You have no edge! Get over it..

Everyone is out searching for an edge.  Some investing insight that will give them an advantage over everyone else.  Investors all define an edge as something different, but everyone is looking for something.

I have news, unless you're a fly on the wall in a Board room, or snuck some inside information you have no edge.  None, nada, zilch.

"But wait Nate.." you say.  "What about patience?" or "What about my variant perception?" or "What about all of my in-depth research?" or "I have read their annual reports from 1675 to present and wall papered my room with Buffett's letters.."  What about those things?

Consider the raw numbers.  In the US alone there were 7,000,000 accredited investors in 2008, there were probably another 7,000,000 non-accredited investors.  Maybe there are another 20-30m investors outside of the US plus a few million people in the investment industry.  For argument's sake there are probably about 50m investors worldwide.  And those 50m investors are looking at the same pool of 60,000 stocks.  In the US there are 4,000 traded firms and 15,000 OTC firms, with another 39,000 firms worldwide.

If every company received equal coverage by investors there would be an average of about 1,000 people looking at each stock.  For some large stocks it's even higher.  Of the 4,000 US listed stocks I'd wager there are 50,000-100,000 people at a minimum combing over each company.

That means if you think you have an edge you're saying "I'm smarter than the other 1,000 people looking at this name."  Are you?  Do we all live at Lake Wobegon?  A place where all of the women are strong, all of the men good looking and all of the children above average?

If you don't have an edge then what do you have?  Simply put you have two options.  When a stock is appreciating by investing you agree that the future is brighter than the present, and you agree with the crowd.

When a stock is flat or declining you disagree with the crowd about the future.  That's it.  You either agree with everyone, or disagree with everyone.

Buffett famously quipped that the market is a voting machine.  It's the weight of the votes that determine a stock's direction.  If you're agreeing with the crowd you hope no reasons for people to disagree occur.  And if you're disagreeing with the crowd you're hoping news or opinion changes and people start to agree with you.  When the weight of agreement crowds out disagreement the price appreciates.

But what about patience?  The supposed edge that all value investors have?  In theory professionals have to dump their stocks every few months because their clients aren't patient enough to wait for opinions to change.  I think this theory is bunk.  If an investment manager buys a position that they're convinced is going to go up they will move heaven and hell to stay in it.

Recognize that all investors are doing the same thing as you.  They're reading, they're researching, they're talking to other investors, they're weighing the information.  And they're all making the same decision, do they agree with everyone or disagree?

So how do you make money?  You can make money two ways.  The first is by being savvy and understanding how the crowd works.  You buy into a stock when there is a small amount of excitement and hang on until the excitement has reached a critical mass.  This is the growth or compounding approach.  You are in names that everyone loves that are growing and getting bigger.  To be a winner with this strategy you need to recognize when the psychology is about to change and get out before others.

The second approach is to disagree with the consensus and buy when others are selling, and sell when others are buying.  With this method you're picking up the pink flamingo Hawaiian shirts on sale for $2.99 in the winter betting that they'll be a hit in the summer.  In this market this second approach is stomach churning and leads to heart burn.

Right now if you want to make money you buy things, anything, and simply agree with everyone else.  But at some point sentiment will change and everyone will be selling and you'll be forced to disagree and buy.  Doing so doesn't mean you have an edge, it just means you can control your emotions.  And if you're going to be a successful investor you need to be able to control emotions.

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

RIP - Value Investing

The term "value investing" is one of those words where the more you think about it the weirder it becomes.  What is value after all?  It seems anything can be value investing, because value is in the eye of the beholder.

Security Analysis author Benjamin Graham made the comment in his book Intelligent Investor that

"Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success."

Let's take a step back for a few minutes.  One of the most basic rules of business, if not THE most basic rule is you sell your products for more than it costs to create or obtain them.  This is simple.  If you are going to open a ice cream shop where your cone has $.25 worth of ingredients and $.50 worth of labor and rent in it you need to sell it for $.75 if you want to stay in business.  This concept is so simple that even children understand it.  Have a child purchase an item for a few dollars and then ask to buy it off of them for less than they paid, they'll protest.  It simply makes sense.

Unfortunately this business logic doesn't extend to the stock market.  Our fictitious ice cream shop selling cones for $1.00 that cost $.75 would trades for less than the trendy ice cream shop selling the same cones with the same cost structure for $.50.  Why is this?

In the stock market there is a second dynamic at work, it's investor psychology.  It isn't just what the underlying business is doing, it's what other investors are willing to pay.  In our example investors prize trendiness and losses over profits, and so they are willing to pay more for company B.  Of course there will be stories explaining why B is better than A.  The psychology is that investors feel that since they love company B that everyone loves company B and they will always be able to sell their shares for more than they paid.

Maybe company B will make it up on volume, or they're growing, or they have a visionary ice cream scooper.  The reality is unless company B raises their prices, or figures out a way to lower their costs they will eventually end up out of business.

There is no magic to this, it's simple math.  And when you argue with math you lose, every, single, time.

Sometimes value investing is described as buying unloved companies.  The story goes that the value investor would purchase company A in our example because they aren't as trendy, or as popular.  If you extrapolate this idea you end up with the idea that a value investment is just a piece of unpopular garbage, or something no one else likes.  I think it's neither.

There is another way to view a value investor, they're an optimist.  Someone who looks at the ugly duckling and says "Hmm, they're still a duck, they can still swim, walk, fly, do duck things.  If other ducks are valued on duck things the ugly one should be as well.  And besides, beauty is fleeting, maybe those beautiful ducks will age out over time.."

Or let's take another analogy, sports.  The market values the MVP's (most valuable player) of the team.  They are popular, have great stats, and do well every game.  How could you not like the MVP?  The value investor looks at the teams that are doing poorly and works to determine which underdog has a real chance.  They're looking for the upset team, or the breakout star.  Sure that underdog might only win a game or two, but if you're gambling on single games picking the underdog will result a bigger jackpot.

The optimist isn't stupid, they don't buy what's unloved just because it's unloved.  They buy it because after evaluating the circumstances they've determined that a company has a chance.  There's a reason to be optimistic about the future when everyone else is pessimistic.

Value investing is difficult because it's hard to be optimistic when everything looks bleak.  It's easy to be a growth investor because everyone is optimistic and you're optimistic along with them.  

Unfortunately at this juncture in the market value investing is dead, completely dead.  The reason is there is almost nothing that people aren't optimistic about.  

My view on this was crystalized when I spoke to a client earlier today who specializes in small rural banks.  They said that what they're seeing is unbridled optimism about economic expansion in places that haven't been optimistic since the post World War II boom.  When optimism has crept down to the sleepiest of places it has become persuasive.

Of course a retort to this post is that there are still 'cheap' companies.  There will always be companies with struggles or issues, and dying industries.  But the caveat is sometimes the market's pessimism is justified.  Industries die, companies die.  Sometimes a dying company is simply a dying company, not a value investment.  A value investment is a company that looks like it might be dying but it isn't.  Or one that the market has left for dead that is going to survive.

