The Power of the Individual Investor

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I spent a good deal of time over the long weekend working on a paper about illiquid bank stocks. I was digging through the universe of banks looking for candidates for the Trade of the Decade that are miniscule and way off everybody’s radar screens.
During my research, I was talking to a friend who wondered why I would bother with illiquid stocks at all. Illiquid stocks are dangerous, he said. They are hard to buy, and you cannot sell at a second’s notice whenever you want. Nobody has ever heard of them and no analysts follow them, he continued. Why would you ever want to own such a thing?

I’m reminded of something Ben Graham once said, that investing works best when it is most businesslike. Investors need to view the purchase of a stock as taking part ownership of the business and not just buying a betting slip in the world’s longest ongoing popularity contest. If you and I decided to buy the local bookstore today, it would take months to close on the purchase. If we decided to sell at some point in the future, it would take months to find a buyer and close the deal. The liquidity of a stock to a true deep-value investor does not matter anywhere near as much as the relationship between the price paid and the actual value of the company.

The ability to buy illiquid stocks is one of the individual investor’s biggest advantages. The hedge funds can’t own them. They would end up owning the whole company, or at least having to file a 13D with the Securities and Exchange Commission, to take even a small position with their fund’s assets. You can drive a truck through the bid/ask spread on most illiquid stocks, so the short-term traders will not be whipping around the price of the shares anytime soon. You can concentrate on the value of the company and buy shares in an actual business. If you are buying a business, you do not need the ability to sell right away.

It is not like there is a lack of potential opportunities in the microcap market. According to my screener, there are 4,295 stocks with less than $50 million of total market capitalization. If you are a value investor, you will like the fact that 1,005 of them trade below book value. If you prefer growth, you can take delight in the 74 tiny companies that have grown earnings at a five-year compounded rate of 15% and the 156 that have a return on equity of more than 10%. I don’t want to leave out income investors, so there are 51 stocks that have a dividend yield of 5% or more. Twenty-four of the microcap companies are dividend growth stars with the payout growing by at least 10% annually over the past five years.

You can mix and match the small stocks as well. There are 114 stocks in the microcap class that trade below book value and have a Piotroski F-score of 6 or more on a scale of 0 to 9. Fifty-four of them trade below book value and have a return on equity of 10% or more. Twenty-five have high earnings growth rates and a return on equity above 10. Six dividend darlings have grown their dividends at a double-digit rate and yield more than 5%. There are 151 of these little stocks trading below book value that have safe balance sheets with an Altman Z-score of 2.9 or higher (the higher that number, the less likely the company will go bankrupt).
Keep in mind how many of these stocks are left now, after an extended rally in the stock market. In normal times, or the aftermath of a severe correction, there are many more opportunities in small stocks than exist right now.

When you buy the smaller, less-liquid stocks, you are in a universe where the fundamentals of the company matter much more than day-to-day swings in the overall stock market. No pundit will be making remarks that cause your stock to move 20% in one direction or another. You will have to think before you impulsively hit the sell button and dump the stocks. You will be in the investing business, and not the trading game.

When individual investors sell, they do not need the liquidity of the well-known and heavily traded stocks. If you are taking a businesslike view of your investing, you do not need to exit your 500 or 1,000 shares of Apple (AAPL) or Netflix (NFLX) in milliseconds. Warren Buffett once said that if you are not willing to own the company if the stock market closed for five years after you purchased it, then you should not buy it. That is solid advice that most investors should take to heart. Stop avoiding smaller, less-liquid issues that offer real value and huge upside potential.

The money-management industry has for years sold us the story about all the disadvantages we face. We poor little folks are much better off turning our cash over to the professionals to manage — for a small fee, of course. They point out that we do not have the time and vast resources that they have available to study stocks full-time, and that they utilize these benefits to make wise and learned decisions on our behalf. With their highly trained traders and million-dollar electronic systems, they can work more quickly and efficiently than you can. They even have fancy brochures. In the grand scheme of things, what’s a couple of percentage points off the top anyway?

In one sense, some of this is quite true. If you wade into the market armed only with your copy of how to get rich using squiggle patterns, trying to go head-to-head against the big firms, you will probably get slaughtered and be carried out on your proverbial shield. If you go forth to make a fortune as an options trader or a short-term market player, your lunch money will be taken by the professorial types with multidisciplinary math degrees and computing power that would make HAL 9000 blush. If you try to gain an advantage against the major institutions while buying the same large popular stocks they own, they will beat you. It is their game in their house, and you don’t stand much of a chance.

Still, as individual investors we have substantial advantages over the major players — ones that go unused by most of the people I talk to. Aside from our flexibility regarding liquidity and position-sizing, when folks tell me they have IBM (IBM), Apple (AAPL) and General Electric (GE) in their portfolios, I want to scream. When I meet successful businesspeople or busy professionals who describe their earnings-related trade for Netflix (NFLX) or Priceline (PCLN), I have to resist the urge to slap them then and there. When you do what everyone else is doing, you give away one of the biggest advantages you have as an individual investor: time.

We do not have to play the short-term-performance game and worry about how we stack up over a quarter or two. We can adapt the thinking of a private-equity manager, rather than one of a mutual-fund manager. We can hold stocks throughout a full business cycle, or even two, and capture gains that are measured in multiples rather than percentages. No one — with the possible exception of our spouse — is looking thorough our portfolio and asking us why we still own that dog stock. No one is questioning why our three-month return is not as good as that of the people next door.

