Corporate Governance: Do Microcap Stocks Do Wrong by Shareholders? – Small vs. Young

Sivaram – of Can Turtles Fly? – asked a great question about my post on microcap stocks:

How about poor corporate governance? Based on your experience, would you say it’s hard to price the risk of poor corporate governance?

Yes.

It’s very hard to price the risk of poor corporate governance. But in my experience: people generalize way too much about big caps having good corporate governance and microcaps having bad corporate governance. Big caps get more attention from outsiders. But big caps can still have bad corporate governance. The issue is that fewer people are paying attention and looking out for you in microcaps. You aren’t going to have analysts, reporters, fund managers, and activists – until things get real ugly – looking out for you and saying bad things about management in microcaps. You will have that in big caps that do wrong by investors.

One huge warning: There are microcap frauds.

I would say – and this is just my own experience talking – microcap frauds tend to be in more speculative and young companies rather than purely small companies. A lot of small companies are also young so people get the two confused. Old microcaps are often like old big caps and young microcaps are often like young big caps.

Another thing to look for in terms of fraud is a company that wants to stay public regardless of the business it’s in. Some microcaps will change their business completely more than once without ever going private. Does that worry me? Sure. There may be exceptions. But if a company wants to stay public more than it wants to stay in the same line of business that’s a huge warning sign that something is very wrong with management.

At the other extreme: a microcap that is an old, family controlled company with tons of retained earnings in some mundane business is often just that. If it’s hoarding cash, it’s usually doing it for the same reasons a big cap company hoards cash. Management has few options in the existing business and doesn’t know much about putting money to work elsewhere. They aren’t doing right by shareholders. Paying the cash out would be better. But they probably aren’t criminals either. They’re probably just humans running a no-growth business that throws off more cash than they can use.

I would read the SEC reports carefully. Some people come to different conclusions. So for me all the George Risk (RSKIA) related party transactions – and there are a ton of them – aren’t nefarious, because if you look at the actual dollar amounts they aren’t generous. The family doesn’t pay themselves as much as it could get away with, it doesn’t pay the board at all, and the other transactions aren’t egregious.

Then look at a bigger stock I’m in: Barnes & Noble (BKS). The Riggio related party transactions are egregious. Len’s brother, Stephen, stayed on as Vice Chairman after they got a new CEO to replace …

Infrastructure Spending: High Speed Rail, High Speed Internet – And Paul Krugman

Case Study: Geoff’s Investment in Bancinsurance – Both His Letters to the Board of Directors

In an earlier post about Bancinsurance (BCIS), I answered a reader’s email that asked:

I came across your Barnes and Noble write up on GuruFocus. I noticed in the comments section you mentioned two letters you sent to the board of directors of an insurance company you owned. Would I be able to get those off of you? 

I only included my first letter to the board in that post. This post – at the bottom – includes both my letters to the board of directors.

I’m not showing you these letters because they influenced the board. They didn’t. The CEO first offered $6 a share. The board finally agreed to $8.50. I had nothing to do with that.

I’m showing you these letters, because readers ask about my own investments. What kind of stocks do I pick? And how do I value them? These 2 letters give you an idea.

Obviously: they were written for a specific audience.

So – yes – I went out of my way to use conservative estimates of Bancinsurance’s value in these letters. I asked the board to reject any offer less than book value. Does that mean I thought Bancinsurance was worth book value?

Hell no.

I thought Bancinsurance was worth more than book value. Still do. And – in private – I would’ve told you that. I talked about book value in the letters, because I was asking for something. I wasn’t being rational. I was being reasonable.

I only owned 0.5% of Bancinsurance. As I said in an earlier post: I would’ve liked to own a lot more. I didn’t have the time and volume I needed to get the shares I wanted. That’s life.

I wasn’t a big shareholder. The board didn’t care what I wrote.

They eventually settled on an arbitrary number: $8.50. Book value had risen to $9.50. There’s no logical reason for the $8.50 a share number. They outline reasons in the going private transaction report. None of them are logical.

If you want to learn about the $8.50 a share Bancinsurance deal and how it values the company, read my 2 letters to the board, Raymond James’s presentation, and the going private report to the SEC.

Here are my letters to the Bancinsurance board of directors. The first letter was sent in April and argues against the CEO’s original $6 a share offer. The second letter was sent in July and argues against the CEO’s raised $7.25 a share offer. The board later agreed to the CEO’s re-raised $8.50 offer.

