Lumber Prices vs Saw Log Prices

Tom McClellan tweeted this chart showing that lumber prices have been on a tear while log prices have not.



This is similar to what has been going on at the grocery store. Cattle futures prices are down this year, but I'll bet your cost per pound for a nice steak isn't.

Processing is a bottleneck: meatpacking and sawmills. Often when processing is a bottleneck the processors make a lot of money. If you are in refining and a big competitor is down for maintenance, the crack spread rises and you clean up.

Except in this case, covid is just screwing up processing plants: decreasing volumes and increasing costs. Here is what Tyson Foods said in the second quarter:
We are experiencing multiple challenges related to the pandemic. These challenges are anticipated to increase our operating costs and negatively impact our volumes for the remainder of fiscal 2020. Operationally, we have and expect to continue to face slowdowns and temporary idling of production facilities from team member shortages or choices we make to ensure operational safety. The lower levels of productivity and higher costs of production we have experienced will likely continue in the short term until the effects of COVID-19 diminish. Each of our segments has also experienced a shift in demand from foodservice to retail; however, the volume increases in retail have not been sufficient to offset the losses in foodservice and as a result, we expect decreases in volumes in the second half of fiscal 2020.
This is relevant in thinking about our Oddball companies who own timber, for example: Keweenaw Land Association, Pardee Resources, and Coal Creek Company. (Be sure to also read one of our older pieces, The Problem With "Sum of the Parts".)

We will have more about this topic in upcoming Issues of the Newsletter. If you are curious about the Oddball Stocks Newsletter, you can find out more (including à la carte Issues). Also be sure to follow Nate Tobik and the Newsletter on Twitter.

Update on Hauppauge Digital Inc. ($HAUP)

In December we did a post on a lawsuit that had been filed against Hauppauge Digital Inc. ($HAUP): a Verified Complaint to Compel Inspection of Books and Records in Delaware Chancery Court.

Regarding Hauppauge Digital Inc. (HAUP), see also these posts from other bloggers:
There have been some new developments in the case. The court granted Plaintiff a default judgment on April 24th:

Then, at the beginning of June, Hauppauge filed a motion to set aside the default judgment.

The motion was granted, and the default judgment has been set aside:


Conclusion:

I conclude that Hauppauge has met its burden of showing excusable neglect, a meritorious defense and that Rivest will not suffer substantial prejudice if the Motion is granted.39 However, recognizing that Section 220 actions are intended to be summary proceedings,40 and given the delays that have occurred related to this Section 220 action, I intend, once this report becomes final, to ensure that this matter proceeds as expeditiously as possible in the future.

Scheid Vineyards ($SVIN) Releases Quarterly Earnings

Nate did a post last month, "Interpreting the Scheid Vineyard 2019 Results". The trends that he noted in that post, and also in our post last summer about developing concerns with Scheid, have not really changed.

Gross profit was flat year over year, but SG&A is $4.2 million quarterly and gross profit is only $2 million. And that does not include interest expense, which at $1.2 million is now almost 60% of gross profit. There was a comment on our last Scheid post that is worth including here:
Nice post. COVID will certainly put a damper on their cased goods growth this year. Their new low calorie/health conscious line of Sunny with a Chance of Flowers seems like the right move, though.

One thing I would add is that they're currently in the process of monetizing a few parcels of unencumbered land. This has been in the works for some time, but looks like it was gaining significant ground before COVID hit. Check out the Greenfield town meetings documents on "Las Vinas" and "Pinnacles Plaza". Unfortunately, it looks like they will need to monetize these properties relatively soon. If they can sustain their case growth for two more years (e.g., sell over 600,000 cases), I think they will be fine. Though it truly is a binary, option-like play. 
Shares are now offered for $18.75, which is a seven-year low. We will have an update with our thoughts and analysis in the upcoming August Issue (#31) of the Oddball Stocks Newsletter.

Earnings 1st Qtr Fiscal 2021 by Nate Tobik on Scribd

Bank of Utica Statement of Condition for June 30, 2020


Bank of Utica (ticker symbols BKUT and BKUTK) is a perpetually cheap (relative to book value) bank that we have covered for a long time.

If you are not a Newsletter reader, you can check out a sample that mentioned BKUT a couple of years ago. We also posted about the 2019 annual results, and investors' reactions, back in February, and their Q1 results in May.

You can view the financials directly on CompleteBankData.

We are planning to make the upcoming August 2020 Issue of the Oddball Stocks Newsletter (Issue 31) a "Bank Issue," so we will of course be updating readers about Bank of Utica in detail.

SouthFirst Bancshares ($SZBI) 2019 Annual Report

We posted on SouthFirst Bancshares (SZBI) way back in December 2014 (actually twice), and it was also mentioned on Credit Bubble Stocks back in 2017. In the Newsletter, we talked about SouthFirst in the following Issues: 20, 22, 24, and 26.

At the current $1.65 per share, the stock is the lowest it has been since the summer of 2013. The annual report and proxy statement just came out as you can see below. We noticed something interesting in the footnotes to the 2019 financial statements:
On February 26, 2020, the Board of Directors of the Company elected to cancel the executive Change in Control Agreements (“Agreements”) that were in place for certain officers, as described in Note 13. The cancellation constitutes a 12‐month prior written notice of the Agreements in place. The Agreements remain in effect until February 26, 2021, in which any benefits may be provided under the Agreements in the event a change in control occurs prior to February 26, 2021. From and after February 26, 2021, the Agreements will be cancelled and no benefits will be provided under the Agreements for any change in control that occurs on or after that date.
We are planning to make the upcoming August 2020 Issue of the Oddball Stocks Newsletter (Issue 31) a "Bank Issue," so we will of course be updating readers about SouthFirst in detail.

Notes for a Beginning Investor pt 1

We recently had a birthday party for my two middle sons.  They share the same birthday three years apart.  To celebrate we invited close family to swim and relax, my parents, brothers, and their families.  While floating in the pool my sister-in-law mentioned she is interested in investing, but didn't know where to start.  I told her I'd help her.  I gave her a few good beginning books, and said I'd help her understand what she's doing.  After reflecting on my offer I also decided to build out a guide for beginners.  Casey, this post is for you!  If you are a beginning investor, or know someone who is interested in investing basics start with this post.

The act of investing is committing some of your capital (money) to another business.  You can either invest directly, or invest in a secondary market.  Regardless of what you do, you are always investing in a business.  Every business shares the same goal.  They offer a product or service to a customer that is value enhancing to the customer personally, or as a business and in exchange receive a small amount as compensation.

