Did I make a BLUD-dy mistake?

Immucor (BLUD), a company I thought I had a lot of things to like, just announced that it is getting bought out for a cool 30% premium.  Not bad for a ~3 month time frame.  Too bad I never purchased it.  Stocks, and women for that matter, are a lot like buses.  If you miss one, another will be along in 10 minutes.  There were a couple factors that are worth mentioning that maybe indicated this buyout would happen, although it's not something I would actively seek in an investment.  Looking at the role a CEO can play in how an investment plays out is worth digging into.

The CEO until last month was also the founder.  He took this company from nothing to a $1.2bn company.  It is hard to depart and it's hard to maybe affect the kind of change necessary when the company needs to put their shoulder to the wheel during hard times.  This is a qualitative factor I hadn't really taken into account before, which is why I tend to shy away from a company like this.  The Buffett's, Sequoia's, and Simpson's are just so much better at identifying the really good companies with a margin of safety than an amateur.

I identified BLUD as a good company, but I couldn't figure out the margin of safety.  I'm not even positive it existed.  A 30% premium is mostly a takeover premium and doesn't exactly reflect the idea that I missed some hidden value (this is just a gut feeling).  I think noting that a founder/CEO with a decent inside ownership is not always a de facto sign that they are running the company really well, something to look out for with large cap tech as well.  Obviously TPG sees room to better the operations and they aren't exactly paying a cheap price at 22x earnings.  A new CEO can be a catalyst for public shareholders, although I'm reluctant to believe it's always a positive one.

The new CEO ran a company that was acquired.  When I saw that Immucor had a new CEO, my interest was rekindled.  A new CEO can mean tons of things.  I saw that the new CEO was the former CEO of Mentor (the breast implant maker) that got acquired by JNJ a few years back.  Could I interpret this as a sign that the CEO didn't have the typical CEO ego of wanting to not be his own boss?  I could, but I don't have industry contacts or the scuttlebutt ability to figure out if that really was true.  He did stay at Mentor for 2 years as a subsidiary company.  I'm reluctant to read into this too much since it just confirms what I want to believe.  It certainly meant that some change would occur at the company, although it's difficult to say it would be an acquisition without hindsight.  Certainly the speed indicates that TPG probably was looking at the company before the CEO change, at least beyond preliminary stages.  The CEO change probably gave them the courage to step forward with a bid.  This is all back room kind of dealing though, which is not the basis of an investment process.  It looks hard to do if you aren't a professional.

I can think of one good example of looking at a CEO change as a positive catalyst, although it clearly is based on a lot of research that is scuttlebutt.  The hedge fund manager who had lunch with Warren Buffett after sending him stock research focused on a management change to make a profitable investment in Fiat (source):

"Sergio Marchionne, the new CEO, was a guy with a track record for creating value in Switzerland. He spent time in GE and made his mark at a Swiss quality control company.  He came into a company [Fiat] whose reputation was tarnished and whose brand equity had been decimated. But philosophically smart people choose smart businesses. Marchionne saw the opportunity, and we saw Marchionne.  We were likely the only investors outside Italy interested in Marchionne at the time. After some begging and pleading, he granted us a meeting.  Marchionne joined Fiat with a mandate to do whatever was necessary to fix the company. We bought some shares. He confirmed what we surmised. He had full support of the board and its new chairman. If auto was worth more dead than alive, he'd kill it.  Fiat was the biggest employer in Italy at the time. He took on the labor unions. He was fearless. He had real skin in the game and his incentives were aligned.  Marchionne saved Fiat. He got $2.25 billion to cancel a legacy agreement that Fiat could "put" itself to GM. No one thought it could happen -- there's no way this debt-laden, cash strapped Italian company will win in an international court of law. But Marchionne walked away with $2.25 billion of cash and Rick Wagoner [then CEO of GM] was fired shortly thereafter. This was half of Fiat's market cap.  We exited the position in the mid-teens and made a lot of money. It was the biggest profit generator in Brahman's history."

