The Illiquid, Inefficient Bunny Rabbit Approach to Investing

I keep trying to lead the charge on community banks but every time I look behind me I am almost alone in the sector. Everyone is looking for a magic five minutes-a-night-swing-trading system that beats the market every week, day and hour of the year.

The biggest problem most people seem to have is the lack of liquidity in these smaller stocks. Others think the idea of holding shares of First Community Bank of Middle of Nowhere is too boring. There seems to be an almost compulsive need for excitement and action among individual investors when that is exactly the wrong approach.

I am fond of quoting Charlie Munger as he is almost as much of a curmudgeon as I am and he has far more money and success in the financial markets. He pointed out that he got rich by having a long attention span and practiced sitting-on-his-butt investing.

I call small banks the trade of the decade but in truth it is an investment, not a trade. If you are going to keep score against the indexes every day, week, quarter or even year, then this is probably not for you. That is, unless you are willing to change your mind set to improve your profits.

Although my portfolio of little banks is beating the market rather handily over just about any time frame you can mention, there will be periods of underperformance. Anyone who claims to outperform all the time under any conditions are liars. Anyone who could actually do that would never leave their house for fear of someone figuring out how they are doing it.

Owning these stocks can be boring for extended periods of time. Many of these stocks are what Louis Navellier calls bunny rabbit stocks. They tend to just sit around doing not much of anything until there is news that moves the stock. It may be a new buyback, a big earnings report, a 13D filing, a management change or a takeover offer. But it often takes a news announcement of some sort to get these stocks moving. Until you get an announcement you have to just be patient. They are not liquid, so don’t try to trade around your position

Be very aware that activists matter very much in this sector. We held shares of Naugatuck Valley Financial Corporation (NVSL) and received a takeover offer for the shares this week that is going to give us a nice gain. The stock has not done much over the past year, but I knew that both Joseph Stilwell and Lawrence Seidman had representatives on the board. One way or another, they were going to find a way to boost shareholder value.

The Sterne Agee study done by Matthew Kelly and his team last year clearly demonstrated that community bank stock with an activist presence in the stock had enormous excess returns during the activist ownership period. You need to know who the activists are and which ones have been the most successful in pushing stocks prices higher or forcing the sale of the target banks.

Smaller is better in this space. It is the banks under $500 million in total assets that will have the most problems with increasing compliance costs, expensive technology upgrades and the slow growth economy. To add fuel to the smaller bank preference, regulations just took hold that allow smaller banks with between $500 million and $1 billion in assets to take on additional debt at the holding company level. They are allowed to use the money to buy other banks, buy back stock or pay dividends.

That makes extra capital available for banks in that size range. They can use more borrowed funds, up to 75%, to buy smaller rivals and increase their asset base and branch network. The banks with $300 million and under are now more attractive takeover candidates than they were before these regulations took effect

A peek inside my bank portfolio might be instructive. I own lots of banks with more than 60 positions right now. I have no idea which ones will be taken over or when so I just own the ones that fit my criteria. I have a marked preference for the smaller stocks as my average market cap is below $40 million.

My latest buys have been under $20 million total market cap. I like to buy at 85% of book value. or less, but will occasionally pay as much as 90% for one with several activist or high performance metrics.

Almost all of my holdings have at least one activist or bank stock specialist as shareholders. Most of them have low, nonperforming assets and above average equity-to-assets ratio. Although not planned, most were once a mutual thrift. I am content to hold them forever as long as they don’t trade too close to the current takeover multiple of 1.35x book value.

I never said the trade of the decade was easy money. I just said it has the potential to make you a lot of money via a close focus on valuation, activists and insiders and the aggressive practice of sitting-on-your-butt investing.

The Illiquid, Inefficient Path to Profits

Originally Published on Real Money

I recall reading some years ago, probably in one of John Sooner’s excellent novels on Wall Street and the brokerage industry, about an interaction between a broker and his client.

The client was day trading the hot stocks of the day back in the 1970s. He was not really making or really losing any money — just piling up commissions and going nowhere. He asked the client why he was doing this when the way to make money was to buy dividend-paying stocks and hold them for a long time. “Do you want to make money,” the broker asked, “or are you just messing around?”

The client thought about it for a minute and answered that he was really just messing around. The boardroom and the ticker tape (it is an old book) was closer and better appointed than the racetrack and the company was better.

All his real money was in real estate, the family manufacturing business and municipal bonds. Trading stocks was something he did just for fun and to stay out of his wife’s hair now that he was retired. If that describes you, feel free to stop reading now. If your intent is to make money in the equity markets, however, allow me to climb atop my soapbox.

Each time I chat with folks about the opportunity in community bank stocks they will inevitably ask for a name or two and then pull up the chart. Inevitably, you get a little gasp and then hear some variation of the phrase: “I could never trade that. It is illiquid.”

Individual profit-conscious investors worrying about liquidity is like Clayton Kershaw worrying about his inability to kick a field goal. Kershaw is one of the best pitchers, if not the best, in baseball right now, and does not need to ever kick a field goal.

Individual investors with the proper time horizon and thought process when approaching the market do not need liquidity. They should seek illiquid, inefficient markets and exploit the size-and-time advantage they enjoy over institutional investors and most other market participants.