Let's get to basics.  What is a business?  At the bare bones a business is a collection of people or products that solves a problem for someone or something.  Here is a simple example.  Imagine you are lost in the woods and are out of water.  Would you as a thirsty individual be willing to pay a guide a token amount to lead you to water?  Of course you would!  If you didn't pay the guide you would likely die of thirst.  Paying a guide to lead you to water in unfamiliar terrain seems like a simple exchange.  You pay the guide, and they provide something of far greater value, continued life.  That is the essence of most businesses.  Their goal is to provide something to their clients that far exceeds the price they charge for the product or service.

Ok, so we recognize what a business is, but how can we invest?  And what is it worth?

You're probably familiar with stock quotes.  These are numbers that float on a screen.  Some companies are worth $14.67 and others $1467.  What's the difference?  And does it matter?

To understand this let's back up and understand what an investment is.  When a company is formed an amount of initial capital is required.  This is the money founders and initial investors put in to fund initial operations.  For the sake of this post let's use a fictional lemonade stand.  Someone wants to create a lemonade company and they're looking for investors.

In considering our lemonade company we have a few startup costs.  We'd need a table, some materials to make a sign, and of course lemons, sugar and water.  Maybe we need $100 all-in to start our stand.  But unfortunately we only have $10.  At this point most people just give up.  They need $100 and have $10, it seems futile.  But there is a path forward!

We take our $10 and solicit friends and family for the other $90.  Our family is generous and contributes $90 but tells us "I want a return on my money."  We get started and setup our stand.  We spend $100 funding our stand and initial lemonade inventory.  Lucky for us the stand is right at a busy intersection with lots of traffic.  We're able to sell cups of lemonade for $1 apiece with ease.  At the end of the day we've sold $40 worth of lemonade and are excited.  After tallying costs we spend $100 to build our stand and buy ingredients.  Our $40 in sales represents a 40% return on investment (the initial $40 divided by the $100 in initial capital.)

Unfortunately we need to spend $20 of our $40 to buy ingredients for the next day.  But the next day we hit the pavement and make another $40, and it continues like this for a while.  We are able to make a profitable return on our initial investment.  Our family will be happy with their investment.

The initial investors paid in $100 in capital.  Because we're legal minded we formed a corporation and issued 100 shares.  Each investor will receive $1 for each share, and our company will have 100 shares outstanding.  Each share represents a 1% ownership in our lemonade stand. 

If our stand is open 100 days a year we'd make $2,000 in profit on that initial investment.  Maybe we decide to pay that out as a dividend.  Each owner would receive $20 for each share they owned.  The math is this, 2000 divided by 100 shares is $20 per share.

This stand is a spectacular investment.  Initial family invested $1 and received $20 back their first year.  But let's imagine that we want to expand.  Instead of a single stand we want an empire of stands.  We decide we need more investors.

The next investors won't be investing at $1 per share because this company is already throwing off $20 per year in dividends.  If we wanted to raise additional capital, say $1000 to expand we might offer equity based on our current profits.  If the company did $20 per share in earnings maybe new investors might be willing to wait five years for a return of their capital.  This means they might pay $100 per share for that $20 in earnings.  After five years they get their money back and anything beyond is gravy.

If we can sell new shares on this basis we can raise our $1000 by selling 10 new shares for $100 per share.  Remember when we had nothing we were selling our shares for $1 per share, now they're $100 per share based on our earnings.  Our share count would expand from 100 to 110.  From here we grow larger and continue to expand.

The lemonade stand example is simple, but proves two points.  It shows the value of earnings to a company, and also shows that as earnings grow the value of the company grows. 

But understanding earnings and growth is a small part of investing.  It is the "meta" to investing, but there are a few other nuts and bolts pieces that need to be understood.

Financials

There is a saying that "accounting is the language of business."  This saying is largely true.  To understand a business is to understand their accounting.  

When I was in college there were plenty of people who were failing out of accounting left and right.  It was a dark art of business.  If you couldn't hack accounting 101 you were destined for an Anthropology Major.  Accounting was seen as scary and difficult.  Accounting is neither scary nor difficult.

Accounting is a way to describe how a business functions using numbers, and the numbers represent the money flowing through a business.  If a business isn't generating revenue it isn't much of a business, it's more of a hobby or idea.

A real business earns money via sales (called revenue).  This revenue is used to pay expenses.  After expenses are paid the company pays taxes.  What's left after taxes is called profit or net income.

In most businesses the majority of revenue is spent trying to make the next dollar, equipment, salaries, office supplies.

There are three financial statements that describe the operations of the business.  The balance sheet, the income statement, and the cash flow statement.  For a publicly traded company they are required to file all of these statements quarterly on the SEC's website.  You can search for a given company at this link.

Let me break down the financial statements.  The easiest way to think about them are this:

The income statement shows a company's ability to price their products over their costs.

The cash flow statement shows if they're lying.

The balance sheet is a snapshot of this process at a point in time.

Let's start with a company's balance sheet.  A balance sheet is showing a company's accounts, sometimes called their assets (what a company owns) and their liabilities (what they owe).

At the top of a balance sheet are things called current assets.  These are things a company owns that are either cash, or can be turned into cash within the next year.  Below current assets are longer term assets.  These are things a company owns that can't be liquidated within a year.  A long term asset might be a building, land, or machinery used to create product.

Under liabilities are both current and long term liabilities, just like long term assets.  A short term liability might be money owed to suppliers or payments due on short term debt.  Longer term liabilities are things like long term loans and lease agreements.

A company's assets minus their liabilities equity their equity.  The equity is what shareholders own.  If a company has little equity and a lot of debt the company is effectively controlled by their bankers.  A company's equity is last in line of ownership.  Bank debt has first lien on a company's assets.  If a company were to run into trouble assets are sold to satisfy liabilities.  If assets fall short of liabilities then a company's equity becomes worthless.

A company's balance sheet can be used to evaluate the staying power, or strength of a company.  Are they laden with debt and reliant on perfect business conditions?  Or do they generate ample cash and have enough to make it through a rainy day?

While a balance sheet is important in most cases it isn't as important as the two other financial statements, the income statement and cash flow statement.

The income statement shows the flow of money coming in and where it's paid out.  At the top of the income statement is a company's revenue.  This is money earned from selling products or sales.  Below revenue is the cost of sales.  This is the amount that it cost to create the products or services that a company is selling.  

Revenue minus cost of sales is something called "gross profit" and is often expressed as a percentage.

Below this is salary costs, research and development, taxes and other company expenses.  Before taxes are paid a company pays interest on their debt.  What's left after expenses, interest and taxes is called net profit.  This is what shareholders are entitled to.  A company can either reinvest this amount, or pay it out directly to shareholders as a dividend.

