SFB Bancorp - Too cheap to ignore, especially for activists

"Value is its own catalyst" is a common saying amongst value investors.  When a stock is marginally cheap investors need to pound the table, concoct 80 page power point presentations and create elegant narratives to sell the story.  When a stock has landed in value territory it's valuation is the story.  Such is the case with SFB Bancorp (SFBK) a bank in Tennessee that languished on the edge of the pink sheets until the discrepancy between the market price and book value became too great.  A fund discovered the stock and started to build a position.  The rest as they say is history.

I've talked about the idea with Colin, the Managing Director for Trondheim Capital numerous times. SFB Bancorp was an idea that appeared in the second issue of the Oddball Stocks Newsletter.  The full writeup sample is below.

I had the chance to interview Trondheim Capital and Meixler Investment Management about the bank, why this is a good investment, and what they wish to achieve.  Before getting into the interview I want to outline the investment case for SFB Bancorp in sentence or two.

Investment Snapshot

SFB Bancorp is a holding company for Security Federal Bank in Elizabethton, TN.  The bank has $60m in assets with a 41% Tier 1 ratio.  They have $37m in loans and $19m in cash and securities.  Equity is approximately $14.593m against a market cap of $12m. They trade for 82% of book value.  The bank is profitable and has been for years.  They never incurred a loss during the financial crisis and asset quality is pristine.

The bank's President embodies the community banker saying of "I know my bad loans by name."  I spoke with Carmella Price and asked about a non-performing loan and was given a list of the seizable assets such as a high end power boat that were negotiated as collateral for the loan.  Price certainly knew the bad loan by name, and was on top of the resolution.

The bank has a mediocre 5% return on equity, mainly due to their significant over capitalization.  If the bank were to use their capital to buyback shares, or extend credit it's feasible that they could earn over 10% on their equity without much effort.

Lastly, this isn't a cheap bank sitting on the sidelines waiting for someone to notice them.  As you'll see in the interview below a number of funds are already involved and working to close the valuation gap.

Interview

How did the bank come into being? 
It was founded in 1963 as a mutual. The founder's son (Bill Hampton) told me that his father (Peter Hampton) started it partially to generate more work for his law practice. I assume that means the title and escrow work. They demutualized and went public in May 1997. In 2003 they terminated the securities registration and moved to the pink sheets.

How can a bank so small survive?
Non-interest expenses were only $1.79 million in 2014. Of that, $1.064 million was compensation. They brought in $2.65 million in net interest income and non-interest income, so that leaves a respectable profit. East Tennessee is obviously a cheap part of the country from a compensation perspective.

When most investors look at SFBK their first thought is most likely "so many securities and not enough lending.." do you feel increased lending is what they need?
No. They say their market is too competitive and I believe them. Credit union competition always comes up. They have a culture of conservative lending which is one of the great things about them. They made money throughout the recent depression and bought back ten percent of outstanding shares in 2009.

Why are they so conservative?
That seems to be a part of the culture, inherited from the founder. I think it's admirable that they've let the loan book decline. It peaked in 2006! Hired help will grow for the sake of growth; an ownership mindset seems to result in conservatism at least with regard to credit risk. Now, interest rate risk and the idea of buying back stock instead of building a low-yielding bond portfolio is the area where we differ with management.

What's the ownership structure like?
The founder's son and family own about 25%. There's an ESOP that owns about 11%. The President of the bank subsidiary, Carmella Price, owns about 4%. Together that's 39% for what I call the insiders. Bill and Carmella are on the board with three directors who own less than 1% combined. Then there is Trondheim Capital, Meixler Investment Management, and a private investor named Jack Rubens. The three of us "outsiders" wrote a letter to management in July about capital allocation, and we informed them that our combined holdings were about a quarter of the company.

What's the opportunity for investors?
First, the bank is trading below book value even though it's profitable and overcapitalized. We estimate that the discount is close to 20%, but book value may understate both the liquidation and intrinsic values. Given the discount and overcapitalization, they should be buying back stock. At 12/31/14 equity was 23% of assets and Tier 1 was 41%.

Is there something better the bank can do with their excess cash?
Buy back stock below liquidation value, below tangible book value, below value as an acquisition target. Any of those ways that you look at it, repurchases below these intrinsic value would be a good use of surplus capital.

Are they a potential acquisition target? If so why? If not why not?
I think what we are seeing recently is that every bank is an acquisition target to an equal or larger size bank that wants to get economies of scale. I spoke with the founder of another bank in eastern Tennessee who already made one acquisition and wants to make more.

Is it possible to buy a significant stake?
There are shares offered in the open market. I'm surprised that micro cap investors aren't smarter about finding ways to buy stakes in tiny companies, the way Buffett used to do. In most states, companies are required to send a shareholder list to a shareholder. You could look for someone who owns the same quantity of shares you are looking to buy and make them an offer. I've never been offended by someone wanting to buy something I own.

In an ideal scenario what would you like to do at the bank?
At a minimum, we think that shares should be repurchased to close the gap between the share price and intrinsic value. This would reduce surplus capital, boost ROE, and reduce the interest rate risk if it was funded by selling some of the long duration treasury/muni paper. We also think that the significant shareholders who aren't insiders should have board representation.

Are you like most Wall Street activists who want to strip companies of their assets and leave the carcass to flail in the wind? (Security Federal Bank plays a vital role in their local community, is this something you'd keep?)
That criticism makes more sense with a non-financial company. With a bank that has surplus capital and too much lending competition, it's just so obvious that capital should be returned. Especially when shares are trading at a discount.

Can you walk us through why share buybacks are better than dividends or lending?
I actually found a compilation of all of the Buffett annual report comments on share repurchases and sent it to the President of the bank. It is so obvious that's what you need to do, provided that shares are below intrinsic value and that you have surplus capital, i.e. no investment opportunities that are superior to that. If you are a banker and you've sized up your lending market as being too competitive - which I perfectly respect - you are in the situation where you do not have a better use for the capital.

Is there a limit to what the bank can buy back?
Well, there's obviously a limit in terms of remaining well-capitalized and maybe another threshold of what the regulators are comfortable with. And obviously you want to stay within those limits. We are just talking about low hanging fruit here. See how much stock you can buy back at a huge discount using capital that's currently supporting fixed income instruments at one or two percent yields.

Have you talked to management about your ideas? What did they say?
As I mentioned, we sent a letter jointly with two other large outside shareholders about the repurchase idea. They sent a letter thanking us, saying that they are "in the process of updating the Company's strategic plan" and would be "discussing these topics and others with our financial advisors." Polite, but vague and non-committal.

What's managements plan for the bank?
That is not something they have wanted to share with us. It would be great to have a conversation with them where we compare the share repurchase plan with whatever plan that they have in mind and see which one results in higher IRR to shareholders, especially across a range of economic and interest rate scenarios. I think it would be tough to beat share repurchases at a discount.

Interested in learning more about banks? Buy my book The Bank Investor's Handbook (Kindle and paperback available)

Oddball Stocks Newsletter Investment Writeup

This writeup is from the July 2014 issue of the Oddball Stocks Newsletter, it's unaltered from the original publishing.

SFBK Sample - Oddball Newsletter

Disclosure: Long SFBK

Opt-Sciences - Going dark an excuse to operate in the dark

If you hang around small caps long enough you'll eventually hear the complaint from companies that "it costs too much to be public."  Sometimes this statement is true.  For very small and unprofitable companies being public is costly and a financial burden.  But these are rare cases, usually the cost of being public is an excuse management likes to tout to justify deregistering their securities from the SEC and "going dark" allowing them to operate in obcurity..

A company I've owned and followed for years, Opt-Sciences (OPST) filed their Form 15 on November 4th.  The Form 15 is a document that notifies the SEC that a company intends to terminate their security registration.  A company can do this if they have less than 300 shareholders of record. A shareholder of record is a shareholder who has possession of a physical stock certificate.  If you own shares of a company in a brokerage account your name will never appear on the company's shareholder register.  Rather the aggregated owner, Cede & Co, will appear on the shareholder register.  Small companies like to go dark through this loophole.  They might have thousands of shareholders with brokerage holdings, but these brokerage holdings only count as one registered owner.  Most small companies have less than 300 shareholders with physical certificates.

