Sometimes stocks don’t move much.
I own a stock called George Risk Industries (RSKIA, Financial). I’ve owned it for – I think – a little over six years now. It’s done fine. It was more expensive at one point than it is now. But there has never been a catalyst with this stock. It has earned about what I expected it to earn each year. It’s paid a good dividend yield of 4% or 5% a year. And any earnings beyond that have just piled up in cash.
At the time I bought the stock, I think it was trading around $4.50 a share and had about $4.50 a share in cash and investments. Money in mutual funds. That sort of thing. So, you were getting the business for free. And it was a profitable business. It earned – or would earn, in normal times (not 2010) – maybe 40 cents a share.
Well, over the last six years, the stock has paid dividends. And the yield on the stock has been higher than the yield on a government bond would be. It has piled up maybe a little more cash. We are talking maybe $5 to $6 a share in cash and investments now. But that is largely the result of things like mutual funds going up in value.
So you’ve gotten your dividend. And the cash box part of the business – again, it’s not really cash (it’s investments) – has grown a bit along with the market. But you are still talking about a stock where the operating business is not selling for much of anything above the value of what the company has on its balance sheet. So, say the stock goes for $7.25 a share. Say the company has $5.50 to $6 a share in net cash and investments. Then the value the market puts on the business – which might be earning 40 cents pre-tax – is somewhere between $1.25 and $1.75. Less than 5 times pre-tax profits. I am using round figures. The stock is illiquid. It often moves in increments as big as 25 cents whenever there’s a trade. And then the fair market value of the investments obviously moves constantly. So the numbers are a little different with every 10-Q.
But, you see the situation. It hasn’t outperformed the S&P 500 over the six years I’ve owned it. Now, personally, I’m okay with that. The S&P 500 was cheap to fairly valued from 2010 through about 2012. The last three years it’s been expensive. A lot more expensive than George Risk. So, I’ve never been tempted to sell the stock unless I found something better to buy. And I’ve yet to find something better to buy. And so I’ve held on. But, nothing much has happened with the stock for about six years.
So, are we talking about a value trap?
In this case, perhaps not. And that is because the stock is profitable. It is safe and it is profitable both. The operating business has always turned a profit. And the company has always had a ton of net cash and investments. Liabilities are close to nil. There’s no debt. So, it’s safe and profitable. Those are not the traits of a true value trap. The stock isn’t a melting ice cube. But, it can be dead money. How long is too long to wait for a position to work out?
This isn’t an issue you only have to worry about with illiquid stocks. I own a very liquid stock – Frost (CFR, Financial) – that has something of the same issue. I was talking to someone who owns a lot of Frost shares in his portfolio (bought because I talked to him about that stock a year back) and he went on and on about how the stock had been doing the last couple months or so – where it was finally moving. So, I had to tell him: “That doesn’t mean anything. Ignore it. It’s just because of the Fed.” The stock moves a lot on short-term expectations of when exactly the Fed will raise rates.
Now, Frost is a very, very interest rate-sensitive bank. The two most interest rate-sensitive banks I know of are probably Frost and Bank of Hawaii (BOH, Financial). They both are funded almost entirely by customer deposits. And they both pay very little interest on those deposits. Most importantly, they both have huge amounts of deposits per branch. So their operating expense (non-interest expense) as a percent of deposits is very low.
In a high interest rate environment, these banks would have much higher returns on equity than the average bank. In a near-zero environment, a lot of banks will all earn about a 10% ROE regardless of how valuable their deposit base is.
So buying Bank of Hawaii and Frost – and I do suggest you buy both if you don’t own them already – is a speculation on interest rates. But it’s not much of a speculation on when the Fed raises rates. What I mean by this is easier to explain if you think about the George Risk example. I bought George Risk in 2010 and still own the stock in 2016. Now, imagine I buy Frost stock this year and hold it as long as I’ve held George Risk. I’d still own the stock in 2022. So my speculation is on where the Fed Funds Rate will be in six years rather than six months. That’s my bet. But the stock doesn’t move based on the bet. Day to day, week to week, and month to month – Frost shares are reacting to where investors think the Fed will have rates in May of 2016, not November of 2022. They are thinking six months ahead, not six years ahead.
In this kind of situation, what should you do? Imagine you bought Frost a year or two ago. Unemployment was already quite low. You might have expected the Fed Funds Rate to be higher by now than it is. So you’ve been sitting there in disappointment – just waiting without a catalyst – for a year or two now. It can feel like the Fed will never raise rates.
I remember facing the same situation with oil prices. A few years back, I was talking to the co-writer of a newsletter I did about researching cruise line stocks. I wanted to research Carnival (CCL, Financial) and Royal Caribbean (RCL, Financial) as possible stock picks. The reason for doing this was simple. Carnival and Royal Caribbean weren’t earning much. Their ROE was poor. But they were paying a lot for fuel. And when you looked at their results before fuel expenses – they hadn’t diminished the way their overall financial results appeared to. In other words, something the companies couldn’t control – oil prices – was causing their EPS to look worse now than it had in the past.
