This post isn't for most readers, drop back in a day or two, there will be an interesting bank profiled. I have had a number of emails recently from readers asking some basic value investing questions, and I thought I might put a simple resource out there for beginning investors to refer to.
What is value investing
Value investing is the concept of purchasing companies for less than their worth. It's almost strange that this idea has its own title, because this is what all investors are endeavoring to do, whether it's titled value investing or not.
An investor needs to look at a stock as a piece of a real company. A share of stock represents an ownership interest in a company that has real locations somewhere. At their offices there are real people who go to work each day and work their hardest for you (the owner). These people probably aren't thinking about the stock, they're thinking about the product, their upcoming vacation to Disney, and the day to day challenges they're facing. The benefit they reap is a salary, what you reap as the owner is whatever value they generate that accrues to your ownership interest.
The idea of a value investment is to envision this real company and evaluate what it might be worth. A great starting point is the company's balance sheet. Their office, factories, desks, laptops, intellectual property all have some value. Maybe the value is very small, or maybe it's significant, either way look at what the company owns. Then look at what they owe, maybe they've mortgaged their entire future and what they own is actually owned by the bank, examining the asset and liability structure is important, after all, this is what you're purchasing a piece of.
You want to purchase this company for less than what you think they're worth. If the company is worth $10m, then maybe a purchase a $6m is appropriate. The key is to be a disciplined buyer. If you decide something is worth $10m and you won't buy at more than 2/3 of their value don't cheat yourself and buy at 72%, unless you have a very good reason to violate your rule. As a value investor you make money when you purchase a stock, you aren't hoping for the market multiple to expand, or for the company to grow into their valuation. You are buying something worth a fixed value for less than that value. Being sloppy on purchasing is one way to dilute your returns.
The question always comes up, what do you do when the stock price starts to fall? The first thing to do is examine the reasons for the fall. Maybe there are no reasons, maybe it's just moving with the market. Think back to the actual business, think about the factories, the workers, the output; has something changed in their workday that makes them worth 2% less, or 4% less? Most likely not, if the price continues to fall, and the actual value is unchanged consider purchasing more of the company.
How to value a company
I think people get hung up on valuation because it appears to be a financial dark science. I have seen write-ups with complicated math and enormous tables that try to predict the future. I'm not sure how well that stuff works, but I'd advise starting simple. Often you never need to move beyond simple; simple valuation methods leave less room for error.
The best way to start is to screen for companies that are trading for less than book value, or for less than than a conservative earnings multiple (P/E 10, or EV/EBIT 7). Work backwards, take a company you find in the list for less than book value and examine their book value. Is this company's book value as strong as it looks initially? Maybe they have a lot of goodwill, or are laden with expensive debt, discount those items. Maybe their assets aren't as valuable as the company would like them to be, discount that as well. Look at the adjusted book value compared to the market price, is the company still selling with a low valuation? If so then consider buying it, when the company's value approaches your adjusted book valuation consider selling.
A similar method can be applied to earnings as well. If the market is valuing all rubber hose manufacturers at 10x earnings and you find one selling at 6x earnings it's time to investigate. Why is the company selling cheap, are their earnings depressed, or is there a reason they're discounted? Determine what the reason for the discount might be, if it's a valid reason move on, if it's not a valid reason then maybe consider purchasing.
Summary
I believe the items in this post are great building blocks that any starting investor can begin to use now, and as they learn expand into more complicated item. Don't become overwhelmed, focus on what's important, which is buying companies at a discount, and being disciplined in your process. There is no need to jump from elementary investing to advanced investing. A lot of the learning process happens over time with experience. Investing takes patience and perseverance, you can't learn everything on day one! My final piece of advice, if a company appears too hard to evaluate, move on, there are 60,000 traded companies world wide, there is no shortage of simple companies, start with those.
Looking for value in the overlooked margins of the market.
Federal Screw Works, engineering a turnaround?
On my last post someone suggested in the comments that I check out Federal Screw Works, a name I'd seen bouncing around the internet over the past few months. I am familiar with the company, I came across them as I evaluated hundreds of pink sheet companies over a year ago. With the a reader's prompting it was time to look at the company again.
Federal Screw Works (FSCR) is a Michigan company engaged in the manufacture and production of machined parts. An incredible 97% of their sales is to the automotive industry. A sampling of their products is shown below:
Companies like Federal Screw have a tendency to scare me, these are companies with long histories of losing money that suddenly become profitable. When the perennial money losers start to make money it's often a sign that we're in the late stages of a recovery or worse, in a market that's topping out.
Most often asset value plays are considered cigar butt investments, companies with a little juice left in them, but not much more. I believe the analogy could be extended, there is a whole category of earnings based cigar butt investments as well, of which Federal Screw Works is potentially one of them.
When an investment thesis is based around a company's assets the investor is betting that the company isn't worth less than either liquidation value, or book value, and eventually the market will agree with their point of view. An earning based cigar butt is a little different. The market already values companies on the basis of earnings, companies with good earnings are rewarded with high multiples, and low earnings with low multiples, mostly regardless of asset value. A company that suddenly has a few great quarters can be caught up with investor enthusiasm and be priced accordingly. Often the stock price rise for a mediocre company with a few great quarters can be an exciting ride, as long as you know when to get out.
The key to cigar butt investing is knowing when to get out, most deep value investments are not buy and hold investments. Because of this many people have this impression of asset based value investors as glorified traders, swapping in and out of these stocks creating a tax nightmare. The truth is much more subdued, the market is often slow to appreciate their value. An investor might purchase a stake then have to wait a few years before something happens and the share price appreciates. But when it does appreciate sell out at what you consider fair value, and be quick about it, often the price will appreciate quickly, and then rapidly decline right back to where it was prior to its ascent.
Federal Screw Works is levered to the auto industry, with most of their sales directly related to autos they do well if car sales are up, and they struggle if car sales are down. What's impressive is the company found a way to lose money from 2005 until this past year. They blame their most recent losses on the recession and reduced demand, but their losses from 2005, 2006, and 2007 can't be blamed on a poor economy. The oldest annual report I could see was 2007, where they were blaming their difficulties on outsourcing and reduced light truck demand from high gas prices.
