Compelling Evidence Part II- From the Horses Mouth

The idea of the Trade of the Decade in small banks is not something I cooked up just to sell subscriptions. I have been investing in small banks for more than 20 years and I follow the industry closely. Talking to analysts and executives of small banks it is clear to me that conditions are ripe for an acquisition wave similar to the one on the 1990s where bank prices rose about tenfold and deal multiples soared to about 2.75 times book value. With deal multiples at just .3 and dozens of financially strong banks trading below book value now is the time to buy community banks Activists are stepping up in the sector and so should you.

You do not have to just take my word on this. Listen to what the CEOs of banks are telling you. They are telling you that they are seeking to grow by buying other banks. Tracking valuations, activist and insider activity we can put together a portfolio of potential target and reap tremendous rewards. Right now we have more than 20 on our current buy list and will be adding more in the next week or so.Join us at Banking on Profits to cash in on this powerful and long lasting trend.

Ray Davis Umpqua Bank- Small institutions — the capital they require to stay up to snuff and the talent they need — are competing against bigger institutions as well as tech companies. On top of it, you have regulations. So you can’t stay small; you have to join forces. For the first time, size matters.

Roger Busse Pacific Continental Bank -Institutions face additional regulatory costs, which may make them more prone to look for partners and get scale. But transactions such as Capital Pacific arise not just from regulatory pressures. They are opportunities on the strategic level. The acquisitions are a combination of talent and opportunity to get scale in major markets strategically.

Terry Zink Bank of the Cascades-A larger bank can spread its infrastructure costs over a larger number of customers and can earn the profit that is needed for viability. When I came onboard in 2012, we had the option of drastically downsizing or looking for someone to partner with. That’s how we came up with Home Federal. We were able to take out 25% of the cost of the combined companies.

During an April 24 conference call to discuss first-quarter 2015 results, Hancok Holdings President and CEO John Hairston said organic growth is still the top priority, and the Gulfport, Miss.-based company is “working relentlessly” to create it. He said that with the bank’s buyback program complete, M&A is priority No. 2 in terms of capital use as long as the price and the strategic fit make sense. “We will be very prudent in doing it, but I would very much like to use our ability to acquire to augment earnings,” he said.- SNL Financial

The bank would look outside of the markets it already operates in if a strategic and accretive transaction came along, Chairman and CEO Lynn Fuller told SNL. But, in part because the company would not have management on the ground or a deep understanding of the economic cycles of the new market, it would also have to find a target of substantial size. Fuller said the seller would need to be at least $750 million in assets and a clean bank with strong management, a good track record and a good reputation. Heartland would also have to be sure that it could grow to more than $1 billion in the new market within a couple of years. “We are much more critical when we go out of footprint,” Fuller said.- SNL Financial

David Turner Regions Financial- The way we think about it is we want to deploy it in our loan growth. And when we have excess after that, we look to have acquisitions, whether it’s banks or nonbanks,” Turner said. “We’re doing a lot of work around that to use the excess capital. I want to be real clear that when we think about acquisitions, it’s more about using the excess capital and cash versus using our shares where they’re priced today.”

Of course, he added, M&A can play an important role. Increasingly, as banks grow and push for loan expansion, they will need low-cost, core deposits to help fund it. This could prove an important driver of deals in years to come. Banks not ready to break out and innovate but that have solid core funding could increasingly become attractive sellers. And the likes of ConnectOne will be surveying the M&A landscape closely for such opportunities. Already, ConnectOne has made a seismic stride on the deal path. In 2014, it merged with Union, N.J.-based Center Bancorp Inc. in a deal that more than doubled ConnectOne’s size.=SNL Financial

“I still believe in community banks, not only from the small to mid-size business perspective, but also as an investment,” said Mario Garcia Jr., CEO and managing partner of Validus Group. He’s also founding chairman of the bank and currently sits on the board at both the bank and its holding company. “The key, is knowing what we know today, with the additional regulatory costs that are put on the banks at that level, you have to be over a $500 million [asset] bank to absorb those costs, and in order to realize the full value of the business, you have to be over $1 billion- Tampa Bay Business Journal