The company's net profit divided by the number of shares outstanding is called "earnings per share".  This is often a value used when discussing companies and their performance.  It's a representation of the profit shareholders are entitled to per share of ownership.

The last statement is the cash flow statement.  Both the balance sheet and income statement are based on accrual accounting.  This is probably a 200 level topic, but in short accrual accounting recognizes money flow based on contractual timing of money flow, not when money actually changes hands.

The cash flow statement shows the company's accounts in terms of actual cash flow, not accounting flows.

In the US the cash flow statement starts with the company's net income and adds and removes a variety of items such as depreciation and inventory flows.  The end result is operating cash flow.  This is the actual cash generated from operations.

One thing to watch out for is when a company claims they are profitable on their income statement, but then don't generate any cash.  Alternatively some companies claim they don't earn much of a profit, but have substantial cash flows.

This has been a whirlwind tour on the basics of a company and their financial statements.

In part two I'll cover the basics of valuation.

Best of luck!


Goodheart Willcox FY 2020 Annual Report

We've mentioned educational publishing company Goodheart-Willcox (GWOX) a number of times in the past. Nate first wrote about it on the blog way back in October 2012 when shares were trading for about $72. We did three update posts last year; in March about the tender offer, in June with the tender offer results, and in July about the FY 2019 annual report.

This week we received the FY 2020 annual report, showing that sales and net earnings were down from the prior year. We will have more analysis and commentary in the upcoming 31st Issue (August 2020) of the Oddball Stocks Newsletter.

If you are curious about the Oddball Stocks Newsletter, we've added a couple low-risk ways that you can try out what we are about. First, there are our back Issues. The most recent June one was Issue 30. The issues before that are available à la carte: Issues 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, and 29.

We also compiled a collection of Highlights from the back catalog which is available as a "Highlights Issue". If you have been curious about the Newsletter, then this is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

GWOX FY 2020 Annual Report by Nate Tobik on Scribd

Next generation of Warehimes at Hanover Foods?

We noticed this recent obituary,
John Alan Warehime, aged 82, passed away on March 11, 2020. He was born on November 17, 1937 in Hanover, to the late Alan R. and Rosedrey (Rohrbaugh) Warehime. He is survived by his wife of 57 years, Patricia (Mosebrook) Warehime, their children Jennifer (Warehime) Carter and husband Michael, Jeffrey A. Warehime and wife Amy, and J. Andrew Warehime and wife Michelle, and seven grandchildren.

Mr. Warehime graduated from Massanutten Military Academy in Woodstock, Virginia and Penn State University with a Bachelor of Science degree in Agricultural Economics. He was Chairman of the Board of Hanover Foods Corporation since 1990.
What will the future hold for Hanover Foods? See our recent posts about quarterly results and the Hanover annual report.

Interested in trying the Oddball Stocks Newsletter?

If you are curious about the Oddball Stocks Newsletter, we've added a couple low-risk ways that you can try out what we are about.

First, there are our back Issues. The most recent June one was Issue 30. The issues before that are available à la carte: Issues 19, 20, 21, 22, 23, 24, 25, 26, 27, 28, and 29.

We also compiled a collection of Highlights from the back catalog to demonstrate what the Newsletter is, or what it hopes to be: topical, philosophical, talking about companies that the market ignores, pounding the table for value investing while grappling with problems like rapacious managements that are consuming value.

The "Highlights Issue" is available here for purchase as a single Issue. If you have been curious about the Newsletter, then this is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

This is a "highlight reel," but it is not a victory lap or a tout of what we have written about. A lot of these highlights are our thinkpieces: on shareholder rights, on banking as a business model, on value investing. There are pieces about companies that got taken out at a premium but also about ones that are trading lower now some years later... of course, those may be the most interesting to pay attention to now. There are two companies – Scheid Vineyards and Enterprise Diversified (formerly known as Sitestar) – where we warned about significant risks that ended up materializing.

We have also posted some Newsletter excerpts over the past year to give a taste of the Oddball writing and coverage style - but just remember that the most interesting content is for subscribers only. The excerpts were on The Coal Creek Company, Tower Properties, Bank of Utica, small banks, Avalon Holdings, Boston Sand and Gravel, Conrad Industries, and Sitestar / Enterprise Diversified.

Don't miss our recent Oddball Stocks blog posts on:
Finally, if you want to be completely immersed in the Oddball universe, be sure to follow Nate Tobik and the Newsletter on Twitter.

Interpreting the Scheid Vineyard 2019 Results

This week shareholders in Scheid Vineyards received the annual report in their email inbox. They've had a few rough years, but this year was a wallop to the gut for shareholders. Initially I was going to break down their results in a Twitter thread, but decided a blog update was more appropriate. Let's dive in...

Scheid Vineyards ($SVIN) is an over-the-counter micro cap that owns and operates vineyards and wineries in California. They produce both bulk grapes and cased wines under a variety of brands.

The company reported a loss for 2019 of $12.8m on revenue of $51m. Revenue was down from $58.5m in 2019. The primary driver of revenue decline was a decline in bulk wine sales. This is important because historically their business was built on selling bulk grapes.

Most wineries do not grow their own grapes. Like most industries wine making consists of compartmentalized functions and various suppliers, with everyone balancing the advantages and disadvantages of vertical integration to come up with a model that they think is optimal.

Wine makers tend to enjoy making wine, that is blending yeast and grapes. Wine making is very different from farming grapes. Because of this it is rare for a winery to both specialize in growing and blending. Wineries that do both bottle and sell what are called "estate wines". The estate wine designation means the grapes in the wine were grown on site.

A quick trip to the local liquor store to browse wine will confirm that most wine is not estate wine, but rather blended from bulk grapes. This isn't a bad thing, it's just how it works. A wine maker can choose the type of grapes they want so they can control the taste and quality of what they produce.

When you're running a bulk wine operation you're running a company similar to a corporate farm.  There is a lot of land involved, and expensive machinery to harvest and package grapes for sale.  Contrast this to a winery that only needs a building to store the wine in process that they're producing. This is why most wineries that you might have visited all have a similar resemblance.  They appear to be a warehouse with a tasting room attached and a few rows of grapes growing outside for decoration.

A company can capture a lot more margin selling bottled wine vs bulk wine. Like anything, the margin on the raw material is small compared to the margin on the finished good. With this Scheid decided a few years back to focus on selling bottled wine vs bulk wine sales. They would be completely vertically integrated, from growing to blending, to bottling. In this way they should be capturing the entire margin from making wine.

For years the business did well, it even traded for a few times earnings when I first wrote about them in July of 2013. They were selling for 63% of book value and 6x earnings. Shares were trading for around $31 at that point and had just earned $4.59 per share. A year earlier the company earned $9.13 per share. There was a lot to like about the company!