The company's continued losses since 2005 have resulted in an incredible display of shareholder destruction. Book value declined from $59m in 2004 to -$4m in 2012, and has since recovered to a positive $2m. During this period the company has been working to change their operations, they've dramatically reduced head count, and were able to turn a profit on $57m of sales, whereas in 2005 they lost money on $85m worth of sales.
In the company's defense they are a survivor, despite the continued losses they have been able to hang on and fight long enough to see a small profit. The question is whether their profits are fleeting, or something sustainable?
Besides the company's poor earning history they have sizable liabilities that could become problematic at some point in the future. The company has a sizable pension that's partially unfunded, and retirement health benefits that are sizable. The company has steadily increased their debt, keeping them afloat as losses mounted.
Here's a five year financial history from their annual report:
It's unclear whether Federal Screw Works is cheap at the current level. The company is expensive based on every asset based metric, and even most conventional earnings metrics. The company has significant operating leverage, and it wouldn't take much of an increase in sales before profits start to flow to the bottom line in a significant way. Maybe this is best considered as a speculative value investment. The chance to buy into a turnaround right before it turns, but not having to be a shareholder for the almost decade of losses.
I don't see a margin of safety with this holding at all, and turnarounds of this type are hard to manage, but for an investor wiser than myself it might prove to be profitable.
Disclosure: No position
Federal Screw Works (FSCR) is a Michigan company engaged in the manufacture and production of machined parts. An incredible 97% of their sales is to the automotive industry. A sampling of their products is shown below:
Companies like Federal Screw have a tendency to scare me, these are companies with long histories of losing money that suddenly become profitable. When the perennial money losers start to make money it's often a sign that we're in the late stages of a recovery or worse, in a market that's topping out.
Most often asset value plays are considered cigar butt investments, companies with a little juice left in them, but not much more. I believe the analogy could be extended, there is a whole category of earnings based cigar butt investments as well, of which Federal Screw Works is potentially one of them.
When an investment thesis is based around a company's assets the investor is betting that the company isn't worth less than either liquidation value, or book value, and eventually the market will agree with their point of view. An earning based cigar butt is a little different. The market already values companies on the basis of earnings, companies with good earnings are rewarded with high multiples, and low earnings with low multiples, mostly regardless of asset value. A company that suddenly has a few great quarters can be caught up with investor enthusiasm and be priced accordingly. Often the stock price rise for a mediocre company with a few great quarters can be an exciting ride, as long as you know when to get out.
The key to cigar butt investing is knowing when to get out, most deep value investments are not buy and hold investments. Because of this many people have this impression of asset based value investors as glorified traders, swapping in and out of these stocks creating a tax nightmare. The truth is much more subdued, the market is often slow to appreciate their value. An investor might purchase a stake then have to wait a few years before something happens and the share price appreciates. But when it does appreciate sell out at what you consider fair value, and be quick about it, often the price will appreciate quickly, and then rapidly decline right back to where it was prior to its ascent.
Federal Screw Works is levered to the auto industry, with most of their sales directly related to autos they do well if car sales are up, and they struggle if car sales are down. What's impressive is the company found a way to lose money from 2005 until this past year. They blame their most recent losses on the recession and reduced demand, but their losses from 2005, 2006, and 2007 can't be blamed on a poor economy. The oldest annual report I could see was 2007, where they were blaming their difficulties on outsourcing and reduced light truck demand from high gas prices.
The company's continued losses since 2005 have resulted in an incredible display of shareholder destruction. Book value declined from $59m in 2004 to -$4m in 2012, and has since recovered to a positive $2m. During this period the company has been working to change their operations, they've dramatically reduced head count, and were able to turn a profit on $57m of sales, whereas in 2005 they lost money on $85m worth of sales.
In the company's defense they are a survivor, despite the continued losses they have been able to hang on and fight long enough to see a small profit. The question is whether their profits are fleeting, or something sustainable?
Besides the company's poor earning history they have sizable liabilities that could become problematic at some point in the future. The company has a sizable pension that's partially unfunded, and retirement health benefits that are sizable. The company has steadily increased their debt, keeping them afloat as losses mounted.
Here's a five year financial history from their annual report:
It's unclear whether Federal Screw Works is cheap at the current level. The company is expensive based on every asset based metric, and even most conventional earnings metrics. The company has significant operating leverage, and it wouldn't take much of an increase in sales before profits start to flow to the bottom line in a significant way. Maybe this is best considered as a speculative value investment. The chance to buy into a turnaround right before it turns, but not having to be a shareholder for the almost decade of losses.
I don't see a margin of safety with this holding at all, and turnarounds of this type are hard to manage, but for an investor wiser than myself it might prove to be profitable.
Disclosure: No position
Webco: cheap, but is it safe?
My last post was on the topic of niches, so it's only appropriate that the company that's the subject of this post operates in a niche. I actually didn't plan for this sequence of posts to happen, I was turning over rocks today and stumbled on Webco Industries (WEBC) selling at close to 50% of BV. The discount to book value along caught my attention, and their history of significant past earnings encouraged me to continue researching them.
Webco Industries is a metal tube manufacturer. The company really is that simple, they manufacture a variety of metal tubes to specifications for different industry applications. One thing I spotted on their website is they are the only supplier of full line welded boiler tube in the United States. Maybe this is a big deal, or maybe it's the equivalent of someone being the best athlete in a town of 200, I don't know enough about the industry to know the difference.
The company operates out of Oklahoma, but also has manufacturing locations in Pennsylvania and Illinois. They have a market cap of $81m, and their shares trade for $103. I like when companies have high share prices, it seems to discourage investor interest, a high share price often indicates a higher likelihood of an undervaluation.