Small companies will readily pay dividends and mail reports to shareholders who own shares in street name but when it comes time to determine if a company has enough shareholders to remain public or not companies will claim that street holders are not real shareholders.  I know this is patently false as I've talked to CFO's of companies I own in street name, and they can see the number of shares I own and the name associated with my street holdings.

Opt-Sciences is a familiar name for small cap value investors.  The company manufacturers anti-glare coating for aircraft instrument displays.  The company has traded below book value since the financial crisis.  The last time they traded for more than book for an extended period of time was in the mid to late 1990s.  They are profitable and their balance sheet is loaded with cash and marketable securities.  If one backs out their excess cash and securities the company has some eye-popping returns on equity and an extremely low P/E.

The company has a book value of $20.54 and earned $1.40 for the first nine months of 2015.  Management expects the fourth quarter to generate about $.30 in earnings, for $1.70 in earnings for the full year.  If you back out 75% of their cash and securities, which is $11.93 per share the company trades for 4.4x earnings.  Ex-cash the company earns above 20% on their equity, although this could be misleading depending on how old their facilities are.  It's possible they've depreciated all of their plant resulting in an artificially high ROE.

With the market at elevated levels it isn't often an investor finds a company at 4.4x earnings and trading for less than book value.

The reason that the stock is cheap is also the reason that going dark is a bad idea for the company.  Opt-Sciences is cheap because management controls 66% of the company through a trust and another 6% directly for a 72% insider ownership stake.  The Chairman is the head of the trust, while his son-in-law is the CEO.  The beneficiaries of the trust are the CEO's wife and her brother, who is also on the board.  The board consists of three members, the Chairman (trustee), CEO and his brother-in-law (trust beneficiary). The proxy claims the CEO has no control over the shares held in the trust, but these three family members appear to be on good terms, and it's laughable to say that the CEO's comments about the company wouldn't influence his wife's decisions or that the family wouldn't talk about the company at family gatherings.

Shareholders seem to have lost hope that value will ever be realized at the company and have been unwilling to trade shares for more than book.  I don't blame any shareholders for giving up hope, there isn't much reason to hope with Opt-Sciences.  While the company is generating good returns management is keeping the rewards to themselves.  They don't buyback shares, and don't pay a dividend.

The company's Form 15 filing was terse.  It contained no information as to why the company was going dark and didn't provide any details for the owners of the other 28% of the company who aren't insiders.  The lack of communication speaks volumes as to how management thinks of the company.  They act as if this is a small private company with a few nuisance shareholders hanging on.

As of January 2015 the company had 316 registered shareholders, 16 more than is required to go dark.  Since then the company hasn't repurchased any shares, or announced any reverse splits to reduce their shareholder count under 300.  It's possible the company is going to go dark illegally with more than 300 shareholders and hope the SEC just doesn't care.

I hope that Opt-Sciences will continue to publish financial reports for shareholders, but I'm skeptical.  I've seen this pattern in the past where companies with large cash holdings go dark.  Going dark can be a precursor to management sticking their hands in the cookie jar and looting the cash pile.  When a company files with the SEC salaries and compensation and insider trades must be disclosed.  In the world of dark stocks companies fly fast and loose without rules.  Allegations of insider trading are rampant as well as managements with less than 100% ownership interest stealing 100% of the company's economic interest for themselves through high salaries and undisclosed perks.

It's possible that Opt-Sciences will be a good mannered dark company, but it's just as likely they'll fall off the face of the earth and shareholders will wonder what happened to their investment as management pillages the plunder.

The company is cheap but I'd wait to see how the going dark transaction plays out.  Will the company continue to provide updates to shareholders?  Or will shareholders be forced into suing the company for an annual report that they're legally entitled to have?  A huge red flag is that they're proceeding to go dark with what appears to be more than 300 shareholders without any communication or plan to reduce that number.  It could be a sign that the company believes they can do what they want.

My messages is "buyer beware" to investors interested in this company.  It appears cheap at first glance, but the lack of meaningful communication with investors as well as the blank going dark filing leave me leery.  This has all the markings of a company about to enter the value graveyard.

Disclosure: No position

Microcap Conference speakers and company profiles

In a few weeks I'll be hosting the Microcap Conference at the Marriott in Philadelphia on November 4th and 5th.

I wanted to post the speaker list as well as profiles of the companies that will be attending.  If you haven't secured a spot yet please sign up now.  We are almost out of room.  The response has been so strong that Fred Rockwell, the other organizer of this had to work with the hotel to upgrade our space to accommodate everyone.

Sign up now

More information: http://www.microcapconf.com

Speaker List

Investing In Highly Leveraged Companies 


Gene Neavin, Portfolio Manager - Federated Investors 


Eric Green, Director of Research - Penn Capital

Finding Investment Opportunities in Canada 


Paul Andreola, Director of research - SmallCap Discoveries 


Brandon Mackie, Analyst - SmallCap Discoveries 


Philippe Belanger, Co-Founder - Espace MicroCaps

Social Data’s Influence on Financial Markets 


Chris Camillio, Private Investor with one of the best audited track records in the past decade

Starting an Activist Campaign 


Damien Park, President - Hedge Fund Solutions, Chairman of the Board - iPass

Financial Blogger Panel on Investing Strategy 

David Waters, Founder OTC Adventures and Alluvial Capital 


Nate Tobik, Founder Oddball Stocks and CompleteBankData.com 


Jennifer Galperin, Partner - Bigger Capital 


Chris DeMuth Jr, Founder and Portfolio Manager - Rangeley Capital 


Andrew Walker, Portfolio Manager - Rangeley Capital 


Maj Souiedan, Co-Founder - GeoInvesting Micro-Cap Research

Company Profiles

Microcap Conference Company Profiles by Nate Tobik

Benzinga Interview: Small banks plus a niche small cap with incredible ROE's

I wanted to share my most recent interview on the Benzinga PreMarket Pre show.  I discussed a few small bank ideas as well as Kopp Glass, a classic oddball stock.

Kopp Glass is an example of a perfect oddball stock.  It's a very small company that operates in a niche, yet earns extremely high returns on capital.  The problem is they can't scale their market.  So while they have a nice moat, and earn great returns they don't have much growth potential.  The company has paid out most of their earnings as dividends, and shareholders seem content to earn a close to 10% dividend as well as some appreciation.

Kopp Glass first appeared in the Oddball Stocks Newsletter in July 2014.  The write-up is displayed below.  If you're looking for more write-ups like this I'd encourage you to subscribe to the Oddball Stocks newsletter.

Oddball Stocks Newsletter - Kopp Glass Sample by Nate Tobik

Disclosure: Long Kopp

Titanium Holdings an out of fashion net-net

Investing is similar to fashion in many ways.  There are trends that are short lived, while other seemingly short lived trends become common place.  Some fashion trends will never be fashionable again no matter their usefulness.  Something like the Dogs of the Dow could be closely approximated to hip/fanny-packs.  In theory they're a great idea, but you don't want to be caught with one, or with that strategy.

Other fashion trends appear and have staying power.  The ETF boom is like casual Fridays.  At first it was alright to leave the coat at home, then a polo and pants were acceptable.  Now we've digressed to the point where people wear hoodies to work and showing up in dress pants or a dress shirt makes co-workers wonder if you're interviewing somewhere else.  ETF's were similar.  A few simple trackers for important indexes as a way to plug a hole in a portfolio.  Like casual Fridays the ETF world has descended into craziness.  No one is buying QQQQ anymore, now it's a reverse-inverse levered grain fund portfolio for farms with a ticker IOWA.

Investing fashion is driven by what the largest funds who are on TV and file 13-F reports are doing.  When the market is in a trough anyone and everyone can buy assets cheaply and buying cheap assets is in vogue.  It's also more of a sure thing.  In the midst of 2008 investors were uncertain about how durable company moats and brands would be in the "new normal".  But most investors were relatively certain that if you buy $1 for $.75 and throw in a profitable funeral parlor, a few F-150s written down to zero and other assorted assets that it's likely they'd get their money back, and potentially a gain as well.

As the market climbs out of a bottom value investing becomes more challenging and more complex.  The great deals of the bottom no longer exist that funds can scale into.  This means the funds and investors guiding the value investing fashion cycle move on from traditional asset bargains to companies with moats, companies that can compound at high rates in normal business environments, and companies that generate relatively high cash flow yields.

