Sunday, July 20, 2014

The truth about asset investing

Issue 2 of the Oddball Stocks Newsletter has been published and sent to subscribers.  If you're not a subscriber and would like to learn more visit the Oddball Stocks Newsletter website.  If you are a subscriber and didn't receive this issue please send me an email.

Did you ever play the game of telephone when you were a kid?  The game where everyone sits in a line and passes a message along by whispering it to their neighbor.  It didn't matter how many kids were participating, after a few passes a message like "The Indians will win the World Series" would morph into "My aunt Tilda said the world is near us."  My feeling is that the modern value investing view of asset investing is something like the game of telephone.  Between what Benjamin Graham initially wrote in Security Analysis and what we're telling ourselves today something has been lost.

Asset based investing is commonly referred to as cigar butt investing where investors gamble that a depressed stock has 'one last puff'.  The idea is that down and out stocks selling for less than their asset value will sometimes experience what amounts to a dead cat bounce.  Investors are supposed to watch their basket of depressed stocks like a hawk and trade opportunistically to reap the gains.

I've read countless blog posts that describe a company who's assets are melting away like an ice cube  as a Graham-type value play.  The gross mis-characterization of Graham's asset plays has always bothered me.  I realize that Security Analysis is considered a classic text, which means that everyone is aware of it, but no one has read it.  In response to seeing this mis-characterization recently I went back to Security Analysis (6th edition) and re-read a few of the chapters on asset based investing.  I believe a lot could be learned by investors from just reading these few chapters.

Because I know most of my readers won't be reading Security Analysis I've decided to provide a few quotes that illustrate what asset investing should be.

First a definition of liquidation value:

"Liquidating Value.  By the liquidating value of an enterprise we mean the money that the owners could get out of it if they wanted to give it up.  They might sell all or part of it to some one else, on a going-concern basis.  Or else they might turn the various kinds of assets into cash, in piecemeal fashion, taking whatever time is needed to obtain the best realization from each." (p559)

A common complaint about stocks trading at a discount to their asset value is that they have poor earnings, don't cover their cost of capital.

"Common stocks in this category practically always have an unsatisfactory trend of earnings." (p564)

Graham discusses that stocks selling below NCAV have many potential catalysts that could result in value being unlocked including, general industry improvement, a change in operating policies, a sale or merger, complete liquidation, or a partial liquidation.

Finally Graham discusses that even though many of these types of stocks are cheap they need to be approached with caution:

"Nevertheless, the securities analyst should exercise as much discrimination as possible in the choice of issues falling within this category [below NCAV].  He will lean toward those for which he sees a fairly imminent prospect of some one of the favorable developments listed above.  Or else he will be partial to such as reveal other attractive statistical features besides their liquid-asset position, e.g., satisfactory current earnings and dividends or a high average earning power in the past.  The analyst will avoid issues that have been losing their current assets at a rapid rate and show no definite signs of ceasing to do so." (p568-569)

What can we learn from this?  A company's liquidation value is a rough approximation of what value might be realized if management either sold the company entirely or broke it apart.  Many companies that trade for less than their liquidation value are not great companies, if they were they wouldn't be selling that cheap.  Investors should prefer companies at less than NCAV where NCAV is at least stable, if not growing.  Preference should be given to companies that are growing both earnings and asset value.

Instead of speculating on last cigar puffs the texts from Security Analysis paint quite a different picture.  They show an investor carefully examining a stock like a business and making a purchase if the business is of at least average quality and selling at a reasonable discount.

I recognize that asset based investing isn't for everyone.  Some investors aren't comfortable investing like this.  That's perfectly fine, there isn't one correct way to invest.  But for those who have heard, or read about asset based investing I wanted to clarify some of the misconceptions surrounding it.

Disclosure: I receive a small commission if you purchase anything through Amazon.com.

