A recurring theme to many of my posts on small caps is the reader question "Why aren't activist investors involved?" For a lot of small undervalued situations the solution to undervaluation looks simple on paper. An activist investor buys shares, they distribute or sell assets and then sell the company with everyone reaping large rewards. On paper everything is simple. In life nothing is simple.
In the book The Guns of August author Barbara Tuchman writes about the difference between German planning and French planning for World War I. The French relied on L'Esprit, an idea that plans were loose but soldiers would fight with so much enthusiasm that they would win battles. The Germans didn't rely on an emotional edge, instead they relied on planning. They wrote battle plans for all situations they could imagine, and wrote contingency plans, and logistic plans and plans for plans. Everything was planned and detailed. The book is excellent and I'd recommend it if you're interested in the pivotal first six weeks of World War 1. The summary is this, the French army's enthusiasm wasn't enough to win, their lack of planning was a downfall. On the other hand the German army could have won if they would have been flexible. They had a number of opportunities they never took advantage of because they weren't in the plans.
The market is filled with activist investors who embody both the French and the German approaches to war. Some investors plot and plan, they build 500 page Powerpoint slide decks and carefully telegraph their intentions at investment conferences. Others take the approach of buying a stock with gusto and approach the target company with guns a-blazin'. Sometimes these approaches work, but they're both prone to backfiring as well.
Activists are surprised when their massive Powerpoint snoozer doesn't move the needle, or when management takes offense to a new investor trying to throw their weight around. To those of us on the sidelines an activist investment appears simple. To those in the media activism is simple. To everyone it seems so simple. Yet activist investments are anything but simple, and if they were simple and straightforward why aren't more activists hovering around small undervalued companies?
Legally shareholders are considered owners of a company. There is a long list of rights shareholders have according to the law. The problem is shareholders are passive and management holds all of the power, no matter how many shares managers do or don't own.
In theory a company's Board of Directors answers to the company's shareholders. The Board is entrusted with managing the company for their shareholders. The Board is supposed to be responsive to shareholder requests and be independent.
Typically the Board of Directors for a given company has a very cozy relationship with the company's management. This is expected. A company's Board hires the CEO and potentially other top candidates. People naturally defend their choices, so if a Board picks a CEO it means they liked the candidate enough at some point to hire them. Most CEO's sit on the board of the companies they work for, and some are even Chairman of the Board.
What all of this means is that instead of standing up for shareholders Boards usually stand up for management. In many cases, especially small companies the Board and management are one in the same.
There is no legal requirement for a board member to own a certain amount of stock. Board members simply need to be elected by shareholders after being nominated by management. In most companies shareholders are asleep at the switch and simply elect whomever management decides to nominate. Managers are fond of nominating friends and others who are sympathetic to their own interests. This about this for a few minutes. The people who are entrusted with managing a company for shareholders often have no ownership interest themselves.
I've gone into the weeds to show how disadvantaged shareholders are before they even consider an activist approach. The proxy for shareholder interests don't stand for shareholder interests at all, they stand for management interests.
Many small companies are ripe for activist takeovers. There are just two problems, the first is acquiring enough shares, the second is taking control without management taking action to block the activist.
Let me share a small story. A few years ago Dave Waters texted me about a potentially lucrative small company. The situation was so lucrative we both dropped what we were doing to meet and discuss over coffee. The company had about $4m worth of NCAV and was selling with a market cap of $500k. Management owned less than 6%. This is the type of situation that is begging for an outside acquirer. This is also a situation that looks perfect on paper. Buy the company for $500k and instantly own $4m worth of value. Or fire the overpaid executives and free up operating cash flow increasing the valuation.
I went ahead and purchased as many shares as I could, which came out to about $2,000. Shares have been somewhat liquid on and off and someone could have built a position of maybe $50k relatively easily if they were patient. I stopped buying as I researched the company further.
A takeover had two issues, the first was the activist would need to fire the CEO and Chairman to free up operating cash flow. The majority of the company's operating income goes towards paying high salaries. Both of these officers had golden parachute packages that eliminated much of the potential gain. On the flip side with both officers gone operating income would be north of $1m per year.
