of factors that if true would validate the thesis and result in a gain, and if false would invalidate the idea.  Keeping an investment simple isn't just a matter of simplifying the investment idea, it also includes investing in simple companies.

Readers are aware that most of the time I invest in small companies, usually because that's where opportunities exist, but also because they're easy to understand.  I have two annual reports on my desk from small unlisted companies, both are 15 pages or less.  I can read and analyze the companies in a half hour at the most.  One of them sends only an annual report, the other sends an informative letter quarterly plus the annual report.  The time commitment for both of those companies is about an hour a year at the most.  I can spend an hour a year and keep up with two companies that I'd like to own at a lower price, right now I own single shares of each to stay on their mailing list.  I have a few dozen companies like these two.  They send out short annual reports and it doesn't take many hours to keep up with them.  I also like to scan through the OTC Markets financial reports page.  I will open and read or scan the filings for any company that's filing within the past few weeks.  I can usually read and keep up on dozens of companies without much time spent.

Finding easy to understand, easy to follow companies whose investments hinge on a few factors is one thing, fitting them into a portfolio is another.

Just as investors like to classify themselves as certain types, readers seem to classify me as well.  I'm often thought of as a net-net investor, or maybe a low P/B investor, or a bank investor.  I certainly invest in those types of stocks, but I don't limit myself either.  I manage my portfolio in a somewhat unique fashion.  It's hard to build a portfolio around one specific type of investment idea.  What does a spin-off investor do when there are no spin-offs?  What does a net-net investor do when there are no net-nets?  I guess they'd sit on cash until those opportunities arose again.

What I have done is to divide my portfolio up into a number of different styles.  Low P/B stocks, cash box stocks, net-nets, banks, quality companies I'd hold etc.  My goal is to never let any of these specific strategies overwhelm the entire portfolio.

Dividing my portfolio allows me to diversify across strategies, and it also allows for new investments when one strategy starts to top out.  Right now in the US there aren't many net-nets left, but that's fine, I have been finding cash boxes, some special situations and a few attractive banks.  I'm still able to buy cheap companies even though there aren't net-nets abounding.

The last thing investing like this does is it allows me to compare and fit new investments into a framework of existing investments.  If I'm looking at a bank stock I can compare the bank's relative value to the other banks I own.  If the bank is more expensive than my current holdings I need to either know why it's worth holding or reconsider the position and add to an existing position.  I do the same with all of the other types of investments I own.

To end this post I distilled my approach into a few simple bullet points:


  • Follow companies that are simple to understand.
  • Follow companies that publish short annual reports that are quick to read and easy to understand.
  • Invest in multiple strategies, never let one overwhelm the portfolio.
  • Compare new ideas to existing ones

With the above guidelines I'm able to manage my portfolio without spending a lot of time keeping track of what I own.  I can dedicate most of my time finding new companies I'd like to buy.