I can see how this process can work out well, but as you can see from the manager's explanation, it was based in part on meeting the guy.  I'm unaware how an amateur investor could access the information pipeline to figure out what exactly Marchionne did at GE and the Swiss quality control company.

I'm not a fan of the anecdotal nuggets that get released in journalistic reporting, which is the one way I think an amateur could access this kind of information.  I remember when Ken Lewis was touted as a great integrator who had a successful track record pre-CEO integrating some bank into BofA.  Profiles of CEOs tend to be fairly glowing because no CEO would grant an interview to a journalist looking to expose how poorly they do their job.

Did I miss a quick 30% gain?  Yes.  Did I make a mistake?  Maybe, but I'd lean closer to the no end of the spectrum.  The acquisition angle is speculative, although BLUD had merit as an investment.

Does anyone have any other good or bad examples of a CEO change going unnoticed but being a catalyst to the up or downside?  Ford comes to mind although there were serious survival issues when the company was trading at $2/share.

Is large cap tech really that cheap?

RIM, Google, Apple, Dell, HP, Cisco, Microsoft, Xerox etc.  The list really goes on.  The other list that goes on and on is of value investors going long these names.  I think value investors are missing greater pitfalls than they perceive with some of these companies.

This is glaringly obvious to me, but technology is a much faster changing industry with more out of left field developments than value investors are traditionally accustomed.  I don't see how people who traditionally trumpet their ignorance of these companies all of a sudden have the comprehension to make the investments in these companies.  People seem to be papering over this in order to buy what would otherwise be considered cheap stocks.

Here is where I think many are going astray:

1. Ex cash PE ratios and financial strength - Typically a big net cash position attracts investors.  It's a nice thing in a net-net stock and really any stock for that matter.  The companies are financially strong, no doubt.  The point of contention is that this strength is being applied to expanding the company in different directions (Dell, HP, Xerox, Microsoft, Google).  Even where it isn't being spent poorly, the cash is overseas.  I know what a dollar of overseas cash is worth to a US company - 65 cents.  It is more nuanced than that, but dropping the cash balance right through the valuation  doesn't reflect the underlying reality (neither does 65 cents).

2. Incentivized and intelligent managements - Maybe its heresy to say that someone with a multi billion dollar stake in a company isn't truly incentivized, but these guys aren't.  These guys are egomaniacs for the most part focused on empires.  Many of these companies have historically had such fantastic models too, that they can be run by morons.  This is less the case when a business is acquiring businesses and entering new lines.  Margins are going to be different in the future.  Why should people trust Michael Dell to do the right thing for public shareholders?  He can and is doing whatever he wants.  Whereas large inside ownership is usually a good thing in the eyes of value investors, it is dangerous in almost all of these stocks.

3.  Expanding into high margin areas - Everyone is seeking to enter high margin areas: search, services, switches, etc.  Even if you agree with the acquisitions or overall strategy, everyone is moving into the same spaces.  Not only does this drive up prices paid in the acquisitions and expansion, it drives up the level of competition in those fields.  Dell wants to be IBM.  HP wants to be Oracle, IBM, and Cisco.  Microsoft wants to be Google.  Google wants to be Facebook.  Competition is bad for investors.  It's the last thing you want.  This is the absolute worst kind since people are paying these high prices to enter competitive fields.  It is especially dangerous when these companies have seemingly unlimited resources relative to the markets they are trying to enter.

My criticisms don't all apply to all the companies that fall under the cheap large tech category, but I think investors are guilty of overlooking some of these things.  I think Tweedy Browne articulates a reasonable case for Cisco while expressing some reservation.  I'm sympathetic that Dell is being misperceived as a consumer PC manufacturer that is being beat by Apple, even though that doesn't reflect the sources of its profit.  I'm staying away though since change is more rapid than people acknowledge and their attractiveness is overstated in my opinion.

