Odds and Ends on Identifying Opportunities in Banks

I'm late to the party, but banks are beginning to look interesting - maybe because I'm just beginning to look.    Smaller banks have been smacked around for a variety of reasons.  Competition is pretty fierce.  Some have gobs of shitty loans on their balance sheets.  The market did throw the babies out with the bath water, but now some of the better regional or small saving and loan banks have been repriced to a realistic level.  I find the mutual thrift conversions to be the most interesting area because there are many still coming to market that have strong balance sheets and conservative underwriting standards.

Mutual thrift conversions are a unique transaction that Klarman and Greenblatt highlight in Margin of Safety and You Can Be A Stock Market Genius, respectively.  Basically a thrift issues shares to the market and purchasers end up owning the proceeds of the offering as well as the bank itself since nobody owned the bank prior to the offering.  It's a case of 2+2=5 since the bank doesn't have any shares outstanding, but the bank can't sell shares for nothing.

The typical example is when you can purchase the bank for 50% of tangible book value.  A bank worth $10 has a share offering for proceeds of $10.  The stock trades for $10, but it represents $10 in proceeds and $10 of bank.  What is interesting with some of the small (<$30m) offerings is that interest is so low that some offerings have been below 50% of tangible book value.  While I missed the boat on those, there are still some upcoming.  The nice thing is that even if they are up 20-30%, they still trade at a substantial discount to tangible book value despite having enviously low levels of bad loans, so they are still worth looking at.  Every thrift needs to apply to the OTS to convert.  The OTS is going to be disbanded shortly, but you can find all the application letters here so that you can follow the upcoming conversions.  All their prospectuses are available through EDGAR.  Even though the banks don't have 10 years of information filed with the SEC, they have had to report transparent financial data to the FDIC.  This allows someone to go back in time and see how their loans have performed and what kind of growth the bank has seen.

What first got me interested was this write up of a mutual thrift conversion last month.  I think the level of NPLs at that bank make it less attractive since downside is greater.  There are others that have better loan performance and are overcapitalized.  Their earnings power is low, but the asset quality is strong and are far more valuable than the current market capitalization.  An issue not specific to Wolverine is the liability side comprised of advanced from the Federal Home Loan Bank (FHLB) and deposits.  Advances from the FHLB are a high cost source of funds.  Many of the smaller thrifts have relied on time deposits to attract funds, which are considered lower quality since these tend to flow to wherever is offering the best interest rate.  There are still plenty of banks with core deposits comprised of sticky accounts like checking and savings though.  There is value in these above tangible book value because an acquirer would pay extra for the deposits it would have to pay a lot to acquire through incentives.  That's why you see the megabanks offerings cold hard cash for you to open an account with them.

I haven't really looked at the megabanks, but I have seen some prominent investors tout BofA as cheap.  Jeffrey Gundlach sounded off BofA as a proxy for an echo in the housing bust.  The video is more worthwhile than the article.  He is one articulate guy who backs his ideas up with solid facts.  He makes a very pertinent point about BofA holding tons of subprime loans that are still souring and have worse and worse recoveries.  This opens up the potential that the entire principal on the loan gets written off.  It will be interesting to follow for its broader ramifications on confidence in the rally, but will prove immaterial to the value of many of the thrift conversions since they never wrote poor quality loans.  At the same time, it may push out the timeframe for when the market reprices the banking sector.

An interesting bank stock

Wayne Savings Bancshares is plain vanilla bank with plenty of capital, a good dividend, and a strong deposit base.  Wayne operates through 11 branches in northeast Ohio.  Unlike most banks still working their way through poor loans and repairing their balance sheets, Wayne is healthy with a modest ratio of non-performing loans and strong earnings.  Wayne is well positioned to return more capital to shareholders through buybacks and dividends, and the presence of an activist investor might help unlock this catalyst. 

Wayne trades at 80% of tangible book value and 68% of book value and 11x earnings.  The main problem with valuing a bank is that the numbers are susceptible to manipulation through provisioning and allowances for losses, which fall largely to the discretion of management.  The greatest danger is waking up one day and realizing that the bank is going to take one huge hit on loans that they knew had been souring in prior reporting periods à la Citigroup.

