Why is it that businesspeople and investors see businesses differently? A friend mentioned a derivation of this analogy to me years ago and I brushed it off. But recently I started to think about it again, and the simplicity of it hit me as brilliant. As an analogy there are obvious flaws, but maybe, just maybe this will be good enough to become a framework, or a mental model, or latticework, or whatever other trendy thing analogies are now called.
I present to you The Box.
Think of every business as a box, a very simple box. The box takes inputs, these inputs are materials, labor, or really anything. The box outputs a something. Some boxes create things for other boxes and some boxes create things for people. These boxes all live together in their box world.
Every box can be described the exact same way with three statements, a balance sheet, an income statement and a cash flow statement. These three statements describe everything the box is doing. It describes the items the box is purchasing from other boxes as well as the output of the box itself. The statements describe what the boxes are doing inside the box.
Using the same three statements every box can be compared to any other box and measured against any other box. In the box world there is an industry of box watchers. The box watchers aren't allowed to look inside any of the boxes. Although from time to time a box watcher will take a peek inside a box, or talk to someone who works in a box.
To the box watchers all boxes are the same. They all have inputs, produce output and can be described the same way. Box watchers are hyper focused on the size of the box. Is the box growing or shrinking? Box watchers live for the four times a year that the boxes produce their description statements. Box watchers believe that boxes should combine with other boxes, or at times cut themselves in half. Small boxes should combine with other small boxes, but once a box is too big it should split itself apart. The combinations rarely alter anything inside the box, or change the box's inputs or outputs, but that doesn't matter. These combinations and reductions are important to the watchers.
For a box watcher differences in a box's input and outputs can be described with simple mathematical formulas. They believe that two boxes the exact same size should be described the exact same way with their financial description documents. After all, if both boxes have the same inputs, are the same size, and produce the same output how could their financials be different?
The reality inside of each box is much different than what box watchers see. On the outside a box is a box is a box. It's inside that box where the action happens.
Each box is completely different, no two boxes have the same workers, and the workers are what set each box apart. The managers who are in charge of the boxes are worried about securing their box's inputs and making sure production inside the box continues. Workers are fickle. They are constantly dealing with issues related to other workers and outside issues (with family, friends, and relatives). Sometimes workers have kids who get sick, and the sick kid preoccupies their mind for the day reducing output. Other times workers don't get along but are forced by a manager to work together. The output from feuding workers is drastically less than the output from workers who enjoy each others company, or workers who have complimentary skills. All of these preoccupations and personality conflicts multiply across the box. It is rarely one issue that impacts inefficiencies, but hundreds or thousands of issues, all different, all happening at once.
Box managers spend most of their time worrying about issues related to their workers. And when it's not their own workers it's workers from other boxes. Sometimes the workers of a supplying box are so distracted their quality suffers and downstream boxes are forced to implement processes and procedures to handle the poor quality inputs.
Inside the boxes everything can be reduced to a people problem. It's the people who work together that take the inputs and generate the outputs. It's the people at other boxes that consume the output, and people at other boxes that create the inputs. Inside the box world what's happening takes the backseat to people. People are everything inside the box world. A motivational manager is the difference between underperforming workers and performing workers.
Boxes themselves are interchangeable. A box with a specific input can find that input as the output from a number of different boxes. Likewise what a box produces can be consumed by people or other boxes, interchangeably. It's different inside a box. People are an ecosystem. They aren't interchangeable. People have specific skills and personalities, taking a person from one box and putting them in a different boxes doesn't mean the results generated in the first will follow to the second.
What frustrates box watchers is they don't understand what's happening inside the box. To them all boxes are the same. Boxes that are shaped the same and do the same things should have the same results given a set of inputs. To a box watcher fixing outputs is as simple as fixing the inputs and tweaking a few items on the financial statements.
Box management is frustrated by the box watchers. Everything is so simple to the box watchers, if only those watchers knew what happened inside the box! Box managers try to appease the watchers by using their terms and superficially managing inputs and outputs, but box managers know that changing the box's financials isn't as simple as rearranging the inputs and outputs. Box managers know that production is efficient because of their people, or that production is inefficient because of a few people. People that need to be nurtured and coddled and dealt with individually.
Box watchers can exert enough pressure that a box tries to change itself. It rarely works, the box is the way it is due to the people it has. The only way a box can reinvent itself is by gutting the inside of the box and starting over. A process that isn't much different than creating a box from scratch.
It should be apparent that the box watchers and box dwellers will never see eye to eye. They won't because they're looking at different things. Inside the box (business) employees are concerned about the day to day operational aspects. The box watchers (investment analysts/investment industry) is only concerned with the financial statements the businesses produce. Without the detailed operational knowledge about what happens in a business an investor can only make broad claims and judgements.
The danger to investors is when they adopt the box watcher mentality. Box watchers are paid to watch boxes, not produce investment returns. Investors are paid by understanding what happens inside the box. A curious quirk to this entire analogy is that one doesn't need to become an expert on what's in the boxes to take advantage of this knowledge that each box is different. Some investors recognize this situation and believe the key to earning outsize returns is to know who is in each box and what they're doing. My own view is that this is the wrong approach.
The right approach is to understand that what happens in each box is different, but why things happen isn't as important as understanding the differences reflected in the financial statements. Understanding the differences between the boxes is fundamental to making an investment decision. Ineffient boxes will rarely become efficient boxes. And efficient boxes will probably remain efficient . Don't invest in an inefficient box thinking it'll become efficient, instead incorporate a discount or premium for these differences. Just because a box is inefficient doesn't mean it doesn't have value either.
In most houses there is a closet, or a cabinet where miscellaneous things are stored. And by stored I mean they're shoved into this space carelessly and needlessly never to be used again. When people are placing objects in this space it's common to think "I might need this again so I can't throw it away, but I don't need it now, and won't for a while so I'll store it.." Depending on ones discipline these storage spaces can vary in size from somewhere small such as the corner of a desk to consuming an entire house. Portfolios mimic these storage spaces with positions that we haven't given up on yet, but just haven't realized their potential yet. Maybe we'll need the position later, but surely it isn't doing anything now.
Deciding on when to give up on a stock is a difficult choice. But to get there we need to have a short discussion on liquidity. In true John Kerry circa 2004 fashion I'm about to conduct a "flip flop." In the past I've claimed that a stocks are/can be cheap because of illiquidity. I've come to realize that illiquidity isn't something that manifests itself on its own, it isn't a force like gravity. Instead illiquidity is a symptom of something wrong with a company.
The narrative in the market is that companies become illiquid because they're boring, old fashioned, or "too small". In a minority of instances there are structural issues that results in the lack of liquidity. A structural issue might be one where an insider owns 95% of the outstanding shares and the shares trade for $1,000 per share each. But these situations are true outliers. Most illiquidity is due to company specific issues.
What causes investor excitement and creates a situation where someone might want to trade a stock? Why is GE liquid? Why is Fastenal liquid? They are both boring industrial companies that most investors would have a hard time explaining. Fastenal makes nuts and bolts. I've never witnessed someone standing in the bolt aisle of Home Depot pondering which brand of bolt is the most rugged. I've never seen marketing material that proclaims "We use Fastenal bolts which leads to superior quality." I guarantee if I went down to my garage and examined every nut and bolt in my tool chest I wouldn't find a brand name stamped on any. But somehow there is excitement around this brand and the stock is liquid.
If a company can generate repeatable returns and shows growth it creates investor excitement regardless of the industry or product. That excitement is quickly socialized throughout the investor world and other investors want to buy into that excitement. The increased interest provides a ready source of buyers for current stock holders creating liquidity. Sometimes it isn't excitement that investors crave, it's a dividend yield, or stability, or a historic brand name. But there is a factor that generates interest, and the interest leads to a positive feedback cycle. This is liquidity.
Illiquidity is the exact opposite. The company has a deadly sin that they're carrying around with them. Some investors discover this sin before they buy and decide to pass. Other investors don't recognize the gravity of the situation before they purchase their shares. A few quarters or years later they realize the error of their ways and look to sell, but there are no buyers, most everyone else has identified the cardinal sin and refuses to buy. They refuse to buy unless the price is low enough to overlook the sin. And even then most investors won't buy. This "sin" can range from withholding information to overpaid management and anything in between.
A friend and I were recently discussing how people have different perspectives on potential deals depending on where they live geographically. In general when presented with a deal people who live in the East and in cities have the following response "This looks too good to be true, I wonder what the gotcha is? How am I being played?" They approach a deal skeptically until it can be proved otherwise. Whereas in the Midwest and South when presented with a good deal most people think "that's so nice of them to give me an offer like that." I've lived both experiences, and while the 'nice' attitude has never led to any ruffled feathers the cynical attitude has left more money in my pocket.
This same attitude is true for small, cheap and illiquid stocks. Seasoned market veterans see something that rarely trades with a low multiple and think "what skeletons are in the closet?" Whereas less informed investors think "wow, what a great deal! It's undiscovered!"