Scott Custer, Yadkin Bank- Custer says part of his job is keeping conversations going with potential partners, and that he’s always eyeing potential opportunities – and that means acquisitions.“I would say that I have lots of discussions and we’re certainly interested in continuing to grow the company,” he says, adding that there’s nothing imminent in the works. But the bank’s pattern has been a deal nearly every 15 months.- Charlotte Business Journal

Huntington Bancshares might not be done making deals. The bank, which has put together a string of acquisitions in recent years to help drive growth, is continuing to look at opportunities that fit its goal of providing additional value, said Steve Steinour, the bank’s chairman, president and CEO, at yesterday’s annual meeting.Last year, Huntington completed its acquisition of Camco Financial, bolstering its presence in the Cambridge, Ohio, area and the southeastern part of the state. Huntington also bought 24 Bank of America branches in Michigan last year and has been adding offices in Giant Eagle stores in Ohio and Meijer stores in Michigan. Finally, it just closed its deal for Macquarie Equipment Finance, an equipment-leasing and -finance company based in Bloomfield Hills, Mich. The bank has rebranded the operation as Huntington Technology Finance. Steinour said the bank will consider deals that are “part of our strategy and are disciplined” and are in the Midwest, where the bank operates, or adjacent to it. “We continue to look at different opportunities, as we have over the years,” he said during a conference call with analysts yesterday, a day after the bank reported an 11 percent increase in first-quarter profit. “We look at banks and nonbanks in our footprint.”- Columbus Dispatch

But Hamilton will still have the capital to do future deals in an environment where technology and regulatory compliance costs are easier for larger community banks to handle, Hamilton CEO Robert DeAlmeida said. “We need to get larger,” he said. “We know we need to get to that $500 million mark if not larger.”
The CEOs are telling you that they are looking to buy banks. A portfolio full of target banks should give us outsized returns for years to come. Join us by clicking here today

Compelling Evidence and Hall of Fame Numbers

Don’t take my word about the trade of the decade. Below are some articles dealing with small bank merger and acquisition activity that have appeared since the first of the month. This is real and it is now This is not just going to happen, it is happening right now and a lot of money is being made. So far this year we have had one bank taken over in the portfolio for a 48% gain. One of our bonus picks was taken over at a 36% profit less than 4 months after I suggested it.
Since we started I have made 62 picks in the portfolio. 56 of them are up and 40 of them are higher by double digits. We have closed 4 investments so far with an average gain of 59.25%. In baseball terms that a batting average of .903 and a slugging percentage of .645. Those are hall of fame numbers!
When you read the articles it becomes clear that the trade of the decade is just getting started.
Join us by clicking here

Chattanooga rising
Slippery Slope leads to M&A
Regulation breeds consolidation
The have and have nots of bank M&A
More M&A Please
Stressed into selling?
Easing small bank mergers
Jacksonville heating Up
Shifting motivations, More M&A
Facing the activists
Tracking Tampa

Banking on Exhaustion

In an interview with Columbia University’s excellent publication Graham and Doddsville hedge fund manager Paul Isaac of Arbiter Partners had some interesting comments on community banks and why they are attractive. He told the magazine. “For example, we’ve decided that the increase of compliance and regulatory burdens on community banks is going to make community banking relatively difficult to conduct profitably, particularly in a low-interest-rate environment.So we’re interested in acquiring shares in banks with reasonable footprints that are relatively clean trading at significant discounts to their tangible book value. If the discount is great enough, the lack of profitability is not a deterrent – it’s actually an incentive because chances are they’re more likely to give up the ghost.”

One of the reason we will see an M&A wave in these little banks is that it is a tough, tough business these days. Net interest margins have been compressed and it is hard to make a profit on the few loans that actually qualify under the tighter lending standards. Fees income is dampened by new regulations.Regulatory compliance costs have skyrocketed. What was for a years a relatively easy business of borrow at 2 lend at 6 and print money while your stock went higher every year has become a nightmare for many of these little banks and the people who run them.