Here is a spreadsheet I put together with the company's results over the past eight years:
Long time readers will probably notice that I usually don't post large spreadsheets on the blog. If anyone's curious as to why I don't, it's often because I don't create them for many of my investments. I know the stereotype for Graham investors is that we buy anything that's cheap, but that's not the case for myself. I don't have an unlimited amount of capital, and I'd be killed by trading costs if I was trying to pick up everything trading for less than book value, I'd have a bunch of $4 positions scattered around my portfolio. Rather I start by looking at cheap companies and then I become picky, a company needs to fit certain criteria before I'll invest in it. If a company meets most of my criteria, but not all I will pass. While I'm not a concentrated investor by any means, I also don't just swing wildly at any pitch that's coming somewhat near the strike zone.
When I buy a company I want them to be brain dead cheap, and an obvious slam dunk. Many of the companies profiled on this blog fit that description. Take for example Conduril, they were trading at 40% of NCAV, and at 2x earnings, after some investigation I determined a margin of safety existed and confirmed they were cheap. With something like that I don't care what their results were five years ago, or what their ROE is, if they even start to revert to the mean at all my position will do well, which is incidentally what has happened. Even more amazingly Conduril's results have been outstanding and even with the move up the company is still cheap.
How does this tie into Webco? As I was reading their annual reports I didn't get an obvious cheap feeling about the company, instead I started to feel a desire to accumulate more and more data points with the hope that somehow the data would give me an answer as to whether I should invest. In essence it did, because when I feel the need to accumulate more data it's a sign that I'm not looking at something obviously cheap, possibly only marginally cheap.
I discuss the exact reasons on why I passed on Webco below, but first I want to discuss a few positive aspects of the company. The company clearly has a history of profitability, and at times tremendous profitability. They have also shown the ability to turn their earnings into cash flow. Over the past eight years operating cash flow has outpaced earnings by $10m.
The company's earning history is volatile, but when they are able to push through higher margin products at high volumes the company has significant operating leverage as seen by them earning anywhere from $18 to $31.98 a share in their good years.
And lastly the most attractive aspect of Webco is their valuation, they are trading at a 51% of book value, which is mostly equipment and inventory. Second to this is their ability to compound book value at 8% a year, during very difficult economic conditions.
There are a number of issues that could potentially scuttle an investment in Webco, but I want to focus on the two that turned me away from them. The first is their debt. The company carries a significant debt load, yes they have ample earnings coverage, and yes they seem to operate just fine with it, but it could be a ticking time bomb.
What you don't see in my spreadsheet is the current/non-current breakdown of the company's debt each year. The company doesn't have much long term debt, it's been steadily declining and was $12m at the end of their latest fiscal year. This means the company has $78m in short term debt that is coming due this year. If one looks at their financial statements through the years there isn't a significant capital expenditure use, the cash just appears to mysteriously vanish. Of course it doesn't really, but where it goes is very unclear. The bottom line is the company appears to roll forward a large amount of short term debt year to year, most likely on a line of credit.
Before you think I'm an idiot I want to discuss the second point, which is tightly tied to my first concern. The company is very forthright in providing an income statement and balance sheet, yet they only provide three line items regarding their cash flow, operating cash flow, depreciation, and capex, nothing more. The problem with this is that seeing the company's cash flow statement is vital to understanding how the other two financial statements work together. I recognize that I could construct a cash flow statement from the balance sheet and income statement; I haven't spent the time. I'm not sure it's necessary either, it's very strange to me that a company would intentionally neglect to provide information on the flow of cash in their business and at the same time provide abundant information on their balance sheet and income statement, including a lengthly writeup describing them.
The amount of short term debt, and the company's lack of a cash flow statement didn't put my fears over their debt to rest. Instead it did the opposite, it fanned the flames and encouraged me to move on. When the market is high and good ideas are hard to find the last thing I want to do is lower my standards and invest in marginal companies because there is nothing else out there. Companies that look great, and appear safe at the top of the cycle can often lead to portfolio disasters in a downturn.
I'm glad I spent time investigating Webco, but this won't be a name that finds its way into my portfolio.
Disclosure: No position
Webco Industries is a metal tube manufacturer. The company really is that simple, they manufacture a variety of metal tubes to specifications for different industry applications. One thing I spotted on their website is they are the only supplier of full line welded boiler tube in the United States. Maybe this is a big deal, or maybe it's the equivalent of someone being the best athlete in a town of 200, I don't know enough about the industry to know the difference.
The company operates out of Oklahoma, but also has manufacturing locations in Pennsylvania and Illinois. They have a market cap of $81m, and their shares trade for $103. I like when companies have high share prices, it seems to discourage investor interest, a high share price often indicates a higher likelihood of an undervaluation.
Here is a spreadsheet I put together with the company's results over the past eight years:
Long time readers will probably notice that I usually don't post large spreadsheets on the blog. If anyone's curious as to why I don't, it's often because I don't create them for many of my investments. I know the stereotype for Graham investors is that we buy anything that's cheap, but that's not the case for myself. I don't have an unlimited amount of capital, and I'd be killed by trading costs if I was trying to pick up everything trading for less than book value, I'd have a bunch of $4 positions scattered around my portfolio. Rather I start by looking at cheap companies and then I become picky, a company needs to fit certain criteria before I'll invest in it. If a company meets most of my criteria, but not all I will pass. While I'm not a concentrated investor by any means, I also don't just swing wildly at any pitch that's coming somewhat near the strike zone.
When I buy a company I want them to be brain dead cheap, and an obvious slam dunk. Many of the companies profiled on this blog fit that description. Take for example Conduril, they were trading at 40% of NCAV, and at 2x earnings, after some investigation I determined a margin of safety existed and confirmed they were cheap. With something like that I don't care what their results were five years ago, or what their ROE is, if they even start to revert to the mean at all my position will do well, which is incidentally what has happened. Even more amazingly Conduril's results have been outstanding and even with the move up the company is still cheap.
How does this tie into Webco? As I was reading their annual reports I didn't get an obvious cheap feeling about the company, instead I started to feel a desire to accumulate more and more data points with the hope that somehow the data would give me an answer as to whether I should invest. In essence it did, because when I feel the need to accumulate more data it's a sign that I'm not looking at something obviously cheap, possibly only marginally cheap.