I can identify with both attitudes. When I first started looking at these stocks I had the second attitude. I thought I was discovering gold for the first time in Alaska. I was finding these giant nuggets laying on the beach. What I found out was starving grizzly bears roamed those same beaches full of gold and I was blissfully unaware that they were empty because everyone else knew it.
Now as a skeptic I look at these illiquid situations differently. I'm cynical and think "what's wrong?" But there's a caveat to all of this. Most investors pass on a stock if there is a bit of hair, I will buy a stock with hair if the price is right. And if the price is that good I will wallow and roll in that hair and enjoy it because I got such a good deal.
Let's just say you purchased a stock with a whoolly mammoth amount of hair, but you also barely paid anything. Maybe the seller even threw in a "free" operating businesses on top of that discounted cash you paid. And you're sitting on this pile of assets for years and nothing is happening. Then one day a tiny thought occurs in the back of your mind "what if nothing will EVER happen?" Thoughts like that are easy to ignore when they're small. But over time a thought repeated becomes magnified until suddenly one day you are convinced that nothing will ever happen to the stock...ever.
It's at this point when you realize you own a stock frozen in time that you're faced with the decision on whether to give up on the name. Sometimes it's hard to give up, maybe the stock is illiquid and you are afraid you can't sell. It's probably illiquid because everyone else knew it was going nowhere already. What do you do?
The starting point on giving up on a stock is the same starting point for purchasing a position. Why did you initially buy the stock? What was the attractive feature? If the original thesis is no longer intact, or it's changed, or morphed, or you forgot why you purchased then it's time to re-evaluate. Look at the company with fresh eyes. Would it earn a spot in the portfolio today? Could you pitch the stock to a friend and by the end of the pitch your friend is getting out their phone to purchase? This "friend test" is only valid if they weren't getting out their Blackberry or Apple Newton the first time you pitched the stock. Pitch a stock to a disinterested friend.
Pitching a stock verbally to someone carries a significant advantage. It forces you to be concise, few friends are going to listen to a rambling treatise. In communicating verbally one needs to get to the most important facts first and elaborate on them with just enough detail to carry the argument. We naturally organize our thoughts in an efficient manner. We start with a hook and then back the hook, or the most important piece of information up with details and fill in gaps. Yet when most pitch a stock in writing readers need to to use a magnifying glass and an hour searching for the point of the pitch.
If a company has completely changed during your holding period it's valid to sell. It doesn't make sense to become sentimental about a stock. Sometimes the company doesn't change at all, but the company's story becomes stale or outdated. A great example of this is a potentially ground breaking company that spends years testing and trialing their product. In the meantime their ground breaking developments are surpassed by other companies in the industry with similar inventions. The failure of the company to release their product quickly led to a situation where other competitors developed a similar product and beat them to the market. The company and their product might be the same, but the opportunity set has shrunk.
I want to deviate and discuss an item of importance related to the last point: companies that have trouble shipping products. Businesses can't make money from promises, they can only make it via shipped products and services. If a company has issues executing and releasing their products the company has a cultural issue, potentially a cardinal sin. Unless a company is developing a new type of rocket engine or advanced satellite system it should be able to ship frequently. But even rockets aren't an excuse, there are startups in the space industry that are frequently releasing new rocket designs.
When a company can't ship a product it's a failure of the personalities involved. I've personally been involved on teams that both release products regularly, and others that fail to do so. The ones that fail to ship are either plagued with poor quality team members, or have high level management issues. If a company hires low quality workers it's a sign of the quality of management. Low quality management hires low quality workers. It requires a complete management cultural shift to change the hiring process. This shift is about as common as snow in July. The best way to hire quality workers is to have a high quality management team that is not intimidated by their subordinates that hires people smarter than themselves.
The single largest reason for a company's failure to ship products is a failure in management. I've seen situations where management is like a piece of grass swaying in the wind. One week they're heading one direction and the next week they've changed directions. Without a steady direction a product team has a difficult time executing, they are always chasing their tails. Another common scenario is when management team members are perfectionists. Companies need to be satisfied releasing products that aren't perfect initially but then continually working to refine the product. No one can release a perfect product on the first try, but that doesn't stop hordes of product managers from trying. Beware of perfectionists, they can destroy a company. Sometimes a product is just "good enough."
The best reason to consider giving up on a stock is when the value proposition isn't as good as the alternative. Imagine a situation where you buy an undervalued stock with the expectation that it could appreciate a certain amount, say 50% and four years later the stock has barely budged. Now as you evaluate the holding you're confronted with a similar situation that has the potential to appreciate 100%. Given this scenario it's reasonable to give up on the first position and use the proceeds to purchase the second position. The caveat to this is to beware of your forecasting ability. Anyone can create a "fair value" out of thin air. Look back at your prior predictions and evaluate how they turned out. If you always expect a stock to appreciate 50% and instead they settle at a fair value 25-30% above your purchase price then you over estimate fair value and should revise your estimates downwards going forward. My sense is most investors fall in this camp. They expect everything they buy to appreciate 3x/5x/10x and then two years later sell once it's appreciated 103%.
It's better to be consistent with lower returns verses less consistent with higher returns. Consistency is what generates long term results. Likewise it's better when your accuracy in forecasting the probability of a loss is higher. Long term returns are the direct result of the lack of losses. This concept won't find many followers in a raging bull market, but it'll become the siren song as the market crashes.
To summarize at this point if you're holding a stock where the story changed, the company changed, the company failed to execute on plans or you have better opportunities it's time to sell. Now let's talk about the hardest time to hold.
There are dozens of small companies off the radar that are selling at extremely low valuations with low liquidity and anemic progress. These are the classic "value traps" where investors whittle away opportunity cost for years. They're illiquid, so as mentioned above they have issues with them reducing investor interest a well. I own a few of these in my portfolio. The types of stocks where if someone discovered them they'd be worth 3x-4x their current value. The problem is the story hasn't changed yet they still offer excellent value. What's an investor to do?
I can have extreme patience when a holding is unfairly valued and the company is moving in the right direction. I don't have much patience, and will actively avoid situations where a company is a melting ice cube. If a company is eating outside capital, or eating their own capital in an effort to stay afloat or transform then time is positioned against the investor. The company is hoping their transformation or new products will outrun their limited time frame. Sometimes this happens, but often it doesn't.
The best situation is one where a company is growing, even very slowly and can fund themselves out of profits. If a company is profitable but the market doesn't recognize their current plight shareholders who are patience accrue value to their investment by doing nothing. When a company pays a dividend and returns cash to shareholders it makes being patient much easier. The hardest time to own a stock is when nothing is happening quarter after quarter and year after year. Even if a company is slowly growing and paying a dividend, the lack of inaction cultivates seeds of doubt in our minds.
Most of the time investors give up on stocks because nothing is happening. It's a crazy premise when considered. Do farmers give up on corn because they don't see it growing daily? Investors are like my kids who will sometimes ask "did I grow last night? How much taller am I today?" as if each night they add an inch or two.
To carry with the farming analogy. Plant your investment seeds and wait for them to grow. If the plant is on track and healthy see it through to harvest no matter how long it takes. If at some point during the growing season you notice the plant isn't growing, or something is wrong with it then it's time to cut loose and move on. But otherwise stay the course.
A heuristic is defined as a process or a method. I have a few simple heuristics I've employed throughout life, and especially in investing. The results from these heuristics aren't ironclad, but they have pointed me in the general direction more often than they've failed me. They're simple things to keep in mind that get you in the ball park of reality quickly without doing much work. How to tell if someone has money
There is a verse in the Bible that says "where your treasure is, there your heart will be also". I've come to realize that this saying is one of the best litmus tests to whether a person is wealthy verses just living the high life.
In modern culture if someone lives well, that is they have all of the trappings of wealth people tend to presume that there is real wealth to back it. This myth was laid bare during the financial crisis. A lot of people who had all nice things were really just highly levered.
The litmus test is this: when people find out I am involved in investing it elicits one of two responses. Those with wealth immediately start to talk about investing, they want to know what opportunities I've found or what things I look at. Those without wealth nod and move onto something more interesting.
The results of this have been fascinating. We have family friends who live very large. We've known them for years and yet never a peep about investing. On the other hand I was at the doctor's office recently and got into a discussion with a technician on how to buy large plots of land, subdivide and resell. He had quite a property business on the side.
When a person is concerned about investing, business, or preserving money it's a sign that they have money. Usually all it takes is a mention of one of these things to get a wealthy person to open up about it. Why? If you have money you are always on the lookout for other opportunities, and one never knows where an opportunity might come from.
Determine how well a company pays employees
In the age of Glassdoor.com this heuristic isn't as important if a company's employees self-report their salaries. But it's very telling for companies that are too small for Glassdoor.
