Let’s start with a stock I bought quickly. I tend to buy micro caps quickly. They tend to be easier to analyze. They are often balance sheet bargains. That was the case with George Risk (RSKIA).
The first time I heard about George Risk was over at The Rational Walk. There were two posts on the company. One was in January 2010. The other was in July 2010. I don’t remember reading the first post when it was published. So I probably only learned about the company in July.
It took me a couple months to buy all the shares of George Risk I wanted. It’s an illiquid stock. I was bidding for it – at some price – all the time. But there were many days my order wasn’t being filled. This is typical for micro caps.
And I had all the shares I wanted by the end of October. That means I started buying shares soon after reading the post at The Rational Walk. Probably within one month of reading the article. That’s fast. I can’t think of other times I started buying a stock within 30 days of first hearing about it.
So let’s use George Risk as an example of the shortest research I’ve ever done. What does a stock have to look like for me to buy it so fast?
If you have time – you should read both articles at The Rational Walk. I did. And that’s all I knew about the stock at first. Only what was in those articles.
Let’s look at the July article first – since I think that’s the first one I read. The July article compared George Risk to Warren Buffett’s Dempster Mill:
We first profiled George Risk Industries in early January and noted that the company was massively overcapitalized and represented a potential bargain for investors.
That’s a good start. I like “massively overcapitalized.” You don’t hear that a lot. So those words got my attention. Also, the author of the post – this was at The Rational Walk – is not usually someone who is overly optimistic about stocks. He doesn’t overhype things. So it meant more hearing him say these things. It would’ve meant less from some other blogger. So the message matters. And what you know about the messenger colors the message.
The next sentence that caught my eye was:
Net-net current assets (current assets minus all liabilities) was $5.22 per share compared to a recent market price of $4.50.
So the stock is a net-net. Also, he mentioned investment losses. So we knew the company had an investment portfolio. That backed up his idea of it being “massively overcapitalized”.
The article goes on to say that the company’s cash per share is higher than its stock price. And it has no debt. He goes on to value the operating business. But he was only using last year’s numbers – so I scratched that out of my mind. I don’t like to be biased by one year numbers. I go deep into the past when I study a business. And I always use at least 3-year averages – never one year earnings numbers.
Next, the article says the CEO owns 58% of the company. For many investors, this is a negative. For me, it’s a huge plus. A cash rich company with a majority owner CEO is the kind of thing I like to see.
There’s a section of the article called “But George Risk Isn’t Exactly Like Dempster Mills”. In theory, this is a series of anti-George Risk arguments. They don’t do anything with the cash. They keep too much in uninsured bank deposits. They keep saying they’ll consider an acquisition – but never do anything. And so on.
This is the section that leapt out at me. I loved it. This was the section that sold me on the stock. George Risk became my top research priority after I read that section.
Why? Because I got a feel for management. At least I thought I did. I started to see the situation.
Here’s what it looked like to me. They were 87% in basically one product line. It was a family owned company. When cash piled up – they had $3 million in a local bank – it just piled up. Why? Because they weren’t capital allocators. This wasn’t a professional management team. They weren’t calling in consultants.
I figured they knew how to run the business. And they didn’t know much else. But they knew what they didn’t know. And they weren’t trying to find the optimal capital structure. They were just trying not to do dumb stuff. I guessed they didn’t want to do a dumb acquisition. And they hadn’t found a smart one.
It seemed like a simple stock. One I could understand. And it seemed like a simple story.
I try hard to find out two things when I study a stock. One, what will customer behavior be? Two, what will management behavior be? Those are the big questions for me. I spend most of my time on those.
The balance sheet is critical. But you can’t spend more than a few minutes with it. I look at the past financials. For George Risk, I went back 17 years. It doesn’t take long to do that. Maybe an hour tops. Probably less.
After reading The Rational Walk articles, I went to EDGAR. I printed out the latest 10-K and 10-Q for George Risk. It is a controlled company – so it doesn’t need to file the same proxy statement many public companies do. Also, it’s a small company – so it sometimes used a variant on the 10-K. And it sometimes filed slow. The CEO’s daughter is the CFO. So I expected that would happen.
