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Friday, September 27, 2013

Proven Performance and an Offer

I was going through my desk this morning looking for some research material I was using to set up my new International Deep Value Letter when I came across some print outs of articles I wrote in July 2012. I had used them as handouts at a business networking event and then just stuck them in desk drawer.

One was on the power of asset based investing and why it worked. I suggested buying 4 deeply undervalued stocks in an article called simply Asset Based Investing Works published on July 17, 2012. I suggested four stocks, an oil and gas driller, two banks and a staffing company. Had you purchased an equal dollar amount of all 4 your return through today's close would be 82% in a little over a year.

The second article was called Real Estate is the New Plastics published on July 31 of the same year. I suggested that 7 REITs were deeply undervalued based on the concepts used in deep value investing. If you put an equal dollar amount through today would be 41%. Not as good as the first article but not too shabby either.

Deep value investing works. It works very well and it works consistently though all sorts of different market conditions. I want to help use it to make you money over time.

In order to encourage you take the leap and put deep value to work making you outsized profits here is what I am going to do. If you sign up for my Deep Value letter this weekend I will give you $100 off . Instead of $499 I will let you have it for just $399 for the year. To add a little extra incentive if you join me today at the deep Value letter I will GIVE you a free year of the brand new International Deep Value letter just launched today. 

That’s what I call a deep value. Use this link to sign up.

Thanks .

Tim Melvin

Saturday, September 21, 2013

Gross Profit, Great Gains

I have long held the opinion that for most investors the money is made on the edges. The two top performing strategies I have uncovered over the years are deep value and what I call real growth. Real growth companies are those that are growing revenues, earnings and the net value of the firm higher consistently over the years. It is basically an earnings momentum and growth strategy based on high profitability and management execution. As long time readers are aware I am a bit of a geek and spend a good amount of time reading academic research and I recently forum a paper that basically confirms my thoughts on this subject and brings some interesting new data and possibilities for individual investor.

Robert Novy-Marx is a professor at the University of Rochester and a fellow at the National Bureau of Economic Research. His research efforts are spent studying asset pricing, real estate and finance, He recently produced two studies that are of interest to me as a value investor. The first paper has the provocative name of The Other Side of Value: Good Growth and the Gross Profitability Premium that was originally published in Journal of Financial Economics. The other is a working paper titled the Quality  Dimension of Value Investing. The papers make two discoveries that are extremely useful to us as long term value investors.

The first is that companies with a high level of profitability are as useful as price to book value when it comes to predicting future performance of their shares. However he eschewed the usual standards of profitability such as earnings per share and return on equity. He remarked in one paper that “gross profitability performs better predicting future stock returns than ROE, the profitability variable most frequently employed in earlier academic studies, because it is a better proxy for true economic profitability. In particular, the study points to the fact that accountants treat many forms of economic investment (e.g., R&D, advertisement, sales commissions, and human capital development) as expenses, so these activities lower net income but increase future expected profitability. This makes earnings a poor proxy for true expected economic profitability.” He compares group profitability to total assets an finds that those stocks with high gross profits as a percentage of assets used to produce the profits as the best way to measure profitability.

His study cover a period from July 1963 to December 2012 and finds that stock with high profitability using his measures outperform the market at a rate comparable to those that fit in to the classic deep value approach. The conclusion supports my conclusion that investors would do better focusing on the what I call true growth firms and what he calls profitable firms and classically cheap stocks based on book value. While I prefer picking one for or the other there is a suggestion n the data that investors might be best served by focusing on both strategies.

While that seems like an interesting concept and would probably work very well over the long term the two studies give us another useful idea to apply it the investing process. What would happen if you combined the profitability factor with traditional value approaches? You end up outperforming the market, straight value approaches, and true growth strategies by a pretty significant margin with lower drawdowns and fewer years of underperformance according to the study. It works on both large and small cap stocks over a long period of time. He concludes the study by saying “The basic message is that investors, in general but especially traditional value investors, leave money on the table when they ignore the quality dimension of value.

I am a geek but I am also a cynical optimist. I had to go back and look at some results for myself and how it has worked recently. I looked back one year and selected stocks that had high profitability using Mr. Novy -Marx’s profitability calculation and also traded below tangible book value. The results are incredible. The list of stocks over $100 million in market cap returned on average 45% over the past year. 79% of the profitable value stocks are higher a year later. For the microcap stocks under $100 million the average return was 54.8% and 70% of the small profitable value stocks went higher.

Naturally I then sat down and ran the screen on the current universe of stocks. I found two things to be of great interest. The first is that there are a lot fewer cheap profitable companies right now than there were this time a year ago. The second is that there are some pretty interesting names of the list worthy of further exploration by long term value investors.

That is impressive performance to say the least so I quickly built a screen that looked for cheap stock that have very high gross profits when compared to their asset base.I found some surprises when I ran the screen. Some companies you might not think of as wildly profitable actually are when you measure it by gross profitability. Keep in mind that gross profitability is simply total sales minus cost of goods sold and leaves out all the overhead and other expenses. Mr. Novy- Marx found that this was the best measure of profitability and that it has strong predicative value so that is the one we will use.