When I look at the market, both the public market and the private business world I see optimism everywhere.  That's a good thing, but bad for a value investor.  It's bad because there aren't things that look bad to be optimistic about.  At this point being optimistic is simply running with the pack, everyone is optimistic.  If the future optimism is warranted then everyone will do well.  Maybe we'll finally usher in that period where stocks reach the ever illusive permanently high plateau.

Given the current situation an investor has two choices.  Cheer for the star players along with everyone else, or sit on your hands and wait.  I'm more comfortable with waiting.  The good news is this, when opportunity finally arrives it will be here for a while.  The last time the market crashed there were still eye-popping bargains four years later.  You didn't have to get in right away, you could have sat on your hands for a while and still done well.

If you want to invest with the market buy something, anything really, it will go up.  For those who prefer to be optimistic in the face of pessimism there are always a few companies in little nooks and crannies, but not much else.  Maybe it's time to take a long vacation..

The blessing and curse of being public

The grass always seems greener on the other side.  Managers of public companies want to be private so they don't have to hit quarterly targets.  And strong private companies would love public capital to grow without micromanaging oversight from their VC overlords.  Even though being public is positioned as a black and white binary decision I think it's far from that, the value of being public comes from the company itself.

Let's take an example of something that is public, parks, to see why.  There are public parks and there are private parks.  In both cases a park is a piece of property that exists to benefit some party.  A park is a perfect analogy for public companies.  Parks come in all shapes and sizes, for tiny one acre plots stuck in the corner of a subdivision to the massive and well known Grand Canyon.  In the United States it's hard to travel far without encountering a park of some sort, either a large national park, or a small local township park.  Just as there are people everywhere, there are parks everywhere.

Parks vary in their quality.  The majestic National Parks are considered in a class of their own.  They're destination parks with scenic features unmatched anywhere else.  These are the large caps of the market, the companies that everyone knows that are capitalistic national treasures.  The thing with National Parks is that while they're beautiful they don't hold a monopoly on beauty.  George Washington National Forest is just as scenic as nearby Shenandoah National Park, yet one is known while the other isn't.  Likewise there are many state parks and local parks that harbor stunning attractions too.

The scenery between parks varies as does the care and quality of parks.  If you listened to Americans for long enough you'd have the impression that public parks are universally trashed and full of nepotistic park management.  This view is probably derived from that fact that most Americans visit a park exactly once a year, on the 4th of July, when they do the trashing while watching the fireworks.

For every trashed local park there are dozens of clean parks with diligent rangers.  Sometimes a park will have onerous rules to compensate for some past evils.  For example State Parks in Pennsylvania will give you a ticket if you attempt to enjoy a beer by a campfire, but in Alabama they'll sell you a beer at the ranger station.  Apparently in Alabama the local youth aren't attracted to trashing their state parks, whereas in Pennsylvania they are.  The same could be said for a company's corporate governance.  Governance varies as much as companies vary, and in almost all cases the variance is due to past issues, or perceived future issues that are unique to each company.

The similarities don't stop there either.  At the local level if a park falls into disrepair or becomes outdated often a small group of citizens will band together to get something done.  These are citizens who individually hold very little power, usually just their own vote.  They petition the government to do something with their dilapidated park.  And if nothing is done they can vote out the bums and vote in new bums with the hope these new bums can get something done.  Is this starting to sound like activist investing yet?  It isn't only local parks that can be changed due to a small group's involvement, it happens at the national level too.  Small outspoken groups can change the outcome for everyone by being persistent and loud.

Company managers act as if the metaphorical trashed park they oversea is someone else's problem instead of their own.  They neglect to mention that they looked on when someone trashed it, and that they didn't want to clean things up.  They pretend that if they were private that it wouldn't be trashed, but that's false.

If a company is in disrepair management often has to look only as far as the mirror to see why they're having problems.  But in the same vein, successful managers shouldn't be too quick to pat themselves on the back.  The Grand Canyon will be magnificent regardless of whatever ranger is in charge, the same is true for many large companies.  Their business runs with them or without them, not because of them.

Unfortunately there are too many managers who think that being public is the root of all of their problems.  When the problem is themselves, their company has cultural rot and needs to be changed.  Change is always possible, but it isn't easy, and executive decrying public markets are usually the same executives who want easy solutions.

Being public or private isn't a silver bullet.  Yes, there are costs associated with being public, but there are also advantages.  A public company can raise additional capital with little cost.  Whereas a private company might not have to hit quarterly targets or carry a regulatory burden, but executives might have to hit the road for month's worth of dog and pony shows to raise capital.

Be wary of when a company's management blames being public as the source of all their problems.  It's usually just a cover for their own incompetence.  But that incompetence is also an opportunity for savvy investors to initiate change.

Buy and hold is dead. Long live buy and hold.

My foray into investing was similar to most.  I found myself with a bit of extra cash and wondered "how can I earn more than 5% with this?"  Of course all of the wise and savvy people in my life such as co-workers and parents all said "invest it!" But I didn't know what that meant.  I did what any book worm would do, went to the local library, found the aisle with investment books and proceeded to check a few out.

I read all sorts of books about investment, some terrible, some interesting.  My library seemed to operate on a rolling calendar basis that was about a decade old.  That means most of the books I was checking out in 2005 were from the early to mid 1990s.  There were books on the Dogs of the Dow, and Beardstown Ladies, as well as Stocks for the Long run and many others.  The books all had a common theme, it was that savvy investors used a technique called "buy and hold."  What this meant was investors should scour the investment universe for anointed blue chip stocks, buy them at any price, and hold them forever.

The concept behind buy and hold makes sense.  You buy market leading companies, hold them, and throughout time your shares naturally appreciate.  From the end of WWII onward buy and hold was a brilliant strategy.  With the industrial hearts of Europe and Asia decimated from war the US had a natural industrial advantage.  Those blue chip stocks grew and grew and grew.  Investors would buy, hold, and re-invest their dividends for years.  Some companies even developed specialized programs where investors could invest directly with them and reinvest their dividends in partial shares at a slight discount to the market rate.  The system was focused entirely around buying these quality blue chip companies and holding them forever.

The system can't be faulted, it worked!  I know of people personally who worked for GE and other blue chip names in the 1960s-1990s who invested their entire retirement in company stock and retired a millionaire.  These weren't executives either.

Then a man named John Bogle came along and created a better buy and hold system.  Most investors were only buying blue chips, and blue chips were the main constituents of stock indexes.  This meant that at best the performance for most investors approximated an index.  The problem was that even though investors were approximating the index they were failing to match or beat its performance.  This was due to frictional trading costs, or just bad decisions.  The idea that one could buy an entire index in a mutual fund with low fees, sit back and do nothing more and earn higher returns was attractive.  From Bogle's initial concept Vanguard was born and grew into a juggernaut.

A curious twist has happened in the years since.  Index investing has overtaken buy and hold and become its own investing religion.  Along with this value investors have gone full circle.  From deriding buy and hold as an unintelligent strategy to embracing and proselytizing it.

Value investing drifted from buying companies that were disproportionally cheap to buying companies that earn above average returns that can be held forever.  Does that sound familiar?  It's buy and hold with new terms.  Instead of "blue chip" we have "compounder" and instead of "market leader" we have "high ROIC."  These compounders are discussed as being such good businesses that investors don't need to focus on the price they pay.  All one needs to do is buy them at any price and hold on for decades.  These companies will somehow grow to the sky and make everyone rich.

