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).
Date: Evening of November 4th, all day November 5th
Where: Marriott Downtown Philadelphia (link)
Cost: $150
Looking for value in the overlooked margins of the market.
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.
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
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.
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
The Solitron Proxy Battle
It's refreshing when a little sunlight is finally shines on a dark corner of the market. Solitron Devices (SODI), a Florida chip manufacturer was one such company deserving of sunlight. They operated in the shadows of the market for close to twenty years after emerging from bankruptcy in the 1990s.
When a management team is used to darkness they feel like they can do whatever they want. They don't answer to investors, they only answer to themselves. Sunlight is an incredible disinfectant and a little goes a long way towards killing harmful attitudes and behaviors. Solitron is/was being run by the CEO/CFO/Executive-everything Shevach Saraf for the benefit of himself at the expense of shareholders.
After emerging from bankruptcy Saraf directed the company's free cash flow into Treasury bonds as an insurance policy against ongoing environmental litigation. It's debatable whether this was necessary or not. While shareholders received nothing Saraf paid himself handsomely in both cash and in options. He willingly granted himself options and as far as I can tell never purchased shares on the open market. It must be nice to be in a position where you can take wealth from public shareholders and redirect it to yourself without anyone batting any eye. To put things in perspective Saraf takes home about 15% of the company's gross profit as a salary. These are the sort of things that happen when companies operate in the dark.
In business school theory, a Board of Directors answers to shareholders, and company management to the Board. It doesn't work like this in the "real world". No one answers to shareholders, and the Board answers to management. This is especially true for Solitron. The "Board" consisted of Saraf and two of his friends. One them appeared to have a background in the business and the other was unresponsive and abusive to shareholders. It's hard for me the fathom how a Board that is opposed to shareholders can answer to them.
I've highlighted Soltron numerous times on this blog (Google "site:oddballstocks.com Solitron"). I helped get the ball rolling that resulted in the first annual meeting in decades. What's important to note is I didn't force the meeting, all I did with this blog was start to shine a little sunlight on the situation. An undervalued company plus a lot of sunlight creates incredible opportunities for value investors.
After that first annual meeting Solitron brought on a few more directors. And brought back a director shareholders fired. It was as if Saraf looked shareholders in the eye and said "yes, we'll listen to you" and then proceeded to pull out a giant stick that he stuck in our eyes. If Saraf wants to run Solitron like he owns the company he should just buy us all out. Let me repeat, if Saraf wants to run Solitron like his own little fiefdom he needs to tender and buy us out, with his own money! If he doesn't then he has no right to act like this, and it's time for shareholders to take an ever bigger stick and poke right back.
Thankfully shareholders have a hedge fund that's willing to wield the stick that we're going to collectively poke at Solitron. Cedar Creek Partners, a hedge fund run by Tim Eriksen has gone activist on the company. Cedar Creek has filed a preliminary proxy in order to elect Tim and David Pointer as directors.
Tim has put his money where his mouth is, his fund owns 6% of the outstanding stock. Why doesn't any of Solitron's Board outside of Saraf own that much stock? Why do some members own nothing? How can a director with ZERO shareholder interest stand up for shareholders? They can't, instead they take a payment from Solitron and act in management interest. When you want to know how a director will act look at their own financial interest. Directors with shareholdings will act in shareholder interest, directors just collecting a paycheck will act in management's interest.
Eriksen Capital (Cedar Creek's managing partner) has proposed two individuals who will stand up for shareholders and continue to shine sunlight where it deserves to be shined.
Solitron has responded to Eriksen's proxy with an attack letter. They initiated a dividend (in response to shareholder action) and a buyback (in response to shareholder action) and then go on to attack the credentials of Tim and David. Management is hoping that their dividend and buyback persuade shareholders that they're doing enough to keep their seats.
I have a large capacity to forgive, I believe that people can reform themselves, but I believe in actions, not words. If someone is an alcoholic and claim they're clean, but continue to drink it's the actions not the words that tell the story. Solitron is no different, they claim they've changed but their actions say they haven't. They aren't listening to shareholders, they re-instated the Director that we threw out. They've initiated shareholder friendly actions because shareholders have been putting a lot of pressure on the company. It seems to be that if shareholder pressure is needed for these changes then we need more of it.
