The best research might be no research at all

In sales there is the concept of a "qualifying question."  This is a question that a sales person asks a prospect to determine whether to pursue the prospect further.  A qualifying question might be "Do you have a budget for this project?" If a prospect doesn't have a budget for a dreamed about project why would a sales person continue to pursue said project?  The goal of a qualifying question is to get to "No" quickly and spend time with prospects who meet buying criteria verses chasing dead end leads.

Investors should adopt the qualifying question mindset when looking for new investments.  Our time is limited and we don't have the capacity to cover every investable company. Time spent researching a company not worth investing in means less time spent researching a potentially good investment.  A common investment meme is that knowledge is cumulative and that all that time spent on dead end investment leads will somehow help with good investments.  This is simply not true, time spent on dead end leads is sunk time.

I prefer to research stocks differently in that I take the qualifying question approach in order to save time and focus my efforts.  I prefer to invest in small stocks, so I don't look at larger companies.  This is a personal preference, but that preference eliminates a lot of the investment noise.  Most investment chatter is regarding the largest and most well known companies, the ones I'm not focused on.

I further limit my universe by looking for stocks with a traditional undervaluation on either an earnings or asset basis.  If I come across a stock at 45x earnings at 150x book that's growing at 30% a year I will probably pass.  This might seem crazy, why would I pass up the express train to unlimited profits via growth?  It's because I'm not an expert on valuing growing companies.  I like when companies grow, but I can't tell Crocs from Heelys or Starbucks from Caribou coffee.  I've learned that I'm good at determining a stock's downside, determining the likelihood of a stock trading up to a higher valuation and I stick with what I know.

This isn't to say that growth stocks are bad, or value stocks are better, neither is better than one or the other.  I'm saying that I stick to what I know.  I think all investors should stick with what they know, what style works with their own personality.

My guidelines for an acceptable investment are very broad.  There are many types of strategies that work in certain market environments, but no strategy that always works all the time.  What I mean is this, an investor needs to be flexible.  In some markets net-nets are attractive investments, other times low P/B value stocks, and at times companies that trade at earnings discounts to their peers.  There isn't a golden strategy, and it pays (literally) to be flexible.

The criticism to this approach could be that by being too restrictive I'm missing great opportunities.  The criticism is correct, I'm missing plenty of opportunities, many of them good!  The nature of investing is that unless you're buying the entire market you will always miss great opportunities.  The converse is that by being more restrictive I'm always forcing myself to pass on bad investments.  Or investments that might be fascinating reading, but that ultimately don't have an attractive valuation.

Some investors like to research companies with the hope that one day the company will suddenly trade with a lower valuation.  It's an interesting approach, but why not find companies that right now meet your valuation criteria?  If the answer is "there are none" then it's time to reconsider your criteria.  Of the 60,000 stocks worldwide I would expect that at any given time there would be at least 15-20 investable companies at the desired valuation with desired characteristics.

Spending time on what you own, or what you want to own that is qualified is much more valuable than spending time on something that isn't qualified.  If the ultimate goal of investing is to find undervalued investments and invest in them then wouldn't it stand to reason that any time devoted to research should be spent looking for those undervalued investments now?

Investors are usually afraid to pass on a company because it might do well in the future.  The truth is there will be many companies that do well that we never own.  The fear of missing out is a real fear, but it has no place in investing.  Rather focus on what can be controlled, the time spent researching and what you research.  Stay up to date on current holdings and look for new holdings in a qualified pool of investments.  The best research might be deciding an investment isn't worth further research and moving on.

Is a sum of the parts valuation worthless?

In the aftermath of catastrophic losses on Horsehead Holdings (ZINC) a number of value investors have been asking themselves what went wrong.  Some have said the culprit has been the use of a sum of the parts valuation.

Horsehead Holdings is a Pittsburgh, PA based company that specializes in zinc oxide processing.  Famed value investor Monish Pabrai found the investment during the depths of the financial crisis trading for less than net current asset value.  As the economy, and the company's shares recovered Pabrai continued to talk about the investment, and it transformed from a deep value playt to one with a great management team and an attractive story.  The company supposedly had a best in class processing system that allowed them to process zinc cheaper than peers and as a result once their factory was operational they'd mop the floor with their competition.

Unfortunately the company hit a perfect storm.  Zinc prices declined and at the same time the company's next generation system experienced continual failures and needed of costly repairs.  To make matters worse the company had a risky balance sheet loaded with debt expiring in the near term.  These factors collided and the company now trades for mere pennies down from $15.18 earlier this year.  They missed a debt payment and will most likely be entering bankruptcy soon.