Wayne has $13.6m in total non-performing, impaired assets, and loans past 30 days, which is a wide proxy of things that can go wrong with the balance sheet.  Against $33.7m in tangible capital, $3m in allowances and assuming 25% recoveries on all bad assets, that leaves $26.5m in tangible capital, which would still be above the regulatory definition of “well capitalized” and is marginally higher than the market capitalization.  The bank is earning about $2.8m in pretax pre provision income annualized right now.

Put into the context of the loan book, these broadly defined “bad assets” amount to 5.7% of the loan book and 3.3% of total assets, although some of them are not delinquent (yet?), being renegotiated, or are already in the process of being liquidated to cover the principal.    Non-performing loans were 1.7% as of Dec 2010, which is within reason and about average for peers. 

Funding – the importance of which 2008 really highlighted – is what makes the bank attractive as a potential takeover candidate.  It has a 50/50 split between sticky or low cost deposits with $62m in demand deposits, $101m in savings and money market deposits, and $155m in time deposits (CDs).  The chairman is in his late 70s and the CEO is 65, which makes me wonder if the bank has a greater likelihood of being sold than your average local bank in a similar position.  The presence of Joseph Stilwell, (not to be confused with Vinegar Joe Stillwell, a feisty US general who romped around the Asia-Pacific theater in WW2) an investor – oftentimes activist- who has filed a 13-D in regards to WAYN, might push this process along.  In Item 4, Stilwell lists many of his past investments in small banks.  If you read the summaries of his older investments, many of them sold themselves fairly quickly after his involvement.  In the case of WAYN, it is not his stated purpose, but it seems possible.  The filing states:

“Our purpose in acquiring shares of Common Stock of the Issuer is to profit from the appreciation in the market price of the shares of Common Stock through asserting shareholder rights.  We do not believe the value of the Issuer’s assets is adequately reflected in the current market price of the Issuer’s Common Stock.
 We hope to work with existing management and the board to maximize shareholder value.  We will encourage management and the board to pay dividends to shareholders and repurchase shares of outstanding common stock with excess capital, and will support them if they do so.  We oppose using excess capital to "bulk up" on securities or to rapidly increase the loan portfolio.  We will support only a gradual increase in the branch network.  If the Issuer pursues any action that dilutes tangible book value per share, we will aggressively seek board representation.”

One might read through the lines and think that asserting shareholder rights to have the market price reflect the value could entail an acquisition.  If that were the case, this would be a situation where you could say “heads I win, tails I don’t lose.”

The bank does seem to trade at a discount to what is likely tangible book value when the smoke disappears and it is earning strong returns to justify trading at tangible book value at the minimum.  The TBV is greater than the market price, although not by much.  The upside is only 33% if the reported tangible book value is used.  One might argue it is worth a premium to TBV since the deposits have franchise value.  The problem is that the real attractive upside would be in a buyout scenario, which is feasible considering the consolidation in the industry.  To the extent of publicly available information, such a scenario is entirely predicated on the actions of one individual not directly involved in the company.  As such I’m standing on the sidelines for this, but this its an interesting stock to follow and see how the balance sheet act in the coming quarters.


Disclosure: none

Full House Resorts Update

I’m glad I did an in depth breakdown of my FLL thesis, because there are some things I did that turned out to be grossly wrong.  Luckily, I knew in the back of my head that I wasn’t going to hit the nail on the head so I tried not to overreach on assumptions.  My numbers for the FireKeeper’s contract were way too low, but I missed the boat on the Grand Victoria acquisition almost entirely in terms of deducting the EBITDA or EBIT figures.  While I think the company is less undervalued now that there is more light on the Grand Victoria acquisition, there appears to be less downside risk. 

The bulk of the thesis was that on a sum of the parts, peer, and absolute valuation the company was undervalued.  To redo a back of the envelope SOTP calculation, Stockman’s is worth $14m (7x EBITDA), Grand Victoria is worth $43m (purchase price), and the GEM contract has a NPV of ~$40m ($10m annual payments through August 2016 with a 10% discount rate - management finally broke that out in the most recent earnings announcement) with $21.5m in net debt for a net value of $75.5m.  I think this represents the prices that would be received if the company liquidated tomorrow in an orderly fashion. 