What does all that mean? One, it means there is the opportunity for fraud. If we look at fraud as: “means, motive, and opportunity” – the opportunity is very high at George Risk. There is no motive. In fact, for purely selfish reasons – the Risk family would be better off if the stock traded cheaply year after year. Then they could pay a high premium to take it private. And still get a bargain.
I’m not saying they would do this. Just like I’m not saying you’d kill your spouse for life insurance. I’m just saying you wouldn’t kill your spouse for life insurance if there was no policy. In this case, there was no policy. A higher stock price does nothing for the majority owner of an illiquid micro cap. A lower stock price gives you the option of buying out the minority shareholders.
Control owners can make money in different ways than passive owners. If I buy shares of George Risk, I will tend to think about the stock price rising in the market. This is a bit of a mistake.
The reality is that someone owns 58% of the company. Someone who can either sell his 58% or buy the other 42%. Don’t ignore that. You can get paid other ways. You don’t have to sell your shares in the open market. You can just hold them and see what happens.
I’ve tended to make a lot of money in buyouts. Looking back, I can see that my portfolio has turned over about 20% a year on corporate events. If I never sold a share of stock in the open market – I’d still need to replenish my portfolio about once every 5 years.
I mention this because it drives how you study a stock. When I look at a stock like this – I look at management. I look at how cash might get used. And how the company might get sold. Or how the family might buy out the minority shareholders.
Why would they do that? Because being public is a hassle. And it gets them nothing. It actually gets them less than nothing. Day after day they see the company they own trade for less than it is worth. They get an insulting quote. At times, Mr. Market was offering less than cash for this consistently profitable company.
So I checked the history of share buybacks. And they were there. The company bought back a little stock every year. Not much. It was an illiquid stock. They mentioned in the 10-K that they had found shareholders who had become inactive – they may have even forgot they owned the stock – when dividends were paid on the shares. And some of those shareholders sold to the company.
That was interesting. I also looked at information about how much the CEO and CFO – the family members – were paid. And related party transactions. And things like that. I felt they were paying themselves a lot less than they could be. And the CEO’s pay was tiny compared to his stock position.
That doesn’t mean your interests are aligned with the CEO’s. It just means the CEO thinks more like an owner than a manager. But he’s a control owner. And you’re not. He can wait. Because he can – once he decides to cash out – greatly increase the chance of getting a higher than market price within a couple years. You can’t. It takes time for price to adjust. Especially when there is no catalyst in sight. The CEO can make a catalyst. You can’t.
That’s the kind of stock I like to buy. It’s worth more than it sells for – but nobody knows how or when the market price will meet the intrinsic value. Basically, the sellers are paying you to wait.
I liked what I saw in the SEC reports. So I went and found an interview the CEO did. The interview was from a few years back. I think it was 2007. He said some interesting things about the company. He made it clear he thought the stock price was too low. That the company wasn’t get credit for both the cash and the operating business. But that acquisition prices – this was in the bubble years – were too high.
He also said some stuff about the business. He said they weren’t price competitive. But they did ship the product on time.
There were a couple sentences in there that got me interested in the business as a business – not as a cash pile. So I started looking into the business without thinking about the balance sheet. Just looking at it in terms of whether or not it was a high quality business.
I decided it was. And I decided that was my margin of safety. I started bidding for the stock right after that. I wasn’t too particular on price. I just wanted to keep my average cost right around the amount of cash per share. And that’s what I did.
It took me a couple months to get all the shares I wanted. I got most of my shares in a couple large trades. And I’ve held the stock ever since. It’s been a little over two years now.
So that’s George Risk. That’s an example of a quick gestation period. I basically just stole the idea from The Rational Walk and ran with it. Not much original thought on my part.
Let’s look at the other extreme. Let’s talk DreamWorks (DWA). DreamWorks is a stock I’ve studied for hundreds of hours – and haven’t bought. I’ve been looking at this stock very seriously for at least 18 months.
I went to see Kung Fu Panda 2 in theaters. That was purely because of my interest in this stock. I don’t have kids. And so I never see animated movies in theaters.
Like I said, I need to study customer behavior at any stock I buy. And this was an area I was really lacking in when it came to DreamWorks. So I had to go to theaters and watch the kids and their parents and everyone else there. I’ve done that for a couple DreamWorks movies now.
So, as part of the research for DreamWorks I obviously watched all of the movies they’ve put out. Actually, I watched every one at least twice. Once without the commentary. And once with the commentary.