Thoughts on bank stocks

I'm beginning to get really interested in bank stocks.  I wanted to articulate what I'm thinking about when I look at bank stocks.  The quality of a bank stock is easier to quantify*, although this ease can still cause mispricings since Mr. Market's recency bias cause him to sour on a bank's prospects beyond reason.  It also helps that the pendulum of public opinion is swinging very hard to extreme dislike for all banks.  In reality, a great bank is a really great business to own at the right price.

I recently finished The Most Important Thing by Howard Marks, which easily pushed its way to top of the list of my favorite books so far this year.  One of the overarching themes is that of the cycle.  Assets tend to become out of favor in their down cycles - homebuilders, banks, oil, chemicals - as a result of the pendulum really swinging to the negative extreme.  People tend to extrapolate current events into the future, so they think that the down cycle will continue and the relevant firms will continue to do poorly.  This is what creates a buying opportunity since the revulsion usually causes a bunch of selling which only encourages more selling, etc.  I don't think banks are the buy of the century right now, but I think they are a fertile ground to look for value as they are in a down cycle with poor outlooks.  I've been kicking around some ideas over the past week or two here and here, mainly focusing on mutual thrift conversion that have happened in the past few months.

David Tepper bought bank stocks at the brink, which turned out to be a phenomenal call.  He has since sold them and moved into homebuilders, probably not multibaggers in a matter of months like the banks were in 2009, but definitely an area where people are revolted and maybe not giving the stocks their fair value.  Bruce Berkowitz loaded up on financials about this time last year, although they seem to be around the same price +/- 15% depending on the name.  His reasoning:

We bought at prices reflecting pessimism in the economy. I do not believe that we are going to lose money at the prices we paid. If the economy just sputters along, we’ll do fine. If the economy recovers, we should do reasonably well. Absent a severe double-dip recession, I don’t see how our shareholders can get hurt.

When you buy something this out of favor, even the slightest bit of not bad news can be good news.  He is also focusing on the price, not nitpicking over credit card fee legislation.  This is a sensible outlook.  At least in my head, the cyclical forces that drive the banking business are very clear since it tends to mirror the broader economic cycle of the geography it serves.  Banks possess some identifiable characteristics that make for interesting investments in their own right.

1.  Essential service - Banks provide an essential service that will be difficult to change in the grand scheme.  Any type of financing allows people to purchase goods that would otherwise require huge upfront cash payments that don't match an individuals cash flow.  This is an essential service for people looking to own homes, cars, or for businesses wanting to expand faster without dilution.  Compared to other financing vehicles, banks are the low cost providers since their cost of funding is very low.  Even with financing consisting mostly of certificates of deposit, a bank's interest payments still fall below an equivalent financing vehicle without the same funding options.  This obviously changes in a credit bubble and banks can get sloppy as the lending environment becomes more competitive.

2.  Commodity business - There is no real superiority of a 6% plain vanilla loan from Bank A versus Bank B or even a nonbank financing entity.  For an investor though, behind the loan will be a difference in cost structure (efficiency ratio, net interest margin) as well as managerial competence (loan to value, non-performing loans, capital allocation) that are for the most part easily quantifiable.  Buffett's favorite bank, Wells Fargo, combines a low cost structure with managerial competence.  Its price goes down in bad times, but the bank never loses its enduring competitive advantage or normalized profitability.  This is no different from broad investing principles, but I find it easier to quantify these characteristics in a bank.  Banks are more susceptible to the depressive episodes of Mr. Market since a bad economy depresses loan growth and causes loans to sour.  The recency bias causes Mr. Market to really extrapolate out the bad times, but a calm investor can identify the cyclicality and wait for an attractive price (Berkowitz style).

3. Compounding machines - A good bank is compounding machine.  If a bank has a low cost structure and managerial competence, an investor can earn a lot of money if they purchase at the right price.  If you buy a bank that earns a normalized 12% ROE at 80% of book value, then you can earn a 15% return. The bank can either reinvest the profits in its loan book to continue to grow profits at a 12% ROE or it can return it to shareholders via dividends and share repurchases.  This can happen year after year if the bank has the right management at the helm.  The market for banking services is so huge that opportunities for reinvestment are a lot greater than say home builders or oil companies.

