Shareholder composition has to be one most disregarded aspects of researching an investment. Most investors look to see what percentage insiders own, and maybe what percentage institutions own, but it rarely goes any further. I have been thinking about this a lot recently in the context of smaller companies with larger majority shareholders.
The big issue I've been thinking about is what role does shareholder composition play in value realization, and as a cause for a depressed price? I've read some articles on a company I recently posted about Guinness Peat Group. The company is a busted growth company that's in liquidation, the shareholder base seems to be long time scorned holders who are so frustrated they're just selling on news of the liquidation. Some might stick around, but this is a very disgruntled group. This shareholder base could be helping to create the undervalued situation.
An example on the other end of the spectrum is a company like George Risk. George Risk is small with a $30m market cap. The founder Ken Risk owns 58% of the company leaving $12.6m as the available float. The company is cheap with $23m in net cash and on track to earn $2m this year. A simple valuation of 10x * $2m plus $23m equals $43m as a reasonably conservative value for the company. The company's profits have been stable, but this isn't a growth company by any measure, it's a sleepy Nebraska company trading close to net cash and securities.
So who are the shareholders of a company like George Risk? The smaller float effectively locks out bigger funds and even medium size funds. But a lot of funds won't invest in a company where after buying a sizable stake they can't affect change, and Ken Risk has a tight grasp on George Risk eliminating fund buying. That leaves the shareholder base to smaller individual investors, and mostly value investors who like the cash story, and like the fact that there's about a 50% upside from here. The company also used to be a net-net which means we have some of the deeper value Graham investors holding on as well (yours truly).
What's the problem with this? I think the problem is value investors are disciplined buyers, so they're not going to pay $40m for a company worth $43m, that's left to readers of Barrons. This means if the company trades close to NCAV there will probably be a lot of buying activity, but as the price gradually rises buyers dry up. The same thing could happen as the stock gets close to fair value, the value investor base sees fairly priced shares and begins to sell driving the price back down.
I don't know if this is a real phenomena, but it intuitively seems so. Some net-net's languish forever, eventually net-net investors give up, or management changes direction which forces deep value investors out. A great example of this would be Audiovoxx, a perennial net-net that spent their excess cash on an acquisition. A lot of value investors jumped ship when Audiovoxx transformed, but the acquisition was good, and the company generated some growth which propelled the share price higher. This isn't to say that an acquisition is the way to a high share price, but the acquisition seemed to change the shareholder base from value investors to investors looking for growth.
I tend to invest and write about companies that have large majority shareholders, and attract value investors, companies such as Micropac, OPT Sciences, and Solitron Devices (1,2,3,4). I'm wondering aloud if part of the undervaluation is that we value investors are our own worst enemies, we are keeping the price low, and if the price rises to close to intrinsic value herd selling begins which drives the price back down.
What's the solution? I think in some of these cases the solution to the market valuation/intrinsic valuation gap needs to come from the company itself. If the shareholder base isn't going to drive the price higher the company needs to be the catalyst. This could mean a tender for shares, or a dividend, or even going private at a fair value.
I don't really have any answers, this post is more of a jumping off point for a discussion then anything else. I'd love to hear confirming or contrary opinions, leave them in the comments.
Talk to Nate
Disclosure: Long all stocks mentioned in this post except Audiovoxx.
Good blog post. I believe half the reason is what you stated. The other half is managements inability to act like a "public" company. There are too many public companies running their companies like private companies. These companies are always undervalued for a reason. If most management teams would simply let people know they exist I think a greater number would reap the rewards. I view a public management team as having a fiduciary duty to let people know they exist. If they don't take the time to do so, why should I waste my time as an investor. This is one of those intangible things I look for when investing in any stock and took a few years to figure out. But then again, I'm not really a value investor either and I would never buy something based on Book Value, Trading at Cash, or other metrics :) I get bored easily and often. Good blog post.
ReplyDeleteIan Cassel
MicroCapClub
Ian,
DeleteI agree management is the other half of the problem. Sometimes they're much more than half, unfortunately often investors in general are afraid to engage management. Shareholders are afraid of management and managers are afraid of shareholders, not a good situation for anyone.
Thanks for the comment, very thought provoking.
Nate
Ian,
DeleteRespectfully, I disagree.
I have sat in on so many "investor road shows" and, while I enjoyed the free steak lunches and unlimited iced tea refills, I couldn't help but think, "THIS is what management thinks is a good use of shareholder resources? To attempt to instigate a Ponzi-lite buying frenzy of their stock?"
It's just "greater fool investing" by other means. Instead of writing newsletters pumping a company's stock, you are asking management to do it for you.
If a public company is not going to make use of being public, they should be private. In fact, most company's should probably be private. I think it's actually insane there are as many publicly traded companies as there are. I think this is a consequence of "financialization"... something that seems modern, progressive and good but which is probably mostly a stunt and a game that adds little to no value (and may even subtract value from the equation in many instances).
Better to have the company go private (keep buying back shares until there aren't any), distribute dividends (especially if the company has securities it could spinoff to shareholders tax-free, like Graham's Northern Pipeline example), search for a private or public buyer or liquidate itself.
Nate,
ReplyDeleteI think you stumbled upon the answer right at the end there without realizing it:
It could be value investor activism!
These value investment situations are almost always cases where the management is stagnating and not fully realizing opportunities for value maximization. It behooves value investors in these situations to get active, try to get on the board and agitate for management to do something positive (buybacks, dividends, liquidation) to unlock the value.
Because these are mostly small companies, this is not only probably the "only" way to make something good happen, it's probably the most appropriate. It wouldn't take too many value investors working together and coordinating their efforts to roam around the value world looking for value castles to lay siege to and eventually conquer.
What do you think?
Nate,
ReplyDeleteSorry for comment spam but your underlying point is an interesting one. I was having this same discussion/realization with another investor last week. We were discussing companies that might be good for a takeover and he pointed out that one I mentioned was actually a bad target because there was too much insider ownership.
So, you're right-- institutional, insider and retail ownership value is always contextual. Are you attempting a control buy? Activism? Catalyst? Wait-and-see? Etc. Each strategy requires a different ideal shareholder structure and a lot of the time there's a mismatch.
I think it's one more part of the investment art worth considering before plunging in. A company could be cheap, but if you're approaching it as a control situation which it is really only cheap to an activist, you might get frustrated.
Often value is its own catalyst, as investors mobilize over a cheap situation, and press for change. Patience is good if you have a management team that is motivated to do well for outside passive minority investors, and has the talent to do it.
ReplyDeleteA cheap stock attracts value investors; value investors do not make a stock cheap. If they are too patient when management is not motivated/talented, yes, the stock will remain cheap -- that's a value trap, and avoiding them is what the better value investors do.
But the cheap stock is not the fault of the value investors directly; it is the fault of the management / controlling shareholders.
David,
DeleteThanks for the comment. I think the two keys to what you said are investors press for change, and management isn't shareholder unfriendly.
I don't think value investors make a stock cheap, but I wonder if the shareholders are mostly insiders and value investors if that could keep the price down.
Nate
I think the key to most situations, especially smaller stocks is actually transferring the cash flows to shareholders. If a security is a stream of cash flows, returning those flows to shareholders over time (dividends, buybacks) will drive the stock price and help it trade (up presumably) with intrinsic value. That is how I think of value being its own catalyst. The risk in many of these situations is the cash sits on the balance sheet or is reinvested and wasted. A dollar on a the balance sheet of something you don't have access to is not worth a dollar in a lot of cases. ITPC is a good example. Pink sheet with a negotiated buy back in place.
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