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Analyzing OFS Capital Corporation: The Hard Way And The Easy Way

July 26, 2014 | About:

I expend a great deal of time and effort analyzing stocks in my search for clues that will aid me in identifying overlooked and undervalued businesses that are poised to produce exceptional returns and produce them sooner rather than later. The “why” of this passion eludes most of my friends; they don’t associate the personality they know with the analysis of stocks, which they believe to be tedious and mundane. I find it exhilarating. It is one of the most entertaining and satisfying pursuits to which I allocate my time. It allows me to compete and measure my results against true professionals in the field and apply my skills and knowledge in an aspect of life that has real importance for both myself and my family. Why would anyone not approach such an endeavor with great passion and effort?

My Competition Can Be My Employee As Well

I tend not to spend a great deal of time thinking about financial professionals, simply because I manage my own investment portfolio. I can measure my performance against the industry professionals the same way they measure their own, against the major indexes. Two years ago, I started a project to prove to a relative that an individual could manage a portfolio that would beat the market averages. What I did not promise was that I would not take advantage of professionals in achieving that objective. Allow me to explain.

There are certain publicly traded companies that are almost like hedge funds without the excessive charges. They invest in privately held or very small public companies through financing activities or even equity investments. Some of these only come into public view when you read about a company having executed a “fully bought private placement”. This sort of deal often includes warrants for additional shares in the future at the option of the buyer. They are deals that are not typically available to the average investor and are reserved for what are know as “accredited investors”. Generally speaking, accredited investors are those with either incomes that are comfortably in the six-figure range or liquid net worth over $1,000,000 (excluding their primary residence).

Occasionally, a business like this shows up on one of my stock screeners and I give it a quick pass not expecting it to produce any real prospects for investment but, since I enjoy what I do, I always look. Today, OFS Capital Corporation (OFS) made the effort to look worthwhile.

The Valuation Is Very Attractive On The Surface

After earning $3.26 million in 2009, OFS went on to increase that figure to $7.68 million in 2013; an annualized earnings growth rate of 23.9%. Based on the current projected earnings for 2014 of $1.03/share by the 5 analysts covering the stock, it is currently trading at only 12.4 times this year’s earnings; about half the growth rate of the past 4 years.

But, stock valuations are not about past results, they are about future expectations. Once again, OFS does not look cheap; it looks ridiculously cheap. The same group of analysts covering the stock are projecting annual earnings growth of 22.9% over the next five years as well. This is just beginning to sound too good to be true. And, it is about to sound a whole lot better.

Upon further investigation, I found that the price to cash flow valuation of the business is an obscenely low 3.12 and a price to book of only 0.88. Since book value is generally considered to represent the liquidation value of a business the stock would have to rise about 14% from the current price just to be liquidated at a breakeven price.

During my career, I have been fortunate enough to have had some exposure to this type of business and learned that the potential returns can be enormous when it comes to asset based lending to businesses that need help with cash flow. I have also had the opportunity to experience firsthand the vast potential in private equity placements and leveraged buyouts. Because of that, while seeing a dividend payout of $1.36/share (10.68% yield) in excess of the projected earnings of $1.03/share for this year caught my eye, it did not cause me to run away in fear. I learned long ago that cash flow is much more important than reported earnings. The 3.12 price to cash flow multiple had already apprised me of the fact that the business is a river of cash compared to the market value and reported earnings.

But, If It Sounds Too Good To Be True…

If you were thinking that before you reached this point in the article, I compliment your skepticism. All of my warning bells were ringing loudly. And then, I thought I found out why! Ah-ha! On July 8th of this year, both the CEO and CFO, Glenn Pittson and Robert Palmer, resigned. Surely, I had uncovered the reason for what appeared to be such a stupid-cheap stock price. Despite the lack of any real explanation in the announcement, I assumed there had to be fire behind this smoke.

Well, it turns out that Mr. Pittson will continue being involved with the company as a sitting member of the Board of Directors. That does not sound like someone who was forced out. It sounds like a successful CEO who just wants to slow down a bit. I can certainly relate to that feeling as I have experienced it and acted upon it myself in the past. Maybe this time, I have found one of those cases that falls into the range of those businesses that fall outside the range of “probably” in that favored old adage. If the actions of three key insiders at OFS are any indication, it certainly does.

Between December of 2013 and June 4th of this year, three insiders, including Mr. Pittson, have purchased 68,566 shares of OFS stock in the open market at an average price/share of $12.60. This means that these insiders purchased 0.71% of the the total outstanding shares of the company in just six months, using their own personal funds! The stock is only 1.2% higher than that price now. I do not believe that these insiders invested $863,938.56 of their own money for a 1.2% capital gain and a 10.68% dividend and you should not believe it either. I have to believe these gentlemen see the same ridiculous undervaluation that I do and have positioned themselves to profit from it.

Final Thoughts And Actionable Conclusions

The hard way to analyze a stock is to go through all the effort to evaluate the business based upon the financial metrics, industry in which it operates and past performance coupled with future prospects. The easy way is to follow the actions of key insiders using their own money. OFS delivers an amazingly clear conclusion in both of these evaluations.

I do not remember every finding a stock that was paying a 10% dividend, had heavy and recent insider purchases in the open market at just about the current share price AND appeared to have a 100% upside potential just to reach my estimate of fair value. It is rare to find an opportunity that absolutely screams at us to buy. I suggest we all listen to the scream and not let this opportunity pass us by.

About the author:

Ken McGaha
Ken McGaha has been managing his own investment portfolios for over 20 years. On July 20, 2012 he launched the Self-Made Millionaire Tracking Portfolio with a portion of his capital as an aid to teach younger members of his extended family how he built his own investment portfolios and maintains them today.

Ken's Self-Made Millionaire website now has subscribers in at least 13 countries and the Self-Made Millionaire Tracking Portfolio has delivered a 28.36% annualized rate of return on capital between July 20, 2012 and June 21, 2014.

In late December of 2013, Ken added the Maggie's Money Mountain Tracking Portfolio to his website to show young investors with limited capital how he would invest and trade an account with $4,500 in order to grow it at a compounded rate of 12% annually. From December 30, 2013 through June 21, 2014, this account has produced an actual return of 26.05%.

Visit Ken McGaha's Website


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