Is it any wonder that most funds fail to match their index?  They're back to working with a strategy where it'd be much better to buy the index.

So what's the alternative?  It's my belief that for most companies there is a price where they should be purchased, and a price where they should be sold.  No company grows at 20% forever, the math works against them.  Take a company earning $1b growing at 20%.  After 20 years of growth they're generating $38b in income.  After 30 years of growth it's $237b in income.  And 40: $1.4T, and 50: $9T, and 60: $56T.  A company that starts with $1b in income and grows at 20% a year for 50 years will be earning more than the entire GDP of the US in slightly over 50 years.  Is that realistic?

Let's also note that very few investors get on board when the company is earning $1b, they latch on after 15-20 years of growth once they have a long track record.  It's at this point that most of these companies are hitting their peak scale and growth starts to taper off.

Investors like to delude themselves and say that they know better than most what the future will hold.  That they'll only buy companies that can grown earnings 20% for the next twenty years.  Think about how crazy that is.  Let's go back 20 years.  What companies were going to take over the world?  How about Gateway Computer, they were an all-star.  They had stores, they had cool commercials, they were a popular brand.  They vanished in a string of mergers.  Maybe Apple?  Back in the late 1990s it was a lame computer manufacturer that was on the brink of death.  The weekly Best Buy ads would have them in a line-up compared to other Mac clones as well as PC's.  The Apples always had the worst specs and highest price.  No one would have guessed they'd become a dominant brand selling cell phones.  Back then Motorola was cleaning up with their StarTAC phone.  The cell phone world belonged to Motorola and Nokia.  Yet twenty years later those companies exist in name only now, a bet on them in 1997 would have ended in pain and misery.

Of course a few readers will say "Amazon and Google", which is perfect hindsight bias.  Now that they're the market leaders we all "knew" they'd be like this in the late 90s didn't we?  I remember back then AltaVista was killing it in search, same with Lycos.  Amazon was interesting if you wanted books, but that's all they sold.

There are times when the market is pricing a company too low given their future prospects, or even current prospects.  It's during those times when an investor should purchase shares.  But just as the market likes to undershoot it also likes to overshoot.  And companies that were formerly undervalued can become just as overvalued.  Instead of holding on by justifying a low cost basis it's time to cut the cord and take gains.

Holding too long can become dangerous.  I know of an investor who purchased a deeply undervalued company in the early 1980s.  They held and the stock grew by almost 100x.  His investors who cashed out at that time profited from his holding, but he continued to hold.  As of a few years ago the stock was below his cost basis from the early 80s.  The company went full cycle, from small to an all-star and back again.

If you don't know when to buy or when to sell you might be telling a similar story some day.  It's time to buy a company when they're trading at a deep discount to either their assets, earnings, or the M&A multiple of their peer companies.  The metrics on selling are different, and maybe this is what trips investors up.  When a company appreciates you need to evaluate them differently.  Look at the growth the market is pricing into the stock and estimate if that's appropriate.  Also look at the trajectory of the company's revenue and earnings and estimate if those growth rates seem appropriate.  There are times when you can buy a company at 50% of book and sell at 100% of book when nothing in the business has changed.  But more often something has changed that ignited the move, and usually what's changed is earnings so it's the earnings that need to be evaluated.

The only way to earn above average returns in the market is to do be doing something different than the market.  You can't be doing something different if you're mostly buying large constituents of the indexes and holding on.  Remember that every price has a point where they're a buy, and everything a sell.  For those of us who adhere to this the idea that most of the market is buying and holding blindly is a good thing, it means more opportunity for us.  So seize that and profit!

For more info on how I find undervalued oddball companies, check out my mini-course here:

Are all "Graham" stocks junk?

Have you ever walked down the street and inadvertently stepped on a piece of gum?  It's annoying.  A piece of previously enjoyed food carelessly discarded on the ground and is now stuck to your shoe.  In many ways investing in the mold of Benjamin Graham is like a sticky piece of gum on the street for most investors.  It's an idea that had merit seventy or eighty years ago, but is old fashioned and is now stuck to everyone's shoes.  Most value investors have spent a considerable amounts of time metaphorically scraping Graham's ideas from their shoes.  But amazingly there are still a few still chewing on that old gum and enjoying it, why?

The common sentiment is that Graham-esque stocks, that is stocks that trade at low valuation multiples such as a stock trading at10x earnings and 75% of book are junk and a waste of time to research.  The implicit assumption in all of this is that the market is somewhat efficient and if a business trades for a poor multiple it must have some problem that makes it deserving of the low multiple.

A company might be deserving of a low multiple because there is fraud, or they retain a management team that has decided to loot the coffers.  Although ironically fraudulent companies often earn praise and high multiples from the market until the day they fail, a la Valeant.

The stereotype of a value stock is a company producing shag carpeting run by managers wearing polyester suits with elbow pads who are wondering why sales are declining.  This can be the case sometimes, but it's more of an outlier than the norm.

I think the greater problem with Graham type stocks is they are in unattractive industries, and investors don't like to be out of step with the market.  I ran a screen for stocks trading below 75% of book value and for less than 10x earnings.  The resulting small list contained some sketchy biotech companies, a number of even sketchier Russian mining companies, as well as a few other resource and industrial companies.

These companies with depressed valuations don't appear in anyone's quarterly shareholder letter, and they aren't on WhaleWisdom.  In a perverse sense the increased socialization and ability to network with other investors via the Internet has made this problem worse.  I've heard of investors who search Twitter, Seeking Alpha and hedge fund letters for ideas.  If an idea isn't "approved" by someone well known in one of these circles it must not be worth researching.  The idea is that these high profile managers or prolific Internet posters spend all of their time reading and scouring nooks and crannies for stocks.  So they must have looked at everything already, and if they didn't buy it then it isn't worth buying.

Just because a name doesn't appear on Twitter, or in hedge fund letters, or on Seeking Alpha doesn't mean it's a bad idea, or it's not worth researching.  There are still plenty of areas that are inefficient, and stocks that are out of favor is the biggest area.

People like to be liked.  It's easy to be liked when you're doing the same thing as everyone else.  This is true for all aspects of life.  In sports-crazed cities it's difficult to cheer for an out of town team.  Groups of friends all have similar interests and views.  Political parties change direction often, but party followers keep toting the line.  The market is just a group of people too, and the market collectively likes things like any other group.  These likes and interests are echoed on TV, in letters, and in public speeches about investing.

Currently the market likes artificial intelligence, self-driving cars, automation, mail-order catalogs presented as websites (what is old is new again..Amazon the new Sears?), companies with high ROE's regardless of how they're generated, compounders and moats.  This wasn't always the case, at periods in the past the market's interests were different, and they'll change again in the future.  Yesterday's Nifty Fifty is today's IBM with investors running for the exists.

In large the market points in the correct general direction.  In the 1990s it pointed towards the Internet becoming a thing, it did become a thing.  In the 2000s it pointed towards financialization, which is still a thing.  The finer details aren't always correct, but the general direction usually is.

