Why "dead money" stocks can still be valuable

There's an expression in real estate investing that you "make money when you buy."  The expression means a real estate investor makes money not on growing rents, outsized appreciation, or through cosmetic improvements, but rather by buying a property at a large discount to what comps are selling for (real estate's intrinsic value).  Often a purchase discount is obtained because some material deficiency needs to be remediated and other buyers aren't interested in tackling the project.  Other times the buyer has a vision and means to implement it for a project that other buyers don't.

A real estate investor can make money from appreciation, or growing rents, but the surest way to ensure an adequate return on investment is to pay less at the purchase.  The same principle applies for investors who buy extremely illiquid stocks, or stocks that the market considers "dead money."  These are the stocks that are covered in dust bunnies and haven't seen daylight since the Nixon administration.

Investors have very little patience.  CNBC's entire premise is that you're missing out on something this exact second if you're not watching them.  The WSJ makes money on daily news. Financial websites on the internet are biased to what's happening right now.  This urgency has predictably trickled down investors.  Funds like to talk about how they look for investments with a catalyst, some event that will unlock value quickly.  They need a catalyst because their investors, the ones watching CNBC and reading the WSJ don't have patience anymore to see an idea develop and won't tolerate their managers waiting a few quarters, or gasp, a year or more for a thesis to play out.  This obsession with catalysts has made its way to individual investors as well.  Not many investors have much patience anymore.

This lack of patience becomes a problem with deep value investing because there are some stocks that require extreme patience.  I'm not talking about holding stocks a few months or even a year before value is realized, instead these are companies that might need to be held a decade, or even two decades before an eventual liquidity event or sale near intrinsic value.  Holding a stock this long required extreme conviction, extreme patience, or willful neglect.

Value investors fishing in the deepest ends of the value pool need to be like real estate investors who lock in their gains when they purchase.  Buying at an extremely steep discounts is warranted for these types of stocks.

Because some of this is such a foreign concept to most investors let's look at an example of one of my favorite dead stocks; a stock that has lost all investor interest, Hanover Foods (HNFSA, HNFSB).  The A shares trade for $82, the same price they were trading for in 2003.  The stock has seesawed in the intervening years climbing as high as $120, and then subsequently falling back to the $80 level multiple times.  What's interesting is that while the share price is unchanged from 13 years ago the business has continued to grow.

I put together a small table comparing a few aspects from 2003 and 2016:

The company has also paid $14.30 in dividends since 2003.  A shareholder holding for the past 13 years would have a 17% cumulative gain, entirely from dividends.  Yet the discount gap has grown from shares trading at 66% of book value in 2003 to shares trading for 27% of book value today.  

Let's look at this from the perspective of a 2003 buyer.  They've made a measly 17% return over 13 years, or 1.3% per year.  Yet the company's book value has grown at 7% a year over the past 13 years.

Now imagine that the market continues to ignore the company for another 10 years as the company continues to grow as it has for the past 13 years.  If the company continued to trade for about 30% of book value and an investor sold in 10 years they'd have a roughly 11% annualized return over that period.  This is due to the discount price at purchase plus the growth of the company's book value.  The math for this is compelling, I've built out a table of potential sale prices based on P/B multiples factoring in the company's growth rate as well as the holding period.  The rate of return calculation is a simple cumulative return divided by the holding period.  This table presumes an investor holds the shares the entire time and doesn't add or sell anything.


At worst the company continues to trade at their current discount and an investor sells in five or 10 years and makes 10% annualized plus a percent or so in dividends.  But maybe one day the market might realize there is value in Hanover Foods and the shares potentially trade at 50% or even 75% of book value.  If an investor were to buy today and sell their shares at 75% of book value in 20 years they'd be looking at a 47% annualized rate or return on their investment.  These are numbers that fortunes are made of.  But only fortunes for those patient (or stupid) enough to hold a dead money stock for decades. 

The issue is very few investors have the patience to sit idly and watch a stock do nothing.  Even fewer investors can do this with a stock that isn't SEC filing, is hard to purchase and the market has left for dead.  But those few investors who have an iron constitution can stand to make sizable returns.  A return for doing nothing, just buying into something with a little growth at an eye-poppingly low valuation.