The second hurdle related to the company's incorporation. They are incorporated in Florida and supposedly have operations there. Their operations consist of the CEO's home office in Southern Florida. The company actually operates out of Alabama. Here is the quirk, according to Florida law a shareholder loses their voting rights at certain thresholds, 15%, 25% and 50%. If a shareholder owns 14.9% of a company they have voting rights, if they acquire .1% more the voting rights are lost until the company's Board of Directors reinstates them. This means it's impossible to take over a Florida corporation without the company's cooperation. Of course there is a wrinkle to this. The Florida law only applies to companies incorporated in the state with the majority of their operations in the state. It remained unclear whether this statute applied to the company in question. I didn't know, and lawyers I talked to didn't know.
I did a lot of research on this company including talking to lawyers about the situation. My plan was to tender at 2-3x the bid for investors shares. Then fire the execs freeing up cash and figure out how to go forward from there.
Here is the math on the situation. Pay $1.5m to purchase a majority stake, pay $1.5m in a golden parachute fee. Then pay a substantial amount in legal fees to get the execs to actually leave. The unknown was the legal fees. The problem is management held so many cards that lawyer fees could be racked up quickly without much real progress. I could end up in a lawsuit regarding the Florida shareholder issue, or in a lawsuit over the firing, or in a lawsuit over a poison pill or almost any other situation that management could dream up. By the time I put together a worst case scenario the margin of safety between what the shares could be purchase for and what the company might be worth shrank dramatically. The potential margin shrank so much that it wasn't worth the opportunity cost and hassle to move forward.
I did nothing and the opportunity still exists. I have a stock certificate for the company sitting on my desk. In some ways it's a reminder to the potential opportunity, but it's also a reminder of the potential pain. In the end it's possible I would have made my lawyer rich and walked away with nothing.
My experience isn't unique. Jeff Moore who writes at Ragnar is a Pirate recently engaged in a battle with the small company Sitestar (SYTE). Jeff had managed to get a Board seat and management still pulled out a bag of tricks, from fraudulently signing his name to documents to making false claims. Jeff and a group of shareholders filed a lawsuit against the company to which the company responded with their own litany of tricks. Moore eventually prevailed, but it's yet to be seen if any change can happen.
If you walk away with nothing else from this post it should be that sometimes something that looks good on paper doesn't work out well in real life. The balance of power in a company is heavily tilted towards management and that power imbalance can cause costs to rise, or even thwart a legitimate takeover or activist attempt.
Looking for value in the overlooked margins of the market.
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Danier Leather, a retrospective on a cheap stock.
Almost three years ago to the day I looked at Danier Leather -a Canadian leather retailer- and walked away because I couldn't identify a margin of safety. The company was cheap at 2x EV/EBIT, earned an ROE of 12% and traded for slightly more than NCAV. After passing on the investment I mostly forgot about them until recently when I came across a post on a message board mentioning they were pursuing strategic alternatives. This news grabbed my attention although as you'll see in this post my interest faded quickly once I realized what had happened to the company in the years since I looked at them.
Danier Leather (DL.Toronto) is a Canadian leather retailer. They sell leather handbags, coats, belts and most anything that can be made out of leather. The company has a large sales presence in malls throughout the country.
Common sense would dictate that a leather company would be seasonal with most sales coming in the colder months. This is partly due to weather (winter coats) but also due to holidays and the fashion calendar. It was certainly true for Danier Leather up until a few years ago. The company made an incredible claim for a winter coat company in a recent report, they stated that last year's winter was too cold and sales were down as a result. Maybe sometimes there really is too much of a good thing. Danier Leather hoped to sell warmer winter coats this year to compensate for last year's cold and long winter.
I believe Danier Leather illustrates a number of different points regarding potential value investments: cheapness alone isn't a thesis, buybacks aren't always good, and that a margin of safety is essential for any investment.
Cheapness Alone Isn't a Thesis
Most people prefer to pay less for something verses paying more for the exact same thing. But just because something is cheap doesn't make it good. On weekends neighborhoods near us are littered with garage sales and estate sales in the spring and summer. Shoppers can browse through items sellers have determined aren't necessary anymore. Most things for sale are cheap, almost astounding cheap, but not much is worth purchasing.