If a company isn't part of the cool kids club they might be able to float alongside for a while.  Maybe they'll toss a few keywords in their proxy about automation and technology innovation.  Or maybe their high ROE is good enough for a while.  But eventually those wannabes fall by the wayside.  Sentiment shifts and somehow a wannabe becomes a left behinder.  For years resource companies were the cool kids, now suddenly no one will touch them.  Airlines spent a long time in the ditch, but now they're suddenly cool again.  This is the popularity cycle at work.

One of the foundational concepts that Benjamin Graham taught was that there can be value where others don't believe it exists.  What he didn't say was "buy everything no one else likes."  He said to go poke where others aren't poking, because sometimes the baby is thrown out with the bathwater.

It's in these pools of dirty bathwater that deep value investors go searching for babies.  While the pool might be dirty the discovered baby isn't.  To beat an analogy to death.. the babies we're finding are cute and innocent, unsure of why they're laying on the street out the window in a puddle of bad water.

This is the essence of value investing.  Looking where others aren't looking, but sifting the bad from the good.  The idea is to find companies that have been marked by the market as bad that aren't.  Since these companies aren't bad like the market suggests, their goodness will eventually shine through for investors to notice.  When this happens their price will appreciate to be in line with other similar companies, not the mis-matched peers they were previously trading with.

Like everything in life investing is a popularity contest, and Graham style investing is not popular at the moment, just like the types of stocks it uncovers.  This doesn't mean the strategy isn't profitable.  It's actually the opposite, excess returns are found outside of the main stream of popularity.  I'd wager that a set of randomly selected set of companies trading at low P/B and low P/E ratios will outperform the FANG stocks, or Tesla over the next three to five years.  But this isn't a popular notion, and no one wants to be caught writing about a no-name value stock in their quarterly letter.  And that's why this opportunity exists.

Another look at National Stock Yards

It's easy to follow a company when they release information once a year, and that information is a simple 12 page annual report.  That's the case with National Stock Yards (NSYC), a company I've owned a single share of since 2012. 

Since I last wrote about the company I've received an five additional annual reports.  That's 60 pages of reading material on this company, not much.  All of the information in those reports can be summed up in a simple statement "the more things change the more they stay the same." 

Here's the backstory.  A long time ago in a far away place there was a company that owned stockyards.  A stockyard is a place where cattle are auctioned off to buyers.  Ranchers drive their cattle by horse, or train, or truck to the stockyard at pre-determined dates when auctions are held.  Cattle buyers come and purchase the ingredients for your burgers and steaks and the ranchers return home without cattle, but with pockets full of cash.

The company was established in the 1870s in Oklahoma.  The date and place invokes images of cowboys and Indians, saloons and western movies.  Those days are long gone and the company now consists of three things, their Oklahoma stockyard that's still transacting cattle, a plot of empty land near St. Louis, and an ownership interest in a golf course.

When I last wrote about the company shares traded for $166 a share and the company earned nothing outside of real estate sales.  Last year the company reported an operating profit from their livestock operations.  For years they'd be talking about how the livestock herd in the US was decimated and that was the reason behind their losses.  In 2015 someone came up with the idea of raising prices and lo and behold they earned a profit, and volume didn't decline either!  On the back of continued price increases their livestock operations earned another profit in 2016.  And supposedly the herd is back to normal now.

The real asset isn't livestock, it's their St. Louis land.  The company owns 191 acres of empty land an "easy five minute drive to downtown St. Louis."  The land is carried at $2.9m on the books.  For years they've been chopping off small chunks and selling them for various amounts.  In 2016 the company sold 11 acres for $890,000.  The company seems to prefer to sell 10 acre lots for prices varying from $100k to the most recent $890k.

A danger with real estate valuation is extrapolating the price per acre from one sale across the entire land holding.  The company's sales history shows that not all of the land holds the same value.  On the conservative side we can assume the property is worth at least $10,000/acre, with some plots worth up to $89,000/acre. 

On the low side their 191 acres would be worth $1.91m.  This is an overly conservative value because management lets us know it is.  The property is held on the books for about $15,000 per acre.  But management notes in the report "Management estimates that the fair value of the Company's St. Louis real estate is in excess of its carrying value and demolition costs, and accordingly, the carrying value of the St. Louis real estate has not been adjusted accordingly."

Let's put the pieces together.  In 2016 the company earned $21.72 per share, and if you remove their real estate proceeds earned $13.52 per share from livestock.  Current book value is $7.7m including the St. Louis land.  If we remove that we get a book value of $4.1m for the livestock, or $94.03 per share.  The company's core business is earning 14% on its equity, a respectable return.

Stockyards aren't sexy like self-driving cars or internet advertising, so maybe their earnings only deserve a 10x multiple.  This would mean the core company is worth $135 per share.  Shares trade with a bid of $250 and an ask of $498.  Let's ignore the ask for a minute.

The market, and by market I mean some savvy buyer who's looking at the same material I am, believes the company's remaining real estate is worth $115 per share.  That puts the implied value of the St. Louis land at about $5m, or about 72% above carrying cost.  A $5m land valuation assumes acres are sold at an average price of $26,000.

Is this a reasonable valuation?  Maybe?  The math behind a $250 per share valuation seems sound, but it's interesting that there's a seller who is only happy to let them go at $498 per share.  A $498 per share value implies the non-operating assets are worth $8.3m.

What's great is that you can reduce National Stock Yard's valuation down to two variables, the value of their core business, and the value of their real estate.  Maybe the core business is worth 15x earnings.  If they were a compounder or outsider investors would be trampling each other to pay 30x earnings.  But instead it's a bunch of cowboys selling cattle in dusty Oklahoma warehouses.  Likewise the St. Louis land could be worth a small fortune, or maybe not.  That's up to the investor to decide.

It's also worth pondering that to most investors this is a dead company.  And the narrative is dead companies are dead money.  But it's worth pointing out that I purchased this for $166 a share in November of 2012 and there is an active bid at $250.  That's a 50% gain in about 4.5 years. The company has paid a sizable dividend per year, $20 per share the last two years.  I think I've received $60-70 in dividends bumping the return from 50% in 4.5 years to an 86% return in 4.5 years, or about 20% a year.  That's not bad for something left for dead!

You'll note that I never discussed the golf course outside of a mention at the top of the post.  It's because the company holds it at $0, and we don't know anything about it.  I consider it bit of a valuation bonus.  Maybe the golf course is worth an additional $10-20 per share.  If it isn't it doesn't change anything with the main thesis.

The investment outlook is as certain in 2017 as it was in 2012 for the company.  If the company's core business remains stable and they can sell their remaining St. Louis land then maybe shares really are worth $500 a share.  Until then I'll continue to hold my single share and watch from the sidelines.

Disclosure: I own a share

If you're interested in more ideas like this check out the Oddball Stocks Newsletter.

Why growth can be a killer

It's as if we're wired for growth.  "Growth is good." "If you're not growing you're dying." Everyone wants to be growing, personally, physically, mentally.  Businesses are no different.  Growing companies are rewarded a high multiple and low growth companies are rewarded low multiples.  But is growth always good?

Growth in businesses is exciting.  When a company is growing it's lively, employees are excited, customers are excited, there is momentum.  It is fun to be a part of something growing.