I think the ability to compound is what makes banks so interesting.  Most banks can't do it and the ones that have in the past are easily identified and rewarded with high multiples most of the time.  The smaller banks though are victims of the same inefficiencies  of small cap stocks in general though, so it makes for an interesting space to look.  A small bank beyond a minimum threshold is better suited to compounding too simply due to the law of large numbers.  Geographic concentration can expose you to specific risks, but it can also allow you to apply local knowledge if you live in the area.  You can also coattail on a better local economy (Dallas vs. Detroit) so it works both ways.

*It is easy, but still requires work.  It's certainly easier than figuring out the competitive advantage of a semiconductor company.  I like that I can go on the FDIC website and pull tons of figures and metrics into excel on an annual and quarterly basis and really dig into how the business has looked over a 10 year period.  You can overlay this with economic data to get a good feel on the performance of the bank, which is a lot easier than devoting hours to understand the product cycle of PC makers or really industry specific trends.  These posts on Value Uncovered do a good job in highlighting the specific investment process here and here and are well worth the time.

A banking franchise within a franchiser

Share Plus Bancorp (SPBC) is a well-positioned bank that is trading at a large discount to tangible book value. It has tons of capital, good loan growth prospects, a manageable number of problem loans, and a strong deposit base.  It's former sponsor companies are a mix of Pepsi-related companies including YUM! Brands subsidiaries such as KFC, Taco Bell, and Pizza Hut, which has created a strong customer base.

The bank converted to a public thrift because it needed capital in late 2010. After taking its lumps in 2008-2010, the bank had a tangible common equity ratio of 7.4% pre-conversion. As a mutual thrift, it wasn’t positioned to earn back its capital cushion since mutuals are run with a focus on offering cheap banking services to its depositors. As a public company with an incentivized management team (direct ownership and options), the company is well positioned to exploit its unique customer franchise to generate profits, while the conversion has provided the bank with a strong capital cushion.

SPBC trades at 65% of TBV, while a healthy bank with a nice deposit mix should trade for at least 100% of TBV, with the additional upside of a premium to TBV in the case of a buyout. If management proves especially adept at lowering their efficiency ratio and writing conservative loans, earnings power should receive a boost that will attract a premium to TBV by the market. Even if the bank doesn’t really grow earnings from its current level, it has excess capital from the conversion that it could return $1m/year to shareholders through dividends and buybacks, a 5% yield at current prices.

The bank is going to have a depressed return on equity over the next several quarters as it just increased its capital by 50% in the conversion. In the quarters up to the conversion, the bank was earning a ROE above 5%, but it has since dropped to 3%. If the bank can revert back to earning a 5% ROE, it would represent a 7.5% return at current prices. While this is not a mouthwatering return, the price has a number of catalysts to benefit from. A dividend would draw attention. Continued growth in TBV would exert upwards pressure on the share price even if still trades at 65% of TBV. Banks are pretty much hated right now and any shift from shunned to merely tolerated would boost the psychology behind banks.  Danvers Bancorp, which converted in Jan. 2008 received a bid in January 2011 for the company, which is evidence that these conversions are watched by acquisitive banks looking for access to low cost deposits in areas with loan growth.  SPBC is positioned in a similar fashion, so there is potential for them to be acquired if they do not achieve reasonable returns.

SPBC started out in 1958 as the credit union for Frito employees. Over the years due to Frito-Lay merging then being bought out by Pepsi, who also owned YUM! Brands at one point, SPBC now has branches in the corporate offices of Frito-Lay, YUM!, Taco Bell, KFC, and Pizza Hut. On top of these 6 locations, it has 2 branches, one in the Oak Lawn neighborhood of Dallas and Plano. This footprint has lead to a good deposit mix that has franchise value. Only 38% of the bank’s funding is in CDs of FHLB advances. The rest is in sticky traditional deposits. Interestingly, the bank only owns 1 of its 8 locations, but has a leasing expense of $1.1m in 2010. The corporations that it has locations in likely view it as a benefit to offer their employees and not as a source of rental income. There are switching costs to kicking SPBC out though as all the employees would be inconvenienced with changing their bank.