One narrative I've heard a few times out of the investment is that a sum of the parts valuation methodology is dead, or worthless.  A sum of the parts is where an investment is valued on individual pieces of the company rather than the company as a whole.  For Horsehead their next generation plant had a market value, along with two other ancillary businesses they owned.  Investors looked at this situation as good downside protection because in theory management could sell the side businesses to fund the construction issues.

I don't believe the sum of the parts valuation methodology is worthless, but I do believe it's misapplied.  I want to explore applications and uses in this article.

Let's consider a very simple example.  Imagine you had a bike, a shoulder bag, a cell phone, and nice rain coat.  What is it worth?  This is a simple question, you could find the value for each item separately online.  With eBay or Craigslist you could probably find each exact item in the same condition and determine within a few dollars the true market value for this entire collection.  If you were to go through this exercise and determine the collection is worth $1,500 and someone offered you $1,000 to buy the ensemble you'd probably think "that's crazy, I can sell each item individually for more than $1,000."  That is the essence of a sum of the parts valuation.

But take a step back, if you have all of those items you also have all of the pieces needed to be a bicycle messenger.  And maybe that's why you do have all of those pieces, it's because you make deliveries on your bike.  Now the situation is different, by using all of these items you might earn $10/hr, or $1,600 per month.  If someone were to offer you $1,000 for the ensemble you'd laugh because by putting the pieces together and using them to generate an income would result in $1,600 per month until you decide to stop riding.

The second example is why in most cases a sum of the parts makes no sense.  A company's parts, their factories, their land holdings, their machinery, any other assets are much more valuable as an operating entity as opposed to being parceled off.  And the reason all of those assets are together in the first place is because at some point someone tried to make a go of being an operating entity.  The mandate for those assets is to work together and to create something, that is their purpose.

A sum of the parts makes sense in two situations, the first is if the company has excess assets that on their own are extremely valuable.  Consider our messenger example, what if I said you also owned a set of rare historic bikes in addition to the messenger setup?  These bikes are stored in your garage and never used for deliveries.  If you were not emotionally attached to those bikes you could potentially sell them for thousands apiece without affecting your messenger job.

The second situation when a sum of the parts could be appropriate is when management has made it clear they are willing to part with significant portions of their operations in an effort to streamline/refocus/monetize their company.

If management views their assets as available for sale, and actually sells them when given an attractive offer then it's reasonable for investors to view them as the same.

The key to a sum of the parts analysis is that management needs to be willing to monetize their assets.  A company with an extremely valuable piece of land that they are unwilling to sell because it was purchased by the CEO's great grandfather has a value thats determined by the company's use of it.  Management is the key to unlocking value at companies with valuable assets.

In an issue of the Oddball Stocks Newsletter I wrote about Du Art Films, a film processing company located in New York.  The company owns an extremely valuable plot of land in Manhattan that is underutilized.  They could sell their land to a developer to build a skyscraper for many times their market cap.  They own other valuable assets as well.  The reason shares trade so cheaply is that management has been unwilling to monetize those assets.  But there are indications this could be changing as management is quite advanced in age, and shareholders are agitating for change.  But without management being willing to do anything it's likely these assets will remain undervalued for a while.  Du Art is a typical sum of the parts situation, a set of valuable assets that are at the whim of management.

If a company has excess salable assets and a management that appears willing to sell them then a sum of the parts could be appropriate.  If a company is simply a collection of unrelated assets and there is a management team willing to monetize them then a sum of the parts could be appropriate.  If a company has entrenched management that has a "down with the ship" mentality a sum of the parts valuation definitely isn't appropriate.

In general it's best to look at a potential investment through a number of different valuation lenses.  If a company comes up cheap when using multiple investment approaches then there's a very strong chance that it's truly cheap overall.  But if a company appears expensive using every approach except one, and that one approach says it's blindingly cheap it's probably best to look deeper or look elsewhere.

Like anything, a sum of the parts valuation methodology is appropriate in some situations, but no appropriate in all situations across the board.

Recent podcasts

I have been podcasting with Fred Rockwell for a while now on the topic of micro cap stocks.  If you haven't subscribed to the podcast I'd recommend you do so on iTunes, Android, or RSS.

Here are a series of links to some recent episodes.  We are always looking for new guests, if you want to be on the show please get in touch!