Solitron attacks Tim and David saying they don't have the proper credentials or industry experience to be on the Board. I find it ironic that an executive with title inflation (Saraf is Chairman/CEO/President/Treasuer/CFO) is saying the lack of titles is a stumbling block. Maybe if Tim and David could hand out titles themselves it wouldn't be an issue. Solitron sets up a straw man with this argument. Would they really be willing to take on outside directors looking to return capital if they went to Harvard and worked in defense? If those directors were opposed to management then I'm sure their credentials wouldn't be good enough.
I could disassemble the Solitron letter piece by piece, but by doing that I'd give credence to it. I don't want to give credence to a company who says they've changed yet their actions show otherwise. This is a company that has been living and enjoying it's dark space and is now cowering in the sunlight. Shareholders aren't petitioning for job cuts. We're asking that management answers to the rightful owners, returns excess capital, and operates in a shareholder friendly manner. If management doesn't want to do this then they need to sell the company, or buy shareholders out.
Until management tenders for 100% of the shares, or sells to another company I have a feeling the sunlight will only grow more intense. A little disinfectant goes a long way.
When a management team is used to darkness they feel like they can do whatever they want. They don't answer to investors, they only answer to themselves. Sunlight is an incredible disinfectant and a little goes a long way towards killing harmful attitudes and behaviors. Solitron is/was being run by the CEO/CFO/Executive-everything Shevach Saraf for the benefit of himself at the expense of shareholders.
After emerging from bankruptcy Saraf directed the company's free cash flow into Treasury bonds as an insurance policy against ongoing environmental litigation. It's debatable whether this was necessary or not. While shareholders received nothing Saraf paid himself handsomely in both cash and in options. He willingly granted himself options and as far as I can tell never purchased shares on the open market. It must be nice to be in a position where you can take wealth from public shareholders and redirect it to yourself without anyone batting any eye. To put things in perspective Saraf takes home about 15% of the company's gross profit as a salary. These are the sort of things that happen when companies operate in the dark.
In business school theory, a Board of Directors answers to shareholders, and company management to the Board. It doesn't work like this in the "real world". No one answers to shareholders, and the Board answers to management. This is especially true for Solitron. The "Board" consisted of Saraf and two of his friends. One them appeared to have a background in the business and the other was unresponsive and abusive to shareholders. It's hard for me the fathom how a Board that is opposed to shareholders can answer to them.
I've highlighted Soltron numerous times on this blog (Google "site:oddballstocks.com Solitron"). I helped get the ball rolling that resulted in the first annual meeting in decades. What's important to note is I didn't force the meeting, all I did with this blog was start to shine a little sunlight on the situation. An undervalued company plus a lot of sunlight creates incredible opportunities for value investors.
After that first annual meeting Solitron brought on a few more directors. And brought back a director shareholders fired. It was as if Saraf looked shareholders in the eye and said "yes, we'll listen to you" and then proceeded to pull out a giant stick that he stuck in our eyes. If Saraf wants to run Solitron like he owns the company he should just buy us all out. Let me repeat, if Saraf wants to run Solitron like his own little fiefdom he needs to tender and buy us out, with his own money! If he doesn't then he has no right to act like this, and it's time for shareholders to take an ever bigger stick and poke right back.
Thankfully shareholders have a hedge fund that's willing to wield the stick that we're going to collectively poke at Solitron. Cedar Creek Partners, a hedge fund run by Tim Eriksen has gone activist on the company. Cedar Creek has filed a preliminary proxy in order to elect Tim and David Pointer as directors.
Tim has put his money where his mouth is, his fund owns 6% of the outstanding stock. Why doesn't any of Solitron's Board outside of Saraf own that much stock? Why do some members own nothing? How can a director with ZERO shareholder interest stand up for shareholders? They can't, instead they take a payment from Solitron and act in management interest. When you want to know how a director will act look at their own financial interest. Directors with shareholdings will act in shareholder interest, directors just collecting a paycheck will act in management's interest.