Investors follow the guiding lights that are in magazines, on TV, and in the blogs.  There are few original thinkers or original actors in the investing world.  The great news is that one doesn't need to be original to be successful in investing.

Now that the depths of 2008/2009 are far in the rear view mirror the idea that anyone can buy a traditional Graham value stock is almost laughable.  There are few stocks trading below book value, and few net-nets.  Investors are a fickle bunch.  If you asked investors right now most would say book value is meaningless and should be disregarded.  In a crisis book value and net current asset value are suddenly meaningful concepts only to be forgotten in the wake of gains.

If an investor is looking for a traditional value stock, not just a company selling for a lower P/FCF multiple compared to peers one needs to move down the size ladder significantly.  There are no net-nets with two billion dollar market caps.  As far as I know there aren't any net-nets with market caps above $100m in the US.  Net-nets are in markets that only the brave enter such as Japan, or Vietnam, or in extremely small stocks.

Titanium Holdings (TTHG) is an example of an extreme undervaluation in a bull market.  This is a name I've followed for years.  I've owned it off and on as it fluctuated between dramatically undervalued to just undervalued.  I don't own it anymore, but the stock is still attractive at current prices.

One thing that's nice about small companies is they're straightforward.  Titanium Holdings is simple, they own some cleaning supply stores in Texas as well as marketable securities and cash.

The value proposition is clear, they have $1.7m in cash, $348k in securities and $589k in liabilities.  Their net cash position is $1.486m.  The company has 9.228m shares outstanding and a last trade of $.20 meaning their market cap is $1.86m.  If you back out their cash and securities the market is valuing their cleaning supply stories that have a $2.2m book value for $374k.  This is a business that made $72k in the past six months.  If their earnings run rate continues the market is valuing them at slightly over 2x earnings.

Maybe a cleaning supply store in Texas is only worth $300k, I don't know, but it seems quite low.  What I do know is this.  With infrequent trading shares were trading with a quote 50% lower recently.  A buyer at those prices would have been buying this business for less than net cash, and would have only needed to wait a few weeks to double their money.

Titanium Holdings isn't a great business.  The auditors comment on the financials saying the company only discloses the absolute minimum necessary, and if they disclosed more investors might have a different impression.  Maybe there is more than meets the eye here?  We know the company has a majority shareholder who has used company resources to make bad investments in the past.  But the issue isn't the quality of the company, it's the company's valuation.

A savvy investor who keeps their eye on situations like Titanium Holdings can do well.  A question is naturally "How do you even buy shares?"  Here's a small secret, when a buyer of size wants to get out the price craters.  This serves two purposes for an investor, they get to purchase as much as they want at an attractive price.  The lesson is never dump your stake indiscriminately onto the market.

At current prices Titanium is still cheap.  In a sale they'd probably be worth 50% more, although I'd caution and say that a sale is extremely unlikely to happen.  But the company doesn't need to sell for value to be realized.  Value will be realized when stocks like Titanium come into fashion again.  Wearing neon was a bad decision for years, but then suddenly it was back like the 80s never stopped.

Vulcan International: The ultimate oddball stock

Warning: This company is extremely illiquid and management treats investors somewhere between something to be ignored and something to engage with in battle.  Investors are required to sign a NDA in order to receive financial statements.  This idea is only for sophisticated and experienced dark company investors.  I have not signed the NDA and I have not seen the financial statements for this company.  This write-up is based on publicly available details and certain other sources.  If you contact the company they will require you to sign an NDA.  

Some of the allure to investing in dark companies lies in the hunt for information.  Perhaps it’s our legacy hunter-gatherer instincts rearing their head.  Not many investors, if any, have an informational advantage with large cap companies such as Apple, GE, Kraft or Microsoft.  But with a little work any investor can have an almost unfair informational advantage for many dark companies.  

Investors are sometimes like water in that they prefer the path of least resistance.  There is significant resistance related to procuring Vulcan International’s financial statements and other related information, but stepping over that hurdle can be worth it, especially with what seems to be afoot at the moment.

Vulcan is a Delaware incorporated company with a $59.6m market cap.  The company owns a rubber and foam manufacturing company located in Tennessee, a sizable securities portfolio and various real estate holdings including timberland.  The company appears to believe that rubber and foam manufacturing is their main line of business.  If one visits the Vulcan International webpage they are presented with a nice picture of the company’s facilities along with sub-pages detailing specific manufacturing capabilities at the Tennessee location.

Vulcan reports abbreviated earnings on the OTCMarkets platform for investors.  If a potential investor were to examine Vulcan’s website as well as read their press releases they’d likely have the impression that the company was an overvalued manufacturer with some real estate interests.  This is where public perception, created and nurtured by the company’s management over a long period of time, is divorced from the truth.

Now for a brief digression.  There are three stages in a magic trick.  The first is called the “pledge”.  This is the setup of the trick where the audience is shown something ordinary.  Think of Vulcan’s so-called reporting as belonging here.  The second step is called the “turn” where the magician makes the ordinary act extraordinary.  Management’s extreme efforts to block and obfuscate investors fall in this category.  Finally, there is the “prestige” where the effect of the illusion is shown.  Read on magic lovers.

Vulcan International is a holding company that primarily consists of bank equity holdings, including US Bancorp and PNC shares, as well as real estate interests in Ohio and Minnesota.  Their small money-losing rubber and foam manufacturing firm in Tennessee which appears to the general public as the primary asset is in reality essentially an afterthought.

The company’s ownership is dominated by the Gettler family.  Benjamin Gettler, the former CEO passed away in 2013.  Gettler was well respected in the community.  A Google search reveals numerous articles about his community contributions.  At one point Gettler was Chairman of the Board of the University of Cincinnati.  Gettler's stepson is the company President, and two of Gettler's other sons are on the Board along with his widow.

The company was an SEC reporting entity until they filed a Form 15 in September of 2005.  At the time of their last quarterly filing in 2005 they had $58m worth of shareholder equity and assets of $85.74m consisting primarily of $72.6m in marketable securities, some cash and their manufacturing assets.  On the other side of the ledger, the company had a $3.2m note payable as well as some deferred tax liabilities.  It’s worth noting they are currently trading for only slightly more than their book value of 10 years ago.

Vulcan International at one point ran a large manufacturing operation that made bowling pins along with foam plants scattered throughout the US.  Foreign competitors invaded Vulcan’s market and Vulcan’s formerly profitable operations began to lose money.  The company sold off the majority of their factories except for one located in Clarksville, TN.  Past SEC filings show positive income from continuing operations, but these numbers include securities gains as income.  It’s my understanding that the Clarksville factory hasn’t operated profitably in decades if not longer, yet it continues on like some kind of undead creature.

After winding down their foam operations the company found themselves in a strange position.  They had excess capital, but no real reason to exist.  Management began putting their excess capital to work buying a portion of the Cincinnati Club Building in downtown Cincinnati, a second office in Cincinnati, as well as public bank stocks.  It’s worth mentioning at this point that my brother-in-law and his wife held their wedding reception at the Cincinnati Club Building, the facility is beautiful and my guess is the balance sheet value for this asset doesn’t reflect its true value.

It was only a matter of time before the growing equity portfolio outpaced the shrinking manufacturing operations.  At some point it became necessary to ask whether Vulcan should be classified as an Investment Company under applicable SEC rules and regulations.

Fortunately, someone did ask.  That person was Lloyd Miller, Jr., the infamous activist small cap value investor.  Miller owned a significant stake in the company in the 1990s and was on the Board of Directors.  Miller and the company had a falling out and Miller signed a release related to his right to vote his then current shares.  Miller then sold his stake over the next few years. Subsequently, Miller re-established a new position in Vulcan and took part in a rights offering.

Miller’s various legal filings have formed the basis of this article and they are worth a read.  Miller filed one of the most comprehensive books and record requests (Section 220 demand) I have ever seen.  Asking for access to everything from financial statements to board minutes, records related to sale or issuance of stock, as well as all material transactions with any subsidiaries.  

Vulcan countersued Miller alleging that he broke his release agreement by acquiring more shares and attempting to exercise his shareholder rights; a view the court disagrees with.  In the lawsuit Miller claims that Vulcan is an Investment Company under the Investment Act of 1940 and executives have engaged in insider trading.  So far the SEC hasn’t acted in regulating Vulcan as an Investment Company.