This isn’t a huge discount to the current market price, but that partially hinges on valuing the Grand Victoria acquisition.  Full House purchased the asset for 5x EBITDA, so it would defy rational thought to expect the market to turn around and apply a 7x EBITDA multiple to it.  Recent developments indicate that Grand Victoria’s results might prove more resilient if not stronger relative to the past.  My initial take was that the GV acquisition price implied that management was pricing in a huge drop in revenue and earnings.  This turned out to be wrong.  Hyatt Gaming, part of the Pritzker business empire, has been trying to sell the property for several years not, not just in light of upcoming competition from Cincinnati.  I also totally messed up deriving the EBITDA and earnings of GV.  Grand Victoria generated about $8m in EBITDA in 2010, not $8m in net income as I assumed.  With that disclosure by management though, it also appears that the $8m EBITDA figure is going to be more attainable in the future.  The closer to the $8m figure Full House is able to achieve post 2013, the higher valuation the market will accord to the property (closer 7x+ EBITDA instead of the paid 5x).  The nice thing is that even if this doesn't happen, the price paid might end up being close to 7x normalized EBITDA.

One thing discussed on the conference call was Indiana passing legislation to reduce the required maritime crews on riverboat casinos.  Previously, despite remaining permanently moored, casino riverboats still had to meet regulations for water vessels.  The Indiana Gaming Commission has to approve the casinos actually reducing such staff.  If the staff reductions are approved, starting July 1, 2011, Grand Victoria’s costs will be reduced approximately $1m according to management.  There are tweaks management is making as well, such as converting more hotel rooms into suites.  The 2010 EBITDA of $8m compared to 2010 wins of $100m(IGC figure, doesn’t include hotel, food, or beverage revenue) implies 8% EBITDA margins, which is low.  Assuming a lower market share of 10% of wins (currently 14%) and the $181m drop in casino revenue projected to be taken from the 3 Indiana riverboat casinos from the casino in Cincinnati, the Grand Victoria would still generate $4m in EBITDA or 10.5x its purchase price. 

The downside risk from that scenario coming to fruition is not only limited by the already demonstrated opportunity to lower operating costs, but what now appears to be wrangling over the terms of the Cincinnati casino.  Currently, construction has stopped on the site as the owners and government officials argue over tax rates.  While it will likely just push out the opening date a few months, it gives management more time to maximize unnormalized earnings until either very late 2012 or early 2013.  Indiana is also going to try to keep the casino owners investing in their properties to continue to attract patrons and tax revenues as a result, as evidenced by the maritime crew changes.  This is just gravy, but it will help the business.  

This could just be narrative fluff, but I have considered an additional benefit of the Grand Victoria acquisition that is being ignored.  After talking to a young guy living within the market of the Grand Victoria who enjoys gambling, I realized that the opening of the Cincinnati casino will likely have a disproportionate effect on the revenues of the 2 larger riverboat casinos it competes with – Hollywood and Belterra.  The person I spoke to laughed when I mentioned the Grand Victoria and said that he would never go there.  He and his friends prefer the Hollywood Casino, which is far bigger and glamorous.  That demographic – the ones preferring the glitz and glamor of the casino as a nighttime/weekend outing option over a simple place nearby to gamble after work or during the day – is going to flee the casino that currently suits their taste for the even more glamorous Cincinnati casino.  I can’t quantify this and only time will tell if this translates into stronger revenue and earnings. 

Another tidbit mentioned on the conference call was the potential for additional management contracts.  The FireKeepers management contract has been producing 64% EBITDA margins, which is incredibly high.  This has attracted the attention of casino managements (including bondholders) trying to turn around their operations.  FireKeepers has given Full House a very good piece of proof to tout if approached over a management contract.  This isn’t anything to bank on, but it does present additional upside since it would require little capital and generate a lot of cash flow.  It is also worth noting that FireKeepers has experienced practically no negative effects in light of the opening of the Gun Lake Casino.