Consider a typical American office. Everyone wears similar dress clothes, works in similar spaces with company supplied material and in many ways are undifferentiated from each other. Status is granted via titles and corner offices. But while everyone appears similar their pay might not be. And while employees across different industries might look and talk the same their pay levels are definitely different.
I've heard it said that buying a nice car is pointless because the only people you're impressing are other drivers you don't know. This is partially true, and partially incorrect. As mentioned above most Americans use vehicles and houses to signal their level of prosperity. I get that there are value investors still wearing their best JC Penny suit from 1984, driving a Datsun and eating mac and cheese for dinner while sitting on millions. But they are the exception. For everyone else a raise means they can afford a slightly better car, or a slightly better house.
It's hard to show off your house to your friends. You can't take it with you, and not everyone is comfortable having friends or strangers over to their house for a party. The same isn't true for a car. A car can be shown off by simply driving around. No one needs to sit in it with you, they can see how nice it is from outside. My litmus test is this: a company's compensation level can be determined by looking at the cars in the employee parking lot. Because people tend to want to purchase the most car for their monthly payment the average car is indicative of the average pay.
The posters speak the truth!
Walk down the hall of any company and you'll be confronted with posters. Sometimes the posters have themes such as "Integrity" or "Ethics" or "Quality". Let me ask a rhetorical question, do you think Apple has signs in their hallways "Quality Counts!" or "We Build Awesome Products Here"? No, because Apple employees already know they build high quality products. It's their nature, it's what they do. But let me ask, do you think Samsung has posters like that hanging now?
There is almost an infinite set of qualities that are 'good'. When people embody these qualities they don't need to be reminded to embody them, they already have them. People need to be reminded about the things they aren't good at, or the things that need improvement. This is the same with companies.
When I visit a company their signs and corporate material highlight the company's weaknesses, not their strengths. Pay attention to these things.
Let me demystify a few common ones:
Safety First - This is a dangerous environment and we employ people who make mistakes, sometimes often. We need to shock them out of complacency to reduce errors. Ethics related material - The company has an ethics problem. Maybe self dealing, maybe cut corners, who knows. A quick tell on ethics are posters indicate a minor problem, required training a major problem. Quality related material - The company's employees routinely cut corners and need to be reminded to be careful and take their time. Do Things Right The First Time - Speaks for itself, lots of re-work happening.
The common wisdom is that to be a better investor one needs a edge. This edge is usually regarded as an informational advantage obtained through superior research, or insider information. Investors continually inch closer to the line of what could be considered legal in an attempt to reduce the risk of a trade and earn a more guaranteed return. Informational edges are the "war stories" of investing. Gather more than 2-3 investors and they'll start sharing stories of famous investors who camped out in a van counting delivery vans in the middle of the night, the crucial piece of information that supposedly netted them millions.
An informational advantage is fleeting. Nothing lasts forever, and an edge in the investing world has a half-life that rivals francium (which is 22 minutes). There are simply too many people and too many dollars looking for more dollars. This is not unlike the washout that happened in the poker world.
In the early 2000s my youngest brother started to ride the poker wave. Whatever wiring it takes to be good at poker my brother had. He used to play local games and come away with fat pockets full of his competitor's money. When poker was all the rage there were a lot of players who had full pockets full of cash in search of a better home. My brother had some sort of edge that he used to his advantage. Unfortunately for poker players there were structural issue with the game that led to its demise.
In poker you are playing against everyone else at your table. And for those without much skill, or the inability to find easy tables once their pockets have been cleaned out it's unlikely they will continue to play. What naturally happens is the easy money leaves the game the quickest and the pool of suckers shrinks. As the pool of easy money shrinks only players with some amount of skill continue to play. The same natural selection process continues when previously skilled players become the saps at the table and suffer larger than expected losses. After years of this process the game becomes one limited to players with a very high skill level all still in the hunt for the perfect edge. Eventually the pool of players is distilled down to a group with similar skill sets who are equally suited to compete. Of course there will always be new players entering the game, but if they don't have the skill level held at the top, or extremely deep pockets they will eventually drop out like most other players.
When I asked my brother this summer why he didn't play poker anymore he confirmed my view by saying "it's too hard to make money anymore." The same thing could be said about any previously ripe investing opportunity "large cap value is picked over" or "compounder growth stocks are overpriced." It would seem that every area of opportunity is quickly discovered and edges become worthless.
There are two ways to handle this, the first is to dig deeper and search harder for additional information that can give a better edge. This is the default behavior for most of the market. I think in most cases information is overrated, at times a red herring, and in certain cases even dangerous.
The problem is we delude ourselves into thinking that by exhaustively researching a company we can rest confidently on our knowledge and make superior decisions. I have news for those who believe this, whatever you think you know is nothing, you don't know squat!
Is it ever possible to know a subject exhaustively? Potentially, if you are the person who invented the thing, or are the pre-eminent world leading expert. At that point you probably have a better grasp of the subject than most. In these cases maybe your advanced knowledge gives you an edge, but more likely it probably serves to distract you. You have trouble seeing the forest through the trees because you're so focused on the operational level details of the subject.
I think sometimes we're blinded by how much we think we know that we don't realize how little we know. Sit back for a moment and contemplate how much we don't know. You really have NO idea about what anyone is thinking, or what anyone else's motivations are for anything. This extends beyond acquaintances to even to our spouses and kids. I can 'know' my family by living with them and observing their patterns. It allows me to understand how they think, but I never really know what anyone is thinking. When people tell us what they're thinking we don't have a way to know if that's true or if it's a lie. Maybe it's partially true and partially a lie, we will never know. For anyone with kids you're probably nodding along with me. We think we know our kids, but we really have zero understanding as to what drives some of the wacky decisions they make. We see them daily but we have no idea what's going on in their head.
If a company states they expect to grow at 10% over the next year are they saying this because they believe it's an easy target and management will receive sizable bonuses? Or maybe they believe that investors expect 10% so they say it even if they don't have a plan to hit it. Or it could be a million other reasons. Maybe the CEO's brother-in-law casually mentioned at a BBQ that he heard all companies in the industry should be growing at 10% and the CEO latched on. The point is we really have no idea. And to believe that people will open themselves up and reveal their motivations behind what they say is foolish.
Speaking to a company's management can be helpful to understanding how their business works, or understanding how they view the industry, but beyond that take any talk with a large grain of salt. As we saw with Valeant the company's management was willing to tell their largest shareholder anything to keep him appeased. The job of a manager is to make sure operations move forward, and a large part of that is building consensus for decisions. An executive is quick to find a common ground with an investor, and in doing so builds trust. But don't be blinded by that trust because sometimes causes us to see only what we want to see.
Now extrapolate the idea that we don't know what one person is thinking to the number of employees at a company. Is it really possible to know what's going on? We see the results, but what created those results? Did a company earn more money because of the quarterly rewards program, or was it a new motivational manager, or did the company start catering lunch and workers simply put in more time at their desks? Who knows!
Measuring business results isn't a science, there are too many uncontrolled variables. How many managers divide up departments into equal working groups and then test different work styles with those groups and measure results? But that's not enough, the groups would need to be mixed up and methods tested again to make sure results were reproducible. This doesn't happen, and if it does it's rare. Every business I've interacted with has a sort of dual mandate. The first mandate is to do things the "correct" and proper way, when there's time. But when deadlines are approaching the second "git-r-done" mandate comes into play. The bigger the deadline the more "we'll fix that later" compromises are taken.
So how do you as an outsider know what's happening? If a company is rushing to a deadline can you understand the magnitude and impact of the decisions that were made? It's impossible, absolutely impossible. If each decision has two potential outcomes the possibilities grow exponentially very quickly. And most decisions don't have two outcomes, they have multiple outcomes meaning the graph of the decision tree grows even quicker. Then multiply these decisions across the number of employees. It's overwhelming.
When thinking about companies like this it's almost unbelievable that anything ever gets done. I have worked on the ground level of some large caps and it certainly feels like this. It appears that every person is spinning their wheels and collectively the company is spinning their wheels. But even with that spinning each person is usually making a little progress, and a little progress multiplied by a lot of employees means forward movement.
If at this point in this post business analysis seems like futility it's because at times it is. The information that's important to an investment is probably the information that an outsider might never obtain. It might be information that decision makers never share because it furthers their own agendas, or makes them look bad. I firmly believe that finding out those hidden agendas is something we'll never do. If we don't even know what's motivating our spouse or kids to make decisions, and likewise they don't know what we're thinking then why could we can discern the reasons for a manager's decisions, maybe a manager we've spoken to for 20m at most on the phone?
Through all of this there is an actual litmus test for results, it's the company's financial statements. A company either earned money or it didn't. It grew or it didn't.