Andrew Walker: Rangeley Capital

Thompson Clark: Microcap Millionaires

Tim Eriksen: Eriksen Capital

Lenny Grover:

Christian Ryther: Cureen Capital

Myself on banks and free cash flow

Chris DeMuth: Rangeley Capital

Maui Land and Pineapple, a case of cheap assets depending on where you sit in the capital structure.

Whether or not a company is cheap can change depending on where an investor sits in the capital structure.  A company with enviable assets out of reach to investors is just a dream, not a great investment.

Maui Land and Pineapple (MLP.NYSE) is the type of company investors dream of owning.  Imagine being able to say you own a bit of land in Hawaii in the form of a nature preserve, resort, utilities and commercial real estate.  That's what Maui Land and Pineapple investors can claim.  The company owns 23,000 acres of land on Maui, a magnificent island paradise sitting in the middle of the Pacific.  The company also owns and operates the Kapalua Resort, and manages a private nature preserve.

The company specializes in property management, and real estate sales.  They are focused on selling real estate parcels at the resort, not hotel rooms for weekend vacationers.  Beyond their resort real estate the company owns and operates two public water utilities.  They also own and lease commercial property to businesses on the island.  The company has their fingers in everything related to real estate, sales, leasing, development, preservation, agriculture, and extraction.

A familiar theme in the investing community is "undervalued real estate."  The theme is often that the market doesn't appreciate the true value of a company's real estate.  Sometimes this is because the real estate is held on the books at historical cost and no one noticed.  But more often it's because the real estate is being utilized by the company in a sub-optimal manner and investors don't have faith it's true value will be realized.

Maui Land and Pineapple fits both descriptions.  The majority of their 23,000 acres are held on their balance sheet at historical cost.  The stated value for their 23,000 acres is $5.15m, or approximately $221 per acre.  This is because the majority of the company's land was purchased between 1911 and 1932 and held at those values.  The value for investors is if management is willing to sell off their excess holdings.

Selling real estate is the modus operandi of Maui Land and Pineapple.  The majority of the company's revenue is due to their real estate sales.  From parcels as small as an acre to larger tracts the company is continually selling it's holdings.

In the trailing nine months the company generated $20m in revenue, $12m from outright land sales, $4m from leasing activity, $2.4m from their utilities, and $1.1m from resort amenity sales.  They have a market cap of $94m and are selling for slightly more than 10x trailing nine months net income.

The company's book value is negative due to an accumulated deficit, but is likely grossly understated.  I haven't done a deep dive into the value of the land (you'll see why below), but a recent sale took place at $480k per acre.  If one were to estimate the land was worth 1/3rd of that price, and that only 12,000 acres were salable the company should be worth $1.9b, yes, billion with a "b".

There are good assets, good recent earnings, so what's the issue?  This should be a screaming buy.  A company that is selling for hundreds of book value if they sold off half their land.

The problem is that the storyline might be true, but it is unlikely that equity investors will be the ones recovering the value.

The nature of real estate is that if it isn't levered it's very hard to make a return, or at least that's what real estate management companies tend to believe.  Secondly it's hard to extract the value from real estate without selling it.  One route to extract value is to borrow against real estate holdings and finance whatever ventures one believes are more worthwhile.  And finance they have, Maui Land and Pineapple is no stranger to the world of debt.  They have $40m of revolving debt that is due this year including a $25m loan to Wells Fargo, a $14m AgCredit loan and $400k headed to First Hawaiian Bank.

Unlike equity investors lenders don't get to share in the upside when they make a loan to a company, they are primarily concerned with receiving their money back.  There is no doubt that Wells Fargo, AgCredit and First Hawaiian Bank made prudent loans to Maui Land and Pineapple, even if the company ends up on shaky footing.  Those three lenders have liens against all of the company's assets, the utilities, the land, the resort, and the commercial space.  If Maui Land and Pineapple were to declare bankruptcy the lenders would be the new owners of valuable real estate among other things.

It's uncertain as to how the company will pay their $40m in debt coming due this year.  In their most recent filing the company states that "Absent the sale of some of its real estate holdings or refinancing, the Company does not expect to be able to repay the outstanding balance of the revolving line of credit on the maturity date."  The company will either need to refinance their loans or sell a considerable amount of real estate, or do both to meet their debt maturity this year.

