There's an expression in real estate investing that you "make money when you buy." The expression means a real estate investor makes money not on growing rents, outsized appreciation, or through cosmetic improvements, but rather by buying a property at a large discount to what comps are selling for (real estate's intrinsic value). Often a purchase discount is obtained because some material deficiency needs to be remediated and other buyers aren't interested in tackling the project. Other times the buyer has a vision and means to implement it for a project that other buyers don't.
A real estate investor can make money from appreciation, or growing rents, but the surest way to ensure an adequate return on investment is to pay less at the purchase. The same principle applies for investors who buy extremely illiquid stocks, or stocks that the market considers "dead money." These are the stocks that are covered in dust bunnies and haven't seen daylight since the Nixon administration.
Investors have very little patience. CNBC's entire premise is that you're missing out on something this exact second if you're not watching them. The WSJ makes money on daily news. Financial websites on the internet are biased to what's happening right now. This urgency has predictably trickled down investors. Funds like to talk about how they look for investments with a catalyst, some event that will unlock value quickly. They need a catalyst because their investors, the ones watching CNBC and reading the WSJ don't have patience anymore to see an idea develop and won't tolerate their managers waiting a few quarters, or gasp, a year or more for a thesis to play out. This obsession with catalysts has made its way to individual investors as well. Not many investors have much patience anymore.
This lack of patience becomes a problem with deep value investing because there are some stocks that require extreme patience. I'm not talking about holding stocks a few months or even a year before value is realized, instead these are companies that might need to be held a decade, or even two decades before an eventual liquidity event or sale near intrinsic value. Holding a stock this long required extreme conviction, extreme patience, or willful neglect.
Value investors fishing in the deepest ends of the value pool need to be like real estate investors who lock in their gains when they purchase. Buying at an extremely steep discounts is warranted for these types of stocks.
Because some of this is such a foreign concept to most investors let's look at an example of one of my favorite dead stocks; a stock that has lost all investor interest, Hanover Foods (HNFSA, HNFSB). The A shares trade for $82, the same price they were trading for in 2003. The stock has seesawed in the intervening years climbing as high as $120, and then subsequently falling back to the $80 level multiple times. What's interesting is that while the share price is unchanged from 13 years ago the business has continued to grow.
I put together a small table comparing a few aspects from 2003 and 2016:
A real estate investor can make money from appreciation, or growing rents, but the surest way to ensure an adequate return on investment is to pay less at the purchase. The same principle applies for investors who buy extremely illiquid stocks, or stocks that the market considers "dead money." These are the stocks that are covered in dust bunnies and haven't seen daylight since the Nixon administration.
Investors have very little patience. CNBC's entire premise is that you're missing out on something this exact second if you're not watching them. The WSJ makes money on daily news. Financial websites on the internet are biased to what's happening right now. This urgency has predictably trickled down investors. Funds like to talk about how they look for investments with a catalyst, some event that will unlock value quickly. They need a catalyst because their investors, the ones watching CNBC and reading the WSJ don't have patience anymore to see an idea develop and won't tolerate their managers waiting a few quarters, or gasp, a year or more for a thesis to play out. This obsession with catalysts has made its way to individual investors as well. Not many investors have much patience anymore.
This lack of patience becomes a problem with deep value investing because there are some stocks that require extreme patience. I'm not talking about holding stocks a few months or even a year before value is realized, instead these are companies that might need to be held a decade, or even two decades before an eventual liquidity event or sale near intrinsic value. Holding a stock this long required extreme conviction, extreme patience, or willful neglect.
Value investors fishing in the deepest ends of the value pool need to be like real estate investors who lock in their gains when they purchase. Buying at an extremely steep discounts is warranted for these types of stocks.
Because some of this is such a foreign concept to most investors let's look at an example of one of my favorite dead stocks; a stock that has lost all investor interest, Hanover Foods (HNFSA, HNFSB). The A shares trade for $82, the same price they were trading for in 2003. The stock has seesawed in the intervening years climbing as high as $120, and then subsequently falling back to the $80 level multiple times. What's interesting is that while the share price is unchanged from 13 years ago the business has continued to grow.
I put together a small table comparing a few aspects from 2003 and 2016:
The company has also paid $14.30 in dividends since 2003. A shareholder holding for the past 13 years would have a 17% cumulative gain, entirely from dividends. Yet the discount gap has grown from shares trading at 66% of book value in 2003 to shares trading for 27% of book value today.
Let's look at this from the perspective of a 2003 buyer. They've made a measly 17% return over 13 years, or 1.3% per year. Yet the company's book value has grown at 7% a year over the past 13 years.
Now imagine that the market continues to ignore the company for another 10 years as the company continues to grow as it has for the past 13 years. If the company continued to trade for about 30% of book value and an investor sold in 10 years they'd have a roughly 11% annualized return over that period. This is due to the discount price at purchase plus the growth of the company's book value. The math for this is compelling, I've built out a table of potential sale prices based on P/B multiples factoring in the company's growth rate as well as the holding period. The rate of return calculation is a simple cumulative return divided by the holding period. This table presumes an investor holds the shares the entire time and doesn't add or sell anything.
At worst the company continues to trade at their current discount and an investor sells in five or 10 years and makes 10% annualized plus a percent or so in dividends. But maybe one day the market might realize there is value in Hanover Foods and the shares potentially trade at 50% or even 75% of book value. If an investor were to buy today and sell their shares at 75% of book value in 20 years they'd be looking at a 47% annualized rate or return on their investment. These are numbers that fortunes are made of. But only fortunes for those patient (or stupid) enough to hold a dead money stock for decades.
The issue is very few investors have the patience to sit idly and watch a stock do nothing. Even fewer investors can do this with a stock that isn't SEC filing, is hard to purchase and the market has left for dead. But those few investors who have an iron constitution can stand to make sizable returns. A return for doing nothing, just buying into something with a little growth at an eye-poppingly low valuation.
The largest risk for an investor in a dead money situation is if the valuation gap widens. This is what happened to Hanover over the past 13 years, they traded down from 66% of book value in 2003 to 27% of book value currently. If in 10 more years the company still trades for $82 they'll be trading for 14% of book value.
At some point the discount becomes too large and value becomes its own catalyst. Clearly 27% of book value isn't cheap enough Maybe 14% of book value will be? Maybe 7% of book value will be? I don't know, but at some point the market quote for a growing profitable company simply becomes too great and investors start to take notice. Of course most investors will find a million reasons to avoid the company. And most are valid, and they'd be very valid at 80% or 100% of book value. But can some of those issues be overlooked at 27% of book value? Apparently not. Maybe at 15% they'll be overlooked, or maybe at 7%.
If it seems like there are no investors left interested in Hanover it's because that's true. Almost every long time shareholder I have spoken to has thrown in the towel and moved on. At this point I'm not sure who owns shares anymore, but as shareholders give up the discount widens.
Stocks like this aren't for everyone. There is no catalyst in sight. Interested investors don't need to act soon, you'll probably be able to pick up shares for $80 next year, and in three years and probably again in five years, there's no rush at all. My kids will probably grow up and graduate college before I ever see a return with this stock. But if shares ever do trade up to 50% of book value or even 75% of book value over that time I could end up with an excellent return, and I'm willing to sit on my hands until that happens.
Hanover is a simple example of this principle, but there are a number of companies that are like this. Shares trade for significant discounts to ultimate realizable value, but gains will only be realized by those willing to wait what's considered an eternity in our fast driven market.
For more on how I find undervalued companies like Hannover, check out my free Oddball Investing mini-course.
Disclosure: Long Hanover