Imagine being one of these small town bankers today. Guys you once played high school football with will not talk to you anymore because in 2010 you had to foreclose on their commercial property development when they could not make the loan payments anymore. Your next door neighbor won’t speak to you since you had to turn down his refinance request because he had less than 30% equity and a credit score under 750. You don’t even bother going to Rotary or Kiwanis meetings anymore since you have foreclosed or denied almost every business in town in the last five years. Your attorney tells you that you will have to hire 2 new attorneys at a cost that will reduce net profits by 20% just to keep up with new regulations and compliance issues. There is little demand for new loans and even less demand from people who could actually qualify for one under the new lending standards passed by your board last year. Even your wife wants to know when the stock she bought for her IRA when you went public back in 2007 is going to finally go back up again. It’s exhausting. All you want is your stock to go back up so you can sell and get out of this new version of the banking game.All of the officers and directors feel the same and you start to float the idea that you are for sale at a price that gets you close to even on your investment.

This scenario is playing out all over the United States right now. As buyers begin to emerge the pace will pick up especially among those banks whose stock is below book and the average age of the board is above 60. Banks with older officers and directors will be among the first to sell rather than endure the changes they that will be forced upon the industry.

Little Bank, Big Deal

Originally published on Real Money

I am working down in Islamorada this week, as the wife wanted some down time after all the rushing around of the recent wedding hoopla. As the father of the bride, all I had to do was write some checks, walk her down the aisle and complete a dance without falling on my face, so I was not particularly stressed, but I am also not opposed to hanging out in the Keys for a week either. While she is running around trying things like stand-up paddle boarding, I have been running screens, reading and watching preseason baseball, so we’re both having a pretty good time.

Just before we left Saturday, I got an email from a longtime reader and now friend. He has been following the small-bank trade for some time, and while he is interested, he worries about a 2008-type experience in the sector. He is a fantastic researcher and he talked to some people who have been involved in smaller illiquid stocks who owned a bunch of community banks in 2008 and got absolutely killed. That type of scenario, much as the 2001-02 scenario, is indeed scary. Little banks dropped on the order of 75% or so on both occasions.

However, it is completely avoidable if you just use common sense and valuation. I can tell you that on both occasions I owned no little banks in my portfolio. As the banking cycle peaked along with the market and the economy on both occasions, valuations had gone beyond silly to downright stupid. Takeovers were occurring at about 2.75x book value, or about twice the current level. I recall talking to an investment banker in 2007 who told me with a very straight face that he thought 2x book and 20x earnings would be a bargain price for an acquirer to pay for a bank under existing conditions. He was buying dinner so I didn’t call him an idiot straight out, but I sure thought it.

Much like the perfect stock screen does with non-bank cheap stocks, there is a gentle timing element to community bank investing. Looking at the last 15 years, I find that most of the time there are something on the order of 50-75 potential buys in the space that trade below book value. After a severe selloff, there are literally hundreds of potential cheap banks to pick from. After an extended run-up near the end of the rebound and M&A cycle, there were less than 10 potential candidates and most of them had loan issues that were depressing valuations.

I broke out a back tester to put some numbers with the community bank timing element theory. Back in 1999 when kids trading in Mom’s basement were Internet stock genius millionaires and I was just dumb old dinosaur value guy, there was one community bank stock trading below book value. Coincidentally, there was also just one perfect stock, so I was dumb and loaded with cash at the time. As 2001 came to a close, there were 10. By the end of 2002, there were 60 banks and 40 perfect stocks, so I was fully invested and getting smarter by the minute.

The recent crisis shows why I find it difficult to fathom that anyone with a strong sense of valuation was in a position to get hurt by the bank meltdown. As we neared the end of 2006, takeover multiples were over 250% of book and I could not find anything to buy. With the average bank at 2x book value, I had been selling and had no exposure to banks. There were just five of the more than 800 publicly traded banks trading under book value. I suspect those were the vanguard of the troubled banks to come and were showing weakness in the loan portfolio. As much as I love community banks, they were not cheap and there was no reason to own them.

I ran my screens this morning and found that while the perfect stock screen is screaming an alarm with just 12 stocks, there are still plenty of opportunities in community banks. There 148 bank stocks trading for less than book value. Ninety-five of them are profitable and have equity-to-assets ratio over 10. Of that 95, 69 pay a dividend. Forty of them are buying back stock. Twenty-eight are buying back stock and paying a dividend. I don’t have the exact number that have an activist shareholder, but it’s a significant percentage of them.

Small banks are cheap and there is a more-than-adequate margin of safety in many of them. We do not appear to be anywhere near a meltdown and there are significant tailwinds.