Geoff Gannon’s 1st Letter to Bancinsurance’s Board of DirectorsGeoffs 2nd Letter to Bancinsurance’s Board of Directors

Talk to Geoff about Bancinsurance (BCIS)…

Small Stocks: Should Value Investors Only Buy Microcap Stocks? – 4 Stocks People Ignore

Greg Speicher has posted twice now on a great discussion over at the Corner of Berkshire and Fairfax message board.

Question: Should value investors stick to small cap stocks when investing their own money?

My Answer: Every value investor should try small cap stocks. Most don’t.

I get a lot of emails saying something like this:

I’m getting out of college this year and I just recently got interested in value investing by reading Warren Buffett and Benjamin Graham – what should I do?

I give a lot of responses like this:

You should focus on the smallest stocks out there. Nobody else is. You’ll have to do real work every day. You’ll only be able to work with primary sources: the 10-Ks and 10-Qs. You’ll learn more working with small cap stocks. And you’ll have to decide for yourself. Benjamin Graham’s Mr. Market metaphor is obvious in tiny stocks. In big stocks: even value investors get lazy and listen to the market instead of taking advantage of it.

Microcaps are the best place to learn investing. But are they the only place to make money?

No.

You can make money buying stocks people hate or you can make money buying stocks people ignore.

Here are 4 microcap stocks people ignore – and the reason why:

1. Bancinsurance (BCIS): Unusual Combined Ratio
2. Solitron Devices (SODI): Past Bankruptcy; Can’t Pay Dividend
3. Birner Dental (BDMS): Cash Earnings Not Reported as Income
4. George Risk (RSKIA): Combines Investments With a Business

Here’s where I agree with some folks who say microcap investing is harder today than it was when Buffett started. It is harder. There are mechanical screens. Most of the good bargains you find depend on something you can’t screen for.

A microcap bargain is often the result of an accounting quirk or a one of a kind business.

If Bancinsurance had a combined ratio of 100, it might’ve been worth 2/3 of book value. Lots of insurers write at a combined ratio of 100. And lots of insurers trade below book. But Bancinsurance had a very long history – 29 years – of writing at very low combined ratios. If Bancinsurance was a big cap stock, everyone would know that. Nobody thinks Progressive (PGR) is worth book value. Everybody knows a dollar of Torchmark (TMK) book value is worth at least as much as a dollar of MetLife (MET) book value, because everybody knows MetLife – blimps and all – can’t write at a lower combined ratio than Torchmark.

Since Bancinsurance was a microcap – delisted in fact – it’s incredible underwriting history was ignored. Even after the CEO offered $6 a share, I could get some shares at $6 and under. Try doing that in Torchmark or Progressive. In years that don’t end in ’29 and ’08 – it just doesn’t happen.

Let’s look at the 4 examples of microcap bargains I threw out off the top of my head. There’s a madness to the market’s method in each case. Basically: …

Investing Ideas: 26 Things Geoff Looks for in a Stock

A reader sent me this email:

Hey Geoff

Just curious, where do you get your investing ideas?

Blogs are the best source. Screens are good too. Certain things catch my eye.

Here’s what I look for in a stock:

1. Market capitalization under $100 million
2. Low float
3. Foreign – especially from a small country
4. Not listed in home country
5. Controlling shareholder (maybe owns 30% – 70%) runs company
6. Long history of free cash flow
7. Share buybacks that reduce the share count – especially if done every year
8. A Dutch auction to buy back a lot of stock at once
9. Delisted
10. Just spun-off
11. Huge, one-time problem (think American Express Salad Oil scandal)
12. Bankruptcy in past caused by legal trouble
13. Hostile takeover attempt by someone who owns good chunk of company’s shares
14. Mismatch between reported earnings and free cash flow – FCF is much higher
15. Accounting quirk – amortization, carrying at cost, owns part of another public company
16. Selling for less than cash and investments
17. Selling for less than net current asset value
18. No analyst coverage
19. Niche business
20. Lack of price competition – or the price leader
21. One of a kind business
22. Wrong time in cycle to buy this kind of stock: advertising, credit, homes, autos
23. Goodwill write-downs and restructurings cause reported losses when making money
24. “Too much uncertainty”
25. Nowhere near a 52-week high
26. Stock once traded at several times today’s price

Talk to Geoff about Where He Gets His Investing Ideas…

Rome: Civil Wars, Plague, Economics – And Paul Krugman

Paul Krugman blogs about the fall of Rome and Adrian Goldsworthy’s book. Goldsworthy is a great military historian (for proof, read his dissertation turned book: The Roman Army at War 100 BC – AD 200). But he’s not an economist. Krugman is. Yet Krugman doesn’t look at Rome’s economy.

