Reflections from Twenty Years of Investing (2010 and Beyond)

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John Emerson
Aug 05, 2013
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“Formal education will earn you a living; self-education will earn you a fortune.” – John Patterson

The financial crisis of late 2008 and early 2009 had a profound effect on the future investing strategy which I would employ going forward. It literally changed my entire outlook on value investing; I would become a balance sheet oriented investor who held large concentrations in a limited amount of stocks.

The credit crisis had served to remind me of Buffett’s three most importance words in investing: margin of safety. It seemed that my investing success had caused me to lose sight of the potential downside in a stock purchase. That failing had caused me to temporarily underperform the market during the Great Recession. It also had injected an elevated level of risk into my investment portfolios which I was unable to tolerate. The remedy involved making fewer investments and demanding a higher margin of safety.

Instead of attempting to assess the business value of a company in calculating a margin of safety, I decided to use an approach that relied upon its balance sheet value. I surmised that an assessment of tangible assets was less subject to error and interpretation than estimating the future earning power of a business. Additionally, any business value that the company possessed would be included free of charge as long as I purchased equities at a discount to their net tangible assets.

Of course I would seek out businesses which I believed would be profitable in the future, but I committed myself to only purchasing businesses that traded at discounts to their tangible book value, at least for the most part. While this approach might occasionally result in the purchase of stagnant businesses which held limited future earning potential, I felt that it would also effectively limit the potential downside in an investment. It was at this point in my investing career that I more or less adopted the strategy of the late Walter Schloss.

Applying the Investment Strategy

As the outrageous net-net bargains began to disappear by 2010, I started searching for companies which traded at discounts to their net tangible assets. If the companies were routinely profitable, I would pay an amount that was close to the price of their tangible book value. If they were unprofitable then I would demand a price that reflected a much larger discount to the value of their tangible equity.

I wanted companies with a long history of profitability, although I did not care if their earnings were cyclically uneven or if their retained earnings had been decimated by goodwill impairment charges during the credit crisis. Since the advent of goodwill impairment testing slightly over a decade ago, the value of scanning the retained earnings to determine the long term profitability of a business had become misleading to say the least. For that matter, so had the analysis of return on equity (ROE) and return on capital (ROC) if one did not account for the non-cash impairment charges which ubiquitously sprung up on financial statements during the Great Recession.

To illustrate the confusion, suppose I owned shares in a business that recorded $500 million in profits during the last two decades prior to the credit crisis; those profits were reflected in the retained earning portion, in the equity section of the company’s balance sheet. Let’s further assume that the company had made a series of astute acquisitions over that period of time; those purchases had added $500 million in goodwill to the balance sheet of the company.

The acquisitions of the mythical company resulted in the majority of the company’s $500 million in profits; however, since these businesses carried little in the way of tangible assets, accounting rules demanded that the sum which the parent company paid over and above the value of the tangible assets of the acquisitions must be recorded on their balance sheets as goodwill.

As a result of the credit crisis, the previously profitable businesses uniformly showed earnings losses for the 2008 fiscal year; hence, all the acquired divisions failed the FASB goodwill impairment tests which were administered near the end of the year. Subsequently, the entire value of the goodwill which appeared on the long-term asset section of the company’s balance sheet was removed in adherence to FASB requirements. Additionally, the retained earnings were deducted by an identical sum to reflect the non-cash goodwill impairment charge, leaving the equity portion of the mythical business with nothing in the way of retained earnings.

Bear in mind that the previously acquired businesses had supplied the majority of the company’s $500 million in net profits prior to the Great Recession; however, with one stroke of the accounting pen, the intangible value of these excellent businesses had been entirely written off the balance sheet of the company. Shortly following the credit crisis, the aforementioned divisions would all return to profitability, but the intangible value of their assets would be permanently deleted from the company’s balance sheet.

If an investor took the balance sheet equity of the company at face value, they would be making a grievous error. The intrinsic value of the company was now materially understated as if the credit crisis had permanently impaired its future sales and profits. To quote Buffett: “Businesses logically are worth far more than net tangible assets when they can be expected to produce earnings on such assets considerably in excess of market rates of return.”

Just imagine if an investor was able to purchase shares in companies similar to the hypothetical example which possessed outstanding earnings power while selling at prices below their tangible book value. Talk about having your cake and eating it too! In 2010 that scenario still existed in a limited amount of stocks; it was merely a matter of being able to uncover them. I was able find just such a company, Stage Stores (SSI, Financial).

Stage Stores (SSI, Financial): A Discount to Book Value with Earnings Power

In the summer of 2010, I allocated approximately 13% of my investment funds into Stage Stores (SSI, Financial), a small apparel retailer which was trading at about 85 percent of its tangible book value. The company had a long history of profitability and utilized a business model which I believed would result in ongoing profits. I had uncovered the stock from a screen that identified companies with increasing cash return on invested capital (CROIC).