I discuss the exact reasons on why I passed on Webco below, but first I want to discuss a few positive aspects of the company. The company clearly has a history of profitability, and at times tremendous profitability. They have also shown the ability to turn their earnings into cash flow. Over the past eight years operating cash flow has outpaced earnings by $10m.
The company's earning history is volatile, but when they are able to push through higher margin products at high volumes the company has significant operating leverage as seen by them earning anywhere from $18 to $31.98 a share in their good years.
And lastly the most attractive aspect of Webco is their valuation, they are trading at a 51% of book value, which is mostly equipment and inventory. Second to this is their ability to compound book value at 8% a year, during very difficult economic conditions.
There are a number of issues that could potentially scuttle an investment in Webco, but I want to focus on the two that turned me away from them. The first is their debt. The company carries a significant debt load, yes they have ample earnings coverage, and yes they seem to operate just fine with it, but it could be a ticking time bomb.
What you don't see in my spreadsheet is the current/non-current breakdown of the company's debt each year. The company doesn't have much long term debt, it's been steadily declining and was $12m at the end of their latest fiscal year. This means the company has $78m in short term debt that is coming due this year. If one looks at their financial statements through the years there isn't a significant capital expenditure use, the cash just appears to mysteriously vanish. Of course it doesn't really, but where it goes is very unclear. The bottom line is the company appears to roll forward a large amount of short term debt year to year, most likely on a line of credit.
Before you think I'm an idiot I want to discuss the second point, which is tightly tied to my first concern. The company is very forthright in providing an income statement and balance sheet, yet they only provide three line items regarding their cash flow, operating cash flow, depreciation, and capex, nothing more. The problem with this is that seeing the company's cash flow statement is vital to understanding how the other two financial statements work together. I recognize that I could construct a cash flow statement from the balance sheet and income statement; I haven't spent the time. I'm not sure it's necessary either, it's very strange to me that a company would intentionally neglect to provide information on the flow of cash in their business and at the same time provide abundant information on their balance sheet and income statement, including a lengthly writeup describing them.
The amount of short term debt, and the company's lack of a cash flow statement didn't put my fears over their debt to rest. Instead it did the opposite, it fanned the flames and encouraged me to move on. When the market is high and good ideas are hard to find the last thing I want to do is lower my standards and invest in marginal companies because there is nothing else out there. Companies that look great, and appear safe at the top of the cycle can often lead to portfolio disasters in a downturn.
I'm glad I spent time investigating Webco, but this won't be a name that finds its way into my portfolio.
Disclosure: No position
What ponds are you fishing in?
"There are riches in niches."
What's your specialty, do you have one? I've started to come to the conclusion that people who are successful find a niche and exploit it. No one has made a name for themselves as a generalist, "Oh talk to Bob, he knows a little about a lot.."
There is a common American (is this universal? I don't know) expression that asks "would you rather be a big fish in a small pond, or a small fish in a big pond." The implication is if you find a small pond it could be rather easy to become an expert, rather than trying to be the biggest fish in a very big pond.
Niches fascinate me, most investors would agree that almost all successful businesses have a niche that they actively exploit. Some companies grow to the point where they have economies of scale either in their branding or in their network where a niche is no longer needed. Wal-Mart doesn't need a niche, they have the scale to crush any local competitor. But a local grocery story that wants to compete with Wal-Mart needs to differentiate themselves. A local store might play up their local-ness, or carry high end organic brands, or offer superior customer support, or even locate themselves in a better location. But they have to do something different, if they advertise that they will beat any of Wal-Mart's prices they won't last much longer than their Grand Opening.
The concept of a business having a niche is well accepted amongst investors. The concept of having an investment niche doesn't receive as much attention. I've had a number of conversations with successful investors recently and this idea of investment niches really struck a chord. It might seem strange for me to say that because my blog is the epitome of a niche, I mostly write about net-nets and other tiny deep value stocks.
The investors I talked to all know their strengths, whether it is unlisted stocks or small banks. They work on knowing a small area better than almost any one else, and with that they end up with an investment edge. That's one way to exploit a niche, find one and become the expert of it.
Another way to exploit an investment niche is to find an area of the market that others don't care much about. This is how I approach my international investments, in many foreign markets there simply aren't enough investors who care about the smaller stocks. An example of this would be French small caps, most investors in France care about the larger stocks and foreign markets leaving their small caps under followed and neglected. Another example is Japanese small cap net-nets, a neglected market, a neglected segment, and net-nets, a niche unto themselves. I don't face much competition when investing in a Japanese net-net. Conversely most investors worldwide are looking at US stocks, so when looking at US stocks I bury myself into tiny holes most avoid, small companies, often very small.
Buffett's circle of competence comment gets a lot of use, people will say things like "oh fast casual restaurants in the Mid-Atlantic aren't in my circle of competence, I only know fast casual in California, know of any good books to get up to speed?" I believe niche thinking is more valuable, I'd rather be the person who knows everything there is to know about unlisted stocks, or contingent value rights, or something, rather than building up a circle of competence that's the same as many others.
I want to extend this post beyond investing because I think it's very applicable in life. The way to provide value to an organization or clients is to do something very specific very well. I remember early in my career receiving some bad career advice. A boss told me I shouldn't focus on any specific practice area because my skills could become outdated and I'd be pigeonholing myself in a very narrow area. A few years later after leaving and working at a number of other companies I realized that advice was wrong. Experts are paid handsomely and are sought after, no matter how esoteric. Companies don't only run, they thrive on ancient tools and processes. There is an enormous skill shortage for people who know things very well, instead we have multitudes of employees who all know the same basic knowledge, and not much beyond it. Even stranger a person who is an expert in a niche can be terrible in every other aspect of their job. I have worked with many people who are hands down experts in one very critical irreplaceable aspect of their job, and barely function otherwise. Yet I've seen executives fall all over themselves to keep these people in place. I'm not saying this is good behavior, but I'm saying you don't need to be a top performer in all aspects of your job, find an expertise, excel at it, and if you can perform at an average level for everything else you will do well.
