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Wednesday, June 26, 2013

Graham Income Stocks

There were three very important conversations around Chez Melvin. One had to do with the woeful status of the Baltimore Orioles starting pitching while the other two focused on more market related topics. A 1976 interview with Ben Graham floated around the interwebs this weekend that focused on the more mechanical value formula he developed after he retired. Graham said that a simple quantitative measure of picking stock using low PEs and low debt to equity ratios had outperformed the market in the 60 years leading up to 1976. Tobias Carlisle and Wesley Gray updated the study in their excellent book Quantitative Value and found that since 1976 the strategy has continued to work with a compound annual return of more than 17%.

The third conversation has to do with the almost desperate need for income investors to find suitable securities. Intense buying has lifted many of the traditional alternatives to unsustainable levels. The Wall Street commission machine is in overdrive creating products, many of them potentially toxic, to feed the need for income. I am frankly surprised that retirees in need of income are not staging furious rallies at the Federal Reserve and Capital building as government policies have destroyed their retirement plans.

It occurred to me that while I can do nothing about the Orioles pitching problems I might be able to combine Graham’s formula for successful investing with the need for equity income ideas. I added an income component to Graham’s basic screen and came up with some ideas worth including in an income portfolio.  It looks to me like this could be a very fertile and productive approach for income investors.
Universal Insurance Holdings (UVE) is an insurance company based in Jacksonville Florida that primarily underwrites homeowners insurance. In addition to its home staet the company has recently expanded operations into six additional states. They also have a specialty division, American Platinum Property and Casualty Insurance Company, which writes multi-peril homeowner coverage on homes in Florida worth more than $1 million. There is nothing overly exciting about the company but they show solid results and pay a dividend yield of 4.5%. The shares trade at just 8.7 times earnings and have cash balances in excess of their market cap and more than 10 times the debt they have outstanding. They recently purchased 4 million shares from the former CEO at a discount to the market price, reducing the overall share count by 16%.

Sterling Financial Corporation (STSA) is the holding company for Sterling Savings bank in the Northwestern United States. The Spokane based bank has 174 branches in Washington, Oregon, Idaho, and California and total assets of $2.96 billion. Sterling has chosen to be a buyer in the current depressed market for bank stocks and has made several acquisitions this year including the Puget Sound operations of Boston Private Bank and Trust. They are also the leading Small Business Administration lender in Washington and Oregon so far in 2013. Once again this not an very exciting stock but a sound institution with a decent dividend yield.
The company did a private equity led recapitalization back in 2010 and Warburg Pincus and Thomas Lee Partners still each own 20% of the shares outstanding. Since then they have sold problem assets and cleaned up the balance sheet. Right now total nonperforming assets are just 1.58% of total assets and the equity to assets ratio is over 15. The bank is in good shape and should be able to grow both organically and by acquisition for the next decade. The stock trades at less than 5 times trailing earnings and yields 3.7%.

Building an income portfolio using the techniques developed by Ben Graham is a worthwhile exercise in todays complicated markets. I will note that there were several additional stocks that were cheap with decent yields that seemed to have an adequate margin of safety for individual investors but are too small to write about here on Real Money. I am going to continue exploring the possibilities of solving the dire need for investment income using basic time tested value techniques as develop by Graham and practiced by folks like Walter Schloss, Irving Khan and the folks at Tweedy Browne. I suspect this approach to income investing will work a lot better than whatever high yield product of the week is turned out by Wall Street.

In addition to using simplified price to earnings and debt metrics to pick stocks in the 60 year study he completed in the mid-1970s Ben Graham also noted that you could substitute asset to price measures and achieve similar results. This is something of a relief to me as I have found that over the past 40 years the reliability of earnings measures has become somewhat suspect. Using the generous accounting standards, strategic buybacks and other financial engineering shenanigans most CFOs can make the earnings number come out where they want each quarter. Not everyone does this but enough do that earnings, and therefore price to earnings ratios are a bit trickier to use when searching for stocks. It will come as no shock that I prefer to use book value in my search for stocks.