Shares eventually skyrocketed from $31 to $108 on the back of solid earnings and a great narrative about value and future growth. Subsequently shares crashed as earnings turned negative and losses accelerated.

I initially tempered my bull case to Sheid with the quote 

"Scheid Vineyard’s flaw is found in their balance sheet -more specifically, their debt. The company is highly levered, and is exposed to both agricultural cycles and market cycles. The wine market cycle peaked right before the 2008 recession and has slowly recovered. The company produced a record harvest this past year that requires capital to process, but should also result in higher earnings next year. The company’s bank is Rabobank, which an industry contact related is known throughout the industry as the best bank for wineries. They are willing to work with wineries when downturns occur, and will drag their feet on calling loans until there are no other options. So while their debt could be a stumbling block for investors there is a small silver lining in that Scheid’s bank is very winery friendly."

It turns out that this quote was quite prescient. We wrote another post last summer about developing concerns with the Scheid results.

In 2020 the company had $83m in long term debt, and $30m in operating debt, for a whopping $113m in total debt against equity of $30.3m.  

The company earned $51m in revenue and had $41m as cost of goods sold for a pre-write down gross profit of ~$10m. The problem is interest costs were $4.7m, or 47% of gross profit. This past year the company wrote down $4m of inventory leaving them with a GAAP gross profit of $5.6m, meaning interest costs along were 83% of gross profit. To say that's concerning is an understatement.

A retort could be that GAAP gross profit isn't a cash number, so this isn't a true picture of their ability to serve their debt. The problem is when you look at their cash flow statement it's even more ominous.

The company had a negative $4m in operating cash flow, $5m in cash interest expense and had to borrow an additional $14m to make ends meet.

The sad thing here is the company does have true value. They mortgaged their land for $100m to Prudential Financial. The problem is the land is generating a negative return for shareholders, and to fund that negative return the company needs to continually increase their debt load.

If Prudential were to take the land and sell it off they would almost surely realize more than $100m.  Unfortunately shareholders would get nothing.

So what's the bull case here? It would be that the company increases their case sales at a really high rate while figuring out a way to manage their debt. IF they can pull this off and start to pay down debt this becomes a private equity type scenario where as the debt is repaid the equity becomes more valuable. Additionally as the debt is paid down earnings would accelerate as interest costs were reduced.

The bear case is that the pandemic hits their sales hard and they have to restructure. In the company's annual letter they noted that sales are down and they are expecting a difficult year. I'm not sure the Prudential credit team should be sweating much, but shareholders sure should. Scheid's financial statements disclose that their debt has financial covenants, including "debt service coverage ratios, and the amount of total liabilities to tangible net worth." From what I've heard, Scheid is not willing to tell people what the threshold ratios are or how close the company is to tripping them.

On the bright side I believe shareholders still qualify for discounts at the company tasting rooms, and tasting rooms opened June 12th. I'm not sure the discount will compensate for shareholder losses, but maybe you wouldn't feel as bad about them afterwards...

Disclaimer: I own a single share of the stock

Is the market expensive or cheap? What the small cap net-nets are telling us...

Imagine you're on a trip driving through a distant city.  You take a wrong turn and find yourself in a seedy and industrial part of town.  It isn't bad per se, but gritty, grimy and full of buildings that look like they were last taken care of before the computer age.  You find yourself thinking "I couldn't be paid enough to own a building like that in a place like this..."

That's most people's thoughts.  But what if you found out one of those buildings was for sale.  And inside the building was nice and clean, a bit outdated, but orderly.  On top of that there was a file cabinet with a drawer full of stock certificates.  The lower drawer of the cabinet was loaded with cash.  There were also some piles of coins that had questionable value along with some machinery that could be worth a lot to the right buyer.  All told the value of the cash and stock certificates alone were far in excess of the list price for the building.  Would you purchase it then?

That's the situation some small cap investors find themselves in when digging through the forgotten names of the OTC market.  Names that are a little dusty, in the wrong parts of town, but full of cash and valuables that exceed their listed price.  The technical term for companies like this is a net-net.  That is, a company whose cash, receivables, securities and inventory minus all liabilities is greater than its market cap.

Net-net's were popularized by the father of value investing, Benjamin Graham.  Value investing is a historic type of investing that was popular when stocks traded on fundamental metrics such as revenue or profits.  These days if a modem can't dial into your company's website on the information super highway then why even invest?  Or maybe the phrase is "if your company hasn't figured out how to turn capex into opex though software subscriptions while burning cash then don't invest."  I sometimes get my bubbles mixed up..  

The market has shifted from valuing companies based on fundamentals to valuing them based on their story.  If a company can tell a great story they trade with a nice valuation.  If a company is run by stalwarts who care about things called margins and cash then they might as well be worthless, or even less than worthless!  The market will pay you to buy shares in some of these companies.  

Historically purchasing a basket of net-net stocks has outperformed the market.  The reason for this is simple.  These companies are left for dead and trade for less than being dead.  When they inevitably show signs of life investors become excited and bid up their price from less than dead to dead, or maybe they appreciate all the way to "we might be a viable concern."

A second reason that these stocks work is because in theory their downside is limited.  If you are trading for less than dead it is really hard to fall much further.  Someone will always argue that at any level your stock can fall even more.  But as you fall the valuation gap increases, and at some point that gap becomes so crazy that the valuation itself can become a catalyst.

The problem around net-nets is the narrative.  They're already viewed as less than dead.  Most are probably still advertising on MySpace or in the YellowPages.  There are a lot that enter the net-net stage as they are falling towards a terminal value of zero.  The ones heading to zero are affectionately called "melting ice cubes."

You can sometimes invest in a melting ice cube and get out before it totally melts, but it's rare.  Don't waste your time.

There are other times, like now, when you can invest in a handful of companies that are net-nets, that have been around for decades, are profitable, and some are even growing.

While the overall market appears to be wildly expensive given the state of the economy there are a handful of net-nets that are crazy cheap.  Crazy cheap as in trades for less than net current assets and for 3x EV/EBIT.

In the most recent issue (our Thirtieth, published yesterday!) of the Oddball Stocks Newsletter we covered half a dozen of these. Some were covered on the blog in the past but are back to trading at discounts, thanks to the Oddball bear market inside of the bull market. (Or biggest bubble of all time?) This happens with the net-nets: they round trip it and back again. If you subscribe to the Newsletter you can see the latest batch.

The point of this post isn't to pitch my product, it's more about what the resurgence of these names says for the market.

When markets are high there are usually no net-nets to be found.  Everything is elevated including companies that probably should be trading for less than net current assets.  And when markets crash there are dozens to hundreds of net-nets as investors give up and sell everything they can.