One worrisome development was the approval of a motion to increase the number of authorized shares for the company.  Full House did use a stock offering to partially finance its acquisition of Stockman’s, which didn’t result in the share price falling much.  Management stated that they have the capacity to announce another deal by the end of the year, but it wouldn’t be completed until 2012.  They provided some further light on what they would look for in an acquisition, namely a low multiple and management already in place.  While it bears consideration, this risk is mitigated by the intelligent acquisition of Stockman’s and Grand Victoria.  While acquisitive management can be worrisome, management hasn’t done anything stupid in the 5 years it has had an acquisitive stance.  On the face of it dilution would be a negative due to what I perceive as an undervalued stock, but a stock offering to finance acquiring an undervalued property would net out the effect while providing a more diversified earnings stream that would be more highly valued.  The current environment is filled with distressed or heavily indebted casino owners (Harrahs/Ceasers, whatever they call it) and tons of peers have high leverage ratios.  They also have tons of excess cash from the FireKeepers contract including debt service, so there is also the potential that cash will be a large component of future acquisition and either modest additional debt or modest share issuance will finance the remainder.  The combination of Full House's modest leverage, rock bottom interest rates, and a distressed environment increase the likelihood that any acquisition will be a net benefit.

Additionally, here is an interview with the CEO about the company from 2004.  It’s outdated, but gives some nice background on the company if you are interested. 

It might be tenuous to count the FireKeepers contract as traditional EBITDA (although all the proceeds drop through to net income) but Stockman’s and Grand Victoria are generating about $10m in EBITDA right now and FireKeepers is generating at least $10m in FCF.  The stock trades at an EV/EBITDA+FCF of less than 5x compared to the 7-8x range of its peers, many of which have higher leverage ratios.  The core thesis that the uncertainty regarding Grand Victoria is causing the market to ignore the earnings power of the business remains intact, albeit with a slightly lower upside potential.  In addition to upside from business as usual though, newer catalysts that aren’t priced in or crucial have emerged in the potential for additional management contracts or much better Grand Victoria results than expected.  

Disclosure: Long FLL

Exotic ETFs - the innovator, the imitator, the idiot

Warren Buffett has been quoted saying something along the lines of every idea goes through 3 stages; the innovator, the imitator, and the idiot.  The ETF idea went straight from innovator to idiot.  Frankly, ETFs have always been a dumb idea after they created broad based ones that followed broad indices.  The implicit benefit behind the creation of an ETF has always been low cost access to the broad return of the market.  That's simply no longer the case.  A Russell 2000 or S&P 500 tracking ETF is an investing vehicle that intuitively and empirically makes sense.  All of these alternative energy, Brazil this, China that, triple leveraged future gold or oil and all these new derivative ETFs are a fee driven perversion of a simple idea that was beneficial to markets.

This paper by the Financial Stability Board says it all in more diplomatic and eloquent tone as well as warning about all the danger that lies ahead as these products are traded in more volatile markets.  Obviously this will turn into the black swan of 2013 or whatever "oh, shucks" nonsense the media, financial industry, or politicians/"regulators" cook up.  That isn't sarcasm, that's cynicism.

The paper focuses on the increasing innovation in the industry, which I would call blatant idiocy.  The real innovation was creating the plain vanilla funds that broadened access to liquid, tax efficient ways for passive investors to achieve better returns than through handing it to mutual funds.  All the other stuff is just an excuse to take your money.  If you have the capacity to establish X industry is going to do well or is undervalued, why not take the extra step and identify the companies that will really win?  I like what some investors are doing with buying baskets of large cap tech like Microsoft, Cisco, and Dell, but a tech ETF would leave you owning plenty of unsavory names.  If you can't do that work, just stick with the broad based ETFs because you probably couldn't articulate an objective data driven thesis on the industry anyways.  I digress.  The paper is short and filled with fairly easy to digest analysis on where it can all go wrong.

On financial stability risks from exotic ETFs:

Among recent innovations, a specific trend warranting closer scrutiny is the recent acceleration in the growth of synthetic ETFs on  some European and Asian markets. In this type of ETF, the provider (typically a bank’s  asset management arm) sells ETF shares to investors in exchange for cash, which is then invested in a collateral basket, the return of which is swapped by the derivatives desk of the same bank for the return of an index.  Since the swap counterparty is typically the bank also acting as ETF provider, investors may be exposed if the bank defaults.  Therefore, problems at those banks that are most active in swap-based ETFs may constitute a powerful source of contagion and systemic risk.  

