I’m a concentrated investor. But I’m also a selective investor in the sense that I don’t flip the stocks I do own very fast. This means I sometimes go a long time without buying a new stock. For example, at the end of last quarter I had 42% of my portfolio in Frost (CFR, Financial), 23% of my portfolio in BWX Technologies (BWXT, Financial) and 6% of my portfolio in Natoco. I consider Frost and BWX Technologies to be good businesses that should be fairly predictable EPS growers in future years. They’re high quality companies. The kind of thing Warren Buffett (Trades, Portfolio) would be more likely to buy than Ben Graham. They’ve also both gone up a lot in price. I got my shares of Frost under $50. I got my shares of BWX under $28. Frost now trades at $91 a share. BWX now trades at $56 a share. I still like the stocks fine. But I wouldn’t be loading up buying them today. That’s because I don’t just buy stocks I like when they’re cheap – I usually try to focus my purchases on those moments when the stocks are especially mispriced.
Generally, I want Mr. Market to offer me a 35% discount to my own appraisal of a stock. And, generally, that doesn’t happen unless something has caused a stock to be temporarily hated or at least misunderstood.
A couple years ago, oil prices were down a lot. The Federal funds rate was not yet rising. Frost is a Texas bank that makes a large amount of loans to the oil industry. It is very interest rate sensitive. Frost’s loan losses are usually higher when oil prices plummet. Its net interest margin is lower when the Fed funds rate is low. So when I bought the stock there were some concerns about oil and Texas and there was not yet conviction on the part of many investors that the Fed would begin raising rates very soon. Everyone agreed it would happen.
But it wasn’t quite happening yet. That made it possible to buy Frost for about $50 a share instead of something like $90 a share today. You could call it “timing,” and I wouldn’t object to that idea. I don’t market time. And I don’t trade around a position at all. For a very liquid stock like Frost or BWX, I simply put 100% of what I want to own of a stock into that stock all in one day. Then, I never buy or sell till I’m ready to eliminate the position. This saves me from having to think about trading. It also means that if I time my purchase to be at a moment when the market perceives there to be real troubles or even knows the short-term results will be bad – I’ll do better than if I eased into the stock over time. You can see this with Frost’s historical stock chart. The stock has rarely traded anywhere near $50 a share.
I think my timing was lucky. But my interest in the stock wasn’t lucky. The timing of when I bought was luck. But the timing of when I was deep into researching the stock was intentional. I wanted to research a Texas bank that benefited from interest rate rises at the moment when Texas and oil were unpopular with investors and yet interest rate hikes hadn’t started yet. Once the trend seemed like oil prices were gradually recovering and the Fed was gradually raising rates – the future would seem more comfortable for a stock like Frost. The stock’s price would then reflect this.
There was something similar at work in BWX Technologies. I didn’t want to wait to buy that stock till after it was spun off from Babcock & Wilcox. Babcock & Wilcox combined a money-losing experimental modular nuclear reactor business with a shrinking boiler business serving coal power plants and a growing nuclear reactor business serving the U.S. Navy. What I always wanted to own was the growing nuclear reactor business serving the U.S. Navy. However, I was afraid that if I waited till after the spin-off, Babcock & Wilcox would have gained a lot of attention and now all investors who liked quality businesses would zero in on that U.S. Navy nuclear business I really wanted to own. So I bought the stock before there was time for BWX to trade on its own for a year and report clean standalone numbers. I was afraid BWX would have a much higher multiple once that happened. So I thought the time to pounce was when the situation was still a little murky looking on the surface because Babcock & Wilcox was all one company still, and some parts of it were really attractive and some parts of it were much more speculative.
Natoco is a leftover from my basket of six Japanese net-nets. Natoco is also a good example of me prospecting for an especially mispriced stock, however. On March 11, 2011, there was a tsunami and earthquake in Japan. Later, images of an ongoing nuclear disaster at the Fukushima Daiichi nuclear plant would be broadcast around the world. The tsunami can be dated to March 11, and I believe the nuclear disaster to between March 12 to March 15, 2011. I wrote a post entitled “Buy Japan.” The post is dated March 16, 2011. So I had decided to buy Japanese stocks within one week of this major disaster.