The problem with growth is that it's hard to manage well.  Humans seem to make the best decisions when they can assess the inputs, thoughtfully consider those inputs and make a decision.  When a company is in the midst of rapid growth management doesn't have the opportunity to make thought out decisions.  People need to be hired yesterday, customers are ordering things that don't exist yet, it's all hands on deck all the time.

Some of the excited from working at a growing company comes from the fact that no two days are the same.  There are always new challenges.  The reason for this is because the workplace is chaotic and employees don't have fixed roles yet.  No two days are the same because on Monday you might be solving an engineering problem, and on Tuesday you're helping to pack boxes in the warehouse.  When a problem comes up everyone huddles to figure out how to tackle it.  Unfortunately playing whack-a-mole with problems isn't efficient, or sustainable way to conduct business.

Companies are successful when they can introspect, identify why they are successful and systematize their success.  This systematization is the process that turns a start-up into something sustainable.  It's also the point where most of the initial cowboy (or cowgirl) employees leave because a company has becoming "too corporate."

Companies are typically started by people who are willing to do anything at any time to get a job done.  These are people who enjoy challenges and thrive in chaos.  They are the people who are willing to try new things, but usually aren't very structured, they can't be.  As a company grows it needs to become organized and organization doesn't come from the initial employees.  It comes from new hires with experience in structured environments.  These new hires usher in the second phase in a company's lifecycle.  The sustainable corporate phase.  Success is systematized and becomes sustainable.

Growth can kill companies when they refuse to systematize their processes and become corporate.  This could be because a company's Founder doesn't want to lose their start-up culture.  Or it could be that the initial management team doesn't know that it needs to systematize. 

Eventually the chaotic fire fighting becomes unsustainable and a company collapses under its own weight.  Unfortunately the collapse is sudden and unexpected.  There isn't always a specific reason for the collapse.  But the underlying reason is always the same.  The chaos became unmanageable and obligations went unfulfilled.

The corollary to growing too fast are companies with little growth that never seem to die.  These low growth companies are some of the stalwarts of value investing.  Just like growth is lauded no growth is despised.  Who wants to work for a company that grows at 3% a year?  Even worse, who wants to invest in such a slow-poke?

The perception around low growth companies is fascinating.  Even though most are exhibiting some absolute level of growth, even if small, investors see these as "dying" companies.  They are dying in the eyes of the market because they're not growing fast.

Just as it's difficult to systematize a fast growing company it's hard to take a systematized low growth company and turn on the growth spigot.  Low growth companies are set in their ways.  Their ways are often successful in generating consistent returns, but not consistently high returns.  Some of this could be due to their products or market, or it could be that the company doesn't know what needs to be changed to generate increased growth.

In the book Security Analysis the author Benjamin Graham discusses buying stocks and encourages the reader to look at a company's past growth history.  He states that if a company had experience with growth or high earnings in the past then management is familiar with what it took to get there, even if they aren't experiencing it currently.  This is preferable to a company that has never had more than middling growth.  The implication is that the management team doesn't know what's necessary to create conditions that generate growth.

The world of venture capital investing is filled with carcasses of companies that grew fast and failed.  Most of the companies didn't fail because customers didn't like their products, or there wasn't market demand, or they couldn't generate revenue.  They failed because they grew too fast.  Their growth was unmanageable and they grew their way to failure.

Venture capitalists are hoping to leech onto a company that can mitigate the growth landmines.  They are looking to find companies that grow fast, but also figure out how to become corporate and sustainable.

Investors in public markets should avoid high straight line growth and instead favor companies with moderate, but sustainable growth.  High paced growth is exciting for a while, but when the bottom falls out shares crash and investors become bewildered wondering "how could this happen?"

A company with sustainable growth can retain excitement from growing.  But without out of control growth the investor stands more of a chance that they'll be able to enjoy the fruit of their growth investment.  If you're in the market for growth don't be a moth attracted to the flame from a rocket investment.  Rather look for sustainable growth identifiable by a management team that is corporate and has systematized their success.  

Podcast interview plus a new investing system course

Planet Microcap Podcast

I recently had the chance to be interviewed by Robert Kraft on the Planet Microcap Podcast.  We had a great conversation that ranged from investing in microcaps, to bank investing, and some background on how I got started.

You can listen below:



If you have a chance listen to some of the other podcasts from Planet Microcap.  There are some interesting guests worth listening to.

My Investing System Course

I have quite the back catalog of content on this blog.  Scattered throughout old posts are theories on how I look at investments and how I find new ideas.  I know a few brave souls have dove into the more than 1,000 pages of material and read from start to finish.  But most of you don't have that much time to go trawling through pages of posts to find what you're looking for.

One question I'm asked over and over is "How do you find investments?" and "How do you evaluate investments?"  In one sense finding an oddball investment is like finding my posts on how I do it.  You start with a lot of content and begin to dig...  We decided to short-circuit the digging step and provide all of this in a simple email newsletter.

If you sign up for the course you'll receive one email a day on the following topics:

• Day 1: Where to hunt oddballs (Is screening dead?)
• Day 2: Assets and book value (Where 50 cent dollars hide)
• Day 3: Earnings (Growth isn’t everything)
• Day 4: Management: (Roach motel avoidance 101)
• Day 5: Catalysts (Who needs em?)
• Day 6: Activism (Can anyone go activist these days?)
• Day 7: Portfolio Management and When to Sell (The system I use to manage 50+ positions)

You can sign up below:

Get my Oddball Investing System

Homemade economic indicators

It was the summer of 2006, my wife and I had been married a year and we were going on our first real vacation since our honeymoon.  It felt very grown-up.  As a young-20s married couple the offer of a free hotel room at a relative's hotel in Florida was too good to pass up.  I'm not sure we could have afforded anything else.  We packed up our late-90s model Accord and headed down to the Sunshine State.  What we saw when we got there blew us away, and I'm not talking about the blue waters and palm trees.  We arrived in an area that was in a manic state of construction.  There was a palatable euphoria in the air.  Everyone was getting rich on real estate, and developers were building anything anywhere there was a bare patch of sand.

On that trip I had two unshakable observations.  The first was I had trouble envisioning where all the people were going to come from to buy these new construction condos and houses.  The second was I couldn't believe how many banks there were.  On most street corners stood four branches, all different banks.  Again, I couldn't understand what I was seeing.  How could there be enough money to support hundreds of different banks?

It turns out my questions were justified, a mere two years later the bottom fell out on the Florida housing market.  The state's overextended banks were dragged with housing into the abyss.  For a while we were annual visitors to the same free hotel north of Palm Beach and I watched the whole crash and recovery unfold.  In 2006 a condo oceanfront in a tower cost $500k. In March of 2009 condos in the same building were for sale for $150k, and in 2013?  They were back up to $500k.  Most of the bank branches closed, some were redeveloped into Mexican restaurants or stores, others bulldozed, and others still standing with "For Sale" signs.

What I witnessed in 2006 was the euphoric stage near the top of the market.  I didn't know what I'd seen until later, but when looking back it became clear.