All of this is interesting and most likely entertaining, but you’re probably thinking, “Why is this company even being written about?”

While there are some egregious corporate governance issues, the company is an attractive investment.  An investor buying today is effectively purchasing PNC and US Bancorp stock at a large discount to their market prices.  

I’ve noticed a strange and familiar pattern with investors who do obtain the Vulcan financials.  They immediately become as guarded with the information as the company is so they can purchase as large of a stake as possible.  I’ve also heard more than one Vulcan investor mention that this is one of the more attractive opportunities they know of.  This is considerable given the types of investors who invest in Vulcan know the dark market very well. 

Before writing this article I asked what a few investors thought the shares were worth.  They all agreed at least double the current price if not more.

The problem is there are other dark companies trading for 50% of their intrinsic value with bad management.  Companies like this aren’t value traps they are value graveyards.  Places where investor dollars go to sit in the ground and disintegrate.  What’s different about Vulcan?  It seems investors have finally had enough of the Gettler black hole and there is a concerted effort to get the company to open up.

Management has been intentionally vague about the operating results at their Clarksville facility.  This is presumably because they have close personal bonds with employees there, as well as the notion that owning a money-losing factory will somehow help them avoid the fate of being classified as an Investment Company.  The reason Vulcan wants to avoid this classification is because if they were to be classified as an Investment Company they would suddenly be required to be more transparent as well as undergo regulation.  Note that it is extremely difficult if not impossible for a long-standing operational company to comply with the requirements of being an Investment Company.

Management at many dark companies operate with their head buried deep in the sand blissfully unaware of anything outside of their small kingdom.  Vulcan is the opposite.  A Gettler on the Board acts as their outside counsel and is extremely savvy regarding shareholder rights and securities law.  I have been told they play the clueless managers at company meetings, but they are far from it.  This is also why the company vigorously countersued Miller in response to his record requests and various lawsuits.

If shareholders have their way Vulcan International won’t become a value graveyard.  This is because a number of shareholders besides Miller have decided they’ve had enough with management and have decided to push for changes.  The Gettler family controls the company, but without a shareholder register it’s unknown as to their ownership percentage, or how firmly they really are entrenched.  Sometimes management at companies such as Vulcan will act as if they own a majority stake when they don’t actually own a true majority holding.

Management has responded with surprise that there are investors interested in the company.  The CEO has mentioned that changes are underway towards transparency, although nothing has occurred to date and its ultimately it’s unknown what might happen.

Fortunately for shareholders, the Gettlers don’t need to be removed and a shareholder uprising doesn’t need to take place for value to be realized.  Improved transparency is likely all that’s needed before Vulcan shares start to appreciate towards fair value.  Sunlight often is the best disinfectant.

There is a very good reason that Vulcan is selling for half or less of its intrinsic value.  They have a management team that has ignored shareholders and actively worked to block information from being released.  Yet, value has a way of being realized, especially if the discrepancy between market price and value becomes too large.  The gap between price and value has become large enough that a number of shareholders are interested in poking and prodding management until the gap closes.  For investors who have a taste for the darkest oddball companies the market has to offer Vulcan International might be worth a look.  If anyone is looking to purchase a sizable stake and help open this company up, please contact me and I can put you in contact with other Vulcan investors.

So how much cloak and dagger can an investor stomach before running for the hills? I talk about how I evaluate management more in my free investing mini-course. 

Recent interviews and podcasts

While I haven't been posting as often as I'd like (and I'm hoping to correct that!) I have been active in co-hosting a microcap investing podcast as well as giving interviews.  I wanted to link to all of these items in case you missed any of them.

Benzinga PreMarket

Here is my most recent interview on the Benzinga PreMarket show:

As always I spoke about banks and other related issues.  So far I've been correct in my prediction that the Fed wouldn't raise rates in 2015, maybe we'll be thrown a bone in December.

Interview with Tim Melvin

I also had a lengthy interview with Tim Melvin of the Banking on Profits newsletter.  Listen here

Microcap Investor Podcast links

As always I continue to co-host the Microcap Investor Podcast with Fred Rockwell.  You can subscribe on iTunes.

Here are a few recent episodes:

• Talk with Brandon Mackie about Canadian stocks: listen
• Interview with Wilson Wang of Twin Peaks Capital: listen
• Talk with Maj Souiedan of GeoInvesting: listen

Microcap Conference

If you missed it I'm working with Fred Rockwell to organize The Microcap Conference in Philly on November 4th and 5th.  We have an exciting list of companies attending as well as a full slate of investor attendees.  There are still a few attendee spots open.

You can find out more information and register to attend on the website below.  The list of companies as well as a preliminary schedule will be posted soon.

The Microcap Conference

Beyond value traps: The value graveyard

He couldn't stop talking about the great deal he got on his boat.  My friend purchased his boat over the internet from what he considered a sap Florida.  The boat was supposedly in mint condition, everything was like new, it ran well.  We looked at the same batch of pictures over and over as we listened to his savviness in buying cheap online.  Since he didn't live in Florida he paid someone to tow the boat to Pennsylvania.  It was there the problems started.

On the way back the boat trailer developed a problem with the wheel bearings.  My friend explained it away as something simple that happens to trailers that sit a lot.  He had a great reason too, in Florida boats are always in the water so the trailers rarely are used.  Once the boat was back in Pennsylvania the list of repairs began to grow.  That mint condition vinyl was a bit sun faded, it just needed to be replaced.  Then there were some issues with the engine that required an overhaul.  Some patches and paint and a number of other things were needed before the boat was sea-worthy.  Suddenly this incredible deal my friend got on his boat wasn't such a great deal.  He put so much money into the boat that if you added it all up it's likely he overpaid.

Investments can be like my friend's boat.  A company looks great on the surface and even cheap, but after a little while the problems start to crop up.  A bit of faded paint here, an old engine there, minor things, but all together they become a disaster.  Investors like to refer to companies like these as value traps.  Companies that appear to be cheap on a statistical basis, but once an investor has a little experience they realize the company isn't cheap at all, in many cases it's very expensive given the issues.  Value investors who purchase shares find themselves trapped in a bad situation.

Value traps are bad,  but they aren't the worst.  With a value trap in most cases an investor can escape with a loss and move on.  There is a category of investments so bad that they make value traps appear attractive, these are stocks in the value graveyard.  Perpetually cheap on a statisitical basis but with negative factors so large investors would be lucky if they merely experienced a loss.  Rather they're likely to have their capital tied up forever in a company who's management is slowly destroying value.

Value traps are usually companies caught in a shifting industry that fail to adapt.  A company like Radio Shack that believed we'd still be sodering our own toasters together in the age of iPhones.  Value traps are passive failures.  A company failed to act in response to some macro event.  Value graveyard stocks are active traps.  Management at these companies is either actively working to destroy value (and line their pockets in the process), or working to create value that shareholders can't partake in.

Many companies in the value graveyard trade on the pink sheets and file financial reports occasionally, or never at all.  It's much easier to hide what's happening if you don't give financial updates.  The best way to identify a value graveyard situation is one where management is clearly running the company for the benefit of themselves.  They earn a large salary, issue shares to themselves and regard shareholders as an annoyance.

When a company's management takes such a negative stance against shareholders it's no surprise that shareholders give up and sell the stock en masse.  Sometimes these stocks are illiquid because there are no buyers for such a terrible company.  Other times these stocks are illiquid because the company won't give out financials without an NDA, and for 99.999% of the market that is too high of a hurdle to overcome to invest.

Given enough time companies in the value graveyard atrophy.  Sometimes management is able to destroy (or take) value quicker than the share price falls.  But other times the price falls quicker than the slow decline initiated by management.  It's in the atrophy mismatch where opportunities arise for investors who wish to get their hands dirty.

Before the US Senate Benjamin Graham was asked why undervalued stocks eventually appreciated to fair value.  Graham responded it was a mystery and that no one knew why it happened.  We still don't know exactly why a given stock might appreciate, but I think we can make an assumption in general about why this happens.  With millions of investors combing the world of opportunity enough eventually find an undervalued situation, purchase, and push the price up. 