In Japan post 1992 crash there have been periods where hundreds of profitable, well capitalized and growing companies trade for less than net current assets.  Investors who purchased baskets of these (myself included) and sold when valuations went from horrible to not-so-bad did especially well.  Investors who kept holding didn't do as well.

In the US there were hundreds of net-nets in the wake of the 1929 market crash.  Since then we've had periods where there might be a dozen or a few dozen.  In these periods investors who dipped their toe into the net-net pool, or into slightly higher quality small stocks trading at low book values did especially well against the market as whole.

What's different this time is there are green shoots in the net-net space at a time when the market as a whole appears overvalued.  One possibility is that an investor buying a basket of net-nets and shorting the indexes could crush the market if history repeats.  Of course this time seems different than most times and it's possible the growing group of net-nets will simply expand as more small companies fall in price as investors move to larger tech names.

It's impossible to know the future.  But what I do know is that personally I've been rewarded for buying profitable net-nets in bulk when they start to appear in the market.  I don't know if the future will be anything like the past, but I know where I'll be placing my bets..

Just Published: Issue 30 of the Oddball Stocks Newsletter!

We just published Issue 30 of the Newsletter. If you are a subscriber, it should be in your inbox right now. If not, you can sign up right here.

In this Issue, we mention three companies that trade for negative enterprise values and three that trade for less than their net current assets.

Remember that we have made some back Issues of the Newsletter available à la carte, so you can try those before you sign up for a subscription: Issues 19, 20, 21, 22, 23, 24, 25, 26, and 27.

We also published a "Highlights Issue" in February. The "Highlights Issue" is available here for purchase as a single Issue. If you have been curious about the Newsletter, this is the perfect opportunity to try about two Issues worth of content (much of which is still topical and interesting) at a low cost.

Oddball News Roundup

Hanover Foods Reports Quarterly Results

Hanover Foods is a name that is familiar to Oddball investors. We have covered this one four times on this blog (in 2012 twice and in 2013 and 2016). It has also been written about on Corner of Berkshire and Fairfax, Credit Bubble Stocks (twice), and other blogs.

Hanover A shares traded as low as $55 in March and are currently $68, which is where they traded as long ago as 2003. Back then, with about 1.07 million A and B shares outstanding, the market capitalization was $73 million. Now with only 715k A and B shares the market capitalization is down to $49 million.

Shareholder equity then was $95 million. Now, as you'll see below, it is $242 million! Current assets net of all liabilities was only $13.6 million. Now it's $126 million. (So, the price to book is now 0.2x and the price to NCAV is 0.39x.)

Part of the problem is that earnings have declined. In the 2003 fiscal year, Hanover earned $9.8 million on $290 million of sales. In fiscal 2019, earnings were only $2.6 million on $395 million of sales.

The 1% return on equity translates into a 5% earnings yield thanks to the 80% discount to book value.

Will Hanover ever return to greatness? We will be writing about some ideas in the upcoming Issue of the Oddball Stocks Newsletter.

Letter Sent to Life Insurance Company of Alabama (LICOA) Shareholders $LINS $LINSA

We originally posted in November 2019 about Life Insurance Company of Alabama (LICOA), and then did an update last month about a new shareholder activism effort, which includes lawsuits by investors such as Jeff Herr, Mitchell Partners, and Trondheim Capital Partners. The latest development is a letter from Trondheim to shareholders of the company.

We'll have more on this situation, and other activist investing situations, in the upcoming June Issue (#30) of the Oddball Stocks Newsletter.

York Corrugating Company Reverse Split $YCRG

Be sure to read a great post this morning by Value Investing Blog on a YCRG reverse split squeeze-out:
Every now and then I like to highlight a transaction that to me looks unfair to minority shareholders. For example, two years ago, Waxman Industries tried to buy out shareholders at a ridiculous price that amounted to just 12% of book value. Apparently so many shareholders asserted their appraisal rights that the company ended up cancelling the whole deal about a year later.

This week I received the financial statements of York Corrugating Company (OTC:YCRG). The company is a manufacturer of precision metal components and sheet metal products. [...]

In previous years I only received financials and the notes to the financial statements. There was no letter from the CEO describing how the business performed that year. This year there suddenly was a letter. It was even titled “Important Letter to Shareholders”, so that made me curious.

Unfortunately the letter announces an attempt from the company’s management to cash out the remaining minority shareholders. They plan to do this by way of a reverse split at a ratio of 2960-for-1. Every shareholder holding less than 2960 shares will see their fractional shares (post-split) cashed out at a price of $308 per share, determined on a pre-split basis.

The company has obtained a valuation from Baker Tilly Virchow Krause LLP to deterimine the “fair market value” of the minority shares. Their report is not included, nor is there any explanation offered why this price is deemed fair.

The company only had 20,841 shares outstanding as of December 31, 2019. At a price of $308, the Board of YCRG thinks that $6.4 million is a fair valuation for the company. Looking at the balance sheet and the company’s recent earnings, this valuation looks much too low.
He did not post a copy of the letter to shareholders, but we are trying to track it down.

York Corrugating Co. is a classic Oddball (it's in the Century Club) although we have not written about it on the blog before. It is based in West York, PA; a half hour or so from the headquarters of Hanover Foods, but pretty close to little York Airport where Hanover keeps its Cessna Citation jet!

Whatever is in the water in southeastern Pennsylvania does not seem to promote friendliness to minority shareholders. In fact, in looking for case law on squeeze-outs, we see some old friends: a 2012 Supreme Court of Pennsylvania opinion in Mitchell Partners, LP vs Irex Corporation:
Mitchell Partners, L.P., was a minority shareholder of Irex Corporation, a privately-held Pennsylvania business corporation. In 2006, Irex participated in a merger transaction structured so that some minority shareholders would be “cashed out” and would not receive an equity interest in the surviving corporation, a wholly owned subsidiary of North Lime Holdings Corporation. Mitchell objected to the acquisition, as it viewed the transaction as a “squeeze out” of minority interests at an unfair price. The merger proceeded nonetheless, and Irex commenced valuation proceedings in state court, per Section 1579 of the BCL, to address the dispute with Mitchell.

Meanwhile, Mitchell pursued common law remedies in a diversity action in federal court, naming as defendants Irex, its directors, most of its officers, and North Lime. The complaint asserted claims for breach of fiduciary duties, aiding and abetting breach of fiduciary duties, and unjust enrichment. The defendants sought dismissal on the ground that, under Section 1105 of the BCL, judicial valuation is the sole remedy available to dissenting shareholders in the post-merger timeframe.
Notice that the Irex merger closed in October 2006, Mitchell sued in federal court October 2008, and the case went to the federal court of appeals and the Supreme Court of Pennsylvania, because the federal court certified a question of state law for them to answer. The 2012 state supreme court opinion was a victory, establishing a legal precedent in Pennsylvania: "shareholders [can] bring a non-appraisal action, after the closing of a merger, asserting fraud or fundamental unfairness."