I know I said the analysis was fairly easy to digest and maybe I lied, but I promise most of the paper isn't like that.  The paper continues to note the misaligned interests of banks being in this position.  They note additional fee sources, such as securities lending that are another reason why the creators love these things.  These funds make more money on securities lending than from the management fee on the ETF itself.  The asset management arms of companies use their own parent company trading desks as counterparties for derivatives which is a complete fee-fest.  If this has ignited your interest, I recommend reading the full paper.  It's short and you will be more aware of downside that people will say nobody saw coming whenever this blows up.

There's likely a bunch of money to be made in profiting from this all blowing up.  I don't know enough about the plumbing of the financial system to figure out where it will all go sensationally wrong, but c'mon, how could this not go horribly wrong?  For now, I'm sure the "innovators" are minting money.  The only bet I would make is that in +/-2 years, there will be some Propublica on Magnetar-esque epic documentation of the ETF industry equivalent.  Maybe it will resemble more AIGFP.

Gee golly, G. Willi and my thoughts on hummus

G. Willi-Food International (WILC) is a company that is cheap by just about all metrics, easy to understand, obscure, sits on a huge net cash position, and does most of its business in a foreign country.  All of these factors combined tend to create investment opportunities.  Not here.  This optimistic scenario is incredibly deceptive and ignores a poor track record and the huge benefit from exchange rates which is not exactly sustainable.

The company has growing revenue and profits.  The company has introduced new products that will grow revenue and profits even more.  They are a kosher food distributor mainly in Israel with a minor presence in the US and Europe that they are looking to expand.  With a market cap of $101m, the company trades at 12x earnings, but has $50m in net cash, of which I'll venture $40m is excess, although that might be an understatement since a company with $100m in sales and $10m in inventory might not even need $5m in cash hanging around.  Anyways, netting out the cash leaves the company trading at 7.5x earnings(6.25x if you net out all the cash), which is very low for a company that is growing and earns an 18% ROE adjusted for excess cash.    Additionally, since it is 53% own by insiders, there is likely not enough liquidity to attract any large investors.

The dangle is the purported growth opportunities the company has, and the top line growth has certainly been strong over the years.  Operating profit has been a lot more volatile though due to currency fluctuations since most of the products they distribute have to be imported, and Israel has had some wild currency fluctuations in the past 5 years.  Net income and the cash balance have also received a huge boost from the strength of the New Israeli Shekel (NIS) as well.  Bottom line growth from 2005-2010 has been helped by a 25-30% increase in the value of the shekel.  While Allied Healthcare's growth was being masked by a weak GBP to the USD, G Willi's growth is partially being driven by currency fluctuations. Some might claim they like that exposure to foreign currency and diversification from the USD, but the benefit here is overstating some of the growth, which is a factor that should take precedence over currency diversification.

The cash/securities balance has definitely been helped by the exchange rate of the USD:NIS, but something else has helped the company grow its cash balance to 50% of the market cap.  The ever pernicious practice of pointless share issuance.  While one can quibble over the issuance of JNJ shares for Synthes or Kraft for Cadbury, there is an easy to understand explanation for it even if you disagree with the economics.  In 2010, G. Willi issued 3.3m shares, increasing the share count by 32%.  At $6/share, despite the stock previously trading for ~$7 prior to the announcement, it was done at a pretty steep discount to an already undervalued stock.  The stated purpose was to fund working capital and general corporate expenses, but the company had no debt and $30m in cash and securities.  Their reason doesn't hold up water when you compare the $30m in cash to $6m in net receivables (accounts receivable minus accounts payable) and $12m in inventory.  They could have already doubled the amount of capital tied up in the business and had tons of cash left over.  They didn't need an extra $19m (proceeds from 2010 issuance).  They also issued shares in the 2 years from 2005-2007, raising share count from 8.6m to 10.2m through a private placement and warrants involved with that placement.  Again, they had tons of excess liquidity then as well.  These historical actions speak poorly of management and inspire no confidence.  Additionally, WILC shares a bullish analyst research report on its website.  It's by the people who underwrote the 2010 share offering and who also underwrote offerings for Universal Travel Group  and China Agritech among many other dubious Chinese companies.  Fool me once, shame on you.  Fool me twice, shame on me.