At a garage sale an object needs to be both cheap and useful. An old lampshade for $.50 is cheap, but if you don't have a lamp to put it on the shade is money wasted. The same is true for investments. A company can only have a low EV/EBIT (or EBITDA) ratio by having a lot of cash, or abnormally high earnings. Companies with a lot of cash might be cheap, but if the cash is squandered or the market never values it what's the point? Likewise a stock trading below book value could own valuable assets the market doesn't recognize, or it could own a bunch of worthless assets and IOU's in the form of uncollectable receivables.
When a company re-rates higher it's due to business improvement, market awareness about an asset or earnings, or from a management action. If a cheap stock remains obscure and management continues with a faulty business plan it's likely the price will remain depressed.
At the time of my first writeup Danier Leather was trading with an EV/EBIT of 2, an extremely low valuation. And at barely above NCAV the stock was clearly cheap. The problem was the outcome for the stock rested on what management did with the cash, and how the business performed. In the ensuing years management mismanaged both the company's operations and their pile of cash.
Buybacks Aren't Always Good
There is a piece of common wisdom passed around amongst investors that stock buybacks are always a good thing if the stock trades below intrinsic value. This is mostly true. When a company buys shares below their intrinsic value buybacks are value accretive. If buybacks happen when a company trades below book value the buybacks increase book value per share. Both of these scenarios are good for investors.
Investors prefer buybacks over dividends because they're tax efficient. But buybacks make an assumption that isn't always true for value type companies. Stock buybacks presume that the company conducting the buybacks is stable or growing. If the company is losing money and the stock price continues an unrelenting fall buybacks are merely throwing money into the wind. The list of companies that have purchased their shares at high levels only to see them trade lower on a semi-permanent basis is long.
Danier Leather has been buying back their shares since I last wrote about them. The company has also been incurring losses as revenue has declined. The company's net loss decreased book value, and while the company repurchased shares it wasn't enough to counteract their losses. To make matters worse the company repurchased shares at a value about 3x higher than where shares trade today. Investors have realized nothing from the buybacks whereas if the company paid out the cash used for buybacks as a dividend it would have helped investors reduce their losses, or reinvest elsewhere.
If a company is growing or stable I appreciate buybacks. If the company is very small, has illiquid shares, or the future is uncertain I'd prefer a cash dividend. With cash I can make the decision myself to reinvest back into the company or invest elsewhere. Of course it's never possible to know what the future holds and sometimes it's better to have one bird in the hand (dividends) verses two in the bush (buybacks).
A Margin of Safety Is Essential
A cheap company with a future of losses is akin to a melting ice cube. At the time of my post I couldn't foresee their losses. The problem with a retailing company is they run with a high level of operating leverage. Operating leverage cuts both ways, once fixed costs are paid income increases rapidly as sales volume increases. On the downside losses accelerate on slight sales declines. Danier Leather's sales have been on a decreasing trend for years. They finally hit the tipping point and revenue declines have finally led to losses.
A retailer can be caught in a vicious cycle where in an effort to increase sales they incur even larger losses with investments in sales and deeper product discounts. Danier Leather has finally unveiled a way for potential customers to order online. This is astounding to me, outside of a few luxury brands the inability to purchase something online is a hindrance to the brand. They touted their online marketplace as a replacement for their phone ordering system. An order by phone system is reminiscent of the 80s and 90s. With telephone ordering I wonder who their target market is?
If there was a margin of safety in the shares it has been eroded with the operating losses. The company's cash pile shrunk with their share buybacks and now the company is in a defensive position. Their products appear to be out of fashion and they're caught in a deep discount loop.
What's Next?
The biggest question shareholders are asking at this point is what's next for Danier Leather? If the company can't stop the sales decline this ice cube will melt fast. Management finally decided to take action and issued a press release stating they are looking at strategic alternatives. This should be encouraging, with a book value north of $10 per share shareholders stand to benefit if management were to liquidate or sell. I'm not sure of the likelihood of that happening. The press release mentioned that management will consider raising debt, issuing equity or selling the company. I'd presume the strategic alternatives were in the order that management might attempt to act. They will issue debt first then issue equity and finally when all hope is lost sell or liquidate.
Maybe there is a play here for savvy investors. I've learned a lot reviewing the company and where they've been the last three years. I'll end this post the same way I ended the last one. There still isn't a margin of safety in Danier Leather for me to consider investing, I'll continue to watch from the sidelines.