If a company falls to an incredibly low valuation, essentially too low of a valuation the investment can become attractive, but not by buying and patiently waiting.  For companies that live in the value graveyard investors need to become personally engaged in helping to realize value with the situation.  When management is working against shareholders the company's shareholders need to be working against management.

A recent example of this is Solitron Devices, a chip manufacturer based in Florida.  The company  went bankrupt in the early 1990s and the CEO claimed they've been emerging for the last twenty years.  During this emerging period he felt it was acceptable to ignore shareholders, not hold annual meetings and continually line his pockets with a large salary and stock options.  The stock price drifted downward over the years and eventually settled in net-net territory.  With a price so low for so long value investors and activist investors emerged.  This past week shareholders (who are predominantly value investors at this point) elected two activist investors from Eriksen Capital Management to the Board.  With this management suddenly decided to start thinking about value creation.  They initiated a large buyback and have begun talking about mergers or selling.  Of course what happens verses what is discussed remains to be seen, but this is a step in the right direction.  Shareholders have pushed back forcefully against management, and with only a minority ownership stake management is forced to act.

In the most recent issue of the Oddball Stocks Newsletter I highlighted another value graveyard situation that has finally attracted investor interest.  I will post the name here eventually after subscribers have an opportunity to purchase, but the company is attractive.  Like Solitron the majority of their market cap is in liquid assets that can be sold for a multiple of the current price.  The issue with this company is management is trying to hide these assets and keep them for themselves.  They require shareholders to sign an NDA to receive the annual report, and prefer to operate in secrecy rather than honestly in the daylight.  But like Solitron investors have taken notice of the extreme mis-valuation and have decided it's time for something to be done, and push back against management.

When an investor comes across a company in the value graveyard they have a choice, pass by, or do something.  Larger firms with significant resources might consider buying a stake an actively pushing for value creation.  Individual investors like myself can alert other investors to these types of situations.  You don't have to be an established activist with a large capital base to make a difference.  Sometimes a letter to management letting them know shareholders exist can be enough, or a short article in the local paper.  A little sunlight on a dark situation is never bad for shareholders, but is feared by management.

So how much mismanagement can an investor stomach before running for the hills? I talk about how I evaluate management more in my free investing mini-course.

Recent interview and podcasts

I recently began co-hosting the Bulldog Investor Podcast with Fred Rockwell.  For anyone who didn't know I was doing this I wanted to share the four recent episodes that I've been on.  Each episode is linked with a short description.

• Interview with Tim Melvin discussing community banks and banking: Episode here
• We talk with Tim Stabosz about risk in value investing.  An interesting discussion about distressed turnaround stocks takes place: Episode here
• John Huber of Base Hit Investing joins us to talk about compounding machines, undervalued stocks, portfolio management and Bank of Utica: Episode here
• We talk to Philippe Belanger of Espace MicroCaps about finding investments in Canada: Episode here

July Benzinga Interview

Last Wednesday I had the chance to be a guest on the Benzinga PreMarket Prep show again.  The interview can be found below.

Neglected or distressed?

There is a common perception about value investing that it involves purchasing shares of companies on the brink of financial ruin with the hope they turn around.  Viewed through this lens value investing is risky and the value investor one step away from experiencing individual ruin as their investments go bad all at once.

It's not hard to see where this perception could have come from.  In the world of academic finance where everything can be reduced to a formula investment returns are a product of risk.  Riskless assets generate no returns whereas supposedly risky assets generate outsized returns.  Financial practitioners know what the academics don't, that life isn't a set of formulas.  Assets that appear safe can turn out to be risky, and assets that appear risky might be safe.

The question is how can an investor find a safe asset for a depressed price?  The answer to that lies in the distinction between different types of value investments.

In general low priced stocks can be broadly grouped into two opportunity sets: distressed investments, and neglected investments.

Distressed Investments

A distressed investment is any investment situation where the company is experiencing either business/operational distress or financial distress.  These are the stereotypical "value" investments.  Companies with operational difficulties trading at extremely low valuations.

An investment in a distressed company hinges on a few factors.  The first is an investor needs to be able to determine whether the market reaction to the company's results is too pessimistic or if they're accurate.  Then the investor needs to be able to determine if the company can recover from their operational difficulties.  If an investor can determine both of these factors correctly it's likely they will be able to do well investing in distressed investments.

The trouble with distressed investments is determining when the future of the company doesn't look like the past.  When a company faces a fundamental operating issue they need to innovate and solve their issue.  If they can it's likely results in the future will resemble the past, or might even be better.  If the company has a culture that can't react to their situation the chance that the future looks like the past becomes very small.  Short sellers like to look for companies that have stumbled and don't have the business-DNA to reinvent themselves.  Whereas distressed investors are looking for companies with that reinvention DNA.  It's worth noting that very few companies change their business from one industry or market to another successfully.  In many cases the odds are on the short sellers side.

Many novice value investors will find a distressed opportunity and presume the future will look like the past when in fact the business itself is undergoing a dramatic shift and it's likely the company will never recover their former glory.

With all these pitfalls distressed investing can be extremely profitable if done right.  A company on the brink of bankruptcy and trading at 10% of book value might return 500% or 1,000% if they avert disaster.  Where there's a chance for outsized returns there is also a chance for a complete loss.  Companies straddling a thin line between solvency and bankruptcy court usually don't leave much residual value for shareholders.

Even though equity investing in distressed situations is risky one method to reduce risk is to invest is at a higher level in the capital structure such as through preferred stock, or debt.

Neglected Investments

I feel that distressed equity situations tend to have binary outcomes, either the company will do exceptionally well, or a tax write-off is in short order.  I prefer a different type of value investment, the neglected company.

A neglected company is one that the market has mostly, or completely forgotten about.  Sometimes the company's business is so boring it's hard to generate investor excitement.  Investors, and especially the financial media likes whatever is popular or cutting edge.  A landscaping company that schedules appointments via an iPhone is suddenly the Uber of landscaping.  Whereas the hordes of other landscaping companies quickly fall into the camp of neglected investments, regardless of their investment merit.

The majority of my best investments have been neglected companies.  Companies that are profitable, growing, and trading at depressed valuations because no one knows or cares about them.

In many ways a distressed investment is the opposite of a neglected investment.  Companies that are neglected usually don't release news..ever.  Neglected companies don't hold conference calls, and sometimes it's hard to even obtain financials for them.  Neglected company CFO's are surprised any investors exist, especially ones that have intelligent questions to ask.

Distressed investors often live and die by the news flow.  One news release or announcement can mean the difference between a vacation in the French Riviera or a stay at the Days Inn at the Jersey Shore.

Neglected investments don't appreciate 3-5x in a year, but they might compound in silence at 15% or 20% for decades, all while trading at a large discount to book value.

An investor interested in neglected companies doesn't need to predict the future.  They just need a reasonable assumption that the future will be similar to the past.

The advantage to an investor looking at neglected investments is that these investments are not as risky.  Neglected companies aren't facing an existential crisis.  They can be great companies just operating outside the limelight.

Which is best?

I'm not sure there's a best way, but it's important to understand the differences in each investment you look at on a stand alone basis.  The worst mistakes happen when an investor believes a distressed company is merely neglected.  When this happens the investor misses a significant source of risk in their investment.  The converse can also be true.  An investor mistakes a neglected company for a distressed investment and never invests.  There are many neglected companies silently grinding out significant returns for shareholders.

The Solitron proxy battle heats up

The proxy battle between Solitron management and Eriksen Capital Management has reached new heights.  Solitron is clearly worried that they will lose this battle, and I expect them to.  They've hired an investment relations firm to send shareholders a letter containing their view on Ericksen's nominees.

Eriksen Capital hit back hard with a proxy filing today.  I will let Eriksen's own filing do the talking in this post.

The filing is here.

"Based on SEC filings, Saraf became CEO in December 1992. During the quarter Mr. Saraf was hired (12/1992 through 2/1993) shares traded as high as $8.12 and as low as $3.43 per share, adjusted for the reverse stock split. Solitron’s share price as of June 30, 2015 was just $4.47 per share. Thus under Saraf’s twenty two and half years of leadership, Solitron shareholders total return would range between a loss of 41% and a gain of 39%, including dividends. In comparison the Russell 2000 index, which covers small cap stocks, has risen over 669% since January 1, 1993 through June 30, 2015. Clearly, Solitron’s board has some serious performance issues that they are probably embarrassed to discuss."