During last night’s extensive rain delay in Baltimore I sat down and ran a screen for income stocks substituting a low price to book value for earnings for low price to earnings. I think investors looking for a decent income from their portfolio in these yield starved times should do both in order to find as many stocks as possible. The trick to making a cheap stock income portfolio to work over the long run is to own a bunch of them and let time and value work for you while you cash the quarterly checks.

I found some names that are worth of inclusion in a long term income portfolio that should also have long term upside appreciation potential. I have been a long term fan of California First National (CFNB) for several years now. The stock has not had any spectacular appreciation but it has steadily cranked out dividends and the shares currently yield 13%. The fiancĂ© company takes in deposits via telephone, the internet and mail and uses the funds for their leasing business that specializes in high technology assets. Like every other lending or leasing institution in the US the form is seeing some compression in net interest margins and this is keeping earnings in check for now. The actual leasing business is starting to see some strength as the economy slowly recovers and this should continue as we move from better to good over the next few years in terms of economic activity. The stock trades at 95% of book value right now. Insiders own 82% of the shares and have a vested interested in seeing the stock move higher over the next several years.  I think it will and in the interim we get paid to wait.

Old Republic Insurance (ORI) is probably not going to be the most exciting stock you ever own in your lifetime. The company sells insurance such as aviation, marine, commercial auto and general liability policies. They also sell extended auto warranties policies and title insurance. However it is a classic high yield value stock trading at 93% of book value with a yield over 5.4%. Insiders like the long term prospects of the company as several of them have been buying the shares this year. It may not be exciting but is should be enriching over the next several years. The insurance business should grow a little faster than the economy and as growth picks up so should earnings and revenues.

Ampco Pittsburgh (AP) is another stock that is not likely to make the most exciting list any time soon. The company makes custom engineered equipment and business has basically been flat for some time now. Bothe forged hardened steel and air processing equipment divisions need to see the economy move from the somewhat better to pretty good before business can really pick up. Until then the stock is trading right around book value, the balance sheet is strong and the share yield almost 4% at the current quotation.
The search for income stocks is one of the most frustrating endeavors for investors right now. The market has moved straight up without a significant correction for over a year now. Interest rates are low and in spite of recent gyrations in the long term bond prices are likely to remain so for an extended period of time. It is critical that investors avoid the product push of Wall Street and use common sense in assembling a portfolio of income securities. Adding an income component to the stock selection techniques developed by Ben Graham makes a lot of sense to me.

Wednesday, June 12, 2013

Small Banks: Trade of the Decade

When my son was in middle school he would mark the calendar for Shark Week on Discovery Channel. All activities of that week were then scheduled around shark shows on that network. While I cannot give you quite that level of excitement this week I do think it will be useful to declare the holiday shortened week to be Bank Week. Bank stocks, especially smaller regional and community banks offer extraordinary upside from these levels as real estate and the economy begin the long healing process in the aftermath of the credit crisis.
I have referred to these stocks as The Trade of the Decade and I think that is still the case.  

Bank stocks were the hardest hit when the market melted down in 2008 and first quarter 2009. Plagued by bad loans, tightened credit standards and non-existent loan demand they have been among the slowest to recover. Many institutions were shut down and many more were sold to competitors under special loss sharing arrangements between the acquiring institution and the FDIC. Although credit problems have begun to ebb as the python of stupid loans has worked its way through the system it is still difficult for many banks to generate real profit growth. Since most investors overly focus on the income statement this has weighed on the price of the shares. For those of us who prefer the balance sheet this is creating a real opportunity.