I've encountered the same thing a few other times.  In 1999 I was a wide-eyed college student studying computer science dreaming about working for a start-up and becoming rich through options.  I remember going to a party at a frat house with one of the frat brothers bragging about their start-up.  The guy was so convinced he was going to change the world that he took us into his room to show off a 36" TV, which at the time was impressive itself.  It was a Gateway Computer TV, and the TV was hooked up to a computer.  This alone screamed success to everyone in the room.  This guy was creating a website where people could order pizza online and have it delivered.  You wouldn't have to pick up the phone anymore.

I'm curious by nature.  I want to know how and why things work.  This was definitely true when I saw the pizza website on the giant TV.  I was thinking about how much faster calling would be compared to dialing into the internet and waiting for the modem to connect and then the webpage to load.  I even had the gall to ask this guy about it.  He made some broad statements about how great the future would be and how no one would use phones.  It didn't make sense, especially in the age of modems.  And sure enough this guy was out of business a year or two later.

I didn't know what I was witnessing in 2001 when the dot-com bubble bust because I was too young. But I had a vague sense that what I'd seen in the years prior wasn't sustainable.

The last boom I saw was recently, the oil and gas boom in Western Pennsylvania.  The formerly lonely highways I'd take to West Virginia to ski became clogged with water, fracking trucks, and giant diesel pickups.  I had friends from small towns where farmers were leasing their land to gas companies for $5k/acre per year just so they'd have the right to drill.  When drilling took place the farmers would make even more.  Hotels appeared in the strangest places to accommodate the gas workers.  It was a boom scene.

At one point in 2014 I met with a hedge fund manager who started a fund that only invested in banks that did business in Eastern Ohio and Western PA.  Specifically banks with heavy oil and gas exposure.  The manager marketed his fund as the best way to play the gas boom.

Gas prices finally crashed and along with it the roads emptied out and drilling activity slowed to a crawl.

In each of these three boom situations I was observing something that I couldn't quite put my finger on.  The hysteria was real, it was tangible, and it seemed like it couldn't go on forever.  But the energy was such that it's hard to believe something good like that might end.

I was talking with a friend recently and I noticed myself sharing stories that sounded like boom time stories again.  The more we talked the more I realized that I've been seeing some of the same things I was seeing in 2006 and in 1999.  My experiences and observations are all anecdotal, and maybe this is something only happening in the northern suburbs of Pittsburgh.  But what I'm seeing here is crazy, and as an investor a bit scary.

Let me share a few stories.  A few weeks ago my wife and I had a babysitter scheduled and the event we needed the babysitter for fell through so we decided to go to dinner instead.  It was a Wednesday night, and with her being pregnant I decided to let her pick the destination.  She wanted a blooming onion at Outback.  I'll say upfront that I'm not a big Outback fan, but it was a night away from the kids, so you take what you can get.  Outback shockingly had a wait, the waiting area was full and there were people outside.  It was going to be 45 minutes to an hour for a table.  We looked at each other and agreed that Outback isn't worth waiting that long for (or in my mind at all, but I digress).  We then hit up a number of other restaurants in the area and they all had similar waits.  It was simply crazy that on a weeknight these average restaurants would have so many people trying to eat.  The thing is this trend has continued, restaurants are mobbed now, we're back to pre-2008 wait times everywhere.

Another area I like to keep an eye on is my local craigslist.  I will buy and sell on there when I see deals, and I browse to keep a pulse on the market.  The prices have gone nuts in the past year.  Twenty year old F150s with rusted out bodies and 200k miles are selling for $5k, about $2500 too much.  RVs are similar, late 1990s RVs are selling for a few thousand dollars less than models 10 years newer.

Beyond RVs and trucks I like to look at rural land as well as heavy equipment and businesses for sale (can you spot the trend? Items with titles..).  A few years ago I picked up an acre of forested land in Northern PA for $300, and I've been on the hunt for larger tracts in the 10-20 acre range in the same area.  A year ago there were a few sellers who wanted $1,500-2,000/acre for forested land, but there were always caveats.  The places would be next to a sewage treatment facility, or there were easements.  Now in the same area prices have jumped to $10,000/acre.  Same types of lots, same location, just 5x more expensive.  Right before the oil boom you could buy almost any tract for $1,000 an acre or less, when gas crashed I went hunting again.  While prices fell demand remained strong as people looked for lots for second homes.

Even worse is the housing market here.  I sold a house last year, a nice 1,300 sq ft starter home for $160k, what I thought was a reasonable amount.  Similar houses are now listed a year later for $200k, a $40k jump in a single year.  What's worse is some of the stock at $200k needs another $25-30k worth of work to make it livable.  That is unless you like living in a house with decorations circa 1975.  What's crazier is these places are selling almost instantly.  We have friends whose house sold the day it was listed, they're having trouble finding a place because everything is either an overpriced dump or is selling the day it lists.

I find myself asking the same questions again.  How can people at their first job afford a $230k house?  Who's paying $5k for a 20 year old truck that will probably need another $2,500 in parts and a hundred hours of labor?  Is there really demand for this stuff?  And what is the demand that pushed starter home prices up 25% in a year?

As we discussed some of these stories my friend suggested a theory.  The demand for these items is coming from the marginal overtime dollars of middle class and lower middle class workers.  These are hourly jobs that pay $20-25/hr in wages.  Now that the economy is hitting on all cylinders a company might ask employees to pick up a few extra hours a week before they hire additional employees.  For someone making $25/hr ($1,000/wk) picking up an additional five hours of work per week is a 12% pay increase.  Where does that additional $500/mo go?  It creates demand for restaurants, for vehicles, for RV's, for vacation properties, for houses.  Some are using it to pay down debt, but when everyone is offering all the neatest toys with low monthly payments there are a lot of takers.

This isn't just seen in the hard goods realm either.  Where are the net-nets?  Where is the distressed debt?  Where is anything that isn't having the best quarter and year ever?

If you believe in efficient markets then this doesn't matter.  Because the good times are here to say, they're "right" and "perfect" after all.  I know there is a large contingent of investors who believe that we're just starting a giant bull run and this euphoria won't end.  Maybe it won't.  On the other hand trees don't grow to the sky either.

The problem is when you're in the middle of a situation it's hard to gain a large enough context to make a macro decision.  You can observe and go with your gut, but you can't really ascertain what's happening until after it's happened.  Once it's happened everyone is an expert and everyone has seen it, but in the midst no one knows what they're seeing.

I guess what I'm saying is that we're in the midst of something, it looks like a movie I've seen before, but I'm not sure.  I've had stocks run like crazy since Trump was elected and I'm starting to take money off the table as prices rise.  Unfortunately it's putting me in a spot where I'll have excess cash that needs to be put to work.  Some of it will sit on the sidelines until I find deals on land again.  But for the rest I'll have to look abroad to countries that aren't running as far and fast as the US.

When I consider everything I'm seeing it's easy to say that we must be nearing a market top.  But it was another two years from what I witnessed in 1999, 2006, and 2014 before the top finally blew off. Oddly I've been consistently two years early in noticing these trends, so maybe the bottom won't fall out until 2019?

It's been hard to find deals both in the market and out of the market.  Every official government indicator says it's clear skies and sunny ahead, and maybe it is.  But what I'm seeing on the ground has me questioning things.  Is this demand sustainable?  Can it just last forever?  How many new retail strip malls can be built?  Especially when there is vacancy in prime locations and the world is moving online?