Benjamin Graham pronounced in Security Analysis that the financial results of a company tell us about the quality of a company's management. Great management produces great results, poor management produces poor results. Somewhere along the way Phil Fisher came along and told us that there might be secrets we can discover beyond financial results if we dig hard enough. Fisher played into our common psychology leading us to believe that there is always something more. When I first started investing I understood the logic of Graham's writings, but I thought I could do better by layering a bit of Fisher on top. I would understand the numbers first then dig a little deeper to find these secrets that would allow me to out earn peers.
What I'm writing today is that there are no secrets, and if there are good luck finding them. The secrets are probably located in Florida next to Ponce de Leon's Fountain of Youth.
You cannot out-research others. The more time you put into research doesn't lead to better results. Most investments hinge on one or two factors and discovering those factors and the likelihood of their outcome will generate the same results as someone who exhaustively reads the annals of a given industry. This is what Graham was trying to tell us decades ago, and it took me years of investing for it to sink in.
Instead of trying to understand a company's management or understand the future with complicated decision trees there is a better method. That method is using the statement of record, a company's financial statements and making one or two probability guesses or bets regarding the future. As outside investors with very limited information we are relegated to making educated guesses about the future. If a company is trading for 50% of book value it's up to us to decide whether they will go out of business in the next year as the market has priced, or if they'll last. If the company is profitable and even has a little growth then the probability of them lasting another year is greater than the probability of them failing. And in that case they should be worth more than their current valuation. That's the simple investment case for most value investments.
This thinking can be extended to compounders or growth stocks. If a company is growing at 25% a year is it more or less probable that they'll continue to grow at that rate? And if the result is a "more probable" then the next question is "what's that worth?" These are simple questions, and the answers are simple. For myself if the question isn't simple, or if determining the answer isn't simple then the investment goes into the "too hard" pile.
When Graham talked about net-nets it was a short-hand way of saying "this company appears too cheap given circumstances and the probability of a gain is higher than the probability of a loss." He wasn't making a judgement call as to the quality of the business, it wasn't necessary.
A common retort to this is by mentioning that Buffett is an expert business analyst and with all those years of reading 10-K's he can somehow figure all these variables out in his head and make superior decisions. I don't think that's true. Buffett was a horse handicapper when he was younger, and he just moved onto business handicapping. When he made the investments in Goldman Sachs and Bank of America do you think he spent his nights building Excel spreadsheets modeling out derivative exposure and interest rate risk? No! I think he looked at the companies and said "with my investment they have a much better chance of being in business in five years verses not being in business." And with that he invested. He knew the odds were what mattered, not what the Actuarial Support Department deep in the bowels of Goldman Sachs was doing.
But you might say "But Buffett is constantly on the phone! He's getting better information that we don't have!" And while that might be true I believe he's really just getting information that better informs his probability judgements.
My guess is most readers will disregard this post as simplistic, or foolish, or think they're smarter than me (which you probably are) and go on with whatever they've always been doing. And if the results from doing what you've always been doing are good then why stop? But if your results aren't what you expect them to be then read on.
There are two ways to apply this. The first is to stop wasting your time trying to gain a vanishing edge. This means focusing on a company's financial statements, finding fulcrum points and making a probability judgement about the future. To me this is the essence of value investing. I find companies at depressed valuations, make a probability judgement that they're worth more and invest.
The second way to apply this is through a buy and hold strategy. It is heretical to most investors to promote this strategy, but I think it works. Find stable companies that are likely to be stable in the future with predictable growth, buy and hold on. The only way to get burned with this strategy is to pay too much on the initial purchase, or to buy into nonexistent growth. The best way to apply a buy and hold strategy is to buy companies with lower growth. Growth that is roughly equal to inflation + GDP growth and don't overpay.
Being an outside investor shouldn't be hard work, if it is you're working too hard or looking for an edge in little nooks and crannies. The key is to take in all relevant measurable information, the company's financial statements and then make a judgement call on the company's valuation. Points aren't rewarded to those who read 15 years of annual reports. Rather points are rewarded to those who can make accurate probability judgements. All that's required for that is a bit of common sense and some patience.
It's an easy time of the year to become reflective, kids are going back to school and life begins the school rhythm. My oldest starts school again today and it's had me thinking about schooling and maximizing the school experience all weekend.
I never liked school. In elementary and middle school I'd sit by the window and look out at passing traffic while day dreaming about escaping to do something, anything else. High school wasn't much different. I went to college because that was the expectation. I never buckled down and maximize my schooling in the traditional sense. What's interesting is neither did my brothers, we all did about average and yet all found our footing in life. This is contrary to what society and what teachers might lead you to believe, and anyone less than an A student is a failure in life and will be flipping burgers at Wendy's.
There are a lot of very important things taught in the classroom. But there's a lot that's never taught either. I put together a few things I believe were crucial for my own development and they're things I want to pass onto my own boys as they get older. These aren't universal truths, but rather things I've experienced that I value and I want my kids to value. I've written this as a way to capture my thoughts. I didn't write it in the corny "letter to my kids format" because my kids will never read this. Instead I'm hoping someone out there might find some of the lessons I learned to be useful. I also realize that most students feel they are too smart for advice because they already know everything. And those of us who've learned these lessons wish we would have listened when we were younger. But that's the experience of growing up.
Blaze your own path
If you do the same things as everyone else you'll get the same results as everyone else. You'll also be competing with everyone else for a few scarce positions. If you want different results you need to do something different.
The brutal reality is that very few people are "the best" at anything, sports, academics, business, whatever. But we have a system where everyone tries to work hard to be the best. The end result is a field of people all competing against each other, and if you aren't leaps and bounds better than everyone else the results will be disappointing.
They don't teach you in school that there are other ways to achieve the things you want outside of the traditional path. I'd consider that standard advice is to do well in school, go to a good college, get a good job, put your head down and work hard then get promoted. For some this path works well, but for everyone who isn't the best, or the cream of the crop you'll never reach your maximum potential waiting for someone else to promote you or recognize you.
Look for alternative paths to where you want to go. You need to think creatively, but the results are rewarding. Some of this can be by doing things others aren't doing.
In high school one of my younger brothers approached me about learning how to play guitar. I played and he wanted to play too. I recommended against the guitar and that he play bass instead. My reasoning was that everyone learns to play guitar and you need to be excellent to do anything with it. Whereas there is always a shortage of good bass players. My brother took my advice and a few years later I was watching him perform on The Tonight Show amongst other TV appearances. He is a very good bassist, but not the best, but there is such a demand for bass players that he was able to achieve things most guitar players could only dream of. By choosing his own path he was able to tour the US and Europe on someone else's dime and get paid for the experience. But music isn't forever, and he talked his way into a sales job and from there into a computer programming job, which is impressive given his Psychology degree and music related work experience.
My own career path is a set of twists and turns that couldn't be predicted ahead of time. I've created some roles for myself and fallen into others. But interestingly enough I've only ever received one promotion, a minor one that was inconsequential. I've created my own path and leap frogged others who are working their way up the ladder.
I love talking to entrepreneurs about how they got started and why they got started. Not surprisingly many successful entrepreneurs almost fell into starting a company. Some became extremely successful by taking chances and doing things others didn't want to do. This is how you find an alternative route, you do the work, do it well, and do things others aren't interested in doing.
Ability to execute, not credentials
Popular culture has left us with the impression that a graduate from Harvard will be able to open a door at any company in the US whereas a graduate from a community college will be destined to low level white collar jobs the rest of their career. My dad had an expression "it's not where you go to college, but what you do with it." It's an expression I've seen lived out as I've grown older.
A related story is a good friend was hired for a job a few years after college designing bridges. One of his co-workers at the time was someone he knew from college. The co-worker spent a considerable amount of time working for straight-A grades in college and graduated with a 4.00. My friend did not, yet they were sitting side by side making the exact same of money doing the exact same thing. My friend could execute, but he didn't have the grades, it didn't matter.
Credentials and a great resume can open doors, but the ability to execute once at the job is what keeps you there. It's the ability to execute and complete tasks that opens bigger and better doors. An employer might care about education for the first job because that's the only information they have to work from. But three or four jobs later it's how you'd done in those jobs that matters. If a company is evaluating a student with proven experience verses a straight-A student with no experience the student with experience will be chosen every time.
My first job out of college hammered home this point. It was at a start-up here in Pittsburgh. The company hired based on experience, not on education. This was something of an eye-opener as I had just come out of college where the college institution led us to believe that grades and college performance mattered. This company only cared about what value people could provide, and the more value employees provided the more the company overlooked issues individuals had. There were a number of high performing employees without college degrees. And there was one individual who proved this entire point over and over.
This employee was one of the best in the world at his given specialty, he's written books on the topic and hosted conferences. He also had some personal failings that were quite epic. From drinking too much and throwing up in the backseat of the CEO's car to sending out resignation emails when drunk in the middle of the night. The company's response was always the same. There'd be an apology email from the CEO for the employee's behavior and promises that it'd never happen again. He provided so much value to the company that they were able to overlook and accommodate behavior that wouldn't be tolerated anywhere else.