It's possible to find a niche by examining what you do daily, or the things you're interested in, but that's the tough route. I think a niche often finds you. When I decided to start this blog over three years ago I had no idea where it would be today. I set out to record my thoughts on various investments I was researching. I loved investing in net-nets and low P/B stocks, and was intrigued by special situations, there was a lack of that sort of investment writing on the internet, so I started filling the void. Over the past three years I've solidified my niche, there are very clear categories of stocks that I feel I understand very well, and others I punt on because I know nothing more than what a new graduate might.
Find a void and work to fill it. One more parting thought on this. Many people work to become experts at something but do it privately. I don't know of any private experts, but I know of plenty of public experts. Some are afraid to speak out about their knowledge because they're afraid someone else will steal it or will surpass them. The truth is most people aren't passionate about the same things you are, but they can learn a lot from what you're passionate about. Secondly I'd be honored if someone learned from me and then far surpassed what I accomplish. Teachers teach to impart their knowledge on others, if they wanted to remain smarter than their students they'd stay quiet.
The concept of a business having a niche is well accepted amongst investors. The concept of having an investment niche doesn't receive as much attention. I've had a number of conversations with successful investors recently and this idea of investment niches really struck a chord. It might seem strange for me to say that because my blog is the epitome of a niche, I mostly write about net-nets and other tiny deep value stocks.
The investors I talked to all know their strengths, whether it is unlisted stocks or small banks. They work on knowing a small area better than almost any one else, and with that they end up with an investment edge. That's one way to exploit a niche, find one and become the expert of it.
Another way to exploit an investment niche is to find an area of the market that others don't care much about. This is how I approach my international investments, in many foreign markets there simply aren't enough investors who care about the smaller stocks. An example of this would be French small caps, most investors in France care about the larger stocks and foreign markets leaving their small caps under followed and neglected. Another example is Japanese small cap net-nets, a neglected market, a neglected segment, and net-nets, a niche unto themselves. I don't face much competition when investing in a Japanese net-net. Conversely most investors worldwide are looking at US stocks, so when looking at US stocks I bury myself into tiny holes most avoid, small companies, often very small.
Buffett's circle of competence comment gets a lot of use, people will say things like "oh fast casual restaurants in the Mid-Atlantic aren't in my circle of competence, I only know fast casual in California, know of any good books to get up to speed?" I believe niche thinking is more valuable, I'd rather be the person who knows everything there is to know about unlisted stocks, or contingent value rights, or something, rather than building up a circle of competence that's the same as many others.
I want to extend this post beyond investing because I think it's very applicable in life. The way to provide value to an organization or clients is to do something very specific very well. I remember early in my career receiving some bad career advice. A boss told me I shouldn't focus on any specific practice area because my skills could become outdated and I'd be pigeonholing myself in a very narrow area. A few years later after leaving and working at a number of other companies I realized that advice was wrong. Experts are paid handsomely and are sought after, no matter how esoteric. Companies don't only run, they thrive on ancient tools and processes. There is an enormous skill shortage for people who know things very well, instead we have multitudes of employees who all know the same basic knowledge, and not much beyond it. Even stranger a person who is an expert in a niche can be terrible in every other aspect of their job. I have worked with many people who are hands down experts in one very critical irreplaceable aspect of their job, and barely function otherwise. Yet I've seen executives fall all over themselves to keep these people in place. I'm not saying this is good behavior, but I'm saying you don't need to be a top performer in all aspects of your job, find an expertise, excel at it, and if you can perform at an average level for everything else you will do well.
It's possible to find a niche by examining what you do daily, or the things you're interested in, but that's the tough route. I think a niche often finds you. When I decided to start this blog over three years ago I had no idea where it would be today. I set out to record my thoughts on various investments I was researching. I loved investing in net-nets and low P/B stocks, and was intrigued by special situations, there was a lack of that sort of investment writing on the internet, so I started filling the void. Over the past three years I've solidified my niche, there are very clear categories of stocks that I feel I understand very well, and others I punt on because I know nothing more than what a new graduate might.
Find a void and work to fill it. One more parting thought on this. Many people work to become experts at something but do it privately. I don't know of any private experts, but I know of plenty of public experts. Some are afraid to speak out about their knowledge because they're afraid someone else will steal it or will surpass them. The truth is most people aren't passionate about the same things you are, but they can learn a lot from what you're passionate about. Secondly I'd be honored if someone learned from me and then far surpassed what I accomplish. Teachers teach to impart their knowledge on others, if they wanted to remain smarter than their students they'd stay quiet.
Assorted investment musings
Oftentimes I'll have some market or investing observation that I'll be able to grow into a post. Often though I just have some fragments of thought that don't really merit a post on their own, but are worth considering. This post is a collection of things I've been thinking about recently as they relate to the markets, investing, and business.
Patience
If investing types were like restaurants value investing would be the long drawn out four course meal. Trading and momentum trading would be hitting up the most popular fast food joint for a quick fill up, at the end of the day the diner's stomach is full from both, but supposedly more satisfied from the longer meal. The reality is many value investors are eating at Chipotle and calling it fine dining.
The giants of value investing preach that value will eventually be realized somewhere between three and five years. Yet I read posts where people aren't willing to invest unless there is a catalyst on the horizon that will unlock value in the next six to twelve months. What ever happened to buying cheap things and waiting five years?
I don't think most investors are patient enough to hold a stock for five years, or the majority of their stocks for five years. Granted I would love everything I purchase to jump 100% the day after I buy it as well, but I realize that's not going to happen. Waiting has a nice built in side effect, it slows down portfolio turnover. I own slightly over 50 stocks, somewhere between five and ten appreciate to fair value in a year on average. This means I have a portfolio turnover of about 20% which keeps taxes at bay and keeps the workload for finding new ideas to a reasonable amount.
I couldn't imagine turning my entire portfolio in a year, I couldn't find 50 new investment ideas, I'm not even sure I could find 10. But I am reasonably confident I can fine one or two a month which is all I need.