At the Microcap Conference in Philadelphia in November Chris DeMuth spoke about looking for investments with constrained counter parties.  When a counter party is constrained they're often forced into making uneconomic decisions.  A savvy investor can take advantage of a situation like that and purchase assets or earnings at considerable discounts.  The issue with an investment in Maui Land and Pineapple is an equity investor is buying into a company that is a constrained counter party.  The clock is ticking for the company to either refinance their debt or be forced into real estate sales by the summer.

On the surface Maui Land and Pineapple appears like it could be an attractive investment with valuable land and cheap earnings.  But a deeper dive reveals a company that is a constrained counter party.  The real investment opportunity is for anyone looking to buy Hawaiian real estate on Maui at attractive prices, or anyone in the position to make a secured loan to the company in the next few months.

Announcing the Toronto Microcap Conference

Sometimes the best bargains in the market are the easiest to overlook.  While everyone is searching for value in esoteric places there is a developed market within driving distance from the US that speaks English (mostly) and does business with the US that's hitting new lows.  Yet investors write off Canada because the perception is the Canadian market is 100% gold mining and resource companies.

For example, did you know there are 798 non-resource, non-oil and gas companies in Canada trading for less than book value?  All of these are micro cap companies, off the radar and un-investable for some of the largest and best known Canadian funds.  Canada is a hot bed of value,  22% of their market trades for less than book value.  Compare that to the US where only 11% of the market trades for less than book value.

Maybe you aren't as interested in absolutely cheap companies and want growth, there are plenty of cheap growing companies in Canada.  There are a number of companies with 25% year over year revenue growth trading for less than 5x EV/EBITDA.  In the US there are only nine, and a few of them are China based US listed companies with dubious financials.

It can be hard work to comb through dozens or hundreds of companies looking for a diamond in the rough of potential investment candidates.  There has to be a better way, and there is.

Imagine a setting with 40 hand selected companies that offer excellent investment potential where you can speak directly to management in an one on one setting.  Combine that with dozens of well known speakers and hundreds of like minded investors, all gathered in the same place, all with the same goal, find the best opportunities.  We did just that in Philadelphia in November 2015 and now we're bringing the same format to Canada.

In April 2016 we will be hosting The Microcap Conference at the Hilton in downtown Toronto.

The conference starts Monday, April 11th at 1pm with speakers and company presentations.  The afternoon is completed with a happy hour, dinner, and keynote presentation.  Tuesday is packed full of presentations by well known investors, fund managers, and companies as well as one on one sessions with company management.  We end the conference with another happy hour giving you time to network and share ideas with fellow investors.  We'll have plenty of time to network throughout the conference.

You can find more information as well as sign up to attend here.

I'm looking forward to seeing you in Toronto!

Reading, resolutions and "research"

"Please don't bother me right now, I'm reading about railcar loading trends for 1842, the year of the great hog debacle.  I think I can see parallels between that and the current coal environment."  Ever run into a value investor like that?  Head so deep in a history book that everything current is just a repeat of the past?  Reading is to value investing as ice skates are to hockey.

Reading is so embedded in the value investing mantra that I've seen debates break out over who reads the more.  One of Warren Buffett's protege investors was mis-quoted in an interview saying he read 500 pages a day.  Soon message boards were full of posts positing that if Buffett deputies read 500 pages a day then that must be the path to success.  It wasn't long before legions of investors were burned out trying to plow through the equivalent of a Stephen King novel a day, seven days a week barely giving themselves time to eat or use the restroom, let alone think about what they were reading!  Eventually said deputy clarified that they only read 500 pages a week, but the damage had been done.

This is the time of the year when investors are making resolutions "I'll research more before making the next investment." "I won't sell as quickly" "I'll be more patient" "I won't chase story stock" etc.  One resolution many will make is they want to read more and deepen the research before investing.

By nature I'm a goal type of person, I'm first born, and driven (often go together), and like to accomplish things, even fabricated goals.  For years I'd set new year gold.  I'd build little systems to hit my goals and once I accomplished them I'd fall off my system for the rest of the year leaving the goal just a memory.  The goals were nice milestones, but at each goal I either realized it wasn't worth pursing the activity further, or I was discontent and set another goal further afield.

As I've knocked down goal after goal and grown older I've realized there's a better way.  Instead of setting fixed goals each year I now strive to build sustainable systems.  For example, a few years ago I set a weekly goal of running a certain number of miles.  I found myself in two situations, I'd run 80% of the miles the first three days of the week and then I'd slack off and do an easy run on Friday to make my goal.  Or I'd be busy Mon-Wed and Thursday and Friday would run too much putting myself at risk for injury trying to reach the weekly goal.  The better way is to say that I plan on exercising three to four days a week.  Since I'm not holding myself to an arbitrary number I can be satisfied if I get outside a consistent number of days.  The beauty of this system is that it's sustainable, run (or exercise) three days a week.  If I'm tired maybe I'll walk, or in the summer I might swap a run with a bike ride, but regardless I am out exercising, not maintaining a spreadsheet.