The bank has been proactive in restructuring debt and so the reported NPL ratios are higher than reality. For instance, on a $200m loan book, they had restructured 3 commercial real estate loans totaling $5.1m in the most recent quarter. The loans had extended maturities and lower interest rates in exchange for the borrowers paying back 5% of the principal. In the accounting, this is considered a troubled debt restructuring. All the loans are current. This caused the reported NPL to be over 4%, which reflects poorly on the bank when subjected to a cursory look.

Another curious feature is that the bank has branches in Louisville, KY (2), Irvine, CA (1), and then 5 in the Dallas-Fort Worth metro area. Louisville and Irvine are much less attractive demographically and economically, but the bank only lends to employees of the corporations in which it has locations (Taco Bell and KFC). The area in Texas where the bulk of its lending is focused has a much healthier economy and its freestanding branches are located in affluent areas. Overlaying macroeconomic data on the Louisville or Irvine regions on the banks creditworthiness is a possible reason why the bank remains undervalued.

SPBC looks like a market neutral stock that has a basic undervaluation due to its size and the traditional technical reasons that make mutual thrift conversions cheap.  While the returns aren't thrilling, there is downside protection in the valuation as well as the pretty efficient market for acquiring banks.  The bank is not close to distressed territory to warrant the current valuation, which has catalysts to move higher in the form of the ending on restrictions on buybacks and being acquired in 1 year and 3 years respectively post conversion.

Cheap bank stock: Versailles Financial

Just note that a stock like this is illiquid and to really do your own research.  The price swings and the huge bid-ask means you have to be comfortable not being able to sell your shares whenever you want for a reasonable price.  The only way you'll ever have the confidence to do that is if you do your own research to back up the investment.  That being said, Versailles Financial, a small bank in Ohio, looks like a business that one can get comfortable holding through uncertainty.

In the back of my mind, I'm recalling a circa 2008-2009 CNBC news report on how it was such a great time to be opening up a bank.  The logic still applies.  Interest rate spreads are high.  A new bank doesn't have to work through any bad legacy assets.  Loans written today are comparatively safer than loans written in the credit bubble.  Versailles Financial in many ways possesses these characteristics, trades at a fraction of its capital, and is in the process of conservatively expanding its banking operations.  One can evaluate management's underwriting track record as well.  Their loan book held up well over the past few years with very manageable NPLs and little risk to maintaining strong capital ratios.  In many ways this is better than investing a a greenfield bank, which I don't think is possible for retail investors anyway.

Versailles Financial is a tiny savings and loan bank located in Versailles, Ohio where their high school students win state championships and score high in state testing . Despite converting in January 2010, it still trades at 57% of tangible book value and 52% of book value. It is over capitalized, earns modest profits, trades at a substantial discount to tangible book value, and has a clean loan book. Management and the board own 27% of the company in addition to 8% through an ESOP.  The stock trades very thinly, which is probably a big strike in the eyes of many investors.  Outside of management, there is only $3m worth of stock to be bought at current prices.

The share offering was done at $10/share and 427,504 shares were issued. At the current price of $13/share, the market capitalization is $5,557,552. The tangible book value is $9,602,000 ($22.46/share) and book value is $10,714,206 ($25.06/share). The stock trades at a huge discount to tangible book value despite practically no problematic loans – any bank would wish it had only 1.04% of loans past 30 days due and 0.21% considered nonperforming (Versailles current state). This is what happens when management owns 27% of a small town bank. NPLs/Loans peaked at 1.28% in 2008.  They know exactly to whom they are lending and on what collateral/cash flow. Versailles has a tangible capital ratio of 21.8%, and a tier 1 risk-weighted capital ratio of 37.1%. The strong performance of the loan book indicates that problems should be minimal, but in the case that issues arise, the bank has tons of capital.  The bank has performed extremely well throughout the current recession.