Simplicity
I've spoken before about simplicity but I believe it's always something that needs to be at the forefront for me. I appreciate a complicated investment story as much as anyone else, but it's important to be able to effectively communicate a thesis in just a few words. I was talking to my brother-in-law's brother-in-law this weekend about advertising. He works in advertising and conducts focus groups to determine the effectiveness of labels and ads for some major national brands. He said universally people will give five seconds of attention to something new, if you can't grab their attention in five seconds their interest moves on. This is why simple and straightforward ads work better than walls of text. I think the same thing relates to investing. When I see an investment thesis and it requires that I understand 15 years of backstory I lose interest, unless right up front there is a killer attention grabber.
Some of my best investments could be summed up in about four bullet points. When those points stop being relevant it's time to sell.
Retail
I generally avoid retailers as investments, they're difficult and take a certain type of investor. Many retailers become legitimately cheap because their general popularity has waned. Retailers sell popularity, popular fashions or popular dining. Once the freshness fades sales often move on, but there are always exceptions, Red Lobster and Olive Garden come to mind. There is no freshness there, I'm honestly amazed that anyone eats at Olive Garden considering the much better, and more authentic Italian dining in our area, yet there is always a wait.
The lifecycle of retail is interesting, my wife and I recently had a conversation about this. We drove past a JC Penny and my wife commented how it was dying, but it made sense because so many newer stores had taken its place. Her point was that in the US there are only so many consumers, a number that's roughly growing with population and immigration growth. Unless consumers start to spend more of their income there is a fixed amount of money that can be allocated to retail consumption. This means if a store is experiencing wild growth it's coming at the expense of another store.
If a retail turnaround is going to happen it means that a once dying store needs to steal back their customers from another more popular store.
Another thought along these lines is often that a popular retailer is in a newer area considered a good location. I love comments about older stores where someone will say they wonder why they're located in such a bad spot. At one point that bad spot was the good spot, but time took its toll. Eventually those new spots could become bad spots and the lifecycle continues.
A related thought to this is that while I do a lot of international investing I generally try to avoid foreign retailers. I also avoid retailers that I can't visit. There is a certain pulse to a company that one can gather by visiting. I don't mean foot traffic, but how goods are displayed, how the stores are laid out etc. These things play into the culture. Shopping is such a cultural thing I can't imagine getting it right being thousands of miles away. How do I know if the cheap retailer in Thailand hit a temporary bump, or if they aren't popular anymore? I have this general sense in the US, but overseas it's impossible to know without going there.
Patience
If investing types were like restaurants value investing would be the long drawn out four course meal. Trading and momentum trading would be hitting up the most popular fast food joint for a quick fill up, at the end of the day the diner's stomach is full from both, but supposedly more satisfied from the longer meal. The reality is many value investors are eating at Chipotle and calling it fine dining.
The giants of value investing preach that value will eventually be realized somewhere between three and five years. Yet I read posts where people aren't willing to invest unless there is a catalyst on the horizon that will unlock value in the next six to twelve months. What ever happened to buying cheap things and waiting five years?
I don't think most investors are patient enough to hold a stock for five years, or the majority of their stocks for five years. Granted I would love everything I purchase to jump 100% the day after I buy it as well, but I realize that's not going to happen. Waiting has a nice built in side effect, it slows down portfolio turnover. I own slightly over 50 stocks, somewhere between five and ten appreciate to fair value in a year on average. This means I have a portfolio turnover of about 20% which keeps taxes at bay and keeps the workload for finding new ideas to a reasonable amount.
I couldn't imagine turning my entire portfolio in a year, I couldn't find 50 new investment ideas, I'm not even sure I could find 10. But I am reasonably confident I can fine one or two a month which is all I need.
Simplicity
I've spoken before about simplicity but I believe it's always something that needs to be at the forefront for me. I appreciate a complicated investment story as much as anyone else, but it's important to be able to effectively communicate a thesis in just a few words. I was talking to my brother-in-law's brother-in-law this weekend about advertising. He works in advertising and conducts focus groups to determine the effectiveness of labels and ads for some major national brands. He said universally people will give five seconds of attention to something new, if you can't grab their attention in five seconds their interest moves on. This is why simple and straightforward ads work better than walls of text. I think the same thing relates to investing. When I see an investment thesis and it requires that I understand 15 years of backstory I lose interest, unless right up front there is a killer attention grabber.
Some of my best investments could be summed up in about four bullet points. When those points stop being relevant it's time to sell.
Retail
I generally avoid retailers as investments, they're difficult and take a certain type of investor. Many retailers become legitimately cheap because their general popularity has waned. Retailers sell popularity, popular fashions or popular dining. Once the freshness fades sales often move on, but there are always exceptions, Red Lobster and Olive Garden come to mind. There is no freshness there, I'm honestly amazed that anyone eats at Olive Garden considering the much better, and more authentic Italian dining in our area, yet there is always a wait.
The lifecycle of retail is interesting, my wife and I recently had a conversation about this. We drove past a JC Penny and my wife commented how it was dying, but it made sense because so many newer stores had taken its place. Her point was that in the US there are only so many consumers, a number that's roughly growing with population and immigration growth. Unless consumers start to spend more of their income there is a fixed amount of money that can be allocated to retail consumption. This means if a store is experiencing wild growth it's coming at the expense of another store.
If a retail turnaround is going to happen it means that a once dying store needs to steal back their customers from another more popular store.
Another thought along these lines is often that a popular retailer is in a newer area considered a good location. I love comments about older stores where someone will say they wonder why they're located in such a bad spot. At one point that bad spot was the good spot, but time took its toll. Eventually those new spots could become bad spots and the lifecycle continues.
A related thought to this is that while I do a lot of international investing I generally try to avoid foreign retailers. I also avoid retailers that I can't visit. There is a certain pulse to a company that one can gather by visiting. I don't mean foot traffic, but how goods are displayed, how the stores are laid out etc. These things play into the culture. Shopping is such a cultural thing I can't imagine getting it right being thousands of miles away. How do I know if the cheap retailer in Thailand hit a temporary bump, or if they aren't popular anymore? I have this general sense in the US, but overseas it's impossible to know without going there.