In the end I just don't know.  What I do know is I'll continue to sell as positions become fairly valued.  There are pockets of value here and there, but one needs to dig very deep, or get involved in complex situations.  Maybe in two years I'll look back and this and think "I saw it again.." or maybe I'll be thinking "I wonder how big of a house can I buy with my Tesla gains?"

So where can you find value in a fully priced market? I talk about some screening strategies I use in my Investing System mini-course. Check it out here.

Why I don't use watch lists

I remember as a kid sitting in a chair near our kitchen with my grandfather two chairs away.  I was leafing through a toy catalog.  The catalog's pages were worn and I knew the items and their prices by heart.  Suddenly my grandfather looked at me and said "What are you doing?  Looking at all the things you can't buy but wish you could?"  I was stung by the criticism, but he was right.  I had almost no ability to purchase any of the items.  I was just envying items I couldn't have.  As I reflected on this story recently it reminded me of why I don't keep a stock watch list or research stocks that I wish I can buy someday.

This current moment is all we have.  What has already happened doesn't exist outside of our memory and what happens next isn't guaranteed and is unknown.  We need to focus on the now, because in the now we can take action.  We might regret action taken in the past, but it can't be changed.  We can imagine what action we might take in the future, but futures never work out like we imagine.

When I'm looking for an investment I survey every potential investment candidate available at the current time.  I do this because these are the opportunities that I can take action on now.  From that pool of opportunities I'll research until I find one I wish to add to my portfolio.  

It's happened that I've purchased a number of names from a given pool at once.  I've also passed on investing anything at all if the current opportunity set isn't desirable.  By regardless of the eventual action I take I'm only evaluating the current opportunity set.

This strategy differs from other investors.  Most investors keep a watch list of companies they'd like to invest in at a given price.  I know investors who spend most of their research time researching companies that they might never have the opportunity to purchase.  The idea behind this is that they put in the research hours before an opportunity occurs so when it does finally happen they can act quickly.  This is the theory at least.

Part of the reason the investing public believes that investors should endlessly research companies, even ones they will never purchase is because this is what "great investors" tell them.  In interviews professional investors who understand Marketing 101 utter things like: "we never stop researching" or "We're always hunting for new ideas."  This makes perfect sense when you look at things from their vantage point.  A professional is getting paid for results, and their clients want the assurance that their manager is always at work always ready to make money for them.

I know a number of professional investment managers, some with great records.  I don't know if they're always working, but what I do know is they're always able to meet for lunch or take a phone call, and they're never in a hurry to leave.  It's a very flexible job, and for those with talent and savvy it's possible to earn great returns with less than full time work.  Not that clients would ever know this..

There's a misnomer that hard work generates results.  Work is required, but hard work alone doesn't guarantee anything except for being tired.  The problem with this myth is that if you look at top athletes or the top of anything skilled activity the highest performers are set apart mentally, physically, or genetically.  Some endurance athletes don't generate as much lactic acid as everyone else enabling them to continue when the crowd quits.  Top musicians have an ear for songs and so on and so forth.

If someone doesn't have a musical ear no matter how much they work they will never be a world-renowned musician.  The same is true for any skill set.  Hard work can move you past the average Joe or Jane in the middle of the pack, but hard work won't land you in the top.  The top is reserved for those with an exceptional gifting from birth coupled with time, chance, and some work mixed in.

The same is true for the top investors as well.  Warren Buffett has a gifting that allows him to size up opportunity and act in ways that others can't.  No matter how many annual reports one reads, or how many Munger quotes they parrot, or how many Dempster Mills write-ups they read they'll never replicate him.  It'd be like someone thinking they can become Usain Bolt by wearing the right shoes, practicing in Jamacia and doing the famous bolt stance after each race.

Just because someone famous, or someone in the newspaper (or online) does something doesn't mean that everyone should do it.  In some cases the opposite is true.  Investment managers profiled consider their interviews to be marketing material, not instructional information anyone can use.  In fact the opposite might be true.  Some managers might purposefully leave out their secrets as to give themselves an advantage.  

How does all of this tie into investing watch lists?  I don't think investors need to be researching companies because guru investors proclaim they're constantly researching.  Most professionals are talking to clients, managing their employees, managing their back office systems, prospecting for new clients, and in their remaining time looking for new investments.

Another reason, and possibly a more pertinent reason to avoid watch lists is because the current doesn't mimic the future.  Companies and their results reflect the current and past environments, not the future environment.  This seems like common sense, and it is, but common sense isn't that common either.

Let's take the most common use of a watch list.  One researches a stock that's compounded capital at high rates for years or decades but the current price is too high.  In theory all of this research will enable the investor to act and purchase this quality company once the price is lower.  Here's the problem, no one ever knows what will cause the price to crater.  Maybe the economy hits a recession and this business that's compounded capital sits at the cross hairs of public policy as a result of the recession, will their out-performance continue in the future?  Or how about the situation where the company changes and adapts to the new economic situation, will their past results apply to the future now that they've changed?

When the economic or market situation changes such that watch list stocks are suddenly attractive it's often the case that prior research needs to be discarded.  This is because in the new environment the old research isn't applicable.

Another consideration is whether the prior researched name is still the best opportunity in a market dislocation.  Given two stocks worth a hypothetical $100 per share in a market dip is it better to buy the previously researched company at $80 or another company that isn't quite as high quality for $65?  Maybe the $15 differential in this case is easy to brush away and say "I'd pay $15 for quality and give up that return."  But what happens with the differential grows?  What if it's $80 for the quality company and $25 for a similar company with a few warts?  You'll need a lot of compounding to make up that differential.

When the market crashes dislocations happen quickly and to everyone's repeated surprise prices remain somewhat efficient.  Debt laden companies drop like rocks whereas debt free companies with earnings power don't drop as much.  These quality companies that investors have spent hundreds of hours researching don't drop enough to merit a buy.  Whereas there are companies that drop like rocks that are merely babies thrown out with the bathwater.

I always want to be evaluating the current opportunities, not ones I wish will happen.  Maybe watch lists should be renamed wish lists.  These lists are similar to the toy catalogs I'd browse as a kid.  Full of items that I wished I could purchase.  But now as an adult with the means to purchase any of those toys I don't have a desire to buy them anymore.  This is true for watch lists as well.

I talk more about my system for screening and tracking investment ideas in my Investing System course. Get it here.

Is this bank a quadruple or a zero?

In the market risk equals reward, or so they say.  High risk equals a higher reward.  In the case of Enterprise Bank (EFSG) the bank's business model is low reward high risk, but for investors who are willing to wade through the muck this could be a high risk/extremely high reward stock.

I wrote about the bank a little over two and a half years ago.  They're located near where I live, and I've started to think about them again as one of my running routes takes me near their office.  I hesitate to use the term "branch" because they don't really have a branch, just an awkward office on a weird elbow bend next to pseudo-junkyard (heavy equipment graveyard rental), and an indoor playground for kids.

The bank is a niche lender, they specialize in lending to start-up businesses and small businesses with troubled business models in distress.  I know what you're thinking, this type of niche lending doesn't seem to fit well in a regulated industry especially when the firm is highly levered.  You're right, it doesn't, and why they're a bank mystifies me.