For some in their blind quest for accolades and success trample the very people who help them achieve their goals. The result is the person's success isn't remembered, but rather how much of a jerk they were.
Very few achieve anything on their own without anyone else's help. It's how you treat people that's remembered, not what you achieve.
In sales books there are typically chapters written about how to handle "gatekeepers." These are receptionists and executive assistants who answer the phone and email for deal makers. Most sales literature includes some combination of tricks, brute force and outright lies to get past gatekeepers to the deal maker. But here's the thing. The gatekeeper is a real person showing up to work each day trying to do their job. You can't blame them for trying to shut down people trying to shove their way through.
I've found a different tactic works wonders, treat the gatekeeper like a real person who is essentially an advisor to the dealmaker. This approach doesn't use lying, or brute force. Instead by working with them they start to work for you instead and will sell to the dealmaker on your behalf.
One tactic that's worked well for myself is to always put myself in the other party's shoes. I try to imagine myself on the other end of whatever I'm engaged in. How would I view myself? When I can view a situation from all sides it helps me make decisions that aren't one-sided. Awareness of how other parties feel and act is important, with this perspective I've been able to make headway numerous times where if I was just focused on myself I would have just been shutdown.
But it's not just people who you work with who need to be valued, value personal relationships even more. Success, co-workers, and accolades won't love you back, and when times get tough they won't be there to help you out. But family and good friends will. Relationships that are built on a solid foundation will last even when there's a storm. Relationships like this require work, they're tough, sometimes uncomfortable or inconvenient, but they pay off in the long term. Don't ignore family and friends as you journey down your path.
I've witnessed something that remains somewhat of a mystery to me, but don't let it happen to you. It's people who ignore their kids in their pursuit of their careers. Yet once a career is over some of the only people left in their life their ignored kids. It's short term thinking. Don't burn bridges today for investments that will pay off in the future. Spouses, kids and close friends, but especially kids will pay dividends for years and decades, invest in them now instead of putting off the investment for some other time.
Contentment is a key to life
No matter what you achieve, or what you don't achieve you'll never be satisfied if you're not content. Discontent is a thief that steals joy from your life. Without contentment you will always be chasing something else.
If we look deep into our souls very few of us are truly content with our position or what we have. Some justify this discontent saying it's what fuels the fire that drives us. The problem is that fire can become an uncontrolled raging inferno that will never be quenched.
I think the key to contentment is thankfulness. Instead of looking ahead at what we want to happen we should look around and be thankful for where we are. If you're reading this you're alive, that's a great starting point for being thankful. A thankful attitude breeds contentment. Thankfulness also breeds optimism. If you are always looking for reasons why something isn't up to your expectations you'll never be content.
Contentment is a bit of a paradox. I'd wager that most think if they had unlimited money they'd be content because they could do anything they wanted. But that's not how it works. There are people with very little who are content, and others with more money than they could ever use who are discontent. Contentment is an attitude, not something that can be achieved materially.
If you want to see lack of contentment visit an airport. Most everyone is complaining about something or unhappy about some part of the experience. There are very few who are thankful that they get to fly across the world in a comfortable tube verses riding on a steamship, a cramped train or in a car. How many travelers are thankful that they air travel enables them to do whatever lies at their destination?
These are the lessons and traits I am hoping to instill in my kids (I have three boys). Instead of telling them to "get good grades" at the start of the year these are the lessons I want them to learn. They're timeless, they're just as important in elementary school as they are in college or mid-career. And they are all attitudes that work in any environment. They're also how I measure success. It will be nice if one of my kids is a high performing individual, but if they are never happy and always chasing the next thing while trampling people in their path I'll consider myself a failure. But if my kids embodies these attitudes I'll be satisfied regardless of what they do in life.
This past Friday I was supposed to be a guest on the Benzinga PreMarket show. It turned out the show is revising their format and my spot was cancelled. I had prepared some remarks for the show and instead of letting them go to waste I decided I might as well record them and turn them into a podcast. What follows is my first attempt at a solo podcast. I'm hoping to improve the format and production value going forward.
It's fitting personally that investment changing news about Solitron Devices (SODI) hit the wire while I'm on vacation at the beach. When I think of Solitron I can't help but associate the company with the beach. It was three years ago in June that my wife and I flew down to West Palm for a beach getaway with a short break away from the beach for Solitron's first annual meeting in 20 years.
If I'm honest with myself then Solitron Devices would be considered a hotel stock for small value investors. It seems like anyone who's ever looked for value in small and micro cap stocks has either looked at or owned the stock over the past decade. The stock has at times been a net-net, an activist target and at one point in ancient history a high flying growth stock. If you can believe it Solitron was the Tesla of the 1960s.
The company designs and manufactures integrated chips and components for satellites and military applications. The company was a stock market darling before they spiraled out of control and into bankruptcy in the 1990s. It didn't help that their manufacturing process poisoned the soil leaving an EPA disaster in their wake. In the 90s the company restructured, established a plan to pay for their environmental sins and continued to manufacture specialized chips.
They operated in obscurity for years, so much obscurity that after the financial crisis the company traded for less than their NCAV. One could in theory liquidate the company at firesale prices and end up with a sizable gain. There was only one problem. The company's CEO, Shevach Saraf stood in the way.
Saraf was one of those people who was enamored with titles. He was the CEO/CFO/COO/Chairman and whatever else he could fit on a nameplate. He was also stubborn to a fault and it was his way or the highway when it came to Solitron. Saraf was appointed CEO during the company's restructuring and served in that role until recently. The man appeared to be insufferable to work for. At one point all of the titles he accumulated belonged to other employees, but one by one they quit and he took them for himself.
The allure of the company was that it had a considerable amount of cash and securities sitting idle on their balance sheet. This alone was enticing, but their core business operations weren't bad either. Almost any investor could day dream about a scenario where the cash was returned to shareholders and the business sold for a gain. Outside of outright fraud there weren't any scenarios were shareholders did poorly. The problem was Saraf, the company's largest shareholder and head executive-everything wanted none of it. Instead of returning cash to shareholders net income was hoarded on the balance sheet as Treasury securities. Annual reports were marked with language indicating that the company wasn't certain if it could ever turn a profit in the future and there was an outside chance it might disappear into the night. Saraf was a classic sandbagger. He'd proclaim doom and then easily surpass his proclaimed dire circumstances. He paid himself handsomely and owned a substantial amount of stock. Enough that any attempt to outvote him would be difficult.
I began writing about the company hoping to shed light on an undervalued situation. Eventually I realized that the only way to create value was to do something myself. I helped organize shareholders and bring attention to the company all while pushing them to hold an annual meeting. The unstated goal of the annual meeting was that with an annual meeting an eventual proxy battle to oust insiders could happen. Without a meeting there could be no proxy battle, and without a proxy battle no change. In 2013 we succeeded and shareholders had their first meeting and in some ways the rest is history.
Once the company held a meeting activists and proxy battles followed and culminated last week with the company filing an 8-K announcing Saraf's departure from the company. But if that wasn't enough the company is buying out his shares. This removes the largest stumbling block to value while at the same time returning cash to investors. The Board is now firmly under control of activist investors and the CEO is Tim Eriksen, the hedge fund manager who mounted a successful proxy fight last year.
The question is whether Solitron post-stubborn CEO is worth an investment or not. To decide let's walk through the adjusted balance sheet after the transaction.
Before the transaction the company had $6.48m in securities and $507k in cash on their balance sheet amongst other assets. The company is debt free and liabilities consist of accounts payable and accrued expenses. Let's presume that their cash is needed for ongoing operations and their investment securities (treasuries) are excess and can be used to fund their transformation.
The first thing the company did was repurchase all of Saraf's shares at $3.91 per share. The company spent $1.3m repurchasing 331k shares. This reduces the number of shares outstanding from 2.2m to 1.9m for a more than 10% reduction in shares at less than book value. This action alone is highly value accretive itself. The second action taken was to repurchase all of Saraf's outstanding options for 290k shares for slightly less than $1m, paying $3.43 per option. This buyback removed the options overhang and reduced the fully diluted share count.
Both of these actions are shareholder friend, the company used $2.3m worth of excess cash to eliminate Saraf's share holding and his option position. This is the type of thing value investors dream of, a company using their cash to repurchase shares below book value. While value was created for investors it also eliminated the company's largest shareholder.
Beyond the initial $2.3m share and option repurchase the rest of the buyout can be framed within the context that the buyout expenses were necessary to get rid of a stumbling block for shareholder value. The company paid $410k in severance costs, $45k for health insurance, $18k to transfer ownership of the company car to Saraf, $96k for earned vacation time and other incidentals such as his cell phone.