Banking primer part 3: First Northern Community Bancorp, a cheap community bank
It seems to be a universal consensus that with the market marching higher good ideas are becoming rare. I agree, this isn't 2008, where literally buying anything that wasn't deep in debt did well, or 2009 where that strategy continued to work. My observation has been that obvious value is scarce, but there are pockets of the market where value continues to exist, smaller cap banking stocks is one of those pockets.
In the past two bank primer posts I discussed a specific aspect related to bank investing, in this post I want to profile a cheap community bank. The bank is First Northern Community Bancorp (FNRN). There are hundreds of little banks like this, cheap and safe, First Northern was chosen almost at random, but it's a great case study.
First Northern Community Bancorp is a small community bank located in Northern California. The Bancorp is a holding company for one subsidiary bank, the First Northern Bank of Dixon. The actual bank has a small number of branches, their first branch was established in Dixon in 1910.
In the past two bank primer posts I discussed a specific aspect related to bank investing, in this post I want to profile a cheap community bank. The bank is First Northern Community Bancorp (FNRN). There are hundreds of little banks like this, cheap and safe, First Northern was chosen almost at random, but it's a great case study.
First Northern Community Bancorp is a small community bank located in Northern California. The Bancorp is a holding company for one subsidiary bank, the First Northern Bank of Dixon. The actual bank has a small number of branches, their first branch was established in Dixon in 1910.
Investment thesis
I value banks in a slightly different manner than most, I value banks like I value companies. I find a bank that's clearly undervalued, then I work to either confirm or deny the valuation. This is the opposite of someone who might research and value a company and once the valuation is done look at the market value. I start with the market value, I'm not looking for franchise companies, I'm looking for companies that appear cheap, and I want to confirm they actually are cheap, if so I invest. This means I don't have a watchlist of banks or companies I'd like to buy if the price were right. Rather I continually trawl low P/B stocks and pick up what's on sale that week or month.
Here are a few of the things that caught my eye:
- P/B 77%
- Increasing ROA and ROE in the face of a declining net interest margin
- Overcapitalized
- Low level of troubled assets
Keep in mind, this isn't the world's greatest bank, yet it isn't failing or losing money either. First Northern is a fairly stereotypical community bank. Given their situation I'd argue they should trade at least at book value, if not for more.
The research
There are probably as many ways to investigate a bank as there are bank investors, considering this is my blog you end up with my approach. I first like to take a quick look at a bank's assets, then quickly move onto their liabilities. My theory is if the bank has a costly funding structure, and onerous expenses it's not worth my time investigating the quality of their assets. To summarize, I glance at the assets and make sure nothing catches my eye, then I investigate their liabilities.
First Northern Community Bancorp's liabilities consist almost entirely of deposits, and a very small amount of 'other liabilities.' A bank has a few levers they use to affect their profitability, the cost of their funds, the rates at which they loan money, and their cost of doing business. For a community bank that mainly focuses on mortgage and consumer lending their lending rates are often set by the market. This means that expenses and deposits are the main factors driving profitability.
In the case of First Northern most of their deposits fall into the category of retail deposits, that is deposits by retail banking customers. They have a low amount of brokered deposits, which are often costly. But simply avoiding brokered deposits isn't enough, more than half of First Northern's deposits are interest bearing. It appears most of the deposits are in low rate money market accounts, the bank is paying a .17% rate on all of their customer deposits.
Nothing concerned was discovered with the bank's liabilities, onto their assets, mainly their loans:
Examining a bank's loans is always interesting, there are many lenders like First Northern who make most of their money by lending residentially. The more interesting banks are the ones who are very creative in their lending and able to boost rates. FS Bancorp comes to mind, they're a Washington community bank that has a very strong lending program to local contractors, their rate on earnings assets is 6.09%, quite a feat, but not without risk either. Other banks will have a small but thriving business doing auto lending which is profitable, or investment management, or something else.
Residential loans typically have the lowest rates, but are also safer. A $75k residential default is handled much easier than a $2m commercial default. Banks that can prudently lend commercially stand to earn more money, but also expose themselves to more risk. First Northern isn't a pure residential lender, they have a sizable exposure to commercial borrowers. They also have a somewhat sizable exposure to three risky categories, construction and land, farm loans, and farmland. All of those categories are famously cyclical, if the bank lent when the market was high their recovery in a crisis could be questionable.
For the inquiring type I have included a small business loan drill down:
To determine if the bank is lending appropriately we need to look at their asset quality stats. There are two measures to look at, non-performing loans to loans, and non-performing assets to assets. First Northern has .92% non-performing assets/assets, which is a desirable outcome.
The bank's non-performing loans to loans ratio is 1.62%, higher, but not a number to be concerned about.
There's also the possibility that the bank is over-reserved for loan losses, if this is true they could reverse their provision at some point in the future resulting in a sizable one time earnings gain.
You may have noticed that almost this entire post I've avoided discussing the bank's earnings. A bank's balance sheet is paramount to their survival, a bank's earning power can be derived from their balance sheet. A bank with a poor balance sheet will have poor earnings, and a bank with a strong balance sheet will be able to generate strong earnings. Overall First Northern's balance sheet is average, and their earnings are average as well. The bank has been profitable seven of the last nine years losing money in 2008 and 2009 along with the rest of the banks in the US.
The one last thing I want to mention with First Northern is their capital structure. The bank has common stock, no debt, and preferred shares outstanding. The bank took TARP funds during the financial crisis, and then used funds from the Small Business Lending Fund to repay their TARP sharse. The bank initially issued $22m worth of SBLF preferred shares, of which they repurchased $10m in Q1 of 2013.
In summary the First Northern Community Bancorp is not a franchise bank. They are a slow growing bank serving Northern California. They will never become a money center bank, and most likely will never have brand recognition outside of three counties, but even still they have a sound balance sheet, quality assets and are profitable. When all of these factors are considered together it's reasonable to say that the bank should trade for less than book value. They haven't destroyed book value, rather they've been growing it. I would never recommend building a concentrated position in a bank like First Northern Community Bancorp, but it seems like an investor could do very well building a portfolio position of 15-20+ banks with profiles like First Northern Community Bancorp.