Krugman – following Goldsworthy – confuses a symptom for the disease. He says Rome was brought down by civil war. It was. But Rome fought civil wars before.

Rome built its Mediterranean empire from the destruction of Carthage and Corinth (146 B.C.) to Antony’s defeat at Actium (31 B.C.). During that time: the Gracchus brothers were assassinated, there was a full scale Italian civil war (the Social War), Marius ignored the constitution, Sulla marched on Rome (twice), there was a purge of Roman politicians, Caesar marched on Rome, Caesar was assassinated, and Antony and Octavius fought a civil war.

I’m leaving stuff out.

My point: 100 years of bloody Roman politics breaking out into civil war didn’t stop Rome from rising in the world. Nor did the American Civil War stop us.  And Rome’s civil wars were nothing compared to Europe’s civil wars (Napoleonic, World War 1, and World War 2).

The Roman economy made it through 100 years of pre-Augustan blood politics. The American economy made it through our own civil war. And the European economy made it through Napoleon, Hitler, and the war to end all wars sandwiched in between.

So why did Rome fall?

Krugman says it was partly because childless emperors picked competent heirs. That streak ended with Marcus Aurelius. The timing makes that sound plausible. But Krugman leaves out something kind of important. Marcus Aurelius – along with millions of other Romans – died in a plague.

Any model of a plague like that has to tell you that capital, labor, money, banking, and government will be the wrong size in the wrong places for the economy that comes out the other side.

Rome was hit by a population shock that no society economists seriously study ever faced.

Remember: when we talk about inflation in the modern world, there is more than one currency to reference. When we talk about Japan’s demographics, there is more than one country to sell to. What money but Roman money could the Romans think in terms of? What customers but Roman customers could they sell to?

We overestimate our own intelligence and underestimate theirs, when we don’t take Roman economic problems seriously. The Romans faced a nasty economic puzzle. And they faced it alone. Without our knowledge of economics? Yes. But more importantly: without another example to guide them. There was no G8 or G20. There was a G1.

Rome’s economic problems were damn near unique. But because historians study Rome and economists study the modern world, we act like economics didn’t apply to Rome.

It did. The civil wars were symptoms. The disease was economic.

Does that mean America is like Rome?

No.

It means …

Investment Returns: Home Runs and Strike Outs – What Kind of Hitter is Geoff?

A reader sent me this email:

I’d assume you must either hit home runs or strike out, what’s your long term ROI?

–   Fred

Going back 10 years: my compound annual growth rate is about 15%. That’s misleading. I was down 38% in 2008, up 41% in 2009, and up 39% this year.

I don’t just hit home runs and strike out. I could say why in words, but you’d have to trust my interpretation of what a “home run” and a “single” is.

Instead: I went back and took the non-annualized returns on positions I closed in 2009 and 2010. Here’s the breakdown:

Minimum: 7.57%

Maximum: 61.10%

Median: 22.61%

Arithmetic Mean: 27.45%

Geometric Mean: 22.82%

Harmonic Mean: 18.72%

Standard Deviation: 16.31%

Coefficient of Variation: 0.59

I haven’t closed a “strike out” position in two years unless you count +7.57% as a strike out. Considering how far the market’s bounced from early 2009, maybe we should count 7.57% as a strike out. I don’t see any home runs either. I mean up 61.10% is nice, but individual stocks have moved way more than that since 2009.

I didn’t count open positions. But it wouldn’t change things much. None of my open positions have unrealized losses. Some are close. For example: Barnes & Noble (BKS) is at $16. My cost is $15.36.

I get a lot of doubles and walks. I’m not a home run hitter. 100% returns in a single stock are rare for me. I sell too soon.

Talk to Geoff about Investing Home Runs and Strike Outs…

Investing 101 Toolbox: 12 Books, 3 Lectures, 4 Blogs, and 5 Interviews for Investors

A reader sent me this email:

I saw…that you are more or less self-taught. Do you have any other sources for information you could recommend for me?

– Brian

I’m going to interpret this email as if Brian asked: “How would you teach Investing 101?”. I don’t believe in formulas and definitions. I believe in examples and patterns. I believe you teach Buffett, Greenblatt, Fisher, Graham, Lynch, Pabrai, Burry, etc. You don’t say who is right and who is wrong. You teach the toolbox.