Good for Mitchell for fighting so long and hard - Irex paid a big tax for not asking for minority shareholder blessing of what it wanted to do before doing it. But that 4+ year battle points to something important.

In his post, Value Investing Blog alludes to a problem that minority shareholders have in these situations: a high fixed cost of fighting what the management and/or controlling shareholders are trying to do. It can be a significant cost in terms of time and attention, and for someone to rationally pay that cost upfront he would have to anticipate a higher expected benefit. An appraisal action is likely going to require dissenting shareholders to have an expert report.

That suggests something important for corporate governance theory. The ownership structure of a company matters, and can be very important for the ultimate returns of shareholders. At the limit, if a company were to be owned by a large group of shareholders each holding a single share of de minimis value, it might be possible for the management to convert all of the company's equity to their benefit and rational for the shareholders to acquiesce. (In theory, the shareholders could resist as a class, but in practice those efforts have to be initiated and organized by a shareholder with an economic incentive to do so.)

Speaking of reverse splits, yesterday's post was about shareholder activism at Life Insurance Company of Alabama. On the Concerned Shareholder website, there is mention that LICOA was considering a reverse stock split in 2015 and met with state regulators about it. No word on what happened with it though (or why it didn't happen).

Shareholder Activism at Life Insurance Company of Alabama

We posted in November 2019 about Life Insurance Company of Alabama (LICOA), a micro cap insurance company with two share classes, one of which (LINS, the fully voting shares) trades at a modest discount to book value and the other of which (LINSA, with limited voting rights) trades at a gigantic (70%) discount to book value.

As we mentioned in that post, the State of Alabama Department of Insurance periodically examines the insurance companies that are licensed there and publishes a report about them, and the examination report on LICOA from May 2005 had some interesting revelations on the conduct of the family that controls and manages the company. In particular, we thought it was amazing that the report referred to "an issue with nepotism" and said that "this issue stands to harm the Company due to potential shareholder and/or policyholder lawsuits".

Well, there are now two lawsuits against the company and directors by LICOA shareholders. The first one was filed on August 28, 2019 in the US District Court for the Northern District of Alabama and it is Trondheim Capital Partners LP et al v. Life Insurance Company of Alabama et al.

The second lawsuit was actually a proposed complaint in intervention filed on April 29, 2020 in the same case; it has claims by a second group of LICOA shareholders that includes Mitchell Partners, LP and Jeffrey Herr. The company did not oppose the complaint in intervention and the court has ruled that it will proceed. Here is an excerpt from the opening of that second complaint:
This lawsuit arises from the gross mismanagement and nepotistic practices of the Director Defendants and their oppression of the shareholders of LICOA and suppression of share values for their own purposes. Plaintiffs now sue to enforce their statutory rights, for breaches of fiduciary duty, for securities law violations, and for dissolution of LICOA. [...]

As detailed below, these massive salaries that cripple LICOA’s income are part of sham “compensation structure” that is really a family jobs program for LICOA’s Directors and their families. They are unqualified and wasteful and these salaries are completely unjustified. Moreover, they have purposefully overcapitalized LICOA to keep share value down so they can repurchase them cheap and to keep a nest egg to perpetually fund their exorbitant salaries, luxury offices, and lifestyle while the LICOA shares do not even trade at liquidation value.
There is also a website with information called Concerned Shareholders of Life Insurance Company of Alabama with all kinds of details. The shareholders discovered that the company paid $4,787 for a "desk chair" for President and Chairman of the Board Clarence Daugette last year.

One very interesting thing mentioned on the website was that "LICOA has made offers to settle litigation with some of the plaintiffs via buying them out. In March 2020, they offered some plaintiffs the equivalent of $25 per LINSA share." The LINSA shares are currently offered for $12.00 per share on the OTC...

Obviously there is no way of knowing whether that deal is still on the table or not, or whether it would apply to all comers or not. But it is interesting. Presumably it was not taken because the shareholder plaintiffs thought it was a "lowball" offer.

This reminds us of a dynamic we have seen in micro cap activism, which is that shareholders are rarely well-served by sitting passively on the sidelines while these things are going on. One thing that can happen is management will settle with unhappy shareholders by buying them out, and the remaining shareholders will be stuck in the company. At that point, they have fewer potential allies, and management will probably view them as oblivious or acquiescent.

We'll have more on this situation, and other activist investing situations, in the upcoming June Issue (#30) of the Oddball Stocks Newsletter.

Pardee Resources Company - 2019 Annual Report

We've mentioned Pardee Resources before on the blog in The Problem With "Sum of the Parts", "What is an Oddball Stock?", and a brief mention last year of their share repurchase. Pardee was the main idea that Nate wrote up in Issue 1 of the Oddball Stocks Newsletter. We write about them fairly frequently in the Newsletter and they were in our recent Highlight Issue.

Pardee is normally a great annual meeting to go to - the only one that serves lunch - but it won't be happening in person this year. The virtual meeting is scheduled for Friday, May 22nd.

According to the proxy statement, there were 654,191 shares outstanding on April 1st, which was up from the year-end count of 649,448.

The increase is from stock compensation. Pardee has high SG&A cost some of which seems to stem from compensation. The non-employee directors of the Company get a board retainer of $50,000, and equity award of $50,000, and $3,000 for each board meeting. There are seven non-employee directors. The non-executive chairman receives a retainer of $125,000 and an equity award of $50,000. That's a total of $875,000 not counting the meeting fees and other additional retainers paid to committee chairs.

At a share price of $123, the Pardee market capitalization is now $80.5 million. So the board compensation alone is a 1% annual drag.

Stay tuned for the June 2020 Issue (#30) of the Newsletter coming up next month where we will share more thoughts about Pardee.

The Coal Creek Company - 2019 Annual Report

The Coal Creek Company (CCRK) annual report for 2019 is now out. Coal Creek shares have declined and are currently trading at the same level they were in the summer of 2006. Book value per share was $134 and marketable securities per share were $76 as of year-end 2019.

This is a company that land aficionado Oddballians like, but which happens to have a lot of exposure to the pandemic crisis. Of its $6.8 million of 2019 revenue, almost all of it is vulnerable: rental income, recreational fees, general store income, and gas and oil royalties. It will be important for them to have cut their $5 million of operating expense rapidly as sales fell.