Handicapping Sports and Stocks


Originally published on Real Money

Most of the year, I am not a huge fan of college basketball. I will read articles in the sports page from time to time and glance at the rankings, but I do not track scores or watch any college hoops until March rolls around.

Now that the Madness is upon us, I will watch some games, read all the articles and, of course, crunch the numbers to fill out my bracket. Each year I try some new method to pick my bracket, since I don’t know much about the teams. Last year I picked all the top seeds and my bracket was blown up by the end of the first weekend. The year before, I picked my top two teams for the final and then picked the lower seed in every game not involving either of them. That bracket actually did OK until we got to the round of 16 and was doomed when my top two were eliminated in the round of eight.

This year, I used a combination of three-point shooting percentage, defense stats and points in the paint to pick my winners. We shall see how it performs. For the record, my final four are Kentucky, Louisville, North Carolina and Gonzaga, with the Wildcats whipping the Bulldogs in the final.

All over the U.S. last week, folks were calculating numbers and checking in with various statistical services to handicap the tournament. Serious amounts of time went into filling out brackets and comparing numbers and strategies to win a few bucks and earn bragging rights in the office or local bar as the champion of bracketology. What is amazing is these same folks who were up until 3 in the morning calculating free-throw percentages when leading by less than three with less than two minutes to go in the game for every player in the tournament have a portfolio of stocks that were mentioned on TV or they heard about from Uncle Charlie in Wichita.

The sad part about this is that it is entirely possible to handicap stocks and your portfolio in pretty much the same fashion as you can the NCAA tournament or the Major League Baseball season — using numbers. The best part is that, as a rule, stocks do not tear an oblique or sprain an ankle along the way, so there is less uncertainty about your selections.

The 2013 study “Liquidity as an Investment Style” by Roger G. Ibbotson, Zhiwu Chen, Daniel Y.-J. Kim and Wendy Y. Hu is one of the best examples of how to handicap stocks in the pursuit of better results. Illiquid stocks perform better than liquid stocks. The study finds that illiquid stocks outperform their more-liquid brethren across the board. The less-liquid growth stocks outperform liquid growth stocks. Illiquid value stocks outperform liquid value stocks. If you look at the extremes, the best-performing illiquid value stocks from 1971-2010 had a compound annual return of 18.4%, while highly liquid growth stocks returned just 2.4% annually. However, when you talk to most investors, which ones do they own? The highly liquid, well-known growth stocks, of course.

Last year, Tobias Carlisle, the author of Deep Value, did a study that found that, “Since 1951, the equally weighted PB value decile has generated a compound annual growth rate (CAGR) of 20% and an average annual return (AAR) of 25.4%. Over the same period, the glamour decile returned a CAGR of 6.4% and an AAR of 10.8%.” But which stocks do you think most investors have in their portfolio? The high-multiple, high-growth names that are hot and exciting right at the moment, of course.

Last fall, Sterna Agee released a study of community banks that had an activist investor as a 5% or greater shareholder in the last decade. The study concluded that the average small bank with an activist investor outperformed the Nasdaq Bank Index by 28 percentage points, and 29% of them were taken over at a premium. There were 80 activist bank buys during the study period and 59 of the stocks were winners. I will note that most of the 21 non-winners still have activists as shareholders and many of them are in my community bank portfolios.

If we add these studies together, it is hard not to conclude that most individual investors should have a portfolio of illiquid community bank stocks that have an activist shareholder agitating for changes or the sale of the bank. It is like picking a basketball team with speed, power and size to win the tournament. That might not happen every year, but it is going to happen most of the time. A baseball team with great pitching, power hitters and a high on-base percentage is not going to win every game, but they are going to win a lot of them. Likewise, a portfolio of cheap bank stocks is not going to outperform every quarter or year, but it should most of the time.

The numbers say these are the stocks you should own. Most of you don’t and won’t as you chase dreams of trees that grow to the moon and achieving trading glory. But you should.

Lumpy Returns

Originally published on Real Money

Over the past few months, I have been going back over years’ worth of data regarding stock selection and portfolio construction. I was also testing various definitions of margin of safety and credit models to improve downside protection. Although, on balance, we have held our own the past year or so, it is no secret that I had some real stinkers among energy- and commodity-related stocks.