I don’t like everything in the box. Frankly: I’m not a Pabrai fan. Seems like a decent guy. But we don’t invest the same way. I’m still obligated to learn Pabrai’s model and be able to teach it the same way someone who writes about the U.S. Constitution needs to know Calhoun’s model.

Here’s my Investing 101 Toolbox:

Books

1. You Can Be a Stock Market Genius: Uncover the Secret Hiding Places of Stock Market Profits
2. The Little Book That Still Beats the Market
3. Common Stocks and Uncommon Profits and Other Writings
4. The Intelligent Investor: A Book of Practical Counsel 
5. One Up On Wall Street : How To Use What You Already Know To Make Money In The Market
6. Beating the Street
7. Contrarian Investment Strategies – The Next Generation
8. John Neff on Investing
9. Money Masters of Our Time
10. Investing the Templeton Way
11. Benjamin Graham on Investing: Enduring Lessons from the Father of Value Investing
12. The Dhandho Investor: The Low – Risk Value Method to High Returns

Lectures

1. Thomas Russo
2. Li Lu
3. Mohnish Pabrai

Blogs

1. Cheap Stocks
2. SINLetter
3. Greenbackd
4. The Interactive Investor Blog

Interviews

1. Tariq Ali of Street Capitalist
2. George of Fat Pitch Financials
3. Toby Carlisle of Greenbackd
4. Asif Suria of SINLetter
5. Jon Heller of Cheap Stocks

Other

Warren Buffett’s Partnership Letters

Michael Burry’s Message Board Posts

Michael Burry’s Partnership Letters

Talk to Geoff about his Investing 101 Toolbox…

Case Study: Geoff’s Investment in Bancinsurance – 2 Failures and 1 Success

Two days ago: I wrote about my investment in Bancinsurance (BCIS). My investment was a success in one way and a failure in two ways.

It was a success in terms of return. My cost was $5.82 a share. Bancinsurance’s board agreed to an $8.50 a share buyout. I sold my shares between $8.00 and $8.20, because I saw opportunities elsewhere where good things could happen fast. One example is Barnes & Noble (BKS).

Success #1: That’s a better than 38% return in less than 7 months. If I’d held Bancinsurance through the buyout I would’ve done better with a 46% return in less than 10 months.

So how was my investment in Bancinsurance a failure?

In two ways:

1. I didn’t buy enough stock

2. The board didn’t get a fair buyout price

Failure #1: I only bought 25,000 shares. Some of that was my own clumsiness. I would’ve gotten 35,000 shares if I was a better buyer. My mistake was bad timing. I started buying right before the CEO’s $6 bid was announced. I should’ve started buying in February.

Failure #2: Bancinsurance’s book value was $8.52 a share in March. It’s $9.50 today. $9.50 would’ve been a fair buyout price. The board agreed to $8.50. That cheats shareholders out of 12% in extra returns. It’s not fair. That’s life.

And that’s value investing. You can fail at two things and still make 38% in 7 months as long as you buy at the right price.

Talk to Geoff about Bancinsurance (BCIS)…

Barnes & Noble: Publishing’s Northwest Passage – Bertelsmann

A reader sent me this email:

I am also a BKS shareholder and have enjoyed…your coverage of the proxy battle. There is quite a lot of speculation right now about takeover possibilities. There is the Reuters report that said: “If Burkle doesn’t win at Tuesday’s shareholder meeting, sources tied to this bitter, high-profile battle say he is likely to come back with a bid for the ailing store chain.” Also according to William Lynch, there is quite a lot of interest for the company right now. Do you have any thoughts on…how this may play itself out?

The New York Post sums it up well:

…while about 20 potential bidders have requested informational books on B&N, sources said the auction appears to be generating tepid interest.

The 20 potential bidders are just agreeing to hear Lazard pitch Barnes & Noble (BKS).

Lynch said “companies” in the interview, even though the Bloomberg reporter asked if there were interested “parties”. Lynch looked uncomfortable. So his odd word choice was probably just that. On the other hand: newspapers reported there are interested strategic buyers.

The obvious strategic buyer is Bertelsmann. They own Random House. They have deep pockets. And they would get more out of the Barnes & Noble name, website, and Nook than private equity.

Private equity is just valuing the stores. A strategic buyer would value Barnes & Noble as a Northwest Passage. Long-term: Barnes & Noble is the only online way around Amazon.

Talk to Geoff about Barnes & Noble (BKS)…