They likely lost money on their $7.2 million securities portfolio as well, which underlines the point we made a year ago about how these small company equity portfolios compound the macroeconomic risks and are a poor safety cushion.

We will have our full commentary on the 2019 results in the upcoming June 2020 Issue of the Oddball Stocks Newsletter. (Previously, we published an excerpt from Issue 25 (June 2019) about The Coal Creek Company.)

Who Cares About Profits Anyways?

Have you ever had a moment where it felt like all the pieces of a puzzle fell in place?  Where suddenly a number of things that previously didn't make sense came together into a beautiful picture?  I had that moment years ago when a venture capital friend of mine explained their valuation model.  At that moment everything clicked.

My friend explained that valuations were anchored to information.  To obtain the highest valuation you had to have no revenue.  Without revenue a VC could value the company based on their imagination.  But once you had a dollar of revenue you were suddenly valued on sales, which would always be dramatically lower.  If a startup was crazy enough to earn an operating profit their valuation could fall again once they were measured on this metric.  And if a startup wished to just shoot themselves in the foot they'd report net income, a ghastly number that would force them to be valued on an earnings multiple, just like those old world public companies.

When I looked at the world through this lens it made sense for companies to give their products away for free in return for users or hits.  Just imagine the sales from all those users, and those imaginary sales are extremely valuable!

The name of the game appeared to be to raise equity capital from venture capitalists who saw these metrics and dreamed of sales one day.  Founders could continue to grow their vanity metrics while being funded from equity and eventually sell out to an old world company that saw the same vanity metrics and same imaginary sales.  Sometimes it worked, sometimes it didn't.

What always fascinated me though was why did startups raise funding via equity?  Equity is the most expensive form of financing available.  The answer of course is that most startups fail and banks aren't willing to underwrite github repos and sticker covered Macbooks as collateral for a loan.

But for me the wheels started to turn.  According to the Modigliani-Miller theorm the most efficient capital structure for a company is 100% debt financed.  What if someone could create a company that was perfectly efficient.  It would be funded entirely by debt, and they would ensure that they didn't earn a cent more than their operating expenses and interest expense.  It would be finance-theory efficient and also tax efficient.  Without profits it could be valued like a startup as a high multiple of sales.  It would be the perfect machine. 

Of course shareholders would own nothing because the capital structure was entirely debt based, but maybe some clever lawyers could create tracker shares that legally owned nothing, but allowed people to speculate on the value of the company.  Then we could merge the perfect machine with the perfect investment.  The perfect investment being a legal claim on nothing but market appreciation.

Obviously my perfect investment is very tongue in cheek.  An "investment" like this bears a strong resemblance to sports gambling in Las Vegas.  It's purely speculation.

What's fascinating to me is how the stock market, and general investment environment seems to desire companies like this vs a company that is focused on selling items for more than they cost, or generating a cash return on investment.

If the stock market continues to appreciate forever then owning shares will always be a profitable endeavor.  Of course the US market has always gone up and to the right, and no one can imagine anything else, but what if.... What if there were a period of time when stocks fell and didn't recover a few days later?  What if we hit a sideways market for a decade?

The market used to reward companies paying dividends to shareholders out of profits.  A company might pride themselves on decades of unbroken dividends.  Employees would be granted shares in retirement accounts and dividends on company shares were a sort of bonus.  They were also an incentive to work hard for their employer.  Any improvement in efficiency could lead to larger personal bonuses themselves.

The idea of dividends fell out of fashion once executives learned they could buy back shares while issuing options to themselves and get rewarded by the market.  There are a few companies that are net buyers of shares, but it's really hard to eat buybacks. 

It's fascinating that when someone enters into business themselves on a small scale that they are expected to make a profit very quickly.  One a small scale if a company can't generate profits they can't stay in business.  A landscape company might not be wildly profitable, but if they expect to stay in business for more than a season they need to be slightly better than break even.

At scale the market doesn't care about profits or dividends anymore.  Shareholders don't care about receiving a portion of the profit themselves as long as shares appreciate, or management announces they will repurchase shares.  As long as things are up and to the right the system continues to work.

In a sense venture capital is a cheat code for small businesses to escape the shackles of profit expectations and play in the larger market playground.

Maybe I'm old fashioned, but it seems to me that this might not be the healthiest system.  Instead it seems to be a fragile system built on slights of hand and confidence.  That doesn't leave me sleeping well at night!

There's a part of me that longs for the "old days" when companies were focused on earning money, and then rewarding shareholders with a cash return for holding their stock.  I doubt those days will ever return, but I can imagine..

Podcast: "Finding Oddball Stocks with Nate Tobik"


Bank of Utica Results for Q1 2020

In yesterday's post, we mentioned a very small bank trading at 41% of book value and a 20% earnings yield based on trailing twelve month earnings. The caveats are that half of book value is in that bank's headquarters, and it is not clear how sustainable the earnings are.

Another perpetually cheap (relative to book value) bank that we write about is the Bank of Utica. If you are not a Newsletter reader, you can check out a sample that mentioned BKUT a couple of years ago. We also posted about the 2019 annual results, and investors' reactions, back in February. One thing we missed in the Tweet roundup was this one: That is a healthy amount of BKUTK for someone to own. The Q1 2020 call report is out, so we can see how much money their portfolio lost through March 31st. (Call report is embedded below.)

Total interest income was up from $7.7 million in Q1 2019 to $8.5 million this quarter. Interest expense went from $3.3 million to $3.9 million, so net interest income went from $4.4 million to $4.6 million. Total non-interest expense went from $3 million to only $2 million, which is a big drop. Digging into that further, the 2019 Schedule RI-E "explanations" showed $1.1 million of "Donations". Poor shareholders...

In Q1 2019, the bank's net income was $7.8 million. This quarter, it was negative $11 million, thanks to a $17 million unrealized loss in the portfolio. The bank's equity capital is $230 million, which is slightly lower than the $232 million where it stood a year ago.

The securities portfolio increased from $947 million to $993 million, funded by an increase in deposits. So it looks as though BKUT bought the dip in... whatever kind of securities it owns.

The non-voting BKUTK shares are offered at $370. There are 200,000 non-voting shares and 50,000 voting (BKUT) shares, so the market capitalization is $93 million at the BKUTK offered price. That is 40% of book value.

We generally like to subtract the book value of BKUT's premises and other assets, which lowers book value per share and makes the BKUTK price more like 45% of adjusted book value.

It would be an absolute no-brainer to buy back stock. They are overcapitalized and their stock is a far better investment than the debt they own. 

This type of situation (and it occurs often) is a serious philosophical puzzle for Oddball investors. What are shares in a company like this worth?

Is This Tiny Bank A Buy At 41% Of Book And A 20% Earnings Yield?