The company is earning a runrate of about $200k for 2011, which means that stock trades at a steep 28x earnings. There might be room for additional profits on the margins now that the company is public and incentivized to increase profitability. The bank's efficiency ratio (non interest expenses/revenue) is just below 60%, they are near the bottom limit of necessary expenses and will need to increase revenue to leverage their costs if profits are to expand.

Management and shareholders are aligned. The CEO made $137k and $133k in 2010 and 2009 respectively. In the conversion offering, he purchased $100k worth of stock. The chairman and several directors purchased even larger sums. The directors take home $14-16k in compensation, which pales in comparison to individual ownership stakes ranging from $192-$390k (purchased for $150-250k). The CEO has been at the bank since 1994. The board is mostly comprised of local businessmen. This is an anachronistic small town bank that is conservative and modest.

With such an owner-oriented board and management, the loan book is not likely to get out of hand. The loan book has never had any subprime loans or new fangled financing vehicles. The loan book is divided 75/20/5 in residential real estate, non-residential real estate (agriculture and business), and assorted consumer. The loan book is showing very little trouble. The bank worked its way through higher NPLs since 2008 to where the ratio of total nonperforming assets to total assets is 0.08%. On June 30 2009 and 2008 NPLs to total loans was 0.76% and 0.87% while nonperforming assets to total assets was 0.65% and 0.71%, respectively. To get down to a tangible capital ratio of 10% from loan write downs, the current level of NPLS of 0.21% would have to grow to 11.3% and write-downs would have to be drastic.

Other than expanding the loan book, the only other plan with the raised capital is to build or acquire a large home office which will allow it to offer more traditional bank products. Versailles currently doesn’t have designated parking at their bank. They don’t offer checking or money market accounts. They don’t have an ATM at their location. This might seem like peanuts, but would offer upside in the form of attracting low cost deposits. Its competition consists of 3 other banks in town: Farm Credit Services of America, US Bank, and Second National Bank (division of Park National Corporation, a roll up of local banks). The larger banks benefit from the law of large number watering down poor underwriting policies (theoretically) but Versailles has well incentivized feet on the ground to do business in Versailles, Ohio. If this costs $1.3m (cash held at the holding company level), the bank has the excess capital to devote to it.  It is a worthwhile investment as management and the board have the local connections to draw in customers. They have yet to acquire any land for a branch, so they don’t seem to eager to pay over the odds. If the $1.3m fizzles up and the bank only breaks even with the branch, there is still $20/share in TBV.

The banks funding sources might be considered the weak link in this bank. It is 55/26/19 split between CDs/savings accounts/FHLB advances. This is a relatively expensive funding source, although net interest margins were at 3.78% in the most recent quarter. The bank has room for improvement in its efficiency ratio, currently at 80%.  As the bank progresses with opening up another office, the potential to attract checking deposits or money market accounts will help diversify funding and decrease its cost. This decreased funding costs should be balanced out by an increase in the efficiency ratio.  This still does not justify trading at 57% of tangible book value.

Just theorizing, but this bank could earn a 3% ROE.  If they have a pay out ratio of 50% of earnings, that would equate a 5% dividend yield at current levels, which would drive shareholder interest.  If earnings are retained and continue to generate a 3% ROE, the return would be 10% annually assuming the bank eventually attracts the attention to be priced at 1x TBV.

To recap – extremely well capitalized bank, incentivized management, well performing loan portfolio, low price. The near term catalyst of a buyback is more likely since the 1 year statutory limit on recently public thrifts has now passed. The worst that could happen would be the bank underperforms and gets acquired when the 3 year statutory limit on a thrift conversions change of control provisions. That is about 1.5 years away as the offering occurred in January 2010. Arguably the easy money has been made since the offering with the stock going from $10 to $13, but the stock still trades at a pretty steep discount that can be reversed through buybacks, a successful new home office, a repricing of bank stocks as a whole, or a buyout by a larger bank.