In total the company is paying $2.859m to rid Solitron of Saraf, with the bulk of the company's expense being spent towards repurchasing shares and options. The company is also reimbursing Eriksen Capital $110k for their proxy fight last year. I know some shareholders antsy about a repayment such as this, but in my mind paying $110k to unlock value is very cheap. If shareholders could unlock value other management-trap companies for $110k we'd all be a LOT richer.
Once the agreement is executed the company's equity will drop from $11.36m to $8.391m, which is $4.41 per share. At current prices post transaction the company is trading for 89% of book value, which is cheap in light of recent facts.
One negative is the company has started to report negative earnings. We could speculate all we want, but it's possible that the earnings drop was the catalyst that pushed Saraf out the door. Until recently the company had steady revenue and earnings, and suddenly with activists onboard the company's results took a nose dive. Was this Saraf trying to payback shareholders with bad results? As a one-man executive and selling machine it's possible. But if that were the case his plan backfired badly.
At current prices investors have the ability to purchase $4.41 for $4.01 with an activist investor as CEO and shareholder friendly Directors. The company still has about $3m in excess cash that can be returned to shareholders as a buyback or a dividend and a core business that had a history of earning above average returns. The best course of action would be for Eriksen to negotiate a sale to a private buyer at an above market price. It isn't unreasonable to presume that the core company might be worth $5-6 per share plus the additional $1.50 per share in excess cash. I don't think it's a stretch to say the company is worth 50% more than current prices if not more.
Most readers will brush this writeup off saying that "a 50% gain isn't big enough" but I don't know many other investments that are controlled by activist investors with an upside of 50% or more. Even if it takes Eriksen two years to realize value with Solitron it's still a very respectable 25% a year return.
If you're looking for a cheap investment with a catalyst look no further than Solitron Devices. Disclosure: Long SODI
How many investors have found themselves in an idle moment thinking "If I were the boss at the company I'd do things a lot differently." My guess is if one invests in struggling companies this thought occurs more often.
The difference between thinking something and taking action is a wide gulf crossed by few. In the case of Sitestar (SYTE) a group of investors crossed the chasm and took control of an undervalued asset in a way that most investors can only dream of. Their conquest makes for a great story, and since I'm a sucker for great stories I want to re-tell it, even if there aren't any take-away lessons.
The company came into being during the dot-com boom as an ISP (internet service provider). They provide service to rural areas where major providers ignore because distances between homes are too far, or there isn't enough density to service profitably. Markets like these are littered with small companies that somehow find ways to make a profit where large companies can't.
From the start Sitestar had profitability issues. They earned $200k in revenue in 1999 but spend $3.5m to earn it. Eventually they found their formula for success and revenue peaked in 2008 at $8.8m with $1.2m in earnings. It was around this time that their customers discovered they could access the internet from their pocket at speeds that walloped their dial up modems and subscriber numbers began to quickly fall. In response to the "dying" business the company's management decided that rather than re-invest in dial-up they'd go on a shopping spree and purchase real estate, rehab it and flip for a profit.
I've always been suspicious of public companies that change from one business to something completely different. It is disjointed and almost reckless. Yet, if I meet a private entrepreneur who has a number of unrelated businesses under their control I think "what a savvy individual." But the truth to this is entrepreneurs are always experimenting, always throwing things at walls to see what sticks. The good ones focus on what has stuck, and if something's stuck they focus on it. Sitestar found something with potential but failed to execute on it.
Throughout the years the company acquired a real estate portfolio of properties they intended to rent, or renovate. The key to making money when flipping a house is to buy at low prices, renovate and sell quickly. There are carrying costs associated with owning a house and each month a house remains unsold the carry costs eat into the potential profit. If a house remains unsold for too long the potential for any profit disappears.
Fast forward to 2013. Real estate investor and investment blogger Jeff Moore discovers that the company is trading at a significant discount to it's liquidation value. He purchases a 7% stake, files a form 13 SEC notice and talks to the CEO about joining the board. While I said there probably weren't any lessons to be learned this could potentially be one. From time to time readers will ask me "how do I join a Board?" Jeff's method is as reasonable as any out there, buy a sizable stake in the company then ask the CEO. Don't wait to be asked, but be proactive and ask.
All was not butterflies and roses with the Board position for Jeff. This is where things got interesting. Jeff as a new Board member had grand plans for the company. He wanted to do things like determine the cost basis for the properties and sell ones that needed to be sold. He also requested financials that the company should have easily been able to produce, especially for a Director. He wanted to get his hands dirty and take action on the renovations, after all this was his area of professional expertise.
Instead he was met with resistance and diversion. Battling the company's roadblocks led to a trip with fellow shareholder Steve Kiel to Lynchburg, VA (where the company is located) in 2014 to discuss these issues in person.
Jeff and Steve arrived at Sitestar and requested to speak to Dan Judd, the CFO. One of the company's employees stated he'd come to meet them. Jeff and Steve waited for hours before the same employee came back and announced she was heading to lunch and locking up. Jeff and Steve decided to go across the street during the lock-up and at this time the CFO snuck out the back door and drove away. I can only imagine the CFO peeking out the window all morning wondering "when will they leave?" I think it speaks volumes as to the character of the CFO.
Based on this experience Jeff and Steve took a more activist approach and engaged in a proxy battle to gain additional seats on the Board. Jeff and Steve proposed a full slate of new Directors and the company negotiated a settlement where Steve and Jeff would be on the Board. If at this point the duo worked to fix the company from the inside this would be a very typical activist saves investment story. But Sitestar is anything but typical.
All was quiet on the Western Virginia front for months until suddenly there was a press release that the CEO, Frank Erhartic, a 30% shareholder had been fired. Under what circumstances could a significant shareholder who is CEO be fired? Under suspicious ones. Kiel and Moore discovered that the CEO had made a series of improper loans from himself and his mother, charged the company rent for a building he likely didn't own, as well as other potential securities violations. The problems were so bad that this tiny company with a market cap of $5m aroused the interest of the SEC. The fact that the SEC is spending any time on Sitestar indicates this isn't a simple issue like Steve Jobs accidentally putting a historical and wrong date on his stock options that could be quickly swept under the rug. No, this appeared to be real fraud, the type of stuff so brazen as to seem unbelievable. I can almost imagine the exchange an exchange between Frank and his mother.
Frank's Mom: "Honey, this Sitestar piggy bank you own seems quite lucrative, any way I can make some money on it as well?"
Frank: "Well Ma, you can buy shares in the market, but we're just a penny stock and you might never see a return. Instead why don't you smooth me a check for $50k and I will pay you an above market interest rate on the loan. You'll get some quick cash that's risk free."
As a result of Erhartic's firing Steve Kiel was appointed interim-CEO. After the company metaphorically peed in the pool they were swimming in Steve decided it was time to clean things up. He hired a new audit team and began the process of correcting financial statements and verifying all of their accounts. If you're a one-person sole proprietorship doing some work on the side it might be alright to handle accounting on a wing and a prayer with only a faint knowledge of what's in your bank account. But if you're a company with millions in revenue and a public exchange listing the standards are much higher. You need processes and procedures that are repeatable and auditable, something Sitestar didn't have.
Sitestar's new auditors unsurprisingly found a number of issues. It turned out no one really knew how many shares were outstanding, an interesting problem itself. The company also discovered that they were paying $50k in rent a year for space in an office building the CEO claimed to own. Except it's unclear whether he actually owns it, regardless he still took the rent payments. There are dozens of other accounting fixes from goodwill impairments to the resolution of an outstanding $900k loan for $90k that had to be taken care of as well.
While engaged in the audit Kiel and Moore went through the real estate portfolio with a fine toothed comb. They realized that carrying costs had eaten into most of the potential profits and that the best course of action was to hire contractors and sell the properties as fast as possible. This was the course of action the company should have taken from the start. Kiel and Moore also discovered that the internet operations weren't as bad as they thought. Through some cost cutting and creative growth strategies the ISP holds potential, not a ton, but it holds potential.
The company is still hauling around some of the baggage from their past life. The company's CFO, Dan Judd was fired and asked to resign from the Board. He has since refused to resign and dug in his heels. Kiel and Moore plan on replacing him in the next proxy context, but until then the dead weight is still hanging around.
With the influx of cash from the real estate sales and money saved from cost cutting the new management team invested in an HVAC roll-up fund. The stated goal of the HVAC fund is to purchase small HVAC operations, implement centralized operations and sweep the additional profit back into the fund. This is a fund that is being run by a fellow value investor manager who Kiel has known for years. Sitestar will reap the economic rewards of the situation without having to actively manage the partnership. Additionally the manager will only earn a salary if they can execute profitably, it's in everyones interest to make this work.
The company just released their 10-K from last year as well as Kiel's CEO letter. So what are shareholders left with at this point? Sitestar has morphed from an ISP with an undervalued real estate portfolio to an ISP with a liquidating real estate portfolio and an investment in an HVAC roll-up fund with management that is intent on creating value for shareholders. The company is an interesting investment at these levels. Think of it as cash and an ISP with optionality. As properties are sold cash will accumulate on the balance sheet and management can put it to work. What sweetens the deal is Kiel's track record as a hedge fund manager is above average, and shareholders are getting his skills 'for free'.