The largest risk for an investor in a dead money situation is if the valuation gap widens.  This is what happened to Hanover over the past 13 years, they traded down from 66% of book value in 2003 to 27% of book value currently.  If in 10 more years the company still trades for $82 they'll be trading for 14% of book value.

At some point the discount becomes too large and value becomes its own catalyst.  Clearly 27% of book value isn't cheap enough  Maybe 14% of book value will be?  Maybe 7% of book value will be?  I don't know, but at some point the market quote for a growing profitable company simply becomes too great and investors start to take notice.  Of course most investors will find a million reasons to avoid the company.  And most are valid, and they'd be very valid at 80% or 100% of book value.  But can some of those issues be overlooked at 27% of book value?  Apparently not.  Maybe at 15% they'll be overlooked, or maybe at 7%.

If it seems like there are no investors left interested in Hanover it's because that's true.  Almost every long time shareholder I have spoken to has thrown in the towel and moved on.  At this point I'm not sure who owns shares anymore, but as shareholders give up the discount widens.  

Stocks like this aren't for everyone.  There is no catalyst in sight.  Interested investors don't need to act soon, you'll probably be able to pick up shares for $80 next year, and in three years and probably again in five years, there's no rush at all.  My kids will probably grow up and graduate college before I ever see a return with this stock.  But if shares ever do trade up to 50% of book value or even 75% of book value over that time I could end up with an excellent return, and I'm willing to sit on my hands until that happens.

Hanover is a simple example of this principle, but there are a number of companies that are like this.  Shares trade for significant discounts to ultimate realizable value, but gains will only be realized by those willing to wait what's considered an eternity in our fast driven market.

For more on how I find undervalued companies like Hannover, check out my free Oddball Investing mini-course

Disclosure: Long Hanover

41 comments:

  1. I think Avaya Gaming "AYA" is crazy cheap here...have you looked at it?

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  2. why do you think this stock has been shunned?

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    1. 1. It's gone nowhere for years
      2. Management stinks

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  3. Check your math. That isn't how you calculate annualized returns.

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    1. Did you read the article? I said I knew it wasn't correct, but in the interest of simplification I just divided. Feel free to provide corrected numbers and I'll post them.

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    2. The difference over the years does turn out to be very significant though. I just calculated the last column (after 20 years) and the annualized returns are 7.4%, 10.0% and 12.4% respectively instead of 15.88%, 29.80% and 47.21%.

      Of course this all makes sense as the discount to book only applies to the initially bought book. All the money that is reinvested will be reinvested at *only* 7% dragging down results (versus an average cost of capital of 10%). So we obviously want the discount to book to disappear as quickly as possible for maximum returns.

      Alternatively we'd like the board to pay out dividends as close to net income as possible instead of growing the business. I doubt they'll do that though.

      I really like your work Nate. Thanks for sharing!

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  4. How good are the book assets? From a P/E perspective it doesn't appear to be crazy cheap on the surface.

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    1. It's what you'd expect from a frozen food company, cash, inventory, receivables, a lot of PP&E.

      Earnings are low, and I believe that's intentional to avoid taxes. They are running this like a private company. In 2015 they had $5m in net income and $12.6m in CFO, $2.8m in capes so about $10m in FCF. About a 16% FCF yield, not great, but not bad either. They are clearly not operating to maximize this.

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  5. Book value has increased substantially whilst net income has gone backward. Presumably the growth in book value has come from retained earnings. Unfortunately it appears that every $1 of retained earnings is creating far less than $1 in intrinsic value given that net income has actually decreased over the last 13 years. Is that not a very fair explanation of why it does and should trade at a much lower % of book value today than 13 years ago?

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    1. Jason,

      Thanks for the comment. I think this is a very accurate narrative for the market view on the company. If this were in fact true most companies, if not almost all companies would trade below book value forever. Very few companies earn their cost of capital, and very few create value for each dollar invested.

      This is ultimately what makes a market. I believe that companies that aren't rampantly destroying value should trade close to what they'd be valued at in the private market. If Hanover were a private company that were in the private marketplace my guess is they'd sell for 75-80% of book value if not higher.