Talk to Andrew about Versailles Financial

Thoughtful look at the implications of more stringent capital requirements on banks

A few days ago on Economix, I ran into some fascinating arguments about the capital requirements of banks.  This paper, which was mentioned in the post, is thought provoking because it really fleshes out the idea of banks as utilities is not only a good idea, but not a terrible thing from the perspective of bank shareholders.  I could just be putting up a straw man, but I think there is a tacit acceptance of the big bank argument that higher capital requirements are bad for shareholders/America/capitalism.  It seems to fit with the narrative du jour that Obama has no business experience and is destroying the capitalist fabric of America with his boneheaded policies.  While I doubt most people want to read a 60 page paper on the subject of capital requirements, luckily one of the authors happens to be a JPM shareholder, and wrote an open letter that provides a more cursory rundown of the paper's arguments.  It is also in reference to JPM stock, so the arguments can easily be applied to bank stocks in general.

The letter can be found here.  A brief excerpt of the letter that should whet the appetite for some grounded-in-logic argumentation:

A flaw in Mr. Dimon's argument concerns the "market-demanded return on capital" that he claims banks must earn. In a well-functioning financial market, investments in Treasury bills "demand" a lower return than investments in risky mortgages. The required return on capital depends on the risk to which it is exposed. When funding with a mix of debt and equity, the lower the leverage, the lower the riskiness of equity per dollar invested, and therefore the lower the return investors require as compensation for bearing the equity risk. ...Mr. Dimon's letter displays JPM's return on equity (ROE). ROE does not measure shareholder value because it is affected, through the market, by leverage and risk.   Reaching a target ROE can be helped by leverage and risk without benefiting shareholders. Thus, if increased capital requirements lead to lower average ROE, this need not mean lower value, because it reflects the reduced riskiness of equity.

The rub with Admati's argument might be that in order to achieve the necessary capital levels, dilution of current shareholders would have to occur.  Given time to respond to capital requirements though, banks are entirely capable of earning their way to that level in a pretty short time frame.  Especially in the current interest rate environment in the US, the mega banks are making a bunch of money preprovision pretax, so they are replenishing their capital base a reasonable clip.  If the risk premium demanded decreases in response to deleveraged balance sheets, will this prove to be a wash for share prices?

Give Andrew your opinion on capital requirement's effect on shareholders

Hilltop Holdings - holding on to a hill of cash

Gerald Ford was 38th president, but the Gerald Ford that interest me is the Gerald Ford who made a bundle in buying up busted banks.  He has been profitably investing in banks for over 30 years and has become a billionaire as a result.  He has several vehicles through which he has been investing in financial companies in the aftermath of the credit bubble.  Hilltop Holdings is one of them.  While blindly following the money is not the most prudent investment strategy, the price of Hilltop appears to offer some room for error and recent events might give some confidence that the company is profitably executing its strategy.  The company trades at 82% of book value, which is quite a discount for a $468m net cash position, a $50m loan with warrants, and a profitable insurance business compared to a $536m market cap.

Hilltop Holdings (HTH) has two buckets, the first is comprised of an insurance company that sell fire and homeowners insurance on manufactured/low value homes predominantly in Texas and a small amount around in other southern states.  The insurance division was acquired in 2007.  The second is a pile of cash.  The pile of cash was also acquired in 2007 in exchange for all the assets of the trailer parks they owned and managed  (the company refers to them as manufactured home communities, but I think this means trailer parks).  Gerald Ford became involved in 2005 and affected this change in 2007 when he became Chairman.  The stated plan for the pile of cash is to make opportunistic acquisitions, ostensibly in the insurance and banking sector based on Ford's expertise.