"Summary of the facts:

1.  In 1992 Shevach Saraf was named President and CEO of Solitron Devices. The company was in Chapter 11 bankruptcy at the time. He was granted a very generous package that granted him a good salary, 10% ownership of the company at no cost to him, and ten year options to purchase 8% of the company.

2.  Prior to Mr. Saraf becoming CEO in late 1992 the Company made contributions to its 401k and Profit Sharing Plan to help employees in preparing for their retirement. Since becoming CEO, Mr. Saraf has received over $1.6 million in profit related bonuses, in addition to his generous salary. During that time, the company has made zero contributions to the 401k and Profit Sharing Plan for its employees.
 
3.  For nearly twenty years, from 1993 to 2013, CEO Shevach Saraf and the Board did not hold annual meetings even though Delaware corporate law requires it. From 1996 to 2013 the only directors were Mr. Saraf and two others appointed solely by him after his own term had already expired, and, based on a careful search of SEC filings, it seems clear none were presented to shareholders for affirmation.

4.  In 2000, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors voted to approve an employment agreement granting Mr. Saraf 15% of Solitron’s earnings in excess of a fixed $250,000 per year. The employment agreement also granted the CEO an automatically renewing five year contract along with generous change in control benefits.
 
5.  In 2000, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors granted a massive stock option plan, without shareholder approval, primarily for Mr. Saraf’s benefit. By our calculations 64% of options granted went to CEO Saraf, and 12% to the other directors.
 
6.  CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors granted these massive options to him at ridiculously low prices. The first grant issued in December 2000 was for 10% of the company’s shares, and was priced at just one-third of book value. The second grant issued in May 2004 to replace the original 1992 grant, was for 8% of the company’s shares, and was priced at a substantial discount to book value. 3

7.  In 2007, CEO Saraf’s personally selected, never-shareholder-approved, expired-term directors approved a second 700,000 share option plan without shareholder approval. Thankfully Solitron has not issued shares on it, but they did recently file with the SEC in order to do so. One of our requests to the Board was that they put the plan up for shareholder approval at this year’s annual meeting. They refused. Wonder why?

8.  CEO Saraf’s option grants under the 2000 Stock Option Plan had ten year expirations from the date of the grant. Just prior to expiration, the Board changed the grants to having no expiration even though the plan expressly forbade such action. While Section 10(a) of the 2000 Stock Option Plan grants the Board the right to extend an option grant, it expressly states “that in no event shall the aggregate option period with respect to any Option, including the initial term of such Option and any extensions thereof, exceed (10) years.” No amendments to the Plan were ever filed, and we would add that an attorney representing Solitron stated in a letter to us that “I understand that the 2000 Stock Option Plan has not been amended since the date of its public filing.”

In case you weren’t keeping track. CEO Saraf was granted 10% of shares at his hiring for free. He was later granted options for another 18% of the company, plus 15% of profits in excess of $250,000 per year. If you add that up it is up to 43% of economic gains in addition to his significant $321,500 annual salary. By our calculation, CEO Saraf has received nearly half of Solitron’s economic gains during his twenty plus year tenure.4 Yet Solitron has the audacity to slander Mr. Eriksen and Mr. Pointer as “opportunists” who “care only about themselves.”

Disclosure: Long SODI

Announcing The Microcap Conference

One of the most common questions I'm asked regarding micro cap stocks is "how do you find new investment ideas?"

One problem with microcap stocks is there are so many of them.  In the US and Canada there are over 10,000 stocks with market caps below $500m, and 8,600 companies have market caps below $100m.  This is compared to the 3,600 companies with market caps greater than $500m.  These numbers don't include the hundreds of semi-public companies where information is at times harder to find.

Microcaps have a reputation of being scammy, risky, fly by night operations.  And there definitely are a number of companies that fit that profile.  But within the universe of 10,000 small companies there are also some incredible investment bargains.  The problem is digging through 10,000 names to find those hidden gems.

I've teamed up with Fred Rockwell (I co-host the Bulldog Investor Podcast with Fred) to create a new type of microcap investment conference.

We wanted to create a unique investment conference combining some of the best financial bloggers with microcap companies that deserve to be on your radar.

You will have the ability to choose between sessions on two different tracks on November 5th.  We have dedicated one track to microcap companies so they can tell their story to investors.  You'll have the opportunity to listen and ask questions directly to executives at these companies.  We have also reserved space for investors to schedule one on one sessions with attending companies.  This is your opportunity to meet with an executive and get a feel for how they think about capital allocation, how they view the future of their business, or anything else you feel relevant to your investment thesis.

At the same time we're also going to have sessions featuring some of the biggest names in the value investing blogosphere.  The day will be divided into presentations from bloggers, special panels (such as an activist investing panel), Q&A sessions as well as a stock pitch contest.  These sessions are more educational in nature.  Micro cap experts will spill their secrets on how to find ideas, how to look at companies, how to engage management and more.

You don't have to pick one session track or the other, you can pick and choose to attend whatever piques your interest.  You can attend presentations by companies you find interesting and then pepper a panel of activist micro cap investors with questions

We realize that some of the best ideas and connections happen in the halls and outside of sessions so we've built in plenty of time to network with other investors and companies over drinks or food.

The Microcap Conference will take place on November 4th and 5th at the Marriott in downtown Philadelphia.  There will be a happy hour on the 4th for attendees arriving the night before.  The conference starts early on the 5th and is jam packed with presentations, sessions and plenty of networking time.

The cost to attend is $150 and includes the conference on the 5th as well as the happy hour and all meals on the 5th.  Space is limited, so booking early will guarantee your seat.

I will be presenting and spilling some of my secrets on sourcing ideas, analyzing microcaps and why I love bank stocks.

We also want to make this conference about you, and to do that we want your feedback on what panels you'd like to see or topics you'd like to see presented.  You can reply in the comments or send me an email directly (address on the sidebar).

Sign up now

Date: Evening of November 4th, all day November 5th
Where: Marriott Downtown Philadelphia (link)
Cost: $150

Winland Electronics a case of hidden value laying in plain sight

It's not often that a value fund piles into a stock with a $5m market cap.  Especially a fund with billions under management, but that's exactly what's happened with Winland Electronics (WELX).  The small company was noted in FRMO's latest quarterly remarks (read here).  FRMO, a part owner of Horizon Kinetics a multi-billion dollar asset manager purchased 15% of the company, a strange acquisition given FRMO's size.  The second largest shareholder after FRMO is another value investor named Thomas Braziel, the manager at B.E. Capital. (note: If you're looking for some interesting reading this interview with Braziel is a must read.)

Between FRMO, Braziel, and Matthew Houk (an associate of FRMO) 41% of the company's shares are spoken for.  

Apparently more than a few FRMO shareholders reached out to Murray Stahl (one of the company's two executives) and asked why a $390m market cap company making a roughly $500k investment, and was it even worth their time?  We know this because Stahl took the time to write about FRMO's Winland Electronics investment in the company's Q3 report.

What Stahl pointed out in his letter was two things.  The first was that at one point FRMO was a small company as well and has grown and they believe Winland can do the same.  The second was that the company sells a well known niche product that has very unique characteristics.

Winland specializes in monitoring systems.  They sell monitors to detect smoke, water, chemicals, temperature, and vehicles.  They've built detection devices for most anything that can be detected.  The products are not expensive and are potentially an easy sell to clients.  They're a form of cheap insurance.  If a company's building is flooded the company could incur hundreds of thousands to millions of dollars of losses from damages or outages.  It's easier to purchase a small sensor to detect water and mitigate the flood rather verses dealing with the effects after it has happened.

When one looks at Winland's product page it's easy to visualize how each of their sensors could protect a company against a catastrophic scenario.  Even though the probability of a catastrophe might be remote it's an easy decision to purchase a relatively inexpensive sensor that could detect an issue before it becomes a catastrophe.

Besides selling monitoring devices Winland also sells a subscription software monitoring solution that Stahl believes holds a lot of potential.  The company doesn't break out their sources of revenue, but subscription software is a good business model.

If the business is interesting but the company is overvalued there is not much to research.  But given Stahl's recent purchase it's likely that value is lurking at Winland, and I decided to take a closer look.