Eriksen Capital (Cedar Creek's managing partner) has proposed two individuals who will stand up for shareholders and continue to shine sunlight where it deserves to be shined.
Solitron has responded to Eriksen's proxy with an attack letter. They initiated a dividend (in response to shareholder action) and a buyback (in response to shareholder action) and then go on to attack the credentials of Tim and David. Management is hoping that their dividend and buyback persuade shareholders that they're doing enough to keep their seats.
I have a large capacity to forgive, I believe that people can reform themselves, but I believe in actions, not words. If someone is an alcoholic and claim they're clean, but continue to drink it's the actions not the words that tell the story. Solitron is no different, they claim they've changed but their actions say they haven't. They aren't listening to shareholders, they re-instated the Director that we threw out. They've initiated shareholder friendly actions because shareholders have been putting a lot of pressure on the company. It seems to be that if shareholder pressure is needed for these changes then we need more of it.
Solitron attacks Tim and David saying they don't have the proper credentials or industry experience to be on the Board. I find it ironic that an executive with title inflation (Saraf is Chairman/CEO/President/Treasuer/CFO) is saying the lack of titles is a stumbling block. Maybe if Tim and David could hand out titles themselves it wouldn't be an issue. Solitron sets up a straw man with this argument. Would they really be willing to take on outside directors looking to return capital if they went to Harvard and worked in defense? If those directors were opposed to management then I'm sure their credentials wouldn't be good enough.
I could disassemble the Solitron letter piece by piece, but by doing that I'd give credence to it. I don't want to give credence to a company who says they've changed yet their actions show otherwise. This is a company that has been living and enjoying it's dark space and is now cowering in the sunlight. Shareholders aren't petitioning for job cuts. We're asking that management answers to the rightful owners, returns excess capital, and operates in a shareholder friendly manner. If management doesn't want to do this then they need to sell the company, or buy shareholders out.
Until management tenders for 100% of the shares, or sells to another company I have a feeling the sunlight will only grow more intense. A little disinfectant goes a long way.
I'll be voting my shares for Eriksen Capital and I hope you do as well.
Disclosure: Long Solitron
Why Investors Fail
Almost every investing study tells us that buying stocks at a low price to anything results in market beating performance. Even just buying a S&P ETF and doing nothing else beats most investors and mutual funds. If out performance is a matter of doing a few simple things and nothing else then why is everyone acting so crazy? And if earning market matching, or market beating results are so simple then why don't investors earn those sorts of returns?
Fidelity released a study discussing a performance breakdown for their accounts. The clients that did the best were the ones who were dead. The second best performing set of clients forgot they had Fidelity accounts. It seems like a formula to beat the market is to start an account, forget about it, then die. Your heirs will thank you and marvel at your investing prowess.
How is it that investing is so "easy", yet so hard? If in theory all one needs to do is follow a few simple formulas, or invest in a few ETF's why aren't more investors matching or beating the market?
It's often said that investors are their own worst enemy. Our own emotions get the best of us. When the market is roaring higher we get excited. When the market hits new lows we're too depressed to even open our account statements.
I believe investors fail for a number of reasons with the biggest being the lack of patience. There are many investing strategies that make sense on paper. The problem is few investors have the patience to see these strategies through to the finish. It is more exciting to watch a stock jump up and down 2-3% a day, or see a battle ground stock bantered about on CNBC compared to owning a company that trades in tenths of a percentage point most days. The thing is those tenths add up over time, especially for companies that continue to execute operationally.
Finding a reasonable investing strategy isn't an issue, it's sticking to it. It is very easy to find undervalued investments, but holding onto those undervalued investments for years can be difficult. For many investors it's fun to research and watch holdings, but it's no fun to watch a stock effectively do nothing for days, months, or years. If the excitement is in the research then we'll continually be researching new positions and throwing out the old ones.