What has always intrigued me, and why I looked at them again is their valuation.  The bank has a tangible book value per share of $17.99 and a share price of $8.  The bank trades for 44% of tangible book value.  Incidentally this is the same price to tangible book ratio they traded at in 2014 when I last took a look at them.  Two and a half years into a historic small bank bull market and this stock's price is nearly unchanged along with it's valuation.  It's in situations like this that opportunity can exist, it doesn't always exist, but there is potential.

There is a lot to dislike about this bank.  It's easy to go overboard when looking at a bank still trading with a deeply distressed valuation.  I want to do them justice, this can work out very well for investors as you'll see, but you need to accept before buying in at this valuation.  Let's start by clearing the air with everything that's terrible about the bank.

First they are a small business lender and small businesses have a higher failure rate when compared to established business lending.  But if that weren't enough Enterprise Bank seeks out distressed small businesses.  The bank describes themselves in their annual report as lending to start-ups and small businesses in distress.  For the risk they're taking they aren't making that much money.  In the most recent quarter they had a net interest margin of 5%.  That's hardly compensation for the risk, and it's even worse when you realize they're a levered institution with the majority of their funding from the FHLB and brokered CDs.

Their business model is similar to someone driving a car very fast on an icy road.  There aren't any problems as long as the car stays straight and if the drives doesn't make any sudden movements, but the smallest nudge of the wheel can end in catastrophe.  To management's credit the bank has been traveling this icy road for a while without crashing, but that doesn't mean it's safe, or a crash isn't a wheel nudge away.

If anyone is looking for a good sleep aid I'd recommend reading the first 25 pages of their 2015 annual report.  To say it's unique or unusual discounts what it really is.  In the opening letter management summarizes the company's results then launches into a dissertation as to why they disagree with their regulators regarding revenue and income recognition.

Maybe I suffer from insomnia, or I enjoy the nitty gritty detail of bank regulatory disagreements, but whatever it is I charged through.  In the eyes of a bank regulator a loan is to be classified as "non-accrual" when the loan is more than 90 days past due.  A non-accrual loan can be considered in collection when the bank expects to turn their non-accrual loan into cash within 30 days.  The essence of the bank's argument is that they have a lot of non-accrual loans that they believe are in collection even though collection can take months or years for them.  The bank believes they shouldn't have to classify these loans and that any interest received on them should be recognized as income.

The bank believes they're a special case because they deal with distressed commercial borrowers and it's hard to sell commercial real estate.  My contention is it's hard to sell commercial real estate if the price is too high, or if the real estate holds little value.  It's very easy to sell commercial real estate in areas with strong commercial growth and limited space.  Incidentally those are two overriding traits of the area the bank is located in, yet somehow they were stuck with the dud properties.

It turns out the bank wasn't lending where they're located, a prosporous neighborhood (their current location withstanding) down the street from old money estates.  They were lending in distressed neighborhoods betting on a turnaround.  To make matters worse the bank happened to lend to almost all of the borrowers said neighborhood, and in 2008 when everyone ran for the exit Enterprise was left holding the bag.

The bank has dug themselves out of the pit they found themselves in, but this story illustrates some of the issues they face when selling property.  The properties are not prime commercial real estate.

Let's get back to their income argument with the regulator.  The bank argues that it should have $1m more in income that their regulator won't let it recognize because of accounting rules.  They claim they've received $1m in cash payments on non-accrual loans that hasn't been fully recognized on the income statement.  This is partially true, but also misleading.  On their regulatory financials this $1m in cash received has been applied to the balances of the loans.  The resulting loans are de-risked on the balance sheet, but does nothing for their income statement.  On their GAAP financials the bank has pushed through some of this interest income, but it's lumpy rather than consistent as the company would like.  This money didn't just disappear, it found its way onto the financial statements, just not where management would have liked to see it appear.

I find it noteworthy that so much ink was spilled describing this issue.  I could feel management's anger over the issue as I read their annual report.  They feel this is a hidden asset that shareholders should know about.  My sense is they might feel that if this $1m in income had been reported then they wouldn't be trading at the valuation they're trading at.  I'm guessing, but I don't think that's the reason for the low valuation.

The bank is operating in a very risky segment of the market.  They have a risky business model, and it's built on hot money funding.  For all of this risk the bank isn't printing profits.  They have capped their upside, but unlimited downside.  This is why they have a low valuation.

It isn't all bad news though.  The bank weathered the financial crisis and remains well-capitalized.  They paused the hunt for new business in order to ensure Basel III compliance.  The bank will remain compliant once Basel III is implemented and they don't expect any interruptions in their business.

What's even better is the opportunity set for investors if the bank does nothing other than work down their non-accrual loans and sell off their foreclosed real estate.  The bank has $10m in non-accrual loans, and at any other bank if those loans were brought current they'd continue to accrue interest and generate income.  In a traditional setting with a 5% NIM the bank would earn $500k in additional operating income if the $10m in non-accrual loans were current.  But given Enterprises specialty with investing in distressed and liquidating opportunities we can presume that the bank intends to collect and liquidate the $10m worth of troubled assets.  They also have $4m in foreclosed property on their balance sheet.  This means there is $14m worth of assets waiting to be realized once the bank can find buyers.  Let's discount these assets by 25% and say they ultimately collect $10m.  This is an overly conservative hair-cut, the bank has never charged off loans in an amount that's anywhere near this haircut.  The $10m collected would become equity and the bank's tangible equity would increase from $15.9m to $26m, which is $29.84 per share.

To summarize the opportunity, if the bank does nothing else related to banking, but instead focuses entirely on selling down their OREO portfolio and collecting on non-accrual loans they can almost double tangible book value per share for shareholders.

Beyond this the bank has worked to improve their operations.  Their return on equity is slightly over 7%, which is average for a bank their size.  The bank's efficiency ratio is in the 80s, and management noted in their letter they are working to lower it.  If the bank were to drop five to ten points of their efficiency ratio as well as work down bad assets investors could be looking at a tangible book value per share in the low to mid $30s.  That's attractive considering shares are at $8 right now.

I really like bank investments where the investment thesis rests on the company working off bad assets compared instead of needing to improve their internal operations.  It's easier to work off assets versus changing company culture, or changing morale.  In my newsletter I wrote about Summit Financial (SMMF), a bank that was in a similar position a few years ago, since then it's up over 150% as bad assets have dropped out of view.  Enterprise Bank has a worse starting point, but the appreciation potential is higher as well.

The risk to a situation like this is making sure the bank itself will stay strong and healthy long enough to work off the bad assets.  If the economy takes a dive before they can collect on their non-accrual loans and sell foreclosed properties then the bank will be in a bad situation.  New foreclosures and bad loans could swamp the bank's capital, especially given their focus on distressed assets.  In that situation the bank would be taken over by the FDIC and assets sold, ultimately to another bank that was stronger capitalized would realize those gains.

The reason this bank is trading at such a steep discount is because the market isn't sure whether they can work off their bad assets before the next crisis hits.  If they can this stock should quadruple or quintuple, if they can't then it's a zero.  Lottery ticket?  Perhaps..

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

Disclosure: No position