The company used to file with the SEC before delisting in 2014.  Before their delisting they had a history of losses before Braziel took an outsized position and gained control of the company.  Braziel moved the company from continued losses to sustained profits.

They earned $272k in 2014 compared to a loss of $2.6m in 2013.  Their book value increased from $1.3m to $1.6m between 2013 and 2014.  The company is clearly on better footing, but one needs to ask "where's the value?"

Winland is trading for 19x earnings and 3x book value, not exactly a deep value investment.  But a closer look reveals more.  Of the company's $5.3m market cap a little more than 20% of it consists of cash.  Ex-cash the company earned $272k on $538k worth of equity, for an incredible 51% return on equity.  What's even more encouraging is the company has expanding net margins.  They earned $31k on $964k in sales in Q1 2014, and in Q1 2015 they earned $129k on $936k in sales.  At this run rate they could potentially generate $600k in earnings in 2015 and ex-cash would trade for a 6.8 times earnings.

An additional sweetener for investors is the company's net operating losses carry forwards of $6.3m that expire in 2022.  There is a valuation allowance against them so these are an off balance sheet asset worth $1.64 per share, or more than the current price of the stock.

When an investor looks slightly beyond the financial statements it's easy to see why Winland Electronics is an attractive investment.  For the current price of $1.43 an investor is buying $.33 per share of cash, a business that has turned around, is growing, and has the potential to generate upwards of $.15 per share in earnings this year plus $1.64 a share worth of NOLs.  On top of all these things is the fact that the largest shareholders are value investors with an interest in maximizing shareholder value.

In the interview with Braziel linked to above he mentions that his best investments require digging beyond the initial financial statements.  I find it very fitting that the company where he is Chairman needs to be analyzed in the same manner.  There is value in Winland if one does a little bit of digging.

Disclosure: No position.

Benzinga interview plus thoughts on Goldman vs Lending Club

I had the chance to be a guest on the Benzinga PreMarket Prep show again in June.  A video of the interview can be found below.  One of the topics we discussed at the beginning of the interview was the report that Goldman Sachs might be entering the consumer lending market.  I want to elaborate on my thoughts regarding that in this post.  First the interview:

The NY Times had a report this week that Goldman Sachs (GS) is exploring an entrance into the consumer lending market.  Comparisons have been made between what Goldman has in mind for consumer lending and the company Lending Club (LC) that went public last year.

To understand Lending Club and Goldman's vision of consumer lending we need to discussion traditional lending first.

Traditional Lending

In a traditional banking model, a bank funds a loan through customer deposits.  A bank's source of funding is their customer's deposits.  Traditionally banks pay a small amount on deposits to compensate depositors for access to their money.  Deposit funding costs are low.  In the first quarter of 2015 banks paid an average of .44% in funding costs.

A bank makes money on the spread between the interest received on the loan and the interest paid on their funding (deposits).  If a bank makes a mortgage loan to a borrower at 4% and pays .5% in funding costs they earn a 3.5% net interest margin.  Operating costs to service the loan as well as providing the infrastructure to take in deposits and make loans is subtracted from that 3.5% spread as well as taxes and the resulting value is a bank's net income.

Banks can make money by lending to consumers then keeping the loan on their books and earning the spread.  Banks engage in all types of lending, consumer, credit card, auto, residential, and commercial.  Of those types residential lending is viewed as the safest and rates are the lowest as a result.  Moving up the ladder commercial loans are viewed as risker followed by auto, consumer loans and finally credit cards.

The truth is it's really a toss-up in terms of risk, sometimes commercial loans are much safer than residential loans, and residential loans aren't always safe.  On average banks are usually good at assessing risk.  A loan to IBM might carry a 1% rate, whereas a loan for a sub-prime auto might carry a 15% or 20% rate.  IBM is a good credit and it's almost assured they will pay back their notes.  A troubled car borrower is dicier.  Compound that with little residual value for the auto itself and it's easy to see why rates are so high for poor credits.

Banks usually like to diversify their lending mix.  This is in an effort to both manage risk, exposure, and increase their net interest margin.

The New Model

Lending Club is not a traditional bank as most consumers think of banks.  They own a small bank, Webbank located in Utah, but they are not a traditional lender.  The company is not funded via customer deposits, and they aren't focused on earning a spread via the bank.  There bank holds certain types of loans on their books and for the most part are just an intermediary for the rest of the Lending Club system.

Lending Club makes money by originating loans and selling those loans to investors.  The company takes a 5% origination cut off the top of the loan and then receive 1% of interest for each loan.  As an example if a borrower were to take out a $10,000 loan at 9% Lending Club would receive 1% in interest and investors would receive 8% for backing this loan.  Loans are funded by selling notes to investors.

From a borrowers perspective Lending Club is no different than a traditional bank.  A consumer requests a loan, the company conducts a credit check and if they deem them worthy they'll extend credit.  The borrower then pays back their loan with monthly payments.  Lending Club takes a portion of the payments and passes the rest onto investors in their notes.

If any investor were to read the Lending Club website it would appear that investors fund specific loans and receive payments from said loans.  But that's only partially true.  The Lending Club notes are simply derivative securities, the note itself is to Lending Club corporate, and the company then promises to forward on payments from borrowers to the investor minus service fees.

Lending Club makes money on the initial origination as well as service fees and the 1% of the interest rate paid by borrowers.

The actual notes are fairly complex.  A prospectus is available on the SEC website and contains general details of how the mechanics of the investing and loan funding process work.  Investors are buying Lending Club notes, and then Lending Club pays investors based on what notes the investor has selected via the website.  If a borrower defaults the investor has zero recourse, they don't have an actual claim on the loan like a bank would.  If Lending Club were to declare bankruptcy the investors don't have a claim on Lending Club, the claim directs to the interest in the underlying note.

Lending Club's costs are much higher than a traditional bank's costs.  Any student of the capital markets knows that equity financing carries the highest cost of all types of financing.  But for Lending Club the equity financing isn't borne by them, it's someone else's money.

Can it work?

The Lending Club model is different from a traditional banking model.  Lending Club needs to keep their origination volume strong and growing if they want to increase their revenue stream.  They aren't making much money on each loan so they can't just originate loans then sit and collect interest for years like a bank can.

This creates a unique incentive, the incentive is for Lending Club to drive loan volume regardless of credit quality.  If borrowers default Lending Club itself doesn't recognize a loan loss, they simply lose their 1% ongoing interest stream.  The company makes the bulk of their money upfront.

The company claims on their website that they have a premier platform and can conduct this type of lending profitably because of a low cost IT platform.  Supposedly banks with their high cost personnel and traditional infrastructure are outdated compared to this new IT paradigm.

The problem is the company's financial statements don't match up with what they're saying publicly.  In the most recent quarter they generated $81m from originations and service fees and had $86m in expenses.  Expenses broke down as following, $35m in sales and marketing (to keep the origination machine running), $12m in origination costs, $12m in engineering and development and $27m in "other".  The company reported a GAAP loss, but if investors pretend that stock compensation isn't a true expense then the company was profitable on an adjusted-EBITDA basis.

Lending Club has originated over $9b in loans since they started.  For comparisons sake let's look at them compared to a bank with $9b in loans.  I ran a search on CompleteBankData.com and came up with Apple Bank for Savings located in NY.  They had slightly over $9b worth of loans in the first quarter of 2015.  As a comparison it only took Apple Bank for Savings $29m ($16m in salaries, $13m in premise, data etc) to manage this amount of money.  Apple Bank for Savings earned $10.2m for the quarter, a far cry from Lending Club's loss of $6m.

Of course this isn't a perfect comparison.  Apple Bank for Savings specializes in mostly residential and commercial lending.  And they are funded by deposits.  But the comparison shows that there is a lot of value in being able to keep lower interest but profitable loans on the balance sheet and earning a spread.

Lending Club is a fundamentally different model compared to traditional banking.  Lending Club's model is driven by originations and fees on their loans, not the rates charged to consumers.

The attraction to this model for Goldman Sachs should be obvious.  Lending Club is raising funding capital from ordinary investors for their derivative notes whereas Goldman Sachs has a pipeline to institutional capital.  Goldman Sachs are experts at raising funds for special purpose entities that are eventually repackaged and then sold again to other (or the same) investors.