I'm not knowledgeable about insurance, but from the look of it, the business, called NLASCO, has been underwriting profitably with the exception of 2008 in recent years.  As a property and casualty insurer though, the business is lumpy. It was acquired for $122m in 2007.  The filings break out the operations of the insurance company as the income statement includes the additional expenses of personnel and consulting for finding uses for the companies cash.  I dont' have any strong opinions about this business.  Hilltop bought the company in 2007 and has been conservative in accounting for losses judged by retroactive adjustments (minimal) to claims and keeping its combined ratio under 100 in most years.  So far the return on the investment hasn't been impressive.  Net Income was $6.6m and $7.1m in 2009 and 2010.  Subtracting the net cash position from the market cap, the market seems to be valuing this business in the $18m range or 2-3x earnings.  There isn't much upside form this though because it is quite small relative to the overall market cap.  A repricing to 8x earnings would only mean the stock price increases 5% so while you are getting a good deal, the upside is minimal.

The second bucket is the cash/investments portfolio.  The company is loaning $50m to SWS, a full service brokerage and bank in Texas, at 8% for 5 years in exchange for warrants to purchase 8,695,652 shares at $5.75 each.  This was in response to a buyout offer the bank received for $6.25/share from Sterne Agee.  While I don't know if it applies to this specific deal, these types of deals are usually done because management doesn't want to lose their jobs so they throw shareholders under the bus.  Hilltop is on the beneficial side though because it is getting a great deal (warrants are already in the money) and getting a seat on the board so that SWS can't do to them what it is potentially doing to its current shareholders.  They stand to make some money on this and it is nice to see the cash being spent on promising deals like this.

Gerald Ford owns/controls 26.6% of Hilltop through Diamond Financial, a partnership that Ford is the sole general partner.  Diamond Financial has a consulting agreement with Hilltop where in exchange for $104,000 a month, DF provides financial and acquisition evaluation.  Gerald Ford has also installed Jeremy Ford as CEO, who is his son.  His background is at his fathers various investment vehicles and some investment banking.  Jeremy Ford's brother-in-law is the General Counsel of Hilltop as well.  Hank Greenberg used to say "All I want in life is an unfair advantage."  Nepotism is one of them.

One of the more recent public investments of the Ford clan is First Acceptance Corporation, a direct competitor of Affirmative insurance, which I've written about previously.  First Acceptance has been a real dud.  It was a cash pile several years about before it acquired FAC and has lost 80% of its value since then.  While Ford is a billionaire, that doesn't make him a legend worth investing alongside.  I don't doubt that Ford the elder with his large stake is looking over his son's shoulder, but the mixed investment record doesn't make me want to follow the Fords into Hilltop.  Ford the elder has been making some interesting private investments in distressed financial companies, so it's difficult to know where his priorities are when it comes to directing opportunities to his various entities.  If that is the case, Ford the junior is the one with more authority to invest Hilltop's cash.  He doesn't have the same record as his dad nor the same ownership stake (unless he is invested through the same vehicle of which Ford the elder is the general partner).

While the downside is pretty limited at this price, I don't see tremendous upside.  Gerald Ford is well positioned to make money buying up distressed banks.  He has already made some moves, but not to the benefit of Hilltop shareholders.  The SWS loan is a step in the right direction, but represents only 10% of the company's cash prior to the investment.  Patience and discipline are admirable, but the unexciting NLASCO acquisition, the failure of the FAC acquisition at a prior cash pile company (Liberté Investors, now FAC) and the uncertainty as to Gerald Ford's priorities means that the patience and discipline might not pay off.  There are plenty of opportunities to invest alongside investors with better track records who have strong balance sheets to take make opportunistic investments à la Berkshire, Leucadia, Brookfield Asset Management, Loews, etc.  Although the discount to book is interesting, one must also recognize a poor comparative track record and uncertain alignment of interests compared to other publicly traded investor bandwagons on to which you can jump.

Give Andrew an opposing opinion on HTH