While I could take heart that I am not alone in poor natural resources-related picks and just let it ride, I decided to do a lot searching and testing. It took some time but eventually I found some corrections to the basic credit model I have been using that should help protect the financial downside going forward. I cannot control market movement, but I can make sure my companies are in a good position to survive until they thrive.

All of this searching and researching also turned up some really interesting facts about annual returns. I found there is a definite very lumpy pattern to my returns. In the last few years of a bull market, I tend to underperform — sometimes very badly. I am strict about valuations, so I am usually sitting there with a ton of cash while stocks make their last rocket-ship movements to the top. That same cash hoard leads to outperformance during bad market periods. The first few year after the market bottoms and begins to turn higher are my very best years by far because of all the bargain issues available. It is pretty much a wash-rinse-repeat scenario over the years. The returns have been more than adequate but smooth they are not.

This made me curious, so I spent some time last weekend surfing around the Web looking at other value investors and how different approaches have performed over the years. I found that most of their profiles looked a lot like mine, with strong but lumpy returns. We don’t look good on those risk-adjusted return measurements much of the time, in spite of market-beating long-term returns. The highest returning strategies, like net current asset investing, underperformed most of the time and then soared with triple-digit returns in the year or two after a bear-market bottom. Those with a dividend combined with other valuation factors, like price-to-earnings ratio and price-to-book value approach, had smoother but lower returns.

Most people may like the numbers from this type of ultra-deep value investing, but the volatility can be tough to handle. It is very difficult to earn less than the market for an extended period of time and actually show losses when everyone around you is enjoying decent gains. It works well, but the data suggest you might want to take a Womackian approach to this type of investing and wait for a bear market to implement such an approach. Several studies have shown that the absolute numbers of net current asset value bargains can provide clues as to when to be a buyer of these cigar-butt stocks.

I also found that the strategies outlined by Ben Graham in the 1970s, such as his 10-point checklist and two-factor model, performed very well and had less volatility than other more aggressive deep-value approaches. It is amazing that approaches developed almost 40 years ago have stood the test of time and still work today. It seems that everything else in the world has changed since then, but these measurements of value and portfolio construction techniques still work well.

Some of the newfangled approaches, like Piotroski F- scores, Robert Novy-Marx’s quality value definition and Joel Greenblatt’s Magic Formula, are also worth investigating by value investors looking for returns with different volatility characteristics. Some want to shoot for the very highest returns and others want to grow their capital without the occasional need to vomit when checking portfolios. Some investors need the illusion of liquidity while others are willing to take ultra-long-term positions in highly illiquid stocks to capture the highest returns.

This week, I am going to do some additional number crunching and take a deeper look at some of these strategies and discuss some stocks that fit into the different value approaches. The opening week of baseball is the perfect time for such an investigation, as I can happily crunch away while the grand old game plays in the background.

Find Your Style

Originally Published on Real Money

I write a version of this column pretty much every year. I think it is one of the most important subjects in all of investing.

Over the years, I have met a lot of people who work in and around the markets. I have a huge network of friends and acquaintances and I am not the least bit shy about picking their brain — nor they mine — about making money in the markets.

Many of the people in my network are value types, but many are shorter-term traders, momentum investors, futures and options traders, macro types who invest based on the big picture and even a couple of day-trader types. All of them have been successful at their craft for a long time and have picked an approach that fits their personality and skill set.

Whatever your time frame, if you bring emotion to the game you are probably going to be a losing trader or investor. Emotion leads to what some call swing trading, but in reality is just stock swapping. If you panic when prices move against you, you’ll inevitably sell at the wrong moment. The excitement of a small profit will lead you to cash in your chips just before the real fun begins. Getting caught up in the hype of the big, exciting stocks is almost inevitably going to make you pick the burning match and get blistered.

This is especially true of futures and options traders. They are all highly mathematical and statistical in their approach. Some trade a dozen markets, some just trade one. In either case, they are calm and methodical, and at the end of the day you couldn’t tell from their faces whether they had won or lost. Probably the most important thing about these more leveraged traders is that every single one of them is a full-time trader.