Many banks, especially smaller ones, trade at a significant discount to the tangible value of the underlying assets. This is significant as historically banks have corrected back above book value and mergers in the industry take place at a premium to the tangible book value.  It is an almost certain guaranteed lock that we will see an enormous wave of Merger and Acquisition in the industry over the next few years and most of these transactions will occur over book value.  As economic and industry conditions improve that multiple of book will increase and if this time rhymes with the last few times this has occurred the takeover premium will reach a multiple of more than 2 times tangible book value.

The simple truth is that it is simply going to be in the banking business, particularly if you are a smaller institution. As we have heard in our talks with bank stock investors like PL Capital, FJ Capital and others running smaller banks is going to be extremely difficult for the next few years. Regulatory costs are going to go up and capital requirements are likely to head higher as well. Net interest margins will remain low as long as the fed keeps rates down in an attempt to stimulate the economy. Loan demand is going to stay well below pre-crisis levels as well until we see more robust economic growth. Growth is going to be hard to come by for many institutions and organic growth will be close to impossible in many areas of the country. The only way to grow will to be buy a competitor.

Another factor leading to a merger wave is the simple fact that it just not a lot of fun to be a banker these days. Most of the last four years has been spent dealing with problem loans and cleaning up related messes. Now the regulators are an increased presence and regulations are being added and changed almost daily.  Costs of compliance are going up and staff is being hired specifically to deal with compliance issues. At the same time net interest margins are shrinking and it is harder to make money. 

At the smaller banks this is further complicated by the fact that the share price is down and much of your shareholder base if friends and neighbors. Being grilled about the stock price of your bank every time you go to a little league game with your kids or a social function is wearing to say the least. For many banks, especially its with older officers and directors, it is a lot easier to just sell the bank and move on rather than continue to navigate the troubled waters that are the banking industry today.

There are tremendous opportunities for long term investors in banks right now. There are the perfect TOD banks, smaller banks with strong balance sheets and clean loan portfolios that will either be sold or gain market share at competitors expense. There are troubled banks that have attracted private equity or activist investors’ attention.  There are banks that will be aggressive acquirers and experience strong earnings and asset growth over the next five to 10 years. TARP Warrants from larger banks also offer the opportunity for profits in multiples and not percentages over the next few years. Investors who ignore banks do so at peril to their net worth as this truly is the trade of the decade.

Over the past two years the Trade of the Decade in bank stocks has taken shape nicely. I have suggested and purchased dozens of little banks, and even a few larger ones and they have done pretty well so far. We have had a few takeovers along the way already but nothing like we will see over the next three to five years. Credit conditions have slowly but surely improved and banks have reorganized or disposed of many problem assets during this period. This morning Moodys upgraded the industry from a negative outlook to stable as a result of improving conditions. In spite of the improvement there are still plenty of bank stocks to buy as Wall Street continues to focus on the earnings outlook for small banks and not the asset value and potential for M&A activity.

The first group of banks that make up a TOD portfolio are those smaller banks that are just sleepy little banks that no one really notices. They have solid loan portfolios, an adequate or even excess amount of capital and the shares still trade below tangible book value.  They are not making headlines and they won’t be the subject to cocktail party chatter unless you happen to live in their hometown and have an account with them. Until they day they get taken over they probably won’t be the short term performance leader but my experience has been that if bought right these stocks will almost always be among your top long term performers.

One such bank Is ESSA Bank and Trust (ESSA) a 26 branch bank located in Stroudsburg, Pennsylvania. I have owned this stock for some time and it really has not done a whole lot over that time. They bought First Star Bank last year to increase their presence in the Lehigh Valley and the purchase is working out well for them already. The stock trades at 83% of tangible book value and the equity to assets ratio is a little over 11.  The balance sheet is in good shape with nonperforming assets at just about 2% of total assets.
The Berkshire Bank (BERK) is another bank that has been on my list of bank stock buys for what seems like forever. This is a 14 branch banking institution with 793 million in assets located in New York City. The stock trades for less than 90% of tangible book value and they have plenty of capital with equity to asset ratio of more than 16. The loan book is rock solid with nonperforming loans at just .39% of total loans. It is not a particularly exciting stock but is a well-run, profitable financial institution that is both safe and cheap at the current price.