One of the other reasons I've seen brought up for the share issuance was to acquire a US based distributor to leverage their hummus/Mediterranean food expertise.  This is bunk.  I'm a huge hummus fan.  It's a pain in the ass to prepare on your own (you have to boil chickpeas for a while and don't even get me started on cleaning up the food processor afterwards), but tastes great with pita or crackers.  I'm also a fan of using red pepper or onions, both of which have exceptional naturally occurring scoopable functionality and provide a nice flavor to contrast the hummus.  I'm not sure G Willi's desire to expand into this area, my enjoyment of hummus, and the potential growth in this area can be reconciled as a reason to purchase the stock.  And I think due to currency fluctuations and the fact that the company didn't earn its cash pile, one can't justify this as a "call option" for free with the stock.

Kraft owns the Athenos brand and Pepsi has a JV for its Sabra brand.  They've put a lot of marketing muscle behind it.  Athenos has arguably not done a good job flexing that muscle.  This is more anecdotal, but Sabra has been giving out free samples + coupons at Penn Station in NYC, and doing similar promotional activity around the country.  This will make the overall market bigger, but that doesn't mean WILC is going to capture any of it.  I get Abraham's hummus, which doesn't have preservatives and cheaper than Sabra's ($3.99 vs. $4.49 if I recall correctly.  I do know that I first tried it because it was cheaper).  It's also markedly better.  Hummus tastes best when it is fresh, so anything with preservatives, which I usually have nothing against, tends to be less tasty.  I think that Abraham's is fairly local contributes.  I wonder where WILC would fit in.

My point though is that there is plenty of competition (that link just names a few) out there in the hummus field already.  Certainly WILC could get involved, but this isn't anything novel or exciting.  That they would have to acquire a distributor in the US to do so already puts them at a disadvantage since I would say the field is already crowded.  I'd also question the volume that could be achieved with generic brand hummus that WILC would supposedly supply.  Additionally, a recent article in the WSJ will tangentially give you some additional flavor on the kosher food industry.  The marketing appeal of kosher food is not something only WILC is aware of and will attempt to exploit.  I'm unconvinced that kosher food is an investment angle to play, or that WILC would be a vehicle through which to do it.  It's not such a tiny niche that food distributors in the US wouldn't waste their time on it.  There are plenty of major brands that only produce kosher versions such as Coke.  Even ignoring the fishy share issuance, I find the US/European growth potential unconvincing, although they have and will find growth from introducing new products in Israel.

When dealing with stocks that appear so dramatically and obviously undervalued, it becomes even more important to look for a reason why.  I will admit that I was pretty convinced upon reading several bullish articles on the stock, but I took a moment to closely examine the stock and look at more than just the financials from the past 12 months.  The share offering is doubly suspect due to the parties involved.

Previously it was my hope that by not enabling comments I would spur more substantive discussion via email with readers.  It has been mildly successful, but I would prefer to engage in more dialogue with peers.  As such, I've enabled comments.  Keep it classy, and don't worry about offending me if you disagree.  I would much prefer you disagree with me and will forgive ad hominem attacks since this is the internet after all (hopefully none of my articles have driven anyone to feel the need to attack me though).

How to Sell a Stock and Other Food for Thought from Tweedy, Browne

While the question of when to sell a stock is not something I’m particularly knowledgeable enough to answer, I’ve been doing some reading lately and discovered some thoughtful ideas about how to sell.  Tweedy Browne writes a lot of academic/empirical investing research that is very applicable and easy to understand.  Their paper What Has Worked In Investing is a classic in my opinion for corralling a collection of empiricism to the value investing process that is otherwise just intuitive and logical.  I recently read Investing For Higher After Tax Returns (h/t Whopper Investments) and while the main thrust is equally thought provoking and worthwhile, one of the corollaries struck me as having broader implications and as a worth while topic of further discussion.  While the paper focuses on the implication of investing for after-tax returns, one of the underlying themes is that how you sell a stock can have a large effect on your after tax returns and warrants serious consideration.