Another reason investors fail is because they're doing too many things at once. A few net-nets, a few growth stocks, some shorts, a turnaround or two etc. Their portfolio is a potpourri of strategies, many of them that are complex and require dedicated skills. Each investor needs to find their own style and stick to it. There is a reason there are so many funds with one focus. It's much easier to be a bankruptcy fund, or a turnaround fund compared to a general value fund. The same is true for individual investors. It's much easier to focus on a specific corner of the market rather than invest in any and all things cheap.
Related to doing too much is researching too much. Some investors fail because they can't see the forest through the trees. They are so caught up in the minutia of an investment that they miss the big picture.
I enjoy reading message board posts related to investments I'm researching. I'm always on the lookout for what I consider the obsessive investor. For some reason these obsessive investors often congregate in oil and gas or mining stocks. You've probably seen these posts. A few books worth of material detailing the pressure of well bores the company had in North Dakota in 1988. Excited posts about how rumors are swirling that carpeting is being replace at headquarters and maybe it's a sign of a buyout.
Buried within the pages of notes are usually a few nuggets of information useful to an investment thesis. But my feeling is that the author probably has no idea, they are too consumed with finding out everything related to the company to realize this. The ultimate irony is that the body of knowledge an obsessed investor can accumulate is about the minimum amount of knowledge every middle level employee at the company has. In other words outside investors are always at a significant informational disadvantage to almost any company insider, even the lowest level employees at times.
My favorite investments are ones where the value is obvious and the investment rests on what I consider a few pivot points. These are general assumptions. The larger the gap between the current price and fair value combined with a small number of pivot points makes for investment success. This is because each assumption, each estimation, and each guess adds uncertainty to a model. At some point endless research can blind an investor from realizing what truly matters from what they think matters.
Once I realized that I didn't need compile an exhaustive list of company information to make good investments I began to simplify my research. I only researched what was necessary to confirm or deny the pivot points I'd identified with an investment. By doing this I saved myself the endless research. Maybe the carpet color does matter in a merger. Small details can be exciting. But it's the boring details that matter, such as the age of the CEO, or the age of the Board. Companies with graying executives and graying boards are more likely to sell their company.
The last reason I believe many investors fail is because they don't really know what they own, or why they invested in the first place. Cloning investments is a very popular strategy right now. And like all investment strategies cloning works well on paper, it generates market beating returns. Just buy what Buffett buys and sell what he sells and you'll do well the story goes. The problem is when we buy something on someone else's thesis it's hard to hold through thick and thin. If bad news starts to come out on a cloned investment it's easy to dump it and say "maybe this is one the guru messed up on."
Closely related is when investors purchase stocks on a story basis. That is they feel a given company will benefit from some larger trend at some point in the future. Many times when these story stocks are purchased investors aren't conducting true due diligence to see if the company will actually benefit from the trend.
Story stocks are a favorite of the news shows. There's a very specific reason for this. There are two types of stocks, stocks that are great stories, and stocks that are great investments. As someone who writes about stocks I can say that some of my best investments have been my worst posts. This is because there was nothing exciting to write about. There was no narrative or story around the stock. It was cheap, and all an investor needed to do was purchase and wait. Some of my best and entertaining posts have been about stocks that aren't necessarily great investments. But they make great stories. This is the same with the financial media. Companies that make great stories aren't usually great investments.
When we look in the mirror we're facing the enemy of our returns. The best course of action is to pick a strategy, stick to it and move on.
Looking for more? I reveal the strategy I personally use to find undervalued companies here.
Fidelity released a study discussing a performance breakdown for their accounts. The clients that did the best were the ones who were dead. The second best performing set of clients forgot they had Fidelity accounts. It seems like a formula to beat the market is to start an account, forget about it, then die. Your heirs will thank you and marvel at your investing prowess.
How is it that investing is so "easy", yet so hard? If in theory all one needs to do is follow a few simple formulas, or invest in a few ETF's why aren't more investors matching or beating the market?
It's often said that investors are their own worst enemy. Our own emotions get the best of us. When the market is roaring higher we get excited. When the market hits new lows we're too depressed to even open our account statements.