Taylor Capital Group (TAYC), the parent of Chicago based commercial bank Cole Taylor bank could easily be the poster child for the improvements we have seen in the banking industry. The bank serves closely held business and the people who own them and also engages in asset based lending, commercial equipment leasing and residential mortgages. The bank has steadily worked down the problem loans and real estate and the economy improved and total non-performing loans has fallen from more than 5% to less than 2% at the end of March. In spite of improving conditions the stock still trades for just 80% of tangible book value at the current price.

The San Joaquin Valley of California was ground zero for the real estate collapse but at least one bank in the region has managed to stay in good shape throughout a difficult time in the region. The Fresno based bank. Central Valley Community Bank (CVCY) is a 33 year old bank with 17 branches and $885 million in assets. They just received approval to buy Visalia Bank which will give them 21 branches and more than $1 billion in assets when the transaction closes. The bank has non-performing loans of just 1.24% of total loans and the equity to asset ratio is a very healthy 13. The stock currently trades at just 90% of tangible book value. As California and the Central Valley recover this stock should do extremely well for long term investors. Patriot Financial Partners, a bank focused private equity group owns 11% of the shares and one suspects they are looking for a long term payoff of many times the current stock price.

The core of a Trade of the Decade portfolio is made up of what are pretty boring little stocks. They will move like bunny rabbits over time trading in a tight range before leaping ahead on good news or possible takeover offers. Patience pays with these stocks but the small bank stocks have the potential to be the best investment of your lifetime.

I want  look at some banks that might fall outside the definition of perfect bank. They may have loan losses that are a little , or even a lot, higher than the perfect little bank standard, but conditions are improving. They may need to raise some capital to get the equity to asset ratio up towards my preferred levels. They have more scars and bruises than perfect little banks but there is still tremendous upside.  Most importantly they have attracted the attention of an outside investor or private equity firm with a record of successful bank stock investing. Often these investors are activists who intend to take an aggressive stance towards unlocking shareholder value.

A perfect example of this type of stock is HopFed Bancorp (HFBC) of Hopkinsville Kentucky.  The bank does business in Kentucky and Tennessee with 18 branches and $978 million in assets. The bank has come under fire from noted activist Joseph Stillwell as he pointed out that that management had no business going forward with an acquisition of another bank when they have delivered so little returns with the assets already under their control. Stillwell has advocated for a sale of HopFed to another institution to unlock the value of the shares. He has a point. The stock trades at just 80% of tangible book value and has adequate capital. Nonperforming loans are just 1.30% but returns on assets and equity are well below their peers. Mr. Stilwell won the first round of the fight by having his nominee elected to the board a few weeks ago. I would not be surprised to see the pending purchase of a neighboring institution cancelled and HopFed put up for sale in the near future. PL Capital and Arbiter Partners are also shareholders in the bank so there are a lot of smart eyes on the bank which could help force a sale.

United Community Financial Corp (UCFC) is another bank starting to attract attention form noted bank stock investors. The Youngstown Ohio based bank has 33 offices and $1.8 billion of assets. The bank has struggle with asset quality as nonperforming loans are still a little north of 4%, well above the national average in a recovering market. They have been making substantial improvements. In the first quarter of 2010 total nonperforming assets were above 8% of total assets. Today they are down to 3.32% of total assets. The stock trades at 80 % of tangible book value so there problems would appear to be discounted in the current quote. The equity to assets ratio is 10 so they appear to have enough capital on hand to navigate through the troubled waters. At least two noted bank investors think so as EJF Capital has been a buyer of the stock and our old friends at FJ Capital just filed a 13G disclosing ownership of more than 5% of the bank. The bank raised additional equity earlier this year in a private placement and conditions are slowing improving. As the economy recovers and the Youngstown market begins a long slow recovery this bank should see their problems disappear and profits to begin growing once again.