      Look at it this way, you have $12m in cash flow, plus another $12-15m in exec compensation. The business is throwing off about half of its market cap in cash each year. Shareholders receive half and management receives half. Is this ideal? No, but find me a perfect company at 27% of book value.

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    2. That may be right but there aren't too many companies out there that have invested $172 per share (increase in book value from 2003-16) to create NEGATIVE $6.2 per share of earnings.

      I have no view on whether or not this company is undervalued or not but I am not sure book value is the right proxy for intrinsic value here.

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    3. I don't think the last year's earnings are representative either. They've had good years and bad years, oddly enough for a food business. This isn't a straight line like most public companies.

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    4. Thanks Nate any new insights on the family dynamics playing out?

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    5. Yes, it's MUCH better than before. They've cleaned up the shareholding structure, are now showing share count in the annual report. John Warehime has passed the torch to his son. Michael has passed away and liquidated his stake. The company hired a new marketing director and there are now videos on YouTube about them.

      There is a lot of movement going on, I don't know the end-game. But regardless this is moving in some direction. What it is might not be clear to us now, but it's moving somewhere.

      I'm not sure the family owns 50% anymore, spitballing I am guessing they're at 30-40% or so. At this point an activist could potentially buy the entire company and take it over.

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  6. Nate, assuming 12m in FCF and 12-15m in exec compensation per year, how much do you think the company is worth? if you were a PE firm how much would you pay for the company? Are the execs worth that much or are family in friends padding the payrolls? Could exec comp be cut in half and another 6m in expenses be cut to move FCF from 12m/yr to 24m/yr? If that were possible, it seems the company is worth a lot more than ~90m.

    What do you think?

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    1. I think under a new owner they could have $25-30m of FCF. Management compensation is just taking cash and stuffing it into a pocket away from shareholders. Management isn't all that great, they're average at best.

      I think if you looked at $30m of FCF at say 8x that's roughly book value. I think there's an argument to be made this is at least worth book if not more to a private party.

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  7. ROE is about 2.5%. I guess the 27% of book value seems like an appropriate valuation.

    Nevertheless, there is always an activist around the corner, so you are right - if an activist will be your catalyst it is an attractive investment.

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    1. It's low currently, but it fluctuates a lot. They made $16m in 2010 and earnings are usually around the $12-15m level. This past year they were depressed due to a write-down on some of their inventory from a Central American subsidiary.

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  8. How often do they release reports? Annually and only to shareholders? I sent them a message through their website to send me the latest annual

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  9. They send quarterly and annual reports to shareholders.

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  10. This comment has been removed by the author.

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  11. Dear Nate,
    I know you have much experience dealing with de-listed companies, so I thought I'd ask: are there any requirements that management must provide financials when shareholders request information about the company's performance? I am shareholder in a company that went "dark" 8-9 years ago and I would like to find out what is going on. Thanks, in advance, for your assistance. cs

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    1. Laws vary state-to-state but for nearly all of them the answer is yes.

      http://www.jerryburleson.com/minority-shareholder-rights/shareholder-and-director-rights-to-information-and-remedies-to-get-it/?doing_wp_cron=1459556417.8812348842620849609375

      http://www.shareholderoppression.com/resource-news.html?a_id=17

      Usually search something along the lines of "[your state] minority shareholder rights" and search the attorney pages that come up for state-specific info.

      Good luck!

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    2. At what point is an inefficient, poorly managed and manager-controlled company uninvestable. There's a good chance that an additional >$100m of shareholder profit will be diverted to management before change is even considered!

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  12. Thanks for the information. I will pursue this further. Much appreciated

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  13. It's clear management here is the problem, and that problem is not going to be fixed.

    Absent a way to get cash channeled to shareholders via some sort of meaningful return, this investment doesn't make much sense. In fact, its not even an investment. Its like buying a mattress stuffed with cash, with someone standing on top of it stating you can buy a piece if you want, but he will never allow significant returns to come out for the benefit of you. And when that guy on top of the mattress leaves, he will be replaced by his relative.