I've spoken in the past about building an investing system.  You need to invest in a way that fits your personality.  This is where reading comes into play.  There are many different ways to be a value investor.  Value investing is simply buying something of a measurable value for a substantial discount to that measurable value.  The thing is that to do this you don't need to keep your nose in a book constantly, even if Buffett does.

Have you ever seen someone say the following: "I'm interested in value investing, what should I do?" and the response is to throw a library of value investing books at the person asking a question. "Oh you need to read all of Buffett's letters, plus Security Analysis, plus thirty other books and 10-Ks and 10-Qs and the Farmers Almanac back to 1910 and then you'll be ready to begin.."

The approach we use to teach value investing is strange, almost foreign compared to most other things we learned in life.  Consider a sport.  The student is taught a number of basic rules and techniques and then told to practice.  As they practice and improve they are then taught more difficult techniques.  Or what about a pilot?  Piloting a plane is complicated, but a pilot learns the basics first then gets in a plane and practices with a teacher.  Once they know the basics they learn by doing.  Almost any type of learning I can think of follows this same pattern.  Discover the basics, practice, improve, learn more, practice more, improve etc.

Yet in the world of investing we have it backwards.  We tell a beginning student to read expert level books and never dip their toe in the pool until they've mastered the material.  Value investing is no more complicated compared to flying a plane, yet we're treating it like rocket science.

Maybe we do this because investing is a serious business where we're putting our money into something with the potential for a loss.  It's ironic that we hesitate to invest money where a potential for loss exists but where there's also a potential for gain, because most of our money is spent on things that are a 100% loss.  If I spend money on a burger and a beer, I enjoy it for a few minutes and after that the money's gone for good.  Sure, it converts into energy for a bit, but a few hours later I'm hungry again and need to consume more food (money turned into energy).  Same with almost anything else, food, electric for the house, gas for the car and on and on.  Consumers regularly part with the majority of their paycheck, or in some cases more than their paycheck for 'spent' things.  Items that have no potential for gain.  Yet when it comes to investing, where a potential for gain exists people are like deer in the headlights because they might lose money.  It's nothing to walk into a dealer and spend $25k on a car, but save $200 a month..yikes!

One does not need to be a rocket scientist to be a successful investor.  A simple index fund will result in a gain given enough time.  If an investor wishes to explore the value side of the world basic screens are a great start.  Buy 50 stocks trading for 75% of book value and sell when they hit 1.25x, rinse, repeat.  Will this investor buy bad companies, yup, will they own duds, yup, will it work out over time, yup.

In the new year I'd advise you to ditch resolutions to read more (unless you don't read at all, which is unlikely if you're reading this) and instead treat investing like any other activity.  Learn the basics, then practice and improve.  Once the basics have been mastered move into the next level, add more complicated techniques and work on mastering those.  Continue to improve and master each technique before moving to the next.  It's possible you might never advance beyond the basics, but that's alright, master those basics and stay at a level that you're comfortable with.  Investors get into trouble when they venture far from their abilities.  Sometimes you'll need a book or two to cross the chasm between what you know and what you want to do, that's when it's appropriate to shove your nose in a book.  But not before you're at that chasm.

Let me make a few concrete recommendations.  If you're new to investing I'd make sure you understand how financial statements work before committing any money.  You don't need a Masters level education to understand financial statements, just the ability to read and understand the mechanics.  The heuristic I learned was this: The income statement shows if a company can price their products for more than it costs to make them.  The cash flow statement shows if they're lying, and the balance sheet is a snapshot in time of this process.

If you have been at this for a while look to add a new technique this year.  Maybe it'll be spin-offs, or options, or liquidations.  Make it specific, not broad.  Don't say "I'll invest in special situations", be specific "I'll invest in a liquidation".  Then do what's necessary to learn the basics and practice.

Practice is what internalizes the book knowledge we've read.  Reading without practicing holds little value.  Yet we can learn a lot that's not in a book through practice and experience.  Don't get lost in the weeds reading about the details, get out there and experience it!

So how does research fit into my investing system? I outline my full process here.