One reason cited by professional portfolio managers for selling is finding even more undervalued stocks.  An example would be having stocks A and B, which you think are both worth $10 and are for the purposes of this exercise identical businesses (margins, sales, ROE, etc).  You bought stock A for $6 and now it is trading for $8.  You don’t own stock B, but it is trading for $7.  Theoretically you should sell stock A and buy stock B as your potential return is 43% instead of 25%. 

The Tweedy paper would offer conditions to this, and I would agree.  Say stock A and B both earn $1/share and will grow 10% a year in perpetuity.  At their respective prices of $8 and $7 and a common value of $10 might be reason to sell.  If you sell stock A for $8, you receive $6.80 in after tax returns at the long term capital gains rate.  So you are selling a stock for proceeds that are 6.8x earnings, to buy a stock at 7x earnings.  This should remind you of Warren Buffett's criticism of the frozen pizza business sale by Kraft (Geoff's entire article is a great real world example of exactly what Tweedy is empirically pointing out)

You could truthfully say you bought stock A at $6/share and sold it for a $2 gain at $8/share and theoretically buy stock B at $7/share and sell it for a $3 gain if it goes to $10/share.  You could truthfully say you made $5 in gains.  Or could you?  Within the limits of this scenario, with the after tax proceeds you could not have even bought one share of stock B, since you only had $6.80 per in proceeds from stock A.  Clearly the closeness in valuation of stock A and B are a cause for pause and reflection.  In real life, no situation is guaranteed to be remotely close to this simplistic.  It might help to go to page 37-38 of the paper since the numbers are laid out in greater detail if you don’t find the above clear. 

While none of this will tell you exactly how to go about deciding when to sell, Tweedy (probably not me) does provide a cogent explanation that can at least serve as a starting point.  Depending on how you learn and think, their presentation through the use of a numbers in an example might help. 

I find that investors/bloggers/journalists that say one should sell a stock when it reaches one’s target price are not really telling you or I anything that is all that applicable.  Material events can happen that change the value of the stock for better or worse before your target price is ever reached.  What if you reassess the value and its higher, but at the current price you aren’t going to add more.  Blindly selling at an arbitrary price is not very scientific or thoughtful.  Selling when it reaches a price target oversimplifies something a lot more complex.  While Tweedy doesn’t exactly answer the question (they didn’t set out to and their paper is more about finding stocks that you won't be selling any time soon), they do provide a useful starting point to develop an understandable framework for how to sell your stocks, assuming you are going to buy another in its place.  


Some other interesting nuggets in the paper:
- A defense on their diversification, which I find compelling starting on page 43
- Checklist on earnings outlook in Appendix C starting on page 63
- Checklist on assessing growth prospect, competitive position, and economics of a business starting on page 65

Supertex, an interesting semiconductor company

I’ve been lukewarm to the possibility of investing in broadly defined technology companies.  Semiconductors fall into that category.  That doesn’t stop me from finding some interesting names.  The industry is volatile, subject to obsolescence, and competitive.  With those risks, the short term perspective of the market can be to your advantage.  Supertex is a cash rich company with a history of profitability that popped up on the 52 week low list.  There’s a lot to like about this company, but I’m not sure those factors can make up for not fully understanding the business.

Supertex was founded in 1976 by the Pao family, who still play a role in the firm.  Supertex makes chips for medical, imaging, LED, industrial, and telecom equipment.  For example, they have focused on niche markets such as medical ultrasound imaging and backlighting for LCD displays.  The company has been profitable for the past 10 years, although sales have range bound for the same period.   Supertex has continually invested in R&D, spending 10-23% of their revenue annually over the past 10 years and has come out with ~20 new products annually in the past few years.

The stock popped up on the 52 week low list earlier this week and when I took a brief look at the financials, I noticed it had a huge cash/investment pile of just under $170m and no debt compared to a market capitalization of $270m.  While further digging and the nature of the business reveal that it wouldn’t be prudent to just net out the cash balance, cash has just been building up on the balance sheet for the past 10 years.  The company announced a $60m buyback, which seems to be the proper use of cash as the stock price is languishing.  The most recent 10-Q reveals that they already $2 million worth of shares in the short time between the filing and the announcement, so it looks likely that it isn’t empty rhetoric.