We wrote about Southern Community Bancshares, Inc. (OTC: SCBS), the holding company of First Community Bank of Cullman, in our post last year Small Companies (like Small Banks) As "Jobs Programs". We thought we'd update since the 2019 results are out, and the loan growth, earnings growth, and share repurchases were surprising.

Last year we noted a market capitalization of $4.3 million with stockholders' equity of $10 million, for a price-to-book ratio of 0.43x. The caveat was that the bank's property, plant and equipment were $5 million of the equity, making SCBS a strong contender for the Bank of Utica Small-Town Bank Headquarters Hall of Fame. Having half of the bank's equity tied up in premises made the 57% discount to book value feel much less generous.

This year we notice that assets have grown from $115 million to $127 million, with more than 100% of the increase coming from loan growth. Deposits grew by only $4.5 million; most of the asset growth was funded by FHLB borrowings. The loan portfolio is 92% real estate mortgage loans.

Shareholders' equity grew from $10 million to $10.7 million, while at the same time the bank shrank its share count from 505,592 to 488,296. (A 3.4% reduction.) Book value per share is now $21.90, so the price to book is now 41% instead of 43%.

For 2019 the bank had $883,000 of comprehensive income. Interest and fees on loans were $5.65 million on a portfolio that started the year at $90 million. Interest on deposits were $1.2 million on interest bearing deposits of $86 million.

With the 59% discount to book value and resultant $4.4 million market cap, the 8% return on equity now translates to a 20% ttm earnings yield!

It is somewhat amazing that with $10.7 million in equity, or $5.6 million if you exclude the value of premises and equipment, they have levered up to own $127 million of assets. (Or if you exclude the premises and the investment securities, $117 million of assets.) Only with a government guarantee would a 21x leverage scheme like this be possible.

Also interesting is that SCBS does not lack for competition. Their competitors just in Cullman, Alabama (town of 15,000) are Family Security Credit Union, Traditions Bank, Premier Bank of the South, Regions Bank, Merchants Bank of Alabama, Citizens Bank & Trust, Cullman Savings Bank, Peoples Bank of Alabama, Wells Fargo Bank, BBVA Bank, EvaBank, and Woodforest Bank. That is about one bank per thousand people.

A question for a bank sleuth - how did SCBS grow its loans from $58 million to $103 million in two years? Is this level of interest and fees on the loan portfolio size sustainable?

What is happening? Does anything even matter?

Highest levels of unemployment since the Depression and stocks go up.  Terrible GDP print numbers and stocks go up.  At the same time companies are laying off people, banks are seeing distressed borrowers and there are cracks in the economy.  It's really hard to reconcile what's happening in the stock market with what's happening in the economy.

It's been said that the market is forward looking.  It's also been said that it's fully efficient.  And I've also heard that subprime is fully contained.  That last statement was a joke if you were investing before the Great Recession.

One good thing about a market climb while our country is facing generational economic devastation is that it shows that investors are optimistic.  I believe that ultimately outcomes are built on perspective.  If one mopes through life they will experience less fulfilling outcomes than one who is eager for what lies ahead regardless of the difficulty.

I'm just as biased to optimism as anyone else.  I badly want the virus to go away, for everything to return to "normal" and for life to continue as if this never happened.  But is that realistic?

Most of life is built around narratives.  People form narratives to help them understand what they're experiencing and what they're seeing.  Most of these narratives are formed through first hand experience.  If commentators on TV are proclaiming a recession but "all my local stores are full" one might create a narrative that "things aren't too bad."  Conversely if one sees "Closed for good" signs on all their local stores they might form a narrative that a recession is severe.

These narratives drive our lives, and they drive the market.  In 2008 the narrative on Wall Street was that the sky was falling.  Why was this?  To start with Wall Street itself was affected.  Investors saw large banks closing, a frozen bond market and they dumped equities.  This time around Wall Street seems untouched.  Banks aren't failing, and hedge funds aren't closing, so investors seem to have formed a "how bad can it be?" narrative and bid up stocks.

Yet outside of markets the real economy is acting like investors did in the fall of 2008.  Companies are looking forward and slashing people, expenses and any line item as quick as possible.  They don't see a quick return to normal, they see a period of depressed revenue and depressed earnings.  They're doing what they can to survive.

One company's capex is another company's revenue.  It's a vicious circle.  With each cut in capex another company might have to cut employees.  This isn't the type of cycle that reverses quickly, it takes quarters if not years before companies gain confidence that revenue is here to stay.

All of this cutting, revenue, expenses, employees has the potential to lead us into a deflationary spiral.  If company's don't have confidence in their revenue they will spend less on people and goods.  If there is less demand for goods prices start to fall.  As jobs are cut demand shrinks for consumer goods, and prices get cut in an effort to attract demand.

While the real economy appears to be deflating we still haven't seen deflation in the market.  It's likely that's coming next.

In 2008 I was working for a telecom company.  As the market fell apart life went on like nothing was happening.  The company eventually hit a speed bump because they were debt financed and they struggled to get a bond deal done.  But outside of that nothing really changed.  Co-workers would discuss how horrible headlines were, but it didn't hit us directly.

Eventually after a barrage of bad headlines this telco started to get worried.  Their actions lagged the market.  In 2010 they were still worried about "the crash" and things coming back.  But by that time the market had raced forward.

It's my speculation that something similar might happen now, but with the real economy leading the charge and the market lagging.  Investors are expecting a quick bounce.  The reason for this is as everyone is stuck inside it's really hard to build a narrative.  Instead of building narratives from what people are seeing day to day they're building a narrative based off headlines and optimism that things are almost over.

I think a possibility is that the market is going to be shocked when companies don't turn around quickly in a quarter or two.  And then a quarter or two later will be even more shocked that things are still depressed.  By that time investors will have lost faith and sold out of stocks.  While at the same time companies might be seeing green shoots and things might be turning. 

The question is "what's an investor to do?"  I don't know, but I can tell you what I'm doing.  I came into this whole thing with about 50% in cash.  As stocks fell in March I deployed some cash into bargains as I saw them.  I've also shorted companies that look like they're on the brink of disaster.  My thought is some of those shorts can be cycled into even cheaper names if stocks ever fall again.

But what happens if they don't?  Let me make a wild and unsubstantiated speculation about that.  I think if stocks keep climbing while we experience Depression level economic measures that it could be the breeding ground for civil unrest, or some sort of dark horse politician who imposes punitive taxes on wealth.  I hope this doesn't happen, but the foundation for it already exists.

Ultimately though if I'm reflective on this whole thing I want to stick my head in the sand like everyone else and hope things turn out better on the other side.

Until we get there, stay nimble, and stay healthy!