Don’t take my word for it. Charlie Munger, The co-chairman of Berkshire Hathaway (BRK.A, BRK.B) is a billionaire and generally acknowledged to be a pretty smart guy. Munger is also the chairman of the Daily Journal (DJCO) and at this year’s annual meeting he told investors:

“In my life lime success in investing was easier. If you were rational and disciplined you had a tailwind of 10% per annum. Now, I doubt that the world will be able to get 10%, so it will be more difficult; and it is impossible if you are staying in big stocks.

“If I had to manage $200 billion and were expected to beat the index, I would not welcome the job. I think people who have a good chance of performing well are those who are willing to work in less efficient markets.”

I have a hard time thinking of a less efficient market available to public investors than the community bank stocks.

Professor Roger Ibbotson of Yale is one of the better-known academics who studied the stock market. He did a fantastic study that showed that illiquid stocks beat the more liquid stocks.

His study Liquidity as an Investment Style found the following:

“Among the high growth stocks, the low-liquidity stock portfolio had an annualized geometric mean (compound) return of 9.99% whereas the high-liquidity stock portfolio had a return of 2.24%.

“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-growth stocks with high-turnover stocks.”

I would venture a guess that the majority of the people who read this statement have a portfolio stuffed full of high-growth, highly-liquid stocks. They have those stocks rather than a bunch of community bank stocks with strong balance sheets trading below book value that fit the definition of a high-value illiquid stock.

If you approach buying a stock like you would a piece of property, or an operating business, you realize that you do not need massive liquidity to make an investment. Would you expect to be able to sell a commercial lot in a millisecond? Would you back out of buying a profitable, interesting business because the seller would not guarantee that you could sell it with the push of a button anytime you felt like it?

If you are serious about making money you need to approach buying stocks with the same thought process and time frame you would use when buying any other asset.

If you are just messing around, however, please continue to try and guess where the indexes will close today. Make some futile predictions about how many Apple Watches might sell this quarter, and try to guess when the squiggly line will cross the wiggly one on the price chart.

Community Banks-Even the Risks Could Be rewarding

originally published on Real Money

Over the weekend, I got to defend my trade of the decade theory on two occasions. Saturday morning, I did a teleconference with an East Coast investment group and outlined the idea and had a great discussion about why I am such a big fan of small banks.

Then the New Orleans Times-Picayune ran an article about community banks quoting a KBW analyst as saying they are not in crisis and regulator problems and costs are not a driving issue. I have to disagree with that assumption, of course. I have the industry on my side of the discussion. When you read the commentary from the Gulf South and D.A. Davidson bank conferences in the past few weeks, the folks running the banks are telling us that regulatory costs are, in fact, a huge problem for the smaller banks.

But just for fun, let’s say I am dead wrong and small banks are going to ride out the storm and find ways to deal with increased regulatory costs. Maybe Congress really does act in the best interests of the industry and consumers alike and shrinks the costs of regulatory compliance for small banks. Where does that leave us? What can go wrong?

I think the biggest fear for the community bank stocks is an extended deflationary cycle that causes lower rates longer. Net interest margin compression from the already historically low levels would make it very difficult for the smaller banks to turn a profit. Of course, the flip side of the coin is that this will be a factor that causes many bankers to just declare defeat and sell their banks. Deflation would indicate that the economy is not growing at any reasonable levels, so the regional banks would be scrambling to buy assets and earnings growth. Deflation would make the environment and operating conditions for small banks much more difficult, but that means sellers and buyers alike would become much more active.

Inflation may be a problem for the rest of the market, but it would be fantastic for small bankers. Inflation means higher rates and higher margins, leading to much larger profits. Inflation should mean a stronger economy, which ultimately means more borrowing and rising collateral values. It may slow down takeover activity as higher margins mean bankers can cover the cost, but given that rising profits generally mean rising stock prices, it will be hard to get upset by a slowdown in M&A.

Of course, the big fear is that we have another banking and credit crisis. It is possible, but I have to tell you I have been investing in bank stocks for about 25 years and you can see these coming from a long way off. Asset prices get bubbly. Nonperforming loan levels begin to move higher. You need a boom to have a bust, so bank stock prices are trading at higher levels and the takeover multiples are approaching stupid levels. I went back and looked at the bank stock activists and found that in 2007-08 they filed very few new 13D’s, and the majority of those were related to mutual conversions. They were selling banks, not buying banks.

If we have a big market decline, will the small banks be exempt? Probably not, but they usually fare better than bigger stocks because of the strong local shareholder base and illiquidity. No one is going to be selling their Cape Bancorp of New Jersey (CBNJ) or Atlantic Coast Financial (ACFC) to meet margin calls. Even if they lead the way lower, as long as the capital levels and nonperforming asset ratios do not materially deteriorate, it would be a cause for celebration as we could buy quality banks at stupid prices.

I poke and punch at all my ideas and my first question is always what can wrong here and cause me to lose a lot of money? I have reached the conclusion that if I focus on buying strong banks below book value and favor those that already have an activist involved in the stock, the answer is not that much in the long run.

By the way, the analyst who was quoted as saying regulations are not that big a problem, Collyn Gilbert of KBW, still thinks there will be consolidation. According to the Times-Picayune article “Despite this, the country still has thousands of banks, all competing to offer the same products and services,” she said. The problem is oversupply, not over-regulation, she said. “We’re still way overbanked. We still have way too many banks in what is a very targeted universe of services at the end of the day.”

Tomato, tomahto.