    It only makes sense to buy this if you are intent on actually changing something. Buying 30% and running a proxy fight, demanding Board seats, or something like that. That is how fortunes are made... not by waiting for things to happen. But with voting control firmly with management, it is just a waste of time absent a straight up buyout offer.

    Like you said, maybe the stock stays a $90 for 5 years -- and the discount to book value continues, as book value continues to grow near $400/share. Then management comes along and offers $120/share for the rest of the equity not owned by them -- they say, it's a great premium to "market price". You never get a reasonable value for the company. This is not a small risk; it should not be downplayed.

    I agree with you about the asset values, earnings potential under new leadership, etc. I have followed this company for years, as you have -- there is probably much we do not disagree on. Unlike some other commenters, I am not of the opinion that there sorts of companies are "uninvestable" -- they are just uninvestable in small amounts waiting for someone else to engage and do something. Meanwhile, the time value of money works against you.

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    1. I think the difference here is that the family is not one entity but many factions that oppose each other. At the same time the family doesn't even own more than 50% anymore. I think this will get sold at some point for close to book and that's why I own it.

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    2. This is nonsensical. They see themselves as a family owned business -- and they pretty much are.

      To anyone who thinks it's soooo cheap -- buy a block of shares and demand a Board seat. Make them give you the shareholder list -- buy the shares, request a certificate, and demand the list in accordance with the state law. Figure out who owns what, and force accountability. They are not exempt from the state corporate laws. Stop playing nice, and start getting things done. They MUST hold Annual Meetings. They must solicit shareholders for Director elections. When was the last time any of that occurred? Corporate governance is terrible and they aren't accountable to anyone. You're acting like they are doing you a favor by telling you the number of shares outstanding -- basic corporate information. They need to be much more transparent, and much more accountable. Someone needs to be rattling their cage.

      But if a person isn't willing to do any of those things, then why buy the stock at all? Buying small amount of shares and waiting for someone else to do the heavy lifting for you sometime in the future is just plain a waste of time and intellectual effort.

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    3. How would you go about buying 30% of shares when an average of only 20 class B (voting shares) are traded per day?

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    4. You call shareholders on the phone and ask to buy their shares directly. It's the time tested and best way to accumulate shares in a thin company. Once shareholders know you are a liquidity provider people will come out of the woodwork to sell.

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  14. Anyone know where you can find the financials for Hanover?

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    1. https://www.dropbox.com/s/7e36imx6sfbilvv/hanover_foods_corp_AR2015.pdf?dl=0
      Annual Report 2015 released 10/12/2015 approx

      https://www.dropbox.com/s/zxl4a6wtrsp8gyj/HNFSA%2002-2016.pdf?dl=0
      2Q released approx 2/19/2016

      I must have missed 1Q in my email as I don't have it.

      While I would love for this to be taken out tomorrow at a solid premium, I'm holding with Nate as the company is profitable and growing BV.

      In these financials I see continued debt reduction and could be debt free soon. While I think their debt is already manageable (and should tender for stock), I can understand how some managements want to be debt free. Hopefully, once they are debt free, they can be more aggressive buying back stock.

      Of course it is also possible they just build cash which wouldn't be value add and frustrate shareholders.

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  15. Hanover should not tender for stock. They should avoid buying their own stock at all costs, because the business has no meaningful growth prospects. Incremental investments are not likely to be good investments that generate excellent returns. That's just the reality.

    But... they should return cash to shareholders.

    They should lever up at current low interest rates, and target an appropriate interest coverage on their income statement - say 5x, attributable to long-term debt financing. Since they made $9 million last year, then they should target $1.8 million LT debt expense, (add in some revolver debt and they would probably get to $2-2.2 million total interest expense). They run depreciation at about $10 million per year, and don't need to reinvest nearly that much in capex -- and Cash from Operations last year was $12 million+, so there is plenty of excess to support raising debt level.

    Targeting $1.8 million in interest expense attributable to new debt, financed at 5%, would allow for $36 million for a special dividend. That would be around $48/share in a special dividend. (I am using 750k, a rough number, for the amount of shares.)

    Reducing debt levels when interest rates are so low, and there is clearly an ability to cover interest payments and operate successfully, is just nonsense. It's poor management. My guess is the price of the stock would remain about the same post dividend -- it wouldn't fall $48.