I love the story of Sitestar because it shows that determined investors can gain control of a mis-managed company and turn things around. I don't know the legal costs involved in the proxy battle, but my guess is they aren't substantial. The biggest thing that Moore and Kiel had was patience, conviction and determination to see the battle through.
Is Sitestar the exception? Probably not, there are probably a dozen Sitestar's out there on the pink sheets. I hope there are other determined investors with the resolve to clean those companies up as well.
Imagine for a minute that you had a brilliant idea for a product and needed some capital. To launch your company with this masterpiece product you need capital, so you find some partners who believe in you and they contribute equity to the new venture. The product does well, there's growth and everything is going well as you work to build the company. Years pass, the original investors move on happy with their returns. New investors come along, ones you don't know as well, but they're happy to collect their dividend checks and talk at the annual meeting. Eventually these investors even stop coming to the meetings or calling, you are running the company on your own.
Slowly you start to become somewhat resentful of your faceless investors. They are cashing their dividend checks derived from your hard work, but they aren't involved in the business at all. They don't even seem to care what's happening with the business. You adapt to their disinterest and start to release news less often. Eventually you don't file financial statements as often because you don't think the investors care all that much. They continue to receive dividends in exchange for no effort, so why should you give them any extra?
This relationship disintegrates to a point where eventually you actively hide information from your investors and pay yourself richly. You're doing all the work, the investors aren't doing anything, plus they get dividends and don't make a fuss.
Does this story seem right? Or when you read it does it seem wrong? Does it make you made or angry? It should and unfortunately it's not just a story, it's something that is happening throughout the market with companies both large and small, but primarily small.
Shareholders are the rightful and legal owners of companies they are invested in. As shareholders they're entitled to returns from the company, either dividends or the assets in a liquidation. But there is a strange twist to shareholding, outside shareholders contribute nothing towards the success of the company yet reap the rewards. After a company's initial capital has been contributed outside shareholders are simply trading ownership interests between each other. It's easy to see how a company's management, or employees could see this as a negative. The company's management and employees work hard every day to put money in someone else's pocket. It's also not hard to see how some employees might think "I should take just a little extra for myself and department, we work hard and shareholders will hardly notice."
In financial textbooks shareholders should have power over their ownership interest by virtue of their voting rights for the Board of Director. Shareholders elect the Board, and the Board makes sure the company is managed in the interest of the shareholders. The problem is this scenario is only true in textbooks. Boards consist of people who interact monthly/weekly/daily with management teams, and with that level of interaction it's hard to not become colleagues or friends with management. It's much harder for the Board to stand up for faceless and nameless shareholders who own 100 shares with the certificates stuffed in savings deposit boxes in Dubuque, Iowa.
The idea that the Board is on friendly terms with management and neutral at best or usually on adversarial terms with shareholders isn't new. This relationship has been well known by investors for at least 100 years. In theory the Securities Exchange Commission (SEC) was created to combat this problem as well as further promote transparency and fairness in the markets.
Unfortunately the SEC is swamped with leads, both real and imagined and they don't have the staff or inclination to pursue most of them. A second confounding problem is that the SEC is staffed by people for whom the SEC is a career. These SEC employees have families, friends and hobbies and earning a paycheck and a promotion is only a portion of how they spend their day. SEC employees (rightfully so from their perspective) are focused on bagging the biggest cases because high profile or political cases can result in promotions, which means a nicer car, or a better boss, or a window office, or a bigger house in the DC-burbs, or really anything else career related. But none of those things are "upholding the fairness of the markets". And who could blame SEC employees? How many employees at any company show up to work each day and while passing the mission statement in the hallway think "I'm going to make the customer #1 and provide value in all aspects of my job today!!" Most people are thinking about where they want to go to lunch, or about some difficult project, or socializing with work friends. That work gets done is incidental to the experience.
The area of the market where the lack of a visible regulator or Boards that care about shareholders is most apparent is in small stocks that have "gone dark." These companies were at one point SEC filing companies that used a loophole in the SEC regulations as a way to cease filing financial reports. To cease updating shareholders with details about THEIR company. And to hide in the dark.
The SEC claims that any company with less than 300 registered shareholders (more for a bank) can cease filing financial statements and escape regulatory burdens. This is called "going dark." The theory is that a company this small should be considered privately held. I don't disagree with the SEC's logic, except for one area, the type of shares the SEC counts as 'shareholders'. The SEC believes that only registered shares count as true ownership interests. A registered share are shares held in certificate form. These are the fancy certificates that are held in safe deposit boxes and need to be mailed to to sold. The three day settlement period is an artifact of when everyone owned paper certificates. Three days gave investors enough time to mail their certificate to their broker after instructing a sale.
Since the markets have modernized most shareholders keep shares in street name at their broker. The brokerage has a giant digital lookup with each holder's name and the number of shares they own, which is called a beneficial interest. There is a substantial amount of case law confirming that beneficial holders, investors with street name holdings have the exact same legal standing as a registered shareholding. And it's because of this that beneficial shares receive dividends just like registered shares.
The problem is these dark companies get to have their cake and eat it too. They can pay dividends to beneficial shareholders but then hide behind their dark non-filing designation and claim they don't need to provide legally required information to shareholders.
Companies go dark for a variety of reasons. For some it's to save costs. The cost of being public can be onerous to a small company. Companies that go public for cost reasons often continue to update shareholders with news and their financial condition through the mail and on their website. The cost savers are the exception. The majority of dark companies are literally hiding in the dark. Either management is hiding nefarious dealings with themselves and at times outright theft from shareholders, to other management hiding just how good the company is doing from shareholders. In both cases management is lurking in the dark and escaping through an SEC loophole.
I own shares in a number of dark companies, they range from the cost savers mentioned above who are good stewards of shareholder capital to a number of cockroaches hoping shareholders never realize they exist. One company I own, Kopp Glass, decided this year that as a beneficial shareholder I have ceased to exist. It's almost a comical dance, the company claims I'm not a shareholder and have never been. Which is ironic because I've been to two annual meetings, and at one the CEO told me he'd looked to see how many shares I owned. It's worth noting that I have continued to receive my dividends quarterly just like I should. But if I ask for an annual report I'm "not a shareholder according to our records." The CEO acknowledged in the past I was an owner, but suddenly I'm not. At a dark company hiding in the shadows away from the SEC they can bend rules to fit whatever they want.
Kopp Glass isn't an exception either, they're just one of many companies that play this game. The problem is the game is illegal. In Pennsylvania (where Kopp is incorporated, but this rule also stands in Delaware and other states) it's illegal to grant different rights to shareholders of the same share class. This means you can't pay dividends to only some of the company's shareholders and not others if they all own the same class of shares. This also applies to information, a company can't distribute material financial information to a few shareholders and not everyone. While doing so is illegal it could also be construed as to giving certain shareholders an inside advantage. In the dark market these sort of occurrences seem normal, but they shouldn't be. The public would be outraged to find out that GM executives were mailing out pre-released financial figures to a select group of their friends, those executives would probably end up in jail. Yet with dark companies the SEC has implicitly approved the distribution of material information to whomever a company wants, not everyone by failing to act and take action against this blatantly wrong behavior.
Going dark doesn't mean a company can do anything they want. It just means they aren't burdened with quarterly SEC filings. To make an analogy a company that goes dark is acting like a person who moves from a city with zoning and a full time police force to a rural area without zoning and a local sheriff. Moving out of a city doesn't mean the person can start to distribute drugs, sell weapons, open a brothel and do anything they want because there isn't a full time police force anymore. They just moved from one form of structure to a different form, but the person would need to abide by the law of the land in both places. Unfortunately dark companies have decided that they are above the law and since the SEC has failed to enforce the law these companies are getting away with it.
We now have an area of the marke that's lawless and a complete mess. This is the breeding ground for pump and dump operations, unethical managers and anyone else who wants to hide in the dark. Is it any surprise that pink sheet and non-SEC filing companies are universally derided as scams and dangerous to investors?
As investors there isn't much we can do to change this. I have made it a point to write about companies that flaunt their dark status as a ticket to steal from shareholders, but writing can only do so much. At some point the SEC needs to step in and enforce their own rules.
Investors have a very unique opportunity in that right now the SEC has an open comments period on financial information requests. I know some investors who have let the SEC know their thoughts on dark companies, and I plan to as well. I hope you will also write a letter, no matter how long or short telling the SEC that companies need to treat beneficial shareholders the same as registered shareholders in doing dark transactions. The SEC should also ensure that going dark isn't a license to steal from shareholder pockets either directly or by giving out inside information to select parties.
