Recent interview and podcasts

I recently began co-hosting the Bulldog Investor Podcast with Fred Rockwell.  For anyone who didn't know I was doing this I wanted to share the four recent episodes that I've been on.  Each episode is linked with a short description.

  • Interview with Tim Melvin discussing community banks and banking: Episode here
  • We talk with Tim Stabosz about risk in value investing.  An interesting discussion about distressed turnaround stocks takes place: Episode here
  • John Huber of Base Hit Investing joins us to talk about compounding machines, undervalued stocks, portfolio management and Bank of Utica: Episode here
  • We talk to Philippe Belanger of Espace MicroCaps about finding investments in Canada: Episode here

July Benzinga Interview

Last Wednesday I had the chance to be a guest on the Benzinga PreMarket Prep show again.  The interview can be found below.

Neglected or distressed?

There is a common perception about value investing that it involves purchasing shares of companies on the brink of financial ruin with the hope they turn around.  Viewed through this lens value investing is risky and the value investor one step away from experiencing individual ruin as their investments go bad all at once.

It's not hard to see where this perception could have come from.  In the world of academic finance where everything can be reduced to a formula investment returns are a product of risk.  Riskless assets generate no returns whereas supposedly risky assets generate outsized returns.  Financial practitioners know what the academics don't, that life isn't a set of formulas.  Assets that appear safe can turn out to be risky, and assets that appear risky might be safe.

The question is how can an investor find a safe asset for a depressed price?  The answer to that lies in the distinction between different types of value investments.

In general low priced stocks can be broadly grouped into two opportunity sets: distressed investments, and neglected investments.

Distressed Investments

A distressed investment is any investment situation where the company is experiencing either business/operational distress or financial distress.  These are the stereotypical "value" investments.  Companies with operational difficulties trading at extremely low valuations.

An investment in a distressed company hinges on a few factors.  The first is an investor needs to be able to determine whether the market reaction to the company's results is too pessimistic or if they're accurate.  Then the investor needs to be able to determine if the company can recover from their operational difficulties.  If an investor can determine both of these factors correctly it's likely they will be able to do well investing in distressed investments.

The trouble with distressed investments is determining when the future of the company doesn't look like the past.  When a company faces a fundamental operating issue they need to innovate and solve their issue.  If they can it's likely results in the future will resemble the past, or might even be better.  If the company has a culture that can't react to their situation the chance that the future looks like the past becomes very small.  Short sellers like to look for companies that have stumbled and don't have the business-DNA to reinvent themselves.  Whereas distressed investors are looking for companies with that reinvention DNA.  It's worth noting that very few companies change their business from one industry or market to another successfully.  In many cases the odds are on the short sellers side.

Many novice value investors will find a distressed opportunity and presume the future will look like the past when in fact the business itself is undergoing a dramatic shift and it's likely the company will never recover their former glory.

With all these pitfalls distressed investing can be extremely profitable if done right.  A company on the brink of bankruptcy and trading at 10% of book value might return 500% or 1,000% if they avert disaster.  Where there's a chance for outsized returns there is also a chance for a complete loss.  Companies straddling a thin line between solvency and bankruptcy court usually don't leave much residual value for shareholders.

Even though equity investing in distressed situations is risky one method to reduce risk is to invest is at a higher level in the capital structure such as through preferred stock, or debt.

Neglected Investments

I feel that distressed equity situations tend to have binary outcomes, either the company will do exceptionally well, or a tax write-off is in short order.  I prefer a different type of value investment, the neglected company.

A neglected company is one that the market has mostly, or completely forgotten about.  Sometimes the company's business is so boring it's hard to generate investor excitement.  Investors, and especially the financial media likes whatever is popular or cutting edge.  A landscaping company that schedules appointments via an iPhone is suddenly the Uber of landscaping.  Whereas the hordes of other landscaping companies quickly fall into the camp of neglected investments, regardless of their investment merit.

The majority of my best investments have been neglected companies.  Companies that are profitable, growing, and trading at depressed valuations because no one knows or cares about them.

In many ways a distressed investment is the opposite of a neglected investment.  Companies that are neglected usually don't release news..ever.  Neglected companies don't hold conference calls, and sometimes it's hard to even obtain financials for them.  Neglected company CFO's are surprised any investors exist, especially ones that have intelligent questions to ask.

Distressed investors often live and die by the news flow.  One news release or announcement can mean the difference between a vacation in the French Riviera or a stay at the Days Inn at the Jersey Shore.

Neglected investments don't appreciate 3-5x in a year, but they might compound in silence at 15% or 20% for decades, all while trading at a large discount to book value.

An investor interested in neglected companies doesn't need to predict the future.  They just need a reasonable assumption that the future will be similar to the past.