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    1. Academy, I don't disagree with you about leverage and doing a leveraged recap. I tried to say that the business can handle some leverage in my previous comment.

      I was pointing out that based on past management actions, they seem focused on becoming debt free. Otherwise, why not refi a few years ago and pay out special dividends every year or every few years? Interest rates have been low for 5+ years.

      If my read of the situation is correct, being debt free will hopefully open up some avenues for increased dividends or buybacks/tenders. Both of those options are preferential versus building cash after becoming debt free.

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    2. Josh -- sorry if that came across as directed toward you. It was not meant to be. Rather, I meant it that the whole situation reflects poorly on the abilities of management.

      What kind of management wants to be debt free when interest rates are so ridiculously low? Simple -- people who are not confident in their abilities. When a company could issue a special dividend worth over 50% of their stock value by conducting a straightforward financing, then management is incompetent, getting bad advice, or both. There is no reason for such a policy.

      If they want to pay down debt with earnings, then that is fine -- issue a $50 special dividend, and then go about paying that debt down. In fact, if they were going to pursue that policy, then don't mess around -- dump the tiny quarterly dividend, take interest coverage to 2x, and issue a massive special dividend. Then pay it off with earnings over time -- and when the debt gets too low, do the same thing again.

      But there is no policy right now. They just paid off less than debt cost less than 2%. That interest in deductible -- so their net effective rate was far less then even 2%. What does that say about the prospects of the company? Probably not as much as it says about the financial acumen of the management team.

      Shareholders should not be satisfied with sitting around for years with a stock at the same level, when value realization is so easily achievable. Like I said before (in the anonymous posting on April 3 at 7:10 PM -- that was me) someone should be rattling their cage.

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    3. (also, Anonymous at 9:34 AM on April 4 is me as well.) Sorry for the tardiness in figuring out the username deal.

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  16. Enjoying reading some of the comments for this post. Most value investors who post online here and elsewhere are in the camp of only buying companies that are currently good companies or appear to be good companies. The problem is that most companies aren't going to be Berkshire Hathaway. According to the book 100 baggers (which, for sure, did not look at every company ever traded but nonetheless) there were around 350 total stocks that returned 100x or more for the past 50 years.

    For some reason people only want to look at companies using earnings/dividend/free cash flow discount models. My favorite type of analysis is, "hey the company has $50 in net cash but is trading for $35."

    A favorite thing I like to read is something Nate has mentioned before: people think that a bank is only worth book value or above if it can earn a high ROE. This is totally ignorant of the fact that the stock market is in fact really two markets: a market for stock that everyone thinks of and the market for companies. In addition bank stocks can, contrary to popular opinion, grow at a fast rate even if their ROE is only 6%. I know a small community bank with an ROE of around 6% who grew 2015 earnings (not EPS) at around 30%. This is because they were able to attract many new depositors to their bank and then, after making proper reserves, lent out a great portion of these deposits with a net interest margin of around 4.

    There is a difference between implied and stated catalysts. Cheap companies like Hanover just have implied catalysts. Cheap companies with only an implied catalyst are usually significantly cheaper than ones that have a stated catalyst. This company has an implied catalyst because it's cheap. It doesn't have an implied catalyst in the same way if this company were in Mario Gabelli's control.

    Despite all of what I just said I'm somewhat neutral on the bargain-growth spectrum. Most of my stocks are of the bargain type but I look everywhere to make money. I wouldn't let my "style" of investing get in the way of making money.

    One of these days Nate is just going to have to start LBO-ing some of these very cheap companies.

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    1. This is a great comment. I appreciate you taking the time to lay it out as you did. I agree with you.

      This comment stream is probably the best thing I have read in a long time... Thanks to everyone for adding value.

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  17. I've always been a firm believer that you make your money when you buy. Unfortunately, after many years of a bull market, the deals (I'm talking to-the-core solid fundamentals) are few and far between. I have a lot of cash ready to take advantage of the next bear market though. :)

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  18. Does anyone have the annual reports for fiscal years 2005-2017? I only have FY 2015.
    Thank you!

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