"I'm looking to buy an entire bank, have any ideas on what to do?" That seems like a strange question doesn't it? Yet it's a question I've been asked a number of times over the past few years, and a question that a number of investors have more than a passing interest in hearing the answer. Seeing as there isn't much online, I thought I'd provide a bit of a primer on how to buy a bank as well as include information on how regulators and bankers value banks. This is important because it'd be hard to purchase a bank without knowing how to pay for it.
A bank is just a business like any other except for a few simple details and it's those simple details that make banks seem unlike any other business. And that's what makes buying a bank appear so difficult.
It wasn't that long ago when a group of business people could form a partnership, raise capital and start a bank from nothing. The financial crisis ended that practice with only two de novo (from scratch) banks receiving regulator approval since 2008. That leaves individuals who want to own a bank with only one choice, they need to purchase an existing bank.
Buying a bank seems like a daunting task. Maybe this is because the stereotypical image of a bank is one of an imposing institution. This is an image banks have themselves helped propagate. Rhetorically I ask how many tiny community banks have images on their website of marble buildings with greco columns set high above the road with imposing steps when their actual branches look more like a brick rectangle with a drive through? We imagine our money being kept in large secure vaults, not on servers stored as bits.
Bankers themselves help to create this impression that "we are different." There is banking specific lingo, there are banking specific conferences and bank specific magazines. These things exist in other industries, but other industries share common traits that banking doesn't. You can have a discussion of logistics or product pricing and most executives in any industry will find information that's useful to their specific business. When bankers talk about interest rate risk, or net interest margin compression or deposit growth there is no cross over to other industries.
There are barriers to entry for the industry, but they aren't as large as some would think they are. A little education can go a long way.
When investors think of purchasing companies their minds naturally drift to publicly traded companies. That's because purchasing a portion of a public company is easy, it's a few clicks, or at most a phone call to a broker. Gaining control of a public company is much harder and visible. This is because once investors see another investor is interested in purchasing as much as possible of a company they're less willing to sell their own shares. This usually forces a potential acquiring investor to make an offer for the company rather than slowly accumulating shares in the open market. Banks are no different in this regard.
But one significant difference does need to be mentioned. There are no ownership limits on non-banking companies. For example as an investor I can purchase 25% of a company if the shares are available for purchase. The same isn't true for banks. The most an investor can purchase in a bank is 9.9% of the bank's stock. This is because at the 10% ownership threshold the FDIC and Federal Reserve consider the owner to be an owner of influence and subject to approval and regulation. There are two ways to pass the 10% threshold, the first is to obtain an waiver from regulators, the second is if a bank is buying shares in another bank, they aren't subject to the same threshold limits. If a fund attempts to purchase more than 10% of a bank without a waiver they could be considered a regulated bank holding company and subject to holding company disclosure and regulation. Not something a casual investment fund wants to deal with, unless they intend to become a bank only investment fund.
At 9.9% an investor can significantly influence a bank, but they don't own it or control it. A public investor would need to make an offer for the entire bank at this point. While this is a feasible route, it's akin to taking the longer route to a destination. There are quicker and better methods.
Of the ~6,000 banks in the US only about 1,000 are publicly traded, and by traded I mean they have a ticker associated with them. This means there are 5,000 banks in the US where the owners are private individuals or groups of individuals. These are the types of banks that an investor who wants to own a bank needs to target. There are a number of reasons for this, the first is it's much easier to talk to a private company verses a public company about confidential or sensitive information. A public company needs to issue press releases related to various material events. Private companies don't have this same level of responsibility. Secondly it's much easier to negotiate a transition plan with a private company compared to a public company.
Let's take a look at how this might work. The first thing to consider is that banking is a very congenial industry. Bankers are friendly and politeness and formality is appreciated. The bull in the china shop approach that's common in the public markets isn't widely accepted or appreciated. The first place to start would be to talk to the CEO or President of a small bank and make your intentions known. Maybe take them to lunch and let them know you're interested in purchasing a bank and would be interested in theirs, or an introduction to any bankers they know who might be interested in selling. This is an important point, you want to work through networks. A formal introduction from a friendly banker is extremely valuable. There are always banks shopping themselves formally or informally. The banker network is aware of these banks, you as an outsider might not be. The key is to get inside the network.
Once you find a bank that's willing to sell it's a matter of purchasing your ownership stake. To find the owners of a private bank you need to get a hold of the bank's Y-6 regulatory filing. I'll make a shameless plug here that we have digital versions of every bank holding company's Y-6 filing inside CompleteBankData along with the ability to search them and obtain contact information for individuals. A Y-6 will show who the majority owners are, the number of shares they own as well as their ownership percentage. Interested in buying their shares? Call these shareholders, or have bank management introduce you to the owners. Once you've figured out a way to purchase a majority ownership block you need to determine how much you'll pay for the shares, that's the next section.
It never fails to amuse me when I visit a financial information site that presumes banks are the same as any other business. These sites will prominently show a bank's EV/EBITDA ratio, or other metrics that are completely irrelevant. Banking financials are unlike other financial statements. At the most simple level a bank earns a spread between their cost of funding and the interest earned on the loans they extend. Out of this spread they pay salaries, pay for operating expenses and pay taxes. What's left over is considered net income. See banking really is simple!
Because banks work differently they're viewed differently by the market as well. There are two short-hand metrics for valuing banks, price to earnings and price to tangible book. The rest of the market has moved from these simplistic measures onto more sophisticated ratios such as EV/adjusted-EBITDA or price to earnings-when-my-grandkids-are-in-college. But banking has relied on simplistic short hand measures. Thrifts and smaller community banks are usually valued on a tangible book basis and larger banks with higher returns on capital valued on their earnings. These are quick estimates of value for market participants. Knowing that a bank trades for 105% of tangible book value (TBV) doesn't mean anything itself, it's a relative valuation. Knowing that a bank trades at 105% of TBV when comparable banks trade for 165% of TBV is meaningful, but it doesn't necessarily mean a bank is cheap either. It simply means there is a discrepancy that needs to be investigated to determine if there is value in the difference.
When a bank acquires another bank they don't rely on simple metrics. I'd be laughable to think of a boardroom with a Director saying "our target bank is only trading or 95% of TBV, I think we should purchase it."
Banking is no different than any other industry when it comes to mergers. A bank looks at an institution to be acquired as an opportunity to maximize scale, put idle assets to work, and save on duplicated operating costs. What's unique about banking is that at a high level all of these institutions work the same, that means that a merger is more likely to create value compared to a merger outside of banking. There are differences in operations and cultures, but those chasms can be crossed easily. The fundamentals of merging bank businesses are the exact same, and that's what's important.
In almost every private market the transaction dynamics of a purchase are similar. An acquirer is granted a detailed look at the to be acquired institution after a formal letter of interest and the acquirer makes what's considered a fair market offer. It's rare that a purchaser pays a basement bargain price for a company in the private market deal. This is because the dynamics of the deal are much different. Unless the seller needs cash ASAP, or has a impaired asset bargain deals in private markets just don't exist. This is because both parties receive access to the same financials and a deal is discussed that's agreeable to both parties. There are no public shareholders to please or worry about.
Instead alpha is generated in the private market through operational improvement. A buyer and seller will negotiate a fair price for a deal, but the buyer has an idea in the back of their mind on ways they can better utilize the assets they are buying. Maybe they have better customer service, or can cut costs, or can cross-sell, or a variety of other things. Buyers pay fair prices and make their money back through operational changes. That's one of the benefits of being a majority owner, you can make changes as you see fit to change an entire organization.
The way to value a bank is through this lens of operational changes. The formula we use at CompleteBankData is one made popular by Richard Lashley of P&L Capital. While ultimate credit goes to him for putting the formula on paper I had heard the sentiments of his formula explained by those in the industry long before I heard of his specific formula. The formula is as follows: look at the to be acquired bank's operating expenses and estimate after tax cost savings. Add those savings to the bank's net income and apply a multiple to the projected earnings after cost savings. The concept makes sense on an intuitive level. A second level of valuation is to estimate additional earnings from putting excess capital to work. Typically in a merger cost savings will provide the largest bang for the buck compared to putting capital to work. That is unless you happen to find one of these banks with 50% of their assets sitting in cash waiting to be deployed, but even in that case my guess is there are more than a few cost synergies.
You now know how to find a bank that's looking to sell and then how to value the bank for purchase, so what's next? You write a big fat check and get working! It's a fallacy to think that one could buy a bank, sit back and collect checks without doing anything else. The money to be made from buying a bank is from putting your fingerprint on the institution. If you do it right a lot of money can be made, if done wrong then at best you can hope there's a government backstop to help you out.
Interested in learning more about banking? I'm in the process of writing a book on banking. You can receive a free copy of a chapter "Are Banks Risky?" by signing up for our email updates list. We rarely will email you, but list subscribers will receive special deals on the book when it's released and advanced notice on the release date.