Lending Club is raising money at the retail level, $25 at a time.  Goldman Sachs can come into the market as a whale given their connections to capital and experience securitizing loans.

If I were to wager I'd say that Goldman Sachs will create a newly named consumer loan unit without the Goldman name on the letter head.  This newly created entity will begin to spam American mailboxes offering loans at 15-25% rates.  Goldman will then package these loans and sell them back into the market pushing the risk of a default onto investors, the same way Lending Club does.

The risk to this business model is it requires a steady stream of new originations.  If loan origination volume doesn't stay steady or grow the company could have issues coving their costs.  Lending Club hopes to eventually make money on their origination and service fees.  I'd imagine Goldman Sachs has the same idea, although I'm sure they'll make a little extra on the back end of the deal as well when they resell their packaged securities.  This is where Goldman has an edge.  They can make money up front and make money on the back trading these securities between clients.

Risk will appear when the "good" (good in a relative sense, not many truly good credits are borrowing at high rates) credit dries up and the company continues to make loans to poor quality borrowers in order to hit their origination metrics.

The real risk will be borne by the investors in these notes.  Whereas Lending Club investors can select the types of loans they'd like to be exposed to it's likely Goldman will do the selecting themselves and offer their clients pre-packaged securities.  We've seen what can happen to pre-packaged securitizations of low quality credits in the past, let's hope history doesn't repeat.

West End Indiana, a cheap bank with a slate full of activists

I grew up on the edge of nothing, well it seemed like the edge of nothing; a few miles from the county line.  The invisible county line was the border between corn fields, orchards and the encroaching suburbs.  A scene replayed throughout the Midwest.

The Midwest can be described as a sea of fields broken up by small towns and occasionally larger cities.  The Midwest is homogeneous, a small town in Ohio looks similar to a small town in Iowa.  Omaha doesn't differ that much from Columbus or Indianapolis.

Under all of those seemingly endless fields lies one thing, a lot of tied up capital.  Farming has enormous barriers to entry, the machines, the land, the labor.  Take a minute and imagine starting a farm from scratch.  You would need to spend a few million dollars to buy land, tractors, and plant seeds.  Then you sit and wait and hope your crop grows before attempting to sell it into a speculative market.  A farmer's input prices fluctuate as well as their final output price.  When they purchase their inputs they have no idea if they'll be able to sell their product at a profit or loss.  The scale of speculation that farmers undertake would make many traders blush.

While farming is speculative, one thing that's not speculative is selling services to farmers.  This is the role that West End Indiana Bankshares (WEIN) finds themselves in.  They are a small town Indiana bank located in Richmond.  They provide banking services to farmers and the farming community.  While the bank services the farming community they have very little direct farming exposure themselves.

What makes West End Indiana an interesting investment is they are trading for slightly less than book value and their shareholder register is filled with a slate of activist funds.  Activist bank investors own 38.02% of the bank compared to the 11.46% that the Directors and Executives own.

Fundamentally West End Indiana is a quality small bank.  They are small in the sense that they have a $27.5m market cap and only $263m in assets.  But given their size the bank has impressive financial metrics.

The bank earns an above average 5.05% on their assets and pays .65% on their deposits, which is slightly below average.  This enables them to earn a higher than normal net interest margin of 4.4%.  The bank's ROE has increased from .84% in 2006 to their current 6.73%.  What makes this rise even more incredible is that it's been a steady climb, straight through the crisis.

The bank has five branches, including limited service branches at the Richmond city schools with $2,000 in deposits.  There are at least a few students at the school off to a good start saving!

I went to college in the area where West End Indiana operates.  I've been through Liberty, where they have a branch countless times, as well as Richmond where they are located.  It's amazing the amount of money the bank has considering the area, a very rural area filled with farms and small towns.

The reason the bank has a higher than average NIM is because they specialize in auto-lending.  As shown in the picture below they have $75m in auto lending as of Q1 2015.  Of the bank's total loans at the end of Q1 2015 36% were auto loans.

Sometimes auto lending has a negative connotation associated with it.  Auto loans can go bad quickly if a borrower loses their job.  Typically an auto loan is for an amount higher than what might be realized in a repo and sale situation.  If a bank has a book of auto loans that go bad quickly they could face charge-offs as they sell a glut of used cars for a loss.

On the other hand an argument could be made that auto lending is safer than residential lending.  A borrower needs a car to get to their job and make money for their payments, whereas it's easier to find shelter with family or friends if necessary.

The bank's loan portfolio summary is shown below:

When most investors think of a small rural bank they think of a savings and loan.  A bank making loans to residential borrowers for their homes.  West End Indiana doesn't follow that mold, they only have $64.7m in mortgages while the rest of their loans are auto and commercial.  Bank management has clearly figured out the best way to maximize profit.

While maximizing profits the bank has also kept their asset quality in check.  Non-performing assets as a percentage of assets peaked at 3.53% in 2013.

The bank was a mutual bank and demutualized in 2012.  A demutualization is when a mutually owned bank raises money from depositors and outside investors as part of an IPO process.  The proceeds from the IPO are generally used for growth.  As you can see from the loan table above the bank was able to apply their funds from the IPO into growing their loans from $160m in 2012 to the current $203m.

When a bank demutualizes they are allowed to buy back shares after their first year public, pay a dividend after their second, and sell after their third.  West End Indiana completed their demutualization in January of 2012, making them eligible to sell the bank at any time.

Often activist bank investors are attracted to bank's that are easy to sell.  These activists will push for a sale and investors will realize a nice gain.  Banks that are easy to sell usually have either a lot of costs that could be cut, or a nice niche franchise, such as West End Indiana's auto lending business.

When trying to determine if a bank is salable two things are worth considering, who would buy the bank, and what's the bank worth.

Let's look at who might want to buy West End Indiana.  A new feature recently released in CompleteBankData.com is the ability to view deposit market share information.  The following table shows the metro area ranking for West End Indiana's branches.

The bank has $63.67m worth of deposits that are classified as within the Cincinnati, OH metro area.  Inside this metro area they are ranked 57 out of 70 banks in terms of deposits.  The following picture shows the aggregate metro area details for Cincinnati:

West End Indiana isn't much more than a bit player in the Cincinnati market.  Cincinnati is ruled by heavyweights US Bank, Fifth Third and PNC.  When looking at the overall deposit market share West End Indiana isn't more than a rounding error.

But a rounding error in Cincinnati is ok.  West End Indiana isn't focused on the urban market, they are focused on rural customers across the border in Indiana.  Most of their branches are un-classified, this means they operate outside of statistical metropolitan areas.

A bank looking to acquire a foothold in Cincinnati would have other better options for purchase.  But a bank with experience in a rural area, that wants further exposure to rural Indiana might find West End Indiana a great acquisition.

The second question is what's the bank worth?  The bank has a 66% efficiency ratio; this is a well run bank.  Some small banks are acquired due to their value after costs are cut.  It's  not likely that enough costs could be cut at West End Indiana to make it valuable from this perspective.  Instead of a cost cutting story West End Indiana looks more like a growth story in a niche market.  The bank took the capital from their IPO and put it to work right away generating earnings.  Earnings have grown at the bank from a $600k profit in 2012 to $1.4m in 2014. The bank earned $418k in the last quarter, and if earnings remain on track they could earn more than $1.6m in 2015.

What's limiting the bank's growth is they don't have enough capital.  They have a very efficient auto and commercial lending platform with low losses.  If they had more capital they could grow even quicker.  This is where an acquirer could come in.  A larger bank could acquire West End Indiana and inject more capital into their lending platform fueling growth.  The acquiring bank might realize some cost savings from back office synergies, but I think the majority of the value would come from increased growth.

If a bank were to realize 10-15% in cost savings and growth with additional capital it's not unrealistic to value the bank in line with peers at 1.3x TBV.  If the bank were to trade in line with peers it would mean a 40% gain for investors.  Often times a niche lending franchise can merit a premium.  With 38% of the company's shares owned by investors it's likely this bank will be sold, and probably be sold for at least 1.3x TBV if not more.  If a quick sale doesn't materialize an investor will be left owning shares in a growing bank with a valuable niche lending business at less than book value.  That's not a bad outcome either.

Disclosure: Long WEIN