Stage Stores located their stores in less populated areas, thus avoiding direct competition from larger brick and mortar retailers who possessed greater financial resources. Their stores offered excellent brands of clothing and footwear; additionally, the company was in the process of expanding their make up and perfume departments. It seemed to me the demand for the aforementioned products was nearly universal. Why wouldn’t Americans from smaller communities be just as apt to purchase fashionable clothing, perfume and make up as their urban counterparts assuming they possessed the financial wherewithal to attain them? While the financial crisis may have temporarily diminished the financial means of many Americans, it had no effect on the aspirations of a teenager to purchase “stylish” clothing or the desire for women to maintain an attractive appearance.

I had long held a preference for investing in companies that catered to the smaller communities. One of my few stocks holdings that performed well throughout the financial crisis was Casey’s (CASY, Financial). The company held a virtual monopoly on the small towns to which it supplied high-quality donuts and pizza, as well as offering a modest selection of overpriced groceries, in addition to cigarettes, fountain drinks and gasoline.

Small-town businesses benefit from what Mohnish Pabrai describes as Dhandho Arbitrage. The concept decrees that the distance a person must travel to purchase a product or service has a significant effect upon its price and the profitability of the business which supplies the goods or service. In the example of Casey’s, a small-town family who needs a gallon of milk is not likely to travel an additional 20 miles to save a dollar or two. The price of the gas alone would preclude the trip from consideration. Furthermore, almost no pizza or donut business would attempt to enter a small town which Casey’s already inhabited. It simply would not make any fiscal sense to buck heads with them; the aspiring business would better served by seeking an alternative location.

The concept of Dhandho Arbitrage was delivered directly to my consciousness by a real-life application. Two of our good friends owned and operated a very successful Chinese restaurant in a small college community for a number of years. They had initially opened a similar restaurant in a much larger community; however, extensive competition had severely hindered the profitability of their restaurant. After they packed up their woks and moved to a small college town they enjoyed extraordinary success. It was not as if they suddenly learned how to prepare tasty cuisine; rather, it was the fact that inhabitants of the small community had to travel 20 to 30 miles to engage their palates in a similar delight. The combination of delectable entrées and a lack of competition allowed the business to recognize sizable profits.

I believe Stage Stores (SSI, Financial) enjoyed a sort of Dhandho Arbitrage associated with the location of their stores. Additionally, I did not believe that their previous acquisitions were total failures which did not contain an ounce of legitimate goodwill; rather I believed that the Great Recession was the true culprit in their temporary underperfomance.

In the third fiscal quarter of 2008, SSI had recorded a goodwill impairment charge of over $95 million in regard to the purchase of a large number of Peebles and B.C. Moore and Sons stores which they had acquired a few years prior. I viewed the goodwill impairment to be unjust in terms of the long-term profitability of the group of stores which they acquired. Since the entire market capitalization of SSI was only about $400 million at the time of my purchase (the tangible equity was approximately $460 million), the “unjust” goodwill impairment represented nearly 24% of the book value of the company. Therefore I believe I was purchasing shares in the company at a much deeper discount to its realistic book value than the financials of the company indicated.

My assumptions of the company turned out to be valid. In the five years following the goodwill impairment, the company recorded about $241 million in free cash flow. They subsequently paid out around $46 million in dividends, as well as retiring over 6 million shares of stock and reducing their long-term debt in excess of $34 million. While the capital allocation which the management of the company employed is subject to debate, no one could contend that the company is not worth far more than the sum of its tangible assets. In retrospect, SSI offered extreme value and a large margin of safety when it was trading at approximately 85% of its tangible assets in the summer of 2010. Hence the 13% allocation of capital which I sunk into the stock turned out to be entirely justified.

Federated National Holding Company (FNHC, Financial): A Turnaround Which Possessed a Large Margin of Safety

In the summer of 2011, I was scouring through property and casualty (P&C) insurance companies in hopes of uncovering an overlooked value opportunity. I specifically focused upon companies which were trading at substantial discounts to their tangible book value which had demonstrated a history of increasing their book value per share. I was particularly interested in uncovering P&C companies which had a long-term record of writing good business (as reflected in their historical combined ratios) but had temporarily fallen out of favor. For those of you who are interested, S&P Capital IQ provides an excellent 10-year synopsis of many meaningful insurance ratios. The service is provided free of charge through my brokerage account.

My research turned up a tiny Florida P&C insurer named 21st Century Holdings (the company has subsequently changed its name and symbol to Federated National Holding Company (FNHC, Financial). Although the miniscule insurer fit none of my preset criteria, the company intrigued me since it was trading at around 40% of its tangible book value — it would get cheaper as the summer progressed.