Monday, July 14, 2014

Enterprise Bank, a case study in the potential pitfalls of bank investing

A general misconception I've sensed is that value investors who aren't buying Buffett-type companies are usually lumped into a distressed turnaround category.  Our investments are the proverbial one foot  in a hole and one foot on a banana peel.  A mistake or two away from a complete loss.  I know I've been placed in this category many times, and I think many readers believe I'll buy anything as long as it's cheap.  It might be a surprise to some, but that's not the case.  I prefer to buy undervalued companies that don't run the risk of going out of business.  Sure, the occasional good company at a cheap price might find its place into my portfolio, but more often it's an average company at an excellent price.

Enterprise Financial Services Group (EFSG) is a great example to show that not everything that's cheap is an attractive purchase.  The company has a market cap of $5.7m against a book value of $18m.  Their P/B ratio is 32%, and P/TBV is 44%.  The bank is profitable and trades with a P/E of about 8x.  The bank is undeniably cheap, they are trading at a low valuation of both earnings and their book value, both tangible and otherwise.

Purchasing a company at 44% of TBV should in theory give an investor a margin of safety.  This is the buffer between their current market price, and an investors estimate of fair value.  The concept of the margin of safety is to allow for investor mistakes and errors and still enable an investor to profit.  In most cases a company at 44% of TBV and 6x earnings would indeed have a considerable margin of safety.  But Enterprise Financial Services Group isn't a normal company, it's a bank, and in banking there are other factors that need to be considered as well.

Enterprise Bank is a small one branch bank located a few miles north of me in the suburbs of Pittsburgh.  Their branch is fairly unique, it's a plain office building located next to a heavy equipment rental, and a kids play facility (giant inflatables, indoor playground).  If it weren't for the tiny sign announcing their presence most people wouldn't even know it were a bank.

Enterprise Bank is a great example of potential pitfalls that can trip up a bank investor.  The bank specializes in small business lending.  The bank has $217m loans, of which $20m are for 1-4 family loans, typical single family mortgages.  The rest of their loans are for commercial real estate and commercial ventures.  The bank describes itself as a specialized lend for turnaround financing and startup financing, both categories of risky lending.  For the risk the bank takes on their loans they earn comparatively low rates.  Their yield on earning assets was 4.66% as of Q1 2014.  This is much lower than I'd expect for a company that specializes in lending to borrowers whose future ability to repay loans is suspect.

The bank's funding isn't the more common low cost and stable consumer deposits, but rather wholesale funding via brokered CDs.  The wholesale market is problematic for two reasons.  The first is the funding costs are much higher than what could be achieved via a sticky retail deposit base.  Enterprise Bank is paying .93% for their deposits.  The average funding cost across all banks in the US was .31% as of the last quarter.  Enterprise Bank is paying almost three times more for access to funds compare to the rest of the US banking industry.

The second reason that wholesale deposits are problematic is because they aren't sticky.  Investors putting money into brokered CDs shop for the highest rate.  When a bank's rates aren't competitive they have trouble attracting deposits.  Banks relying on hot money for funding end up in a vicious cycle where they are continually fighting to attract consumers with higher rates, which are costly to the bank.  The types of customers the bank attracts are not the ones a bank would want.  These customers purchased the product for the rate, and when the bank's rate lags competitor's rates many customers cash in their CDs early and move their money.  Wholesale deposits are not a cheap or stable funding source.

If the bank only had a poor deposit base, and a concentrated commercial loan portfolio then their valuation could be potentially attractive.  While the commercial concentration and wholesale funding are not ideal those aspects alone don't merit a 70% discount to book value.  What does merit such a discount is the quality of their loans.

Banks are highly levered companies, and with leverage comes risk.  Enterprise Financial Services Group has a TE/TA (tangible equity/tangible assets) ratio of 5%.  In layman terms this means the company is leveraged 20:1.  The bank's Tier 1 capital ratio is 10.7% and total capital 11%.  The bank's Tier 1 capital also includes their preferred stock as well as loan loss reserves.  Note the difference between the holding company's leverage and the underlying bank's leverage.

The bank's holding company owns a real estate broker, a machinery rental company, an IT consulting firm, a CFO consulting practice, and an insurance brokerage as well as the bank.  From a regulatory standpoint the underlying bank looks alright, although not ideal.  The company doesn't break out the financials for their other businesses, but based on the bank and the holding company information we can surmise that their other companies don't have much in the way of assets, or earnings, but do have debt related to their operations.