I believe investors fail for a number of reasons with the biggest being the lack of patience. There are many investing strategies that make sense on paper. The problem is few investors have the patience to see these strategies through to the finish. It is more exciting to watch a stock jump up and down 2-3% a day, or see a battle ground stock bantered about on CNBC compared to owning a company that trades in tenths of a percentage point most days. The thing is those tenths add up over time, especially for companies that continue to execute operationally.
Finding a reasonable investing strategy isn't an issue, it's sticking to it. It is very easy to find undervalued investments, but holding onto those undervalued investments for years can be difficult. For many investors it's fun to research and watch holdings, but it's no fun to watch a stock effectively do nothing for days, months, or years. If the excitement is in the research then we'll continually be researching new positions and throwing out the old ones.
Another reason investors fail is because they're doing too many things at once. A few net-nets, a few growth stocks, some shorts, a turnaround or two etc. Their portfolio is a potpourri of strategies, many of them that are complex and require dedicated skills. Each investor needs to find their own style and stick to it. There is a reason there are so many funds with one focus. It's much easier to be a bankruptcy fund, or a turnaround fund compared to a general value fund. The same is true for individual investors. It's much easier to focus on a specific corner of the market rather than invest in any and all things cheap.
Related to doing too much is researching too much. Some investors fail because they can't see the forest through the trees. They are so caught up in the minutia of an investment that they miss the big picture.
I enjoy reading message board posts related to investments I'm researching. I'm always on the lookout for what I consider the obsessive investor. For some reason these obsessive investors often congregate in oil and gas or mining stocks. You've probably seen these posts. A few books worth of material detailing the pressure of well bores the company had in North Dakota in 1988. Excited posts about how rumors are swirling that carpeting is being replace at headquarters and maybe it's a sign of a buyout.
Buried within the pages of notes are usually a few nuggets of information useful to an investment thesis. But my feeling is that the author probably has no idea, they are too consumed with finding out everything related to the company to realize this. The ultimate irony is that the body of knowledge an obsessed investor can accumulate is about the minimum amount of knowledge every middle level employee at the company has. In other words outside investors are always at a significant informational disadvantage to almost any company insider, even the lowest level employees at times.
My favorite investments are ones where the value is obvious and the investment rests on what I consider a few pivot points. These are general assumptions. The larger the gap between the current price and fair value combined with a small number of pivot points makes for investment success. This is because each assumption, each estimation, and each guess adds uncertainty to a model. At some point endless research can blind an investor from realizing what truly matters from what they think matters.
Once I realized that I didn't need compile an exhaustive list of company information to make good investments I began to simplify my research. I only researched what was necessary to confirm or deny the pivot points I'd identified with an investment. By doing this I saved myself the endless research. Maybe the carpet color does matter in a merger. Small details can be exciting. But it's the boring details that matter, such as the age of the CEO, or the age of the Board. Companies with graying executives and graying boards are more likely to sell their company.
The last reason I believe many investors fail is because they don't really know what they own, or why they invested in the first place. Cloning investments is a very popular strategy right now. And like all investment strategies cloning works well on paper, it generates market beating returns. Just buy what Buffett buys and sell what he sells and you'll do well the story goes. The problem is when we buy something on someone else's thesis it's hard to hold through thick and thin. If bad news starts to come out on a cloned investment it's easy to dump it and say "maybe this is one the guru messed up on."
Closely related is when investors purchase stocks on a story basis. That is they feel a given company will benefit from some larger trend at some point in the future. Many times when these story stocks are purchased investors aren't conducting true due diligence to see if the company will actually benefit from the trend.
Story stocks are a favorite of the news shows. There's a very specific reason for this. There are two types of stocks, stocks that are great stories, and stocks that are great investments. As someone who writes about stocks I can say that some of my best investments have been my worst posts. This is because there was nothing exciting to write about. There was no narrative or story around the stock. It was cheap, and all an investor needed to do was purchase and wait. Some of my best and entertaining posts have been about stocks that aren't necessarily great investments. But they make great stories. This is the same with the financial media. Companies that make great stories aren't usually great investments.
When we look in the mirror we're facing the enemy of our returns. The best course of action is to pick a strategy, stick to it and move on.
Looking for more? I reveal the strategy I personally use to find undervalued companies here.