I prefer the value approach and, to be more specific, I prefer the Walter Schloss style over the Warren Buffett or Bruce Berkowitz concentrated approach. Owning a lot of cheap stocks keeps the odds of higher returns solidly in my favor, but horrific losses form on particular security. I can be a lot less emotional and rational when a 1% to 2% position tumbles than when a 20% position falls off the ledge.

There is a classic example of that today. LeapFrog (LF) was trading at 80% of book last month with a super-strong balance sheet but some problems with an inventory hangover from last year. The stock was cheap and the balance sheet is safe. There is no real risk at this time of this company going out of business. There were two possibilities with LeapFrog: If they had a strong holiday season, the stock would soar. If it fell below expectations then it would tumble and I could double down at a lower price.

The latter is what happened and the stock was down big Tuesday morning. I doubled down, bringing my overall position back up to 1%. It would have been lovely to see the company exceed expectations and ring the bell on a quick 50% to 100% gain, but I am quite content to buy more lower and hold the stock for a few years.

This approach fits my skills and lifestyle. It is based heavily on research and investigation. It does not require a rigid pose over the keyboard every day. I am highly confident that the companies I own will trade at fair value at some point in the next few years and I will sell them at a good price. In the interim, I do not care that much what the daily price swings are.

Most people are not wired to do this. The pain of the short-term loss is just too much for them to anticipate the long-term gain potential. Another approach might be better for them. The important part is to have an approach that fits who you are. Investors, especially newer ones, need to have a proven approach to investing that they are comfortable with and fits them. You need to read the writings of successful investors to find the one that is best for you.

In your search, you need to read about the different methods of investing, even those you don’t necessarily favor. For long-term success, I think you need to have a sense of market history and how various people have made or lost fortunes.

If you step on the field to make money in financial markets and cannot tell us who George Soros, William O’Neill, Louis Navellier, Guy Wyser-Pratte, James Montier, Richard Driehaus, Jesse Livermore, Walter Schloss, Charlie Munger, Phil Fischer, Howard Marks, Peter Lynch, John Calamos, Nassim Taleb, Lawrence McMillan, J. Peter Steidlmayer and Edward Altman are and how they trade and invest, you are probably going to lose. You simply have not studied enough to find the right approach for you.

Find the approach that fits your lifestyle and your personality and your odds of success go up exponentially.

Quit Paying For Liquidity You Don’t Need

Originally published on Real Money

Last week was a busy one around Chez Melvin. The combination of the Orlando Money Show, a newsletter marketing conference and cold snowy weather up north brought several friends and associates into town for some sunshine and networking at the show. It is always great to catch up in person, even if you are “talking” to someone every day over the phone and web. I met several folks at either the Disney complex or Gaylord Palms over the week, and spent a lot of time talking baseball, politics and of course stocks.

I got a chance to meet in person someone I have chatted with on-line, and it was a very productive cup of coffee. I spent a bit of time with Patrick O’Shaughnessy of O’Shaughnessy Asset Management. He is the author of “Millennial Money: How Young Investors Can Build a Fortune” — a book I highly recommend you purchase for any young adults in your life — and has worked on the latest edition of his father James O Shaughnessy’s “What Works on Wall Street.” We talked stocks in general and quantitative value in particular. He pointed me to a paper that examines one of my favorite theories of individual investors, and why they underperform so badly.

I have long said that the one of the biggest advantages of being an individual investor is the fact that we can go where the big funds cannot venture. We can buy smaller stocks with great abandon if we so choose. The billion-dollar funds cannot buy stocks like the $23 million dollar market cap bank I bought this morning at under 65% of book value. To take a 1% position in one of their fund, a billion dollar hedge fund would have to buy half the bank. Although I have many of these tiny banks, it is not just banks that I have in my trade of the decade portfolio. I have several under $20 million market cap bargain stocks in my portfolio, which are in a range of businesses like HVAC, real estate operations and apparel, and they have done very well. Big funds cannot buy them, and using value and a private equity long-term mindset I have done very well with this type of tiny stock over the years.

I am not sure how I overlooked it, but Roger Ibbotson of Yale School of Management and CEO of Zebra Capital wrote a paper in 2013 titled “Liquidity as an Investment Style.” He recently updated it to include 2014 results and it is eye opening. He looks at stocks based on liquidity levels and finds that from 1971 to 2014 the less liquid stocks are, the better they perform. He compared low liquidity stocks with other well-known market anomalies. He found that “the returns of the low-liquidity quartile were comparable to thoseof the other styles, beating size and momentum but trailing value.”