The next question was whether oil prices were “normal.” At this time, Brent was over $100 a barrel. That obviously wasn’t normal. It might be reasonable to do an analysis of a cruise line with $70 Brent as your assumed cost input. And it might be reasonable to do an analysis of a cruise line with $30 Brent as your assumed cost input. More than $100 a barrel made no sense. You could develop new sources of oil – people were in Texas and elsewhere in the U.S. – for much less than $100 a barrel. This was not difficult to see.
But there was a problem. Oil was – at that moment – priced above $100 a barrel. There was nothing in my investment case for Carnival and Royal Caribbean that would start benefitting shareholders till oil prices dropped. So, it was a speculation on oil prices. I had no problem with saying that $70 oil was reasonable and $100 oil was unreasonable. That was a speculation I was comfortable making. So, I suggested we do a report ignoring the fact that oil was $100 and using $70 as our cost input in the analysis. This is the Ben Graham approach. True earnings normalization. It made sense to me. But, my co-writer was reluctant. And I think subscribers would have been very, very reluctant to embrace the idea. Why? Because oil wasn’t $70 a barrel. It was more than $100 a barrel. How could you ignore that reality? How could you just fast forward to a future that is – as any future must be – speculative?
I think we can only invest for normal times. You may want to short Chipotle because you think same store sales will continue to decline. Another investor may want to buy Chipotle (CMG, Financial) because he believes same-store sales will recover. The one thing that makes no sense is to take today’s sales and use today’s operating margin as normal. Either sales will decline, and the operating margin will get much, much worse. Or sales will improve, and the operating margin will recover to the kind of levels that were normal in the past. I have no opinion on Chipotle. Except I do have the opinion that looking at the stock’s 2016 sales and earnings makes no sense. Those figures are irrelevant. This isn’t a normal year for Chipotle.
When oil is $100 a barrel, I think you can say it is not a normal year for airlines, or cruise lines, or oil companies. And you can safely disregard the current year’s EPS. It doesn’t matter. The same is true for Frost and Bank of Hawaii. It doesn’t matter what they report in EPS for 2016. The Fed Funds Rate is much lower now than it will be in a normal year. So, we don’t need to pay attention to their earnings.
This approach might make sense to you. I hope it does. Because it’s the only approach that makes sense to me. Investing on the assumption that $100 oil or 0% interest rates or anything as abnormal as all that will last sounds odder to me than investing in a company that has never turned a profit. We – as value investors – don’t do that. But even we know that a growing company that has never turned a profit will – if its gross profit margin is sufficiently high – eventually generate profits at some future size. It is a theoretically sustainable trajectory. Oil at $100 a barrel or interest rates at 0% are not sustainable. But, we don’t know when these “bubbles” will burst – do we?
So, it is easy to think this way in the finding and buying stage. It is easy to believe in Frost before you buy Frost. It becomes harder if say you expect the Fed will raise rates in December and then they don’t. That would be a surprise, wouldn’t it? And it might cause some short-term problems for the stock. You’re a value investor – not a value trader. So, short-term problems aren’t a problem for you. But, what if the Fed doesn’t raise rates through all of 2017? How would you feel then? Would it feel like a short-term problem? Or would it feel like you had invested in a dead money stock?
There is nothing wrong with a dead money stock. There is something wrong with a melting ice cube. I have owned both. And there’s a big difference between say George Risk and Barnes & Noble (BKS, Financial). Barnes & Noble was always going to have a declining business. I bought into it on the assumption that the free cash flow its stores were producing could be used to pay dividends, buy back stock or acquire an unrelated, non-print book business. It was also possible that Ron Burkle would win his proxy fight with Len Riggio. Burkle lost. And I sold the stock soon after that proxy vote. Why? Because Barnes & Noble was doubling down on Nook. Unlike the retail stores, Nook wasn’t a shrinking business – it was a money-losing business. It burned cash. And so, the safety of my investment was at risk. This wasn’t a dead money investment. It was a melting ice cube. It was a value trap.
The right time to sell a melting ice cube is as soon as possible. The right time to sell a dead money stock is only when you find something better. A dead money stock is still cheap.
In the newsletter I used to write, we picked a stock called Breeze-Eastern (BZC, Financial). It was a small business. Three investment funds owned most of the company. Their positions were illiquid. They couldn’t easily sell out to the public. So, not surprisingly in hindsight, they sold out to a 100% control buyer. But, until that moment, Breeze-Eastern seemed to have no catalyst. When the deal was announced, it was no longer dead money. A few months earlier, the biggest question people asked us about Breeze-Eastern was, “What if nothing ever happens with the stock?” Then it turns out like George Risk.
Obviously, it is better to find a Breeze-Eastern than a George Risk. But it’s not always easy to know the difference between a Breeze-Eastern and a George Risk. It’s easy to know the difference between a George Risk and a Frost and a Barnes & Noble. The risks are different. The risk of losing money should always be a top concern. The risk of having to wait six years and still not have much to show for your investment – that’s a risk value investors can afford to take.
Talk to Geoff about What to Do When Your Stock Doesn’t Move.
(Disclosure: Long CFR, RSKIA)