I had to check out the TV series – Penguins of Madagascar, Kung Fu Panda: Legends of Awesomeness, etc.
There were also two books published about DreamWorks and Katzenberg. So I read those. And I read a couple books on Pixar. And a couple on Disney. I also read a couple books on the economics of the movie business – but honestly I’d already read the best media business books before getting interested in DWA.
DreamWorks is a very public company. It’s the opposite of George Risk. They do conference calls every quarter. And Katzenberg is on them. So I got every transcript out there. And I read them and took notes and all that.
I should mention here that I always go as far back in time as possible. And I always read the material from oldest to newest. This is important advice. Most people focus too much on the recent stuff. And they read the newest stuff first.
Don’t do that. It’s a bad bias. The future looks uncertain because it is the future. The past looks like a natural progression because it’s the past. Every age is a modern age to the people who live it. When you read old transcripts, old newspaper articles, etc. you learn this lesson. When you read history books – you don’t. Always get your hands on contemporary sources. Not just retrospectives.
You might wonder how useful all that reading is. After all, I didn’t buy the stock. At least not yet. And what did I really learn?
Some things are obvious. Very few things. But they can be useful things. Big things. Quan and I talked about the stock last year and he asked what’s my biggest question about DreamWorks? What would I ask Katzenberg if I could?
And I said: “That’s easy. Are you starting a cable channel?”. I was more worried about the idea of a cable channel than who their new distributor would be. And that’s natural from all the reading I’d been doing, and all the old content I’d been watching.
This brings us to the difference between what matters to an analyst and what matters to an investor. The question of who distributes DreamWorks’s movies (it was Paramount – it will be Fox) is something analysts care about. It hardly matters to an investor. Someone will distribute the movies. There are only a handful of choices. And there aren’t a lot of different rates they can charge. It’s an oligopoly. How much they want the movies and how much they don’t want one of the other guys to have the movies sets those rates.
But a cable channel is different. It’s very speculative. Especially with the changes in online video consumption we’ve seen. But, obviously, there could be a DreamWorks channel one day. And it could be worth as much as DreamWorks’s current market cap.
See how different studying a company like DreamWorks is from studying a company like George Risk. The value is a lot less obvious. And it’s more speculative. It depends more on what management does. And less on the balance sheet.
So it took a very long time to study. I went through everything I could find at Box Office Mojo and The Numbers and all that. I made little Excel Workbooks. I broke down the typical DreamWorks movie. I estimated Paramount’s return on capital as their distributor. Things like that.
I learned a lot. But I didn’t buy the stock. Why not?
It just never got cheap enough. I was very interested around $17 a share. It never went much below that.
In an earlier article, I talked about 3 boxes I needed a stock to check before I could buy it. One, it had to be a stock I felt comfortable owning. Two, it had to promise 10% annual returns. And three, it had to be selling for less than it was worth. In fact, I said I needed “clear and convincing” evidence that the stock was selling for less than its “conservatively calculated” intrinsic value.
I don’t think DreamWorks meets that test. It meets a pure preponderance of the evidence test. But that’s not the test. The test is a real margin of safety measure. There has to be evidence. It has to be clear. And it has to mean that the stock is selling for less than the conservatively calculated intrinsic value of the business.
And DreamWorks doesn’t meet that test at $19 a share. It was worth studying. But it never became worth buying. Because the stock price never got low enough.
But prices fluctuate. Stock prices really do bounce around more than you’d expect. Microsoft (MSFT) is a value stock now. Zynga (ZNGA) isn’t far from being a net-net. And railroads have price-to-book ratios Ben Graham would never imagine.
DreamWorks may get cheaper at some point. And I may buy it.
That happens a lot. I talked about a company – since taken private – called Bancinsurance. I studied the company right after it had a scandal. I didn’t buy it till a couple years later when the SEC investigation was dropped.
It’s normal to study a company deeply for a couple months or a couple years. Then forget about it for 3 years or 5 years. Then end up buying it when it hits some one time snag.
Warren Buffett was reading IBM annual reports for 50 years before he bought the stock. You should end up studying a stock for months and then dropping the idea. That’s normal. It means you have standards. It means you’re willing to wait for the right business at the right price.
Talk to Geoff about How Much Time He Spends Researching a Stock
Read Geoff’s Other Articles