Professor Ibbotson also ran a study over the same time period for stocks with value characteristics and low levels of liquidity and found “among the high-value stocks, low-liquidity stocks had an 18.43% return whereas high-turnover stocks had a return of 9.98%. Value and liquidity are distinctly different ways of picking stocks. The best return comes from combining high-value stocks with low-liquidity stocks; the worst return comes from combining high-growthstocks with high-turnover stocks.”

The study also noticed that the portfolios based on liquidity tend to have very low turnover so total costs associated with illiquid stock investing are very small. They are also less risky and far less volatile than their more hyperactively traded liquid cousins. A long-short portfolio based on long the bottom quartile of stocks based on liquidity and short the top quartile actually had negative correlation compared to the overall market and easily outperformed it over the study period.

I get so frustrated with individual investors telling me they need the liquidity of the large stocks like Google (GOOGL) and Apple (AAPL). They feel better knowing they can get out of their position in a millisecond. That feeling is costing them a lot of money over time. Ben Graham once remarked that investing worked best when it is most business-like, and I don’t know any business people that buy and sell shares of their company several times a day or even multiple times a year. They pay attention to the price they pay and think in terms of years and even decades of ownership.

If you approach stocks with a focus on value and adopt that long-term mindset of a business owner or private equity investor, liquidity is not really a significant concern. If you need your money instantly liquid as an individual, you probably should not own stocks.

Quit paying for liquidity you don’t need.

Get Schooled

Originally published On January 12,2012

having dinner with Real Money contributor Jonathan Moreland the other night, I spent time thinking about the challenges of beating the market and earning a decent return over time.

As we have learned in the past decade, there are extended periods when matching the market’s rate of return is not enough to build wealth. Investing in index funds when the tide is rising, as in the 1980s and 1990s, can be wonderful, but much less so in periods like we have seen since 2000.

To build wealth, you have to find an investing approach that is different from what everyone else does, even when the stock market does not cooperate.

One of the topics Moreland and I discussed was the value of academic research. Academics have found some of the most important market anomalies and theories that investors can use to earn above-average returns. I try to stay up to date on the latest studies and data relating to the financial markets, and I’ve found that the information is useful and makes me a better investor over time.

But there are two major problems with using academic data and conclusions as an investor.

First, let’s look at stocks trading below book value. It is well documented that these stocks outperform the market. Most of the studies break the universe of stocks into deciles and rank performance. Stocks that have the lowest price-to-book ratios, lowest price-to-earnings ratios and highest dividends outperform the broader market, as well as higher-priced but lower-yielding stocks. This is valuable information, but it doesn’t relate to real returns unless you have an enormous amount of capital to work with.

The bottom deciles of stocks with a given characteristic are going to require the purchase of more than 500 individual stocks. The deciles are also going to contain many smaller companies, so an equally weighted portfolio would involve buying some of the companies in their entirety. Most of us are not in a position to buy that many stocks or engage in merchant banking to construct a portfolio.

The other problem with using the market-beating theories of academics is one I wrote about a few months ago. When looking at groups of stocks with certain characteristics that have beaten the market over time, the outperformance is contained to a small subset of the sample. When the Brandes Institute looked at stocks that had fallen 60% or more, they found this group of stocks beat the market by a wide margin. They also found that a large percentage of the group filed for bankruptcy. This was replicated in a study by Professor Edward Altman of New York University’s Stern School of Business of companies emerging from bankruptcy. As a group, they beat the market by an impressive margin. A very high percentage of them re-entered bankruptcy and were liquidated. The outperformance was the result of a few spectacular stocks in both cases.

The trick for individual investors is to find those potentially spectacular stocks. One way is to use credit and financial scoring systems. Using measures such as University of Chicago Professor Joseph Piotroski’s F score and the Altman Z score can help isolate companies that are likely to survive and improve when considering stocks with value anomalies. Investors Louis Navellier, Richard Driehaus and others have done great work identifying persistence in some of the momentum-based outperforming anomalies (all the strategies that I found offering substantial outperformance are either momentum or value based. Everything else seems to be a form of indexing). Using further screening information to narrow the pool of stocks to a manageable number can helps isolate the core stocks that help to grow wealth over time.