Disclosure: No position
My investment disaster: First Bank of Delaware
Only in a perfect world do all of our investments work out the way we want. No amount of planning or research can protect investors against the future, which is one of the most unpredictable forces in existence.
Last summer someone recommended that I take a look at the First Bank of Delaware as an investment. I took a look and quickly passed. I saw a bank that was losing money at an increasingly fast rate, and that had experienced some legal issues in their recent past.
The bank was digging itself into a hole that seemed hard to recover from, that was until I found a news release on the bank's website that explained they were looking into the possibility of winding down operations and liquidating. Suddenly I was interested, here was a bank trading for $22m with a book value of $44m. The trade seemed attractive, especially with such a large discount to book value, if the company's book value was anywhere close to reality I had the chance to double my money.
The downside seemed somewhat limited as well, at 50% of book value what could possibly go wrong? What sort of event could destroy this investment? I was initially worried about a bad loan book, but then First Bank of Delaware sold their entire loan book to Bryn Mawr Bank at a 3% discount to book value. My biggest concern had been cleared up, investors were now set to double their money right?
Here are two spreadsheets I put together last summer showing the value of the bank:
Last summer someone recommended that I take a look at the First Bank of Delaware as an investment. I took a look and quickly passed. I saw a bank that was losing money at an increasingly fast rate, and that had experienced some legal issues in their recent past.
The bank was digging itself into a hole that seemed hard to recover from, that was until I found a news release on the bank's website that explained they were looking into the possibility of winding down operations and liquidating. Suddenly I was interested, here was a bank trading for $22m with a book value of $44m. The trade seemed attractive, especially with such a large discount to book value, if the company's book value was anywhere close to reality I had the chance to double my money.
The downside seemed somewhat limited as well, at 50% of book value what could possibly go wrong? What sort of event could destroy this investment? I was initially worried about a bad loan book, but then First Bank of Delaware sold their entire loan book to Bryn Mawr Bank at a 3% discount to book value. My biggest concern had been cleared up, investors were now set to double their money right?
Here are two spreadsheets I put together last summer showing the value of the bank:
At the time of my research the stock was trading at $2.00 per share, the investment value was straight forward.
What went wrong?
What I neglected to mention above is that the bank didn't willingly decide to enter liquidation, they were forced into it by the FDIC. The FDIC issued a consent order that forced them to either submit a plan of reorganization or to voluntarily liquidate. The company missed a few deadlines on submitting a strategic plan of reorganization, and was forced into liquidation. This should have been my first warning sign, that bank's management was unable to submit a plan of action to satisfy the FDIC's request. At the time I didn't think much of this, but in retrospect is speaks volumes to the speed and reactive nature of management.
The First Bank of Delaware's troubled past had finally caught up with them. In their recent history they had been known as a subprime enabler, they were a clearing bank for subprime credit cards. They were also involved in a supposed security incident where the bank processed a large number of fraudulent Visa and Mastercard transactions. The bank was also involved in a check cashing company from California that was accused of lending at usurious rates. And lastly the bank was involved in an online check cashing and payment system that was allegedly used to send fraudulent payments that they bank was aware of.
On the last point the bank was facing action from the US Attorney General regarding the check cashing scheme. Based on some cases and settlements dug up from the internet it seemed that the bank would be able to settle, and even in the worst case scenario I could imagine shareholders would end up with a small positive gain. I had estimated a settlement in the range of $1m-$5m, with a potential worst case scenario at $10m.
Shareholders never received the full story behind the fine, but the bank was slapped with a $15.5m fine for their involvement in the illegal check cashing scheme. My gut tells me that there was more to the story than just what the filings said, but unless a prosecutor's lips become a little loose we will never know.
The $15.5m judgement was 50% higher than my worse case guess, it knocked the value of the bank's equity from $39m to $23.5m. The bank had also incurred close to $5m in liquidation costs at this point as well meaning that their book value was further reduced to $18.5m. My initial investment was in a bank with $40m in equity at the $22m level. With book value reduced to $18.5m my margin of safety quickly vaporized.
When news of the US Attorney General's fine was released the stock sold down sharply, I realized that I had no hope of a gain on the investment and sold for $1.70 a share, locking in a 15% loss. It was shear luck that I was able to limit my loss to 15%, the stock continued to fall and I know a lot of shareholders who experienced a 50% loss on paper before their shares were converted into liquidating trust shares.
The company is still working through the liquidation. According to the latest mailing I received last week they have $1.37 in net assets per share, but it's very likely the company is over-reserving and might have a little bit more to distribute.
Lessons learned
It's always painful to review a losing investment, but I think the pain is necessary to improve our investment processes. There was no way I knew what the government fine would be, but I had enough warning signs that indicated I should beware.
My biggest mistake was ignoring the company's past. I glossed over their involvement in subprime lending, and questionable short term lending practices. Because the bank was liquidating I didn't think any of the past mattered, but it did. The past spoke to the quality of management, and to their character. The type of management who would willingly engage in illegal activities, or would turn the other way when illegal activities are occurring isn't one I want running a company I own. Whatever the bank actually did was egregious enough that the government didn't back down on their fine, they refused to negotiate a lower settlement with the bank.
My second mistake was that I estimated too many variables for this investment. At one level this investment was simple, $40m worth of value being liquidated at $22m. The gap between the two values was what the market was assuming a settlement plus some legal costs would be. I had estimated costs to be less, and while I believed my guess was scientific, it was after all just a guess. The best investments are ones where there are only one or two assumptions that need to happen for the investment to work in the investors favor. With the First Bank of Delaware there were many assumptions that needed to work as planned for me to earn a return.
I firmly believe that each loss in my portfolio has a lesson attached to it. I will never avoid losses entirely, but there is always something to be learned. Even if the lesson is something I can't avoid in the future, there is value in awareness.
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