I started a week of extensive research on the company which included scrutinizing its latest conference calls and digging through many years of their financial filings. My fixation with the company had temporarily deprived me of sleep and one day, in the wee hours of the morning, I was struck with an epiphany. It suddenly dawned upon me that the company had rid itself of its principle underlying problems which had nearly driven it to bankruptcy, a few years following the horrific hurricane seasons of the mid-2000s.

In my assessment, the problems the company had incurred were largely a result of the actions taken by the management which were sanctioned by the board of directors. Edward Lawson had served as the company’s president and chairman of the board for many years, and he and his wife were the company’s largest shareholders. Further, it appeared to me that Lawson, the company’s former CEO, had orchestrated a business climate which exhibited total disdain for proper underwriting standards, while paying out exorbitant dividends. These dividends actually accelerated following the devastating hurricane seasons which had besieged Florida during 2004 and 2005.

Not only were Mr. Lawson and his wife collecting sizable dividend checks, they were also systematically selling out of their positions in the company. The company filed a series of shelf offerings in the mid-2000s and the Lawson’s name regularly turned up under the list of selling shareholders. Mr. Lawson was eventually terminated in mid-2008, effectively eliminating his influence over the company. However, he would continue to draw his base salary for several more years.

Poorly written business and understated reserves for losses do not appear on the income statements of P&C companies overnight; rather, they tend to show up years later as the claims are steadily paid out and the woefully inadequate reserves are exposed. Such was the case with Federated: As its losses mounted quarter after quarter, the company was forced to suspend its dividend in 2011. Not surprisingly, the market had given up on the stock and its price had descended to its lowest point ever.

As I extensively researched the company, it occurred to me that the fortunes of Federated were about to change. The company had rectified its abysmal underwriting practices and had begun to diversify the geographical footprint of its coverage areas. The company’s new-found adherence to underwriting discipline resulted in a reduction in the cost of their reinsurance premiums. Additionally, favorable legislation had been passed in Florida and the premiums that the company was able to charge were increasing dramatically. It became apparent to me that this tiny regional insurer was on the threshold of returning to profitability.

As it turned out, FNHC did return to profitability the following quarter and since the fall of 2011, it has recorded a series of seven consecutive profitable quarters, as well as restoring a shareholder dividend. Furthermore the management of the company has done an outstanding job of increasing the amount of net premiums written while observing stringent underwriting standards.

By the fall of 2011 I had committed approximately 10% of my investment funds into FNHC at an average cost of 2.64 dollars per share; the investment has resulted in nearly a four-bagger in less than two years. While the gains are impressive the most important part of the investment thesis was the margin of safety that the stock purchase offered at the time of my purchase.

The average purchase price that I paid per share represented a discount to tangible book value of approximately 62 percent. At the time of my purchases, the market price of the company reflected an assumption that FNHC held an enormous negative business value. As it turns out, that assumption was not anchored in reality. Similar to most P&C companies, FNHC invested its equity and float into holdings that primarily consisted of fixed income investments. In other words, if the tiny insurer was able to merely break even on its insurance operations, then investors were effectively buying into a bond portfolio and the other net assets of the business for 38 cents on the dollar.

To illustrate the concept, suppose that along with a partner, I own an apartment complex that is unoccupied because of its inability to meet housing codes (assume its market price is $1 million and the partnership carries a $500,000 mortgage on the property). Let’s further assume that the outstanding mortgage on the complex is collateralized by a $2 million bond portfolio which is drawing 5% a year; thus the partnership's investment income amounts to $100,000 a year.

As a result of the complex being unoccupied, the partnership is losing $200,000 a year in maintaining the apartments. After the investment income is added back, the partnership is losing $100,000 per year. Every year the apartments sit unrented, the equity in the partnership is drained by $100,000. The other partner, who is financially challenged, offers to sell me his stake in the apartment complex (which includes the bond portfolio) for a price of $500,000.

As an investor, I have two ways of perceiving the investment opportunity: 1) the $500,000 investment will cost me an additional $50,000 a year in accrual losses and lost equity, or 2) I have the opportunity to purchase half of an apartment complex and half of a bond investment fund for 40 cents on the dollar. Now let’s further assume that I am aware that the complex is just about ready to pass code and soon I will be able to rent out enough rooms to break even on the apartment. Thus instead of burning equity, I will soon be increasing my equity in the apartment and the investment fund by $100,000 a year for a cost of only half a million dollars.

The decision is a “no-brainer;” I buy out my partner and without ever showing a profit on the apartment complex, I will record a 20% annual return on the investment for “as far as the eye can see,” so long as I can keep enough rooms rented to break even operationally. Now just imagine if I can increase the rent in addition to renting out all the rooms; the return on my investment is likely to increase exponentially. Such is the potential upside of buying assets for 40 cents on the dollar.

The final edition of “Reflections from Twenty Years of Investing” will contain an epilogue and an essay on the true value of investing. This time the author promises that it will be the final article in the series.

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