Another way to narrow the pool of potential winning stocks is to combine characteristics. When I look for stocks currently trading below book value, I get a list of 1609 stocks. That’s too many. If I screen that pool for companies with less than a 0.3 debt-to-equity ratio, I get it down to 738. Better, but still too many. If I add Jonathan Moreland’s favorite criteria and look for companies below book with reasonable debt and have insiders buying shares in the past six months, the list falls to just 126 names. That’s a number I can work with.

The key to long-term success in the markets is never to stop learning. Stay on top of the current research and new ideas and apply them to your approach to investing to see if they add to your efforts.

Making Money in Banks

Originally published June 2013- how we doing?

Investing in small banks has been and incredibly profitable activity for decades now. I first realized the potential of these tiny stocks back in the 1980s when I was studying the track record of Peter Lynch and his legendary performance of the Magellan Fund. Mr. Lynch famously advised investors to buy what you know but he probably should have changed that buy where you bank. If you scour through his holdings during his years at the helm of the fund he owned almost every small bank and thrift in the country. He had money on deposit at most of the mutual savings banks so he could participate in their conversion to a stockholder owned bank. Much of his enormous returns came not from growth stocks whose products he loved but from small community and regional bank and thrifts.

When I became a stockbroker in the late 1980s I found that this was not an easy sector in which to invest. Most of my clients in Modesto, California could care less about a small bank in Ames, Iowa or Columbia, Missouri. The OTC trading desk at Dean Witter didn’t have time or interest in fooling around with some new brokers 500 share order for an $8 bank stock in Jackson, Mississippi.The spreads were enormous, they were hard to buy and no one had much interest in them. In order to succeed in my new career I had to put the little banks behind me and work with stocks people would actually buy.

That changed when I moved back East to Annapolis, Maryland.I joined a small regional firm that made markets in most of the Mid Atlantic Banks. By this time we were on the back end of the S&L crisis and these stocks were dirt cheap. Quality banks with two or three branches sold for a third of book value. They had no junk bonds or South American loans but they were painted with the same brush as their larger brethren. By the middle of the 19990s the M&A wave was in full swing and our investors were cleaning up as banks that were purchased at a fraction of book value sold for a multiple of that number just a few short years later. It was the most fun I ever had as a broker. To a lesser extent the fire sale was repeated following the LTCM blow up in 1998 and again in 2002 when the whole market basically blew up in the internet meltdown.

It has happened again as a result of the credit crisis and real estate collapse. Small banks that had no special purpose investment vehicles or toxic ALT-A and no doc loans saw their balance sheet and income statements hit just as hard as the big guys. Most of their loan collateral was real estate and the value collapsed. People walked away from their homes when the value went well under the loan value. Developers went bust and forfeited their loans on commercial projects. Many were closed down by the FDIC as they simply had too many bad loans to survive. Small banks stocks saw their prices back at valuation levels similar to the early 1990s.

Since the depth of the crisis in 1990 conditions have slowly improved. Real estate has stabilized to some degree and the economy, while far from good, is at least better. Larger bank stocks have recovered some of their decline but many of the smaller banks have not at this point. Investors tend to focus too much on earnings and a lack of loan demand and narrowing net interest margins have kept a lid on earnings. However the asset side of the ledger has improved substantially and we once again have small banks trading at a fraction of their tangible book value.

Most of the banks that are going to fail have already done so. The survivors will see one of three things happen to them. They will muddle along until the economy recovers, profits grow and investors are attracted to these shares again. These banks also will have an opportunity to take market share from big banks as the crisis has heightened many people’s distrust and dislike of big banks. Some of them will become aggressive buyers of cheap assets and grow at a fairly rapid clip by buying up competitors. These banks will move from community banks to mid-size regional institutions by acquisition.The remaining banks will be purchased by competitors at a premium to their tangible book value. All of these will be good for those investors who buy small banks now and this is the reason I frequently refer to small banks as the trade ofthe decade. An enormous amount of money is going to be made by small bank investors over the ten years and Banking on Profit was created to help you be one of those investors.