Leverage can cut both ways for a bank, when times are good it can allow them to earn outsized profits.  When the environment changes a small percentage of loans gone bad means shareholders can loser their investment.

Enterprise Bank reports that 5.29% of their loans are non-current, which is about $11.4m in nominal terms.  The bank has $2.3m reserved for loan losses.  All things considered their loan losses aren't terrible given that the bank is engaged in speculative venture stage and turnaround lending.

The company's absolute level of loan losses is concerning, but there's something a bit more subtle that's even more concerning.  The company makes mention in their 2013 annual report of an accounting change that their regulator, the FDIC forced them to make.  The change is that the bank is now forced to classify their loans after interest hasn't been paid after 90 days rather than wait for an impairment.

Banks are required to classify loans into different categories quarterly (or more frequently) based on the probability of repayment.  Most loans are classified as satisfactory, this means the loan is current and interest is being paid.  For most banks in the US if borrower fails to make a payment on a loan after 30 days the loan moves from current to non-current and is classified.  Banks bucket loans into 30-90 days past due, 90 days past due, and non-accruing.

Enterprise Bank wasn't classifying loans until the bank had considered them impaired.  In the past the bank would consider a loan performing until all hope was lost and they finally impaired it.  Loans that hadn't paid interest for months might be considered current.  It worries me that in the past the bank was only considering a loan classified when it was impaired.

The last item that the bank mentioned that helps justify their valuation is the impact of Basel III.  The bank said they will be about 10% short on Basel III capital requirements.  Instead of raising capital they suspended the dividend and instituted a pay freeze.

The fact that the bank is so close to capital inadequacy under Basel III, and that they had previously been lax in classifying loans is what made me pass on this bank as an investment.  Maybe everything will go well in the future and this is a good value.  But I don't invest based on rosy scenarios, I want to make sure companies I invest in can weather a storm or two, and a potentially bad storm.  I'm not convinced that Enterprise Bank can weather a strong storm.  So even though the bank is trading for a very low valuation this doesn't look like a safe investment to me.

Disclosure: No position

Monday, July 7, 2014

Selling cheap to buy cheaper

I apologize for the lack of recent posts, in many ways it' a bit unusual.  I started this blog in 2010 and became serious about blogging during 2011.  Since then I set a goal of posting twice a week.  If you look at my post history you can see a giant gap over the last few weeks.  We took a nice long summer vacation and I decided to abstain from posting while away.

We drove from Pittsburgh down to New Orleans to visit my brother, his wife and our new nephew. Then we headed over to Pensacola for some time at the beach.  Before this trip I hadn't spent any time in the Deep South.  It was really nice, we had a great experience.  We had some good food, relaxing days, and I was even able to meet up with a reader for coffee, which was awesome.  While away my inbox filled up and I kept my eyes off the market.

Now that I'm back I want to get back into my two posts a week routine; here's to starting!

A friend emailed me recently musing about buying when the market is falling.  It might sound like a strange topic to discuss when markets are soaring higher, but it's always good to be prepared.  My friend asked my thoughts on selling cheap stocks to buy cheaper stocks in the midst of a downturn.  In his view this is the ultimate act of a investor.  The ability to ignore emotions and sell stocks that at other times would be considered extremely attractive for stocks that one deems are even cheaper.

If an investor wants to have the ability to sell a cheap stock and purchase a cheaper one they must have some sense of potential value.  Is a stock at 50% of book value cheaper than a stock at 60% of book value?  Not necessarily.

Some investors (the disciplined ones) keep spreadsheets of all of their holdings and what they feel is the discount to intrinsic value of each holding.  The investing cowboys, of which I am one, tend to play it a bit more loose.  No spreadsheets are necessary, just a rough gut feel of when a stock is getting a bit frothy.  My own process works as follows.  I will initially research a stock and often will write a post about the stock.  The purpose of the post is to help formulate my thoughts on an idea, and to preserve a record of my initial thinking.  If I like the stock I make a purchase and usually forget that I even own it.  I don't follow the news for stocks, or set alerts.  I will check my entire portfolio on  a semi-regular basis.  I check each stock for news or activity and then go back on ignore mode.  If during my check I notice a stock that's run up significantly I will look for news, and evaluate if I need to sell out of the position.