The company has earned $12m in the past 12 months, so it trades for about 23x net income, which is not cheap.  They’ve been able to pay for R&D out of revenue, so most of the cash is not very crucial to the running of the business.  Additionally, capital expenditures are minimal with about $30m over the past 10 years.  The cash/investment balance deserves a close look though because $32m is in frozen auction rate securities (ARS), the result of yield chasing on their cash balance.  At least it wasn’t squandered on a ridiculous acquisition.  That figure was closer to $60m until this year, although the balance of ARS could remain stuck for years.  Luckily they don’t need the liquidity.  The $138m balance of cash/investments is in cash or municipal bonds.  

While one could still entertain the notion of valuing the company by netting out cash, the real problem with doing so is that earnings are not recurring in nature and are based on the success of future products.  Management has expressed optimism in their most recent products, which focus on the LED and ultrasound market.  The sales of LED chips have been growing 100% YoY, albeit from a small base.  The company believes that as its ultrasound chips get designed into equipment, sales will surge.  The company would probably not notice if $100m of that disappeared, so the market is valuing the business at $170m or 14x earnings.  While the company trades at 9x earnings when you net out all of the cash, those earnings are of a more dubious quality than Full House Resorts or Artio Global.  This might represent a good deal if you are comfortable with the future growth prospects.

The company allegedly serves niche markets, so one might conclude that the markets can be profitable due to a lack of competition.  I only say "allegedly" because I don't know enough about the industry to judge the competition.  Intel or Texas Instruments has no interest in a $20m chip market because it wouldn’t move the needle.  Their gross margins and net profit margins are in the 37-60% and 4-22% range over the past 10 years, respectively.  Clearly there is a cyclical component, but one might conclude that this means they’ve never been in hypercompetitive markets.  They also have a portfolio of patents which provide some protection.  The company has been in operation since 1976 as well, so the long record of earnings is comforting, although it is not a long record of consistently strong earnings. 

The problem with this competitive position and strong past earnings is that the market itself is ever changing. Even though the company spends a lot of money on R&D, it is to replace products that are constantly becoming obsolete.  Samsung, GE, and Motorola represent 40% of sales.  This can be sticky if Supertex’s chips get designed into their products, but those 3 consistently release new products.  This dynamic of constantly innovating and updating products could likely be sustained by the company due to its sustained profitability and large cash position, but the need to do so makes the business less attractive as an investment.  The company writes off a few millions worth of inventory each year due to obsolescence, further supporting the case that the business is rapidly changing, although it doesn't restrict profitability too much.  They do possess patents on many of their products though, so it may help ensure that the new products they do design are the only ones incorporating their technology and reducing competition.  

Management and the board are respectful of shareholders, which is a pleasant change from the norm.  The CEO and SVP are the remaining founders still involved at the company.  Pao, is part of the founding Pao family.  The father was the initial CEO, and his estate still holds several million shares.  There was also another relative who used to own a portion of the company that has since moved on.  Henry Pao, the current CEO, owns $20m worth of shares and the SVP owns $4m worth.  The entire management team is very fairly compensated.  Every few years they are granted options, which ups their pay a lot ($800k-900k), but most years pay is in the $300-400k range.  In my unscientific casual observations, that’s rare for most $270m companies or companies that make ~$10m a year.   Board compensation is also fair.

I do think that the combination of a long history of operations, strong cash position, supposed leading position in niche market, aligned management, and recent buyback all bode well for the stock and business.  Try reading this though and tell me you aren’t left completely confused as to what their products do.  It's not like an internal combustion engine, which involves some science/technology but I understand.  I’m comfortable not understanding the science behind semiconductors or drugs or geological formations, but I couldn’t even tell you what these semiconductors do.  Taken from a snapshot perspective of the financial statements, I understand well enough what is going on, but from the perspective of the business as a dynamic entity I am stumped.  As the company is not exactly distressed, an investment in Supertex is contingent on future results which are much more likely to stray from past results due to the nature of the business and semiconductors falling out of my circle of competence.