We can own stocks until they work, and no one is going to fire us from our very cushy fund-manager job if we underperform Cousin Fred for a few quarters. No one is going to call us on the carpet for being wrong in our guesstimate on Wal-Mart’s (WMT) fourth-quarter earnings report. As individuals, we can ignore the short-term noise and focus on the long-term value of the companies we own.

We have no institutional mandate. We can be fully invested or hold as much cash as we want, any time we want. We can buy large stocks, small stocks, foreign stocks or anything other type of stock we wish. We can buy companies that pay dividends, or ones that do not pay them. We can buy foreign stocks or just stocks of companies located in Texas if we choose. No one will be telling us what we can or cannot buy, or what percentage we can or cannot keep in cash or other securities.

Back in 1976, Ben Graham — in an interview with Charles Ellis — explained the advantages this gives us as individuals:

Institutions have a relatively small field of common stocks to choose from — say, 300 to 400 huge corporations — and they are constrained more or less to concentrate their research and decisions on this much over-analyzed group. By contrast, most individuals can choose at any time among some 3,000 issues listed in the Standard & Poor’s Monthly Stock Guide. Following a wide variety of approaches and preferences, the individual investor should at all times be able to locate at least one per cent of the total list — say, 30 issues or more — that offer attractive buying opportunities.

The numbers are larger now, but the advantage still exists. Size, time and flexibility are huge advantages for the individual investor. Quit doing what everyone else is doing and use these leg-ups to build your portfolio and boost your returns.

Trade of the Decade at Work

For some time now I have referred to small regional and community bank stocks as the Trade of the Decade. In the aftermath of the real estate and credit crisis bank stocks collapsed in value and many of the smaller ones were valued at a fraction of their r tangible book value. As regulators rushed to close the barn door now that the horse was gone the costs have jumped dramatically and it is difficult of these banks to deal with the costs of challenges of staying in compliance with alphabet soup of regulations. In addition it is virtually impossible for small banks to grow earnings in an overbanked world with anemic economic activity. The only way to grow is to buy another bank. This also helps spread compliance costs out over a large base of assets and deposits.

The stage is set for a huge merger and consolidation wave in the regional and community banks. It costs too much to go it alone and it is almost impossible to grow profits at a rate that will appease shareholders. Activist investors of noticed the deep under valuations in the sector and have entered the banking sector in unprecedented numbers. The stocks are cheap economic and regulatory climate is almost forcing many of these banks to put themselves sup for sale. In a recent survey 64% of small bank CEOs said they expect to be involved in M&A activity in 2014.

Given these conditions it was no surprise when I flipped on the computers yesterday morning and saw that one of my small bank holdings was being acquired. Jefferson Bancshares (JFBI) is being acquired by HomeTrust Bancshares (HTBI). HomeTrust is based in Western North Carolina and this allows them to expand into Tennessee at a bargain price and add more than $500 million in assets to their portfolio.

Jefferson Bancshares is typical of the type of bank that I have been buying as part of the trade of the decade portfolio. The bank has 10 branches and two limited service locations with more than $500 million in assets. Their service are is primary market areas to consist of Hamblen County, Tennessee, Knoxville, Tennessee, and its surrounding area and the greater Johnson City, Tennessee, Kingsport, Tennessee, and Virginia tri-cites region. Officers and directors owned a little over 12% of the banks shares and the ESOP owned an additional 9.5%.

The bank had struggled a little with their loan portfolio during the crisis and nonperforming assets peaked out at almost 5% of total assets in 2012. Management has worked steadily to improve the quality of the loan portfolio and current nonperforming assets are down to just 3.05%. When I started buying the stock NPAs were about 3.81% of total assets but had been declining steadily. Equity was continually over the 10% of assets level that I like to see so I considered the bank more than adequately capitalized. This was a basic little bank with management dealing with its problems successfully and the stock was trading at just 70% tangible book value.

This in and of itself was enough for me to buy shares of Jefferson. However as a bonus long time bank stock activist Joseph Stilwell had purchased more than 6% of the stock and had filed a 13d disclosing “We intend to seek board representation at next year’s annual shareholder meeting if the Issuer has not announced its sale. Our purpose in acquiring shares of Common Stock of the Issuer is to profit from the appreciation in the market price of the shares of Common Stock through asserting shareholder rights. We do not believe the value of the Issuer’s assets is adequately reflected in the current market price of the Issuer’s Common Stock. We hope to work with management and the board of directors to maximize shareholder value.” We had a good bank and a great price and an activist investor to act as a catalyst for change.

This made buying the stock the equivalent of an uncontested layup in my eyes and I started buying back in June around $5.50 a share. The takeover will give me a total gain of about 45% when the deal closes.

That’s our second takeover in the past six months. Huntington Bancshares (HBAN) deal to buy Cameco Financial (CAFI) netted a 72% gain. I have a portfolio of about 30 stocks that look a lot like Jefferson Bancshares and Camco did when I started buying it. There are another hundred or so small banks that could fall within my buying parameters if we get a decent pullback in the overall market or the financial sector.

The Trade of the Decade in small banks is going to make astute investors an enormous amount of money over the next decade.