In that post, I wrote:
“…I’m going through the Tokyo Stock Exchange and finding dozens of bargains.
Examples include grocery stores, logistics companies, and gas utilities. Some of these companies – unlike the vast majority of Japanese businesses – earn unleveraged returns on invested capital equal to their counterparts in the United States and Europe. Of course, they are all irrationally underleveraged. Many Japanese companies are.
There are tons of net-nets in Japan.
Some of these companies deserve to remain net-nets forever. Such justifiably permanent net-nets are very rare in the rest of the world. In the U.S., I can name – at most – about half a dozen net-nets that are consistently profitable but have such consistently pathetic returns on capital to deserve a fate of staying a net-net forever. One American example is Duckwall-ALCO (Geoff’s note: ALCO Stores filed for bankruptcy about four years after this post was written).
...now is the time to buy Japanese stocks.
You can buy them indiscriminately if you want. I won’t. But you’ll probably hear I bought one or more Japanese stocks very soon.
You can diversify across 5 or 10 Japanese net-nets if you like.
Or you can buy an ETF. Or you can pick just one stock.
Whichever way you do it, do it soon.
If you’re an investor who spends hours and hours every week bargain hunting in the U.S. and around the world – my advice is to drop everything and focus 100% of your time on Japan’s cheapest stocks.
The truth is that fortunes – big and small – are made on only a few investment decisions. And the big opportunities come around very, very rarely.”
I want to talk about that line where I said: “my advice is to drop everything and focus 100% of your time on Japan’s cheapest stocks.”
More than once, I’ve heard myself saying a line very much like this in person to someone I’m talking stocks with. We’ll be discussing different stocks and they’ll say I like stock X and stock Y and stock Z and I’ll say “No, no. Now’s not the time to look at those. Look at stock…”
The “dot-dot-dot” right now is NAACO (NC, Financial). NAACO said it plans to spin off its Hamilton Beach brands business sometime in the third quarter. The third quarter ends in a week. I don’t know if this spin-off will happen and when. But, I do know that if you’re interested in a stock and you know it’s planning a spin-off – you should drop everything and focus on that spin-off.
As a research candidate: NAACO has similarities to BWX Technologies. The business is nowhere near as good. But, the possibility of Mr. Market misunderstanding the stock is just as high. In its present form NAACO includes two businesses – a coal company and a small appliance maker – that don’t usually appeal to the same shareholder base. It also seems to be trading at fairly normal price levels as a combined company. And then the size of the spin-off is potentially quite large relative to the size of the company. Really, this is a break-up. And investors will have to decide whether they want to dump both stocks, keep both stocks, or pick which horse to hop on. When they do this, there’s the potential that even if the combined company’s stock had been correctly valued – there will soon be a mistake made by the market in assigning how much value belongs to Hamilton Beach and how much belongs to NAACO. For an investor who only buys stocks (that is, I don’t short) this potential mistake in appraisal is exciting because you can do your homework ahead of time and have your own personal appraisal of each company as a standalone stock. Then, when the spin-off happens you can compare your appraisal value to each of the newly separated stocks. It’s possible both market values will be below your appraisal, it’s possible one will be below and one will be above, or it’s possible you’ll have nothing to do because the market either gets it right or overprices both stocks.
So, I don’t know if NAACO is necessarily a good stock. But, I know it’s a great research candidate. It’s the company to zero in on and spend 100% of your research time this week. Because compared to stocks that aren’t spinning anything off the chance of you getting an odd quote from Mr. Market are much higher with NAACO.