The advantage to an investor looking at neglected investments is that these investments are not as risky.  Neglected companies aren't facing an existential crisis.  They can be great companies just operating outside the limelight.

Which is best?

I'm not sure there's a best way, but it's important to understand the differences in each investment you look at on a stand alone basis.  The worst mistakes happen when an investor believes a distressed company is merely neglected.  When this happens the investor misses a significant source of risk in their investment.  The converse can also be true.  An investor mistakes a neglected company for a distressed investment and never invests.  There are many neglected companies silently grinding out significant returns for shareholders.

The Solitron proxy battle heats up

The proxy battle between Solitron management and Eriksen Capital Management has reached new heights.  Solitron is clearly worried that they will lose this battle, and I expect them to.  They've hired an investment relations firm to send shareholders a letter containing their view on Ericksen's nominees.

Eriksen Capital hit back hard with a proxy filing today.  I will let Eriksen's own filing do the talking in this post.

The filing is here.

"Based on SEC filings, Saraf became CEO in December 1992. During the quarter Mr. Saraf was hired (12/1992 through 2/1993) shares traded as high as $8.12 and as low as $3.43 per share, adjusted for the reverse stock split. Solitron’s share price as of June 30, 2015 was just $4.47 per share. Thus under Saraf’s twenty two and half years of leadership, Solitron shareholders total return would range between a loss of 41% and a gain of 39%, including dividends. In comparison the Russell 2000 index, which covers small cap stocks, has risen over 669% since January 1, 1993 through June 30, 2015. Clearly, Solitron’s board has some serious performance issues that they are probably embarrassed to discuss."

"Summary of the facts:

1.  In 1992 Shevach Saraf was named President and CEO of Solitron Devices. The company was in Chapter 11 bankruptcy at the time. He was granted a very generous package that granted him a good salary, 10% ownership of the company at no cost to him, and ten year options to purchase 8% of the company.

2.  Prior to Mr. Saraf becoming CEO in late 1992 the Company made contributions to its 401k and Profit Sharing Plan to help employees in preparing for their retirement. Since becoming CEO, Mr. Saraf has received over $1.6 million in profit related bonuses, in addition to his generous salary. During that time, the company has made zero contributions to the 401k and Profit Sharing Plan for its employees.
3.  For nearly twenty years, from 1993 to 2013, CEO Shevach Saraf and the Board did not hold annual meetings even though Delaware corporate law requires it. From 1996 to 2013 the only directors were Mr. Saraf and two others appointed solely by him after his own term had already expired, and, based on a careful search of SEC filings, it seems clear none were presented to shareholders for affirmation.

4.  In 2000, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors voted to approve an employment agreement granting Mr. Saraf 15% of Solitron’s earnings in excess of a fixed $250,000 per year. The employment agreement also granted the CEO an automatically renewing five year contract along with generous change in control benefits.
5.  In 2000, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors granted a massive stock option plan, without shareholder approval, primarily for Mr. Saraf’s benefit. By our calculations 64% of options granted went to CEO Saraf, and 12% to the other directors.
6.  CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors granted these massive options to him at ridiculously low prices. The first grant issued in December 2000 was for 10% of the company’s shares, and was priced at just one-third of book value. The second grant issued in May 2004 to replace the original 1992 grant, was for 8% of the company’s shares, and was priced at a substantial discount to book value. 3

7.  In 2007, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors approved a second 700,000 share option plan without shareholder approval. Thankfully Solitron has not issued shares on it, but they did recently file with the SEC in order to do so. One of our requests to the Board was that they put the plan up for shareholder approval at this year’s annual meeting. They refused. Wonder why?

8.  CEO Saraf’s option grants under the 2000 Stock Option Plan had ten year expirations from the date of the grant. Just prior to expiration, the Board changed the grants to having no expiration even though the plan expressly forbade such action. While Section 10(a) of the 2000 Stock Option Plan grants the Board the right to extend an option grant, it expressly states “that in no event shall the aggregate option period with respect to any Option, including the initial term of such Option and any extensions thereof, exceed (10) years.” No amendments to the Plan were ever filed, and we would add that an attorney representing Solitron stated in a letter to us that “I understand that the 2000 Stock Option Plan has not been amended since the date of its public filing.”

In case you weren’t keeping track. CEO Saraf was granted 10% of shares at his hiring for free. He was later granted options for another 18% of the company, plus 15% of profits in excess of $250,000 per year. If you add that up it is up to 43% of economic gains in addition to his significant $321,500 annual salary. By our calculation, CEO Saraf has received nearly half of Solitron’s economic gains during his twenty plus year tenure.4 Yet Solitron has the audacity to slander Mr. Eriksen and Mr. Pointer as “opportunists” who “care only about themselves.

Disclosure: Long SODI