Cape Bancorp of New Jersey (CBNJ) is another bank that has been showing up in the portfolio of seasoned bank stock investors. Michael Price, PL Capital and EFJ Capital are all owners of the 15 branch, $1 billion in assets institution. The bank serves the Cape May and Atlantic County areas of New Jersey including the beach towns of Wildwood and Atlantic City. Non-Performing loans are declining from almost 6% a few years ago to just 2.57% right now.  The bank is still chipping away at its other real estate owned portfolio with the total decreasing by $1 million last quarter. As the economy improves the banks should see strong profit growth and is also a takeover target given its attractive service area. The shares are trading right at tangible book value and they have plenty of excess capital which they are using to buy back stock.

 I  also want to take some time and suggest some more little bank stocks that do not necessarily fit firmly into the perfect bank category. These banks aren't in perfect condition and are fighting through the cleanup of the loan portfolio and super slim net interest margins.  Bankers are one of the few groups of people who would like to see higher interest rates right now. Richard Lashley of PL Capital told me earlier this week that most bankers would like to see higher rates across the curve to widen interest margins and make it easier to produce lending profits. He thinks a perfect world would be a 2% cost of funds and loan rates around 5.5-6%. Until that happens profits will be compressed and in the income statement focused world of Wall Street that may keep the profits lower than normal into next year. That gives us asset types time to accumulate these stocks at favorable prices.

One bank that catches my eye at the current price is Newbridge Bancorp (NBBC) of Greensboro North Carolina. The bank has 30 branches in the Piedmont and Coastal regions of the state and has total assets of $1.7 billion. The ban recently repurchased the TARP warrants it had issued to the treasury and its TARP preferred was auction off in the first week of May. The bank disposed of over $160 million of troubled assets in 2012 and raised $56 million in new capital to shore up the balance sheet. The lack of losses related to problem loans caused the bank to see a huge jump in earnings of the first quarter and the are positioned to continue that trend. They are seeing organic loan growth and have added experienced commercial banking team to help grow that business in the Charlotte and Raleigh regions of the state. The shares are cheap at 70% of tangible book value and the equity to assets ratio currently stands at 10. After disposing to troubled asset nonperforming assets are now just 1.21% of total assets. This is a very cheap bank in one of the strongest economic regions in the state and is an excellent addition to a Trade of the Decade portfolio.

I touched on Simplicity Bancorp (SMPL) a few months back when I reviewed California banks. This bank used to the credit union for employees of Kaiser Foundation Hospital and concerted to a mutual saving bank in 199. In 2010 they converted once again to a stockholder owned institution. They function as a community bank with 9 offices and $882 million of assets. The still have plenty of capital with equity to assets ratio of more than 15. With the stock at 80% of tangible book value management has been buying back stock and pay shareholder dividends of 2.2%. Non-performing loans are 2.72% of total loans and have been improving over the past few quarters. Given its presence in the LA market I would not fall out of my chair if I saw a takeover offer for this bank early in the M&A cycle.

Mutual First Financial (MFSF) is another bank I have discussed in the past. PL Capital has a large position in the bank and owns more than 5% of the stock right now. Former hedge fund superstar Jeffrey Gendell has more than 4% of the shares as well. The bank is moving to add commercial and consumer lending to their loan portfolio as they are overly exposed to residential real estate. The Muncie Indiana based bank has 32 branches and $1.4 billion in total assets.  If we see a proxy fight between outside investors such as PL Capital and current management it could get interesting. The board and officers are fairly young and own a good deal of stock so they may choose to fight back. With shares trading at 80% of tangible book value it is a decent buy for a long term bank stock portfolio.