This brings me back to Natoco. How did I end up deciding on those 6 Japanese net-nets I bought? I went through all the stocks I could find in Japan. But, early on I realized that I was getting much better pricing on smaller and less liquid stocks. Also, stocks on the Tokyo Stock Exchange were less likely to be as high quality net-nets as stocks on other Japanese exchanges. What I wanted in a Japanese net-net was many years of profits and more cash than total liabilities I noticed the same pattern I see in the U.S., which is that bigger and more liquid stocks that become net-nets are often somewhat less attractive than small and illiquid stocks that become net-nets. I don’t mean that I can back test and see they underperformed. I mean, ahead of time, you can see bigger net-nets often look less safe. More exciting maybe. But less safe. Small net-nets are more likely to look boring but safe. So, big net-nets may work out great if business rebounds. But, big and better known stocks that become net-nets look less like something Ben Graham would buy than smaller net-nets.
So it’s a good idea to look for situations that seem dire, complicated, messy, and generally just overlooked. Smaller is better. But, some bigger stocks can be misunderstood. It’s possible to understand a business better than the other people trading it. What you want to find is some kind of misunderstanding. I felt Frost was misunderstood. It wasn’t a bad lender so those energy loans weren’t going to threaten the bank’s safety. And it was very, very interest rate sensitive. So, if you believed the Fed Funds Rate would be higher in the future than the present, you should not just be buying banks indiscriminately. You should instead focus on banks that benefit more from higher rates. Sometimes the market really does seem to misunderstand even such a crucial point as that one.
You can see this if you chart the stock price of Prosperity Bancshares (PB) against the stock price of Frost. These are both Texas banks. I like them both. But, they’re very different in terms of how their earnings will eventually respond to higher interest rates. Prosperity should be especially interest rate neutral. It shouldn’t make that much more money with high rates than low rates. Meanwhile, Frost should benefit far more from higher rates than the average U.S. bank. This has to do with the way Prosperity and Frost are funded. What do those liabilities cost? And how do they reprice with higher interest rates? That’s what determines their expenses in different interest rate environments. Frost happens to be set up in a way where it has unusually low expenses when interest rates are high. Prosperity isn’t set up that way.
So whenever the odds of the Fed raising rates higher sooner goes up – Frost stock should sprint out a little ahead of Prosperity. Over time, Prosperity’s a good bank with a great management team. So, Prosperity can be priced right by the market and still outperform Frost. But, let’s think about day-to-day changes in market expectations. If those expectations suggest higher rates sooner, then Frost should do better on that day than Prosperity. It doesn’t. Historically, if you look for days on which the two stocks react to the Fed – they move almost in perfect lockstep. Nothing in the price movement of the two stocks suggests that one benefits more from a higher Fed Funds Rate than the other.
That’s the kind of misunderstanding you are looking for. When I was buying into Frost, the market seemed to be mispricing Frost and Prosperity in the sense that it didn’t care one was more interest rate sensitive than the other. I thought they were both good stocks to buy. But, I also thought the market understood Frost worse than it understood Prosperity.
NAACO is a coal miner with a different business model than other U.S. coal miners. So, you want to study this stock ahead of the spin-off and then follow it closely to see if NAACO is priced in line with other coal miners. It shouldn’t be. Day-to-day NAACO’s share price shouldn’t rise and fall exactly in line with other coal miners. If it does, the market is probably misunderstanding the situation. It may think NAACO is just another coal miner the way the market seems to think Prosperity and Frost are both just Texas banks so there’s no need to consider which is more interest rate sensitive.
With coal miners, the market should be trying to figure out which miners are more sensitive to fluctuations in the price of coal as a commodity. NAACO is set up to be insensitive to the price of the commodity. So, for the market to price NAACO correctly – it’ll need to price it differently from other coal miners.
When you catch the slightest whiff of a possible misunderstanding like that – you need to focus 100% of your research efforts on the situation. Right now, my advice is to focus on understanding NAACO and Hamilton Beach. You may not get the price you want to buy either stock. But, you will learn about two businesses that the market has a higher chance of mispricing compared to most stocks.
Talk to Geoff about Zeroing In on Misunderstood Stocks
Disclosures: Long CFR, BWXT and Natoco