Disclosure: No position
Danier Leather (DL.Toronto) is a Canadian leather retailer. They sell leather handbags, coats, belts and most anything that can be made out of leather. The company has a large sales presence in malls throughout the country.
Common sense would dictate that a leather company would be seasonal with most sales coming in the colder months. This is partly due to weather (winter coats) but also due to holidays and the fashion calendar. It was certainly true for Danier Leather up until a few years ago. The company made an incredible claim for a winter coat company in a recent report, they stated that last year's winter was too cold and sales were down as a result. Maybe sometimes there really is too much of a good thing. Danier Leather hoped to sell warmer winter coats this year to compensate for last year's cold and long winter.
I believe Danier Leather illustrates a number of different points regarding potential value investments: cheapness alone isn't a thesis, buybacks aren't always good, and that a margin of safety is essential for any investment.
Cheapness Alone Isn't a Thesis
Most people prefer to pay less for something verses paying more for the exact same thing. But just because something is cheap doesn't make it good. On weekends neighborhoods near us are littered with garage sales and estate sales in the spring and summer. Shoppers can browse through items sellers have determined aren't necessary anymore. Most things for sale are cheap, almost astounding cheap, but not much is worth purchasing.
At a garage sale an object needs to be both cheap and useful. An old lampshade for $.50 is cheap, but if you don't have a lamp to put it on the shade is money wasted. The same is true for investments. A company can only have a low EV/EBIT (or EBITDA) ratio by having a lot of cash, or abnormally high earnings. Companies with a lot of cash might be cheap, but if the cash is squandered or the market never values it what's the point? Likewise a stock trading below book value could own valuable assets the market doesn't recognize, or it could own a bunch of worthless assets and IOU's in the form of uncollectable receivables.
When a company re-rates higher it's due to business improvement, market awareness about an asset or earnings, or from a management action. If a cheap stock remains obscure and management continues with a faulty business plan it's likely the price will remain depressed.
At the time of my first writeup Danier Leather was trading with an EV/EBIT of 2, an extremely low valuation. And at barely above NCAV the stock was clearly cheap. The problem was the outcome for the stock rested on what management did with the cash, and how the business performed. In the ensuing years management mismanaged both the company's operations and their pile of cash.
Buybacks Aren't Always Good
There is a piece of common wisdom passed around amongst investors that stock buybacks are always a good thing if the stock trades below intrinsic value. This is mostly true. When a company buys shares below their intrinsic value buybacks are value accretive. If buybacks happen when a company trades below book value the buybacks increase book value per share. Both of these scenarios are good for investors.
Investors prefer buybacks over dividends because they're tax efficient. But buybacks make an assumption that isn't always true for value type companies. Stock buybacks presume that the company conducting the buybacks is stable or growing. If the company is losing money and the stock price continues an unrelenting fall buybacks are merely throwing money into the wind. The list of companies that have purchased their shares at high levels only to see them trade lower on a semi-permanent basis is long.
Danier Leather has been buying back their shares since I last wrote about them. The company has also been incurring losses as revenue has declined. The company's net loss decreased book value, and while the company repurchased shares it wasn't enough to counteract their losses. To make matters worse the company repurchased shares at a value about 3x higher than where shares trade today. Investors have realized nothing from the buybacks whereas if the company paid out the cash used for buybacks as a dividend it would have helped investors reduce their losses, or reinvest elsewhere.
If a company is growing or stable I appreciate buybacks. If the company is very small, has illiquid shares, or the future is uncertain I'd prefer a cash dividend. With cash I can make the decision myself to reinvest back into the company or invest elsewhere. Of course it's never possible to know what the future holds and sometimes it's better to have one bird in the hand (dividends) verses two in the bush (buybacks).
A Margin of Safety Is Essential
A cheap company with a future of losses is akin to a melting ice cube. At the time of my post I couldn't foresee their losses. The problem with a retailing company is they run with a high level of operating leverage. Operating leverage cuts both ways, once fixed costs are paid income increases rapidly as sales volume increases. On the downside losses accelerate on slight sales declines. Danier Leather's sales have been on a decreasing trend for years. They finally hit the tipping point and revenue declines have finally led to losses.