When considering my investments against each other I like to look at what I consider their potential value.  This is the stock's undervaluation plus their business value.  In Security Analysis Benjamin Graham discusses selling a stock after three to five years if it hadn't reached intrinsic value.  I want to walk through an example of how I calculate potential value.  Let's take a stock at 60% of book value that's earning 3% on equity.  Many readers bash stocks I pick with low returns on equity, but maybe understanding how I view things will help to clarify why some of these low ROE companies can be good investments.

Take the example of a stock that has a book value of $10 and is selling for $6.  The company earns $.30 a year, or 3% on equity.  If the stock reaches its intrinsic value in five years, our maximum holding period, the investor would earn 19% a year.  Between year one and five the company grew their equity at a paltry 3% a year.  Five years of 3% book value growth equals $11.59 in book value at the terminal date.  If an investor held the entire five years, and the stock rose to book value they'd realize a gain of 93%, or 19% a year over their holding period.

The above example shows how even poor companies that don't earn their cost of capital can result in significant gains if the company's market price eventually reverts to intrinsic value.  Of course nothing is guaranteed, and not all investments drift up to what a reasonable investor might consider intrinsic value ever.  At times management is directly opposed to shareholders and works to keep the value of the company low.  Other times there are structural factors that keep the value of a company low forever.

If one believes in the concept of mean reversion then this theory holds.  The key variables to the equation are the company's intrinsic value, and the time period of the holding.  If a short time period is used then potential returns increase.  If a longer period is used then potential returns decrease.  There are a few investments I hold where I've figured that even with a 10-15 year holding period my potential returns could be well above 15% a year.  It's situations like that where I'll potentially hold a stock for a decade or more.

So what does the idea of potential valuation have to do with selling cheap stocks to buy cheaper stocks?  It's the only way I can think of that one can rationally rank investments in a way that lets them compare two potentially cheap investments.  I mentioned above that a company at 50% of book value might not be cheaper than one at 60% of book value.  If the company at 60% of book value is earning 8% on equity and the one at 50% is earning 2% the company selling at the initially higher price is cheaper overall over the same holding period.

When a stock appreciates towards what I might consider a fair value I will go through this exercise to determine out what the potential return is for the stock going forward.  My personal hurdle rate is 10-15% a year.  My hurdle probably seems low for most readers, but if I can earn between 10-15% a year for the next 30 years I'd be extremely satisfied.

In a downturn an investor could use the above system to classify all of their investments.  Then evaluate new investments against the set of current investments.  A company with a potential return of 20% a year could be sold to purchase a company with a potential return of 30% a year.

The caveat with this system is that in a downturn it's hard to know what past numbers could be repeated in the future, and secondly you need to invest in companies that will survive.

I want to come full circle and answer my friend's question.  I agree that selling what's cheap to buy what's cheaper is the ultimate test of emotions.  An investor in that situation is facing a portfolio that's  losing value, and they are out of cash if they're in this situation.  They need to ignore their gut and trust the numbers, sell companies with low expected returns and purchase ones with higher expected returns.  I don't know what different in potential return is meaningful, but I think it's an individual preference.  Based on the potential error from estimated time ranges I wouldn't be exchanging stocks for a few percentage point differences in potential returns.  But I would exchange something with a 15% potential annual return for something with a 30% potential annual return.

In my own portfolio I like to keep 5-10% in cash at all times.  I feel this gives me the ability to act quickly on a new investment idea should I come across something attractive.  I haven't found my cash levels to be correlated with the market levels in generate.  I'm currently floating closer to the lower end of my cash cushion, whereas a year or two ago I was closer to 15% in cash.  As opportunities become available I take positions.  And if the opportunity has a potential annual return of 10-15% I will seriously consider a place for them in my portfolio.