The trade of the decade is developing and is reaching the sweet spot. By the end of the year we should see merger and acquisition activity begin to pick up. I think this sector is going to soar by multiple five to ten times the current quotations over the next decade. The train is building up steam and the time to board is now.  I was asked yesterday if I worried about the market direction when I was buying bank stocks. Other than my insistence on not buying up days I really do not. I am buying these for what is going to happen over 5 to 10 years not next quarter or even 2014 for the most part. Any weakness that is market related just gives me a chance to buy more at better prices. I firmly believe that  buying community banks today will  be helping me pay for my books and wine collections well into the 2020s.

Monday, June 03, 2013

The Lonely Trade

As I was watching the Orioles extract some revenge last night I spent some time talking stocks and markets on the phone with some fellow value type investors. In the midst of the discussion we got around to the shipping stocks. I confess that I am over intrigued by these issues even though I have never really done well with them. It’s one of those industries that seems to defy conventional wisdom with a highly exaggerated boom bust cycle.  Right now it seem to me that we are at the bottom of the bust and as the over capacity finds its way into the scrap yards and global economic activity is at what is hopefully a trough I have been nibbling.

One of the catalysts for an interest in shipping has been the aggressive entry of Wilbur Ross into the sector. I have followed Ross into all sorts of forays over the years including steel, coal, mortgage insurance and mortgages and have always made money. It has also always been a long ride lasting five years or so with lots of ups, downs and twists along the way. Playing the equity vulture and snapping up troubled companies is not for the impatient or faint of heart and I suspect it will be the same with shipping.

Mr. Ross makes a compelling case for the shipping stocks. Container shipping still transports 90% of the worlds consumer goods and energy products so if the economy improves over the next decade so should the stocks. The glut of vessels ordered at the top of the cycle is being worked off as marginal players and vessels leave the industry. Demand and capacity should finally have a positive intersection in 2014 according to the Journal of Commerce. Rates have declined by something like 80% from the peak and may have finally found a bottom and could be headed back up. Although shipping rates rose slightly in the past year they are still well below the levels of a few years ago.

The stocks of the major shipping stocks have been beaten down to distressed levels. I have recently been buy shares of International Shipholding (ISH) at just 60% of tangible book value in spite of decent operating results and dividend yield of over 5%. I own shares of Tsakos Energy Navigation (TNP) and they trade at just 30% of tangible book value. The company has balanced exposure to both the crude and refined products segment. The company is entering the segment of the market with strong growth prospects, LNG transportation. It also pays a generous dividend of 4.7% at the current price.  I still have a stub of dry bulk shipper Paragon Shipping left from my earlier attempt at picking a shipping bottom that trades at 30% of tangible book value.

When I mentioned these names to my fellow value enthusiasts I was greeted with silence. Even the crickets took a break. No one had any interest. This got my curiosity up so I dug into SEC filings to see which value investor s had joined Mr. Ross and I in out shipping plunge. More crickets. Only Donald Smith and Company and quant firms like Renaissance and AQR were buying shipping stocks in the first quarter of the year. It seems that in addition to being a difficult business, shipping is a lonely investment as well.

Now I was really curious so I dug deeper to see who else in the world anywhere might be buying into the idea of a shipping bottom. Mitsubishi (MTU) has formed a private equity fund to buy into depressed shipping assets.  Blackstone (BX) and TPG have made private equity investments in the industry in recent months as well.  Several other smaller Private equity and distressed funds have recently ventured into he field as well.
I found one other noted investor who suggests that shipping stock may have found a bottom. Back in march our own Jim Cramer suggested that it was time to buy into dry bulk shippers as the Baltic Dry Rate Index had plunged to new lows. He suggested shares of Diana Shipping (DSX) which trades at 70% of tangible book value. The stock has done pretty well since then gaining about 25% or so but the stock is still cheap.  Mr. Cramer cited many of the same reason that Mr. Ross and I have such as a decline in capacity and a likely recovery in 2014.

So far shipping stock is a lonely trade.  This may be the first time in my entire career that I find Wilbur Ross, Jim Cramer, a few PE firms and myself standing alone in an industry. I like my team and will stay long the shippers and look for a chance to add more on market declines.