A retailer can be caught in a vicious cycle where in an effort to increase sales they incur even larger losses with investments in sales and deeper product discounts. Danier Leather has finally unveiled a way for potential customers to order online. This is astounding to me, outside of a few luxury brands the inability to purchase something online is a hindrance to the brand. They touted their online marketplace as a replacement for their phone ordering system. An order by phone system is reminiscent of the 80s and 90s. With telephone ordering I wonder who their target market is?
If there was a margin of safety in the shares it has been eroded with the operating losses. The company's cash pile shrunk with their share buybacks and now the company is in a defensive position. Their products appear to be out of fashion and they're caught in a deep discount loop.
What's Next?
The biggest question shareholders are asking at this point is what's next for Danier Leather? If the company can't stop the sales decline this ice cube will melt fast. Management finally decided to take action and issued a press release stating they are looking at strategic alternatives. This should be encouraging, with a book value north of $10 per share shareholders stand to benefit if management were to liquidate or sell. I'm not sure of the likelihood of that happening. The press release mentioned that management will consider raising debt, issuing equity or selling the company. I'd presume the strategic alternatives were in the order that management might attempt to act. They will issue debt first then issue equity and finally when all hope is lost sell or liquidate.
Maybe there is a play here for savvy investors. I've learned a lot reviewing the company and where they've been the last three years. I'll end this post the same way I ended the last one. There still isn't a margin of safety in Danier Leather for me to consider investing, I'll continue to watch from the sidelines.
Disclosure: No position
A market analogy
Have you ever walked through the woods and considered the trees? I mean really considered the trees, looked deeply at them, thought about them, and pondered them? I recently spent some time in the woods and the similarities between the woods and the markets were striking.
Forests do not consist of just one type of plant. There are no forests with only oak trees. A forest is a complete system of plants and animals that all rely on each other for growth, or shelter or food.
Forests grow in cycles. What starts out as an empty field eventually harbors saplings that turn into full grown trees. As trees age they drop seeds that form new trees continuing the cycle. Not all trees grow to maturity, some become vulnerable to disease, some don't have the right growing conditions, and others are timbered. A tree might drop thousands of seeds before one takes root and grows into a sapling.
Not every sapling grows into a mature tree. There are many factors that need to be just right for the tree, the soil, the sunlight, the other trees.
The variety of trees is awe inspiring. No two trees are identical, they grow subject to their location, the light, the soil, amount of rain. Some trees grow very tall, others are short and stubby. Some race straight to the sky not sparing any branches on their trip to the top of the canopy. Others sit low and flat spreading branches in all possible directions. Some are gnarled and twisted in their search for light. A few trees like to grow in the company of others while some are perfectly content to alone be the centerpiece of a field.
A natural disaster can change the course of a forest. Fire, generally viewed as bad for forests are essential for the boreal forest to regenerate. The jack pine in the boreal forest drops seeds in pine cones that only germinate in the presence of extremely high heat. Other forests wither in the face of fire.
It's hard to predict what trees will do well and grow to maturity. In many cases it's easy to tell which trees will not grow to full maturity. A poor sapling trying to scratch out an existence in rocky and nutrient poor soil will never grow as tall as a majestic oak planted in fertile soil. Some trees such as the giant sequoia seem resistant to almost anything nature throws at them.
When I walk through the forest and think about the trees the parallels to the market are unescapable. All companies start out small, no company is born into existence as a mega-cap. Even the largest mega-cap grew from a small seed of thought in some entrepreneur's mind. These seeds turned into small companies over time that grew. Of all of the small companies only a few become medium sized companies and only a few medium sized companies become large corporations. The largest companies in the world might be similar to the giant sequoias. They have grown so large that their size alone becomes an advantage.
A company needs the right conditions to grow from a small company into a larger company. Sometimes the conditions need to exist inside the company itself, other times the conditional elements are external to the company. Some companies are in the right place at the right time and they find success.
Companies like trees need time to grow. Some trees grow extremely fast, but their height is limited. The largest companies weren't founded recently, they've endured business cycle after business cycle. Their size and strength is their advantage, but also a weakness. The largest trees in the forest are susceptible to high winds. Smaller trees are more flexible whereas large trees don't flex as much due to their size. In a severe storm the largest trees are at risk for snapping off limbs or falling altogether. In market disruptions some of the largest companies might find a division without a market, or find themselves out of business entirely.
Sometimes investors believe buying small stocks is easier because there are more companies to choose from. This is like saying it's easy to find which sapling will become a mature tree because there are so many saplings. Neither is easy and both require expertise about both the tree and the tree's environment. A company is reliant on their external environment as much as a tree is. While many managers may not want to admit it a company's success is reliant on external factors, the market, other competition, the management at competitors.
Lastly the market grows and shrinks through cycles like the forest. At times a market can be thriving and growing like crazy. Other times it's stable or shrinking. Extrapolating growth from one period will always result in faulty conclusions. If the growth rate of young trees were extrapolated we'd have trees that touched space. A tree's growth rate slows down with age, the same as a company's growth rate.
No one tree can be viewed in isolation, it must be viewed within the context of the forest. No one company can be viewed in isolation either, the context should always be considered.
Forests do not consist of just one type of plant. There are no forests with only oak trees. A forest is a complete system of plants and animals that all rely on each other for growth, or shelter or food.
Forests grow in cycles. What starts out as an empty field eventually harbors saplings that turn into full grown trees. As trees age they drop seeds that form new trees continuing the cycle. Not all trees grow to maturity, some become vulnerable to disease, some don't have the right growing conditions, and others are timbered. A tree might drop thousands of seeds before one takes root and grows into a sapling.
Not every sapling grows into a mature tree. There are many factors that need to be just right for the tree, the soil, the sunlight, the other trees.
The variety of trees is awe inspiring. No two trees are identical, they grow subject to their location, the light, the soil, amount of rain. Some trees grow very tall, others are short and stubby. Some race straight to the sky not sparing any branches on their trip to the top of the canopy. Others sit low and flat spreading branches in all possible directions. Some are gnarled and twisted in their search for light. A few trees like to grow in the company of others while some are perfectly content to alone be the centerpiece of a field.
A natural disaster can change the course of a forest. Fire, generally viewed as bad for forests are essential for the boreal forest to regenerate. The jack pine in the boreal forest drops seeds in pine cones that only germinate in the presence of extremely high heat. Other forests wither in the face of fire.
It's hard to predict what trees will do well and grow to maturity. In many cases it's easy to tell which trees will not grow to full maturity. A poor sapling trying to scratch out an existence in rocky and nutrient poor soil will never grow as tall as a majestic oak planted in fertile soil. Some trees such as the giant sequoia seem resistant to almost anything nature throws at them.
When I walk through the forest and think about the trees the parallels to the market are unescapable. All companies start out small, no company is born into existence as a mega-cap. Even the largest mega-cap grew from a small seed of thought in some entrepreneur's mind. These seeds turned into small companies over time that grew. Of all of the small companies only a few become medium sized companies and only a few medium sized companies become large corporations. The largest companies in the world might be similar to the giant sequoias. They have grown so large that their size alone becomes an advantage.
A company needs the right conditions to grow from a small company into a larger company. Sometimes the conditions need to exist inside the company itself, other times the conditional elements are external to the company. Some companies are in the right place at the right time and they find success.
Companies like trees need time to grow. Some trees grow extremely fast, but their height is limited. The largest companies weren't founded recently, they've endured business cycle after business cycle. Their size and strength is their advantage, but also a weakness. The largest trees in the forest are susceptible to high winds. Smaller trees are more flexible whereas large trees don't flex as much due to their size. In a severe storm the largest trees are at risk for snapping off limbs or falling altogether. In market disruptions some of the largest companies might find a division without a market, or find themselves out of business entirely.
Sometimes investors believe buying small stocks is easier because there are more companies to choose from. This is like saying it's easy to find which sapling will become a mature tree because there are so many saplings. Neither is easy and both require expertise about both the tree and the tree's environment. A company is reliant on their external environment as much as a tree is. While many managers may not want to admit it a company's success is reliant on external factors, the market, other competition, the management at competitors.
Lastly the market grows and shrinks through cycles like the forest. At times a market can be thriving and growing like crazy. Other times it's stable or shrinking. Extrapolating growth from one period will always result in faulty conclusions. If the growth rate of young trees were extrapolated we'd have trees that touched space. A tree's growth rate slows down with age, the same as a company's growth rate.
No one tree can be viewed in isolation, it must be viewed within the context of the forest. No one company can be viewed in isolation either, the context should always be considered.