Arcelor Mittal  (MT) is  a large integrated steel company and one would not necessarily think of it as wildly profitable as they have struggled in recent years. They took a bottom line loss in 2012 but had managed to paint the bottom line black in the preceding decade. The CEO of the company recently told investors he believed the company had turned the corner and should see conditions in the steel market in 2014. When we measure it in terms of gross profitability compared to assets we find that the company has assets of $112 billion and gross profits over the last four quarters have been a little over $74 billion. That is one of the cheapest ratios in the deep value high profits screen. The stock is certainly cheap trading at less than 60% of tangible book value.

I almost feel out of my chair I when saw Radio Shack (RSH) on the list of high profitability cheap stocks. This has been one of dogs the past few years as I was way to early buying the stock in anticipation of a turnaround or takeover. The company has its issues but it also has a very high level of gross profitability with $1.4 billion of gross profits in the past year on an asset base of $1.9 billion. The stock is still cheap at 78% of book value so if they can find a way to improve the items between gross profits and the bottom line my patience may yet be rewarded.

I was further happily surprised that although my credit and fundamental models use a lot more than 1 factor the gross profitability and book value combination picked  out a lot  of the companies I have mentioned here on Real Money and own for myself as well as family and friends. Stocks like Kimball International (KBALB), Xyratex (XRTX), Real Networks (RNWK) and Sky West (SKYW) have very high gross profits as a percentage of assets.  Transworld  Entertainment  (TWMC)is one of the stocks I hate to love as I think the brick and mortar music and video stores is an industry in the way out but those stock has high gross profits as a percentage of asset and trades at just 85% of book value.

 So do a couple of companies I have had my eye on but haven’t pulled the trigger and purchased yet. Tropicana Entertainment is Carl Icahn’s casino empire based purchased out of bankruptcy a few years back. They now own casinos in Nevada, Indiana, Louisiana, Mississippi, and New Jersey as well as one in Aruba. The stock may not do much until Carl decides to sell or otherwise transform the company but it trades at just 3 times gross profits and 80% of tangible book value.

I have also been negative on for profit education stocks for several years now and Apollo Group (APOL) is one of the best shorts I have ever put on in my life. However many of the stocks in the group such as Corinthian Colleges (COCO) and Career Education (CECO) are now trading below book value and have high gross profits when compared to assets. I haven’t bought in yet as I am still a fan of the business model but the valuation is getting quite compelling.

The idea of using gross profits as a measure of profitability when selecting stock is clearly effective and should be an arrow in every investors analytical quiver. When used with value stocks it appears to work extremely well at locating stocks that can survive to thrive.

Friday, September 13, 2013

Value at Work: The Credit Crisis and Beyond

Now that we have launched the Tim Melvin Deep Value Newsletter and Banking on Profits we have seen a steady flow of subscribers and I think over time we will grow this service. I have been told that if I would be more self-promotional and dramatic about my offerings we could probably accelerate the sales process. I am just not that guy. Even if I wanted to pose in front of fancy cars with half naked women all gained as a result of my terrific trading advice I am pretty sure my wife would kill me for even suggesting it. The fact that I drive an old Jaguar that fits me like a glove and I refuse to part with might also hamper my efforts in that type of marketing.

I am not going to make shrill dramatic pronouncements about my ability to make you millions of dollars in minutes a day. Value investing does not work that way. This is a long term approach to the markets that puts margin of safety first and lets the upside take care of itself. It works but it won’t make you rich overnight either. It is a service for investors who are tired of the hype and the promises and want a way to earn solid returns over time and build their net worth the way private equity and other long term investors do it by buying cheap assets and selling them when they are fully valued.

Rather than try to convince you to subscribe to my newsletters with hype and promises I am just going to run on my track record. Listed below are comments dating back to 2006 that were recorded in my personal blog or published on Real Money, Daily Speculations or one of the other sites where my work has appeared over the years. This is value investing at work over the long run. It runs through the credit crisis when investors were losing a fortune ,the late 2008-2009 period when everyone was terrified to buy and up to 2011 when we started to feel like the worst was behind us. Judge for yourself if my approach to investing makes sense for you and is worth the small cost of an annual subscription. I think it is and hope you will join me by subscribing to the newsletters and putting deep value investing to work for you.
Good luck to us all,



You might be able to sell me the fact that this market is fairly priced, providing I’ve been drinking heavily, but undervalued, I can’t see it. The bond market and the dollar are telling you it’s just not that good out there right now. We have rallied almost 12% since August without a real pause of any length and anybody who is not cautious now pretty much deserves what they get.

April 1, 2008
Even if I am dead wrong here I think the risk of being fully committed to stocks carries too many risks for the idea of a margin of safety to exist. I am willing to miss this run up to protect capital. There appears to be very little common sense being used on Wall Street these days when it comes to the overall economic and financial matters, as well as a total lack of fear. Bottoms are accompanied by fear and loathing not cheerleading and bottom predictions. The bullish arguments are laughable. Anyone who does not clearly see that the recent pullback in gold and other commodities is deleveraging by hedge funds in light of recent volatility is not looking close enough. Anyone who thinks that the bank write offs are at an end has just simply lost their mind. Yes, eventually they will write all this crap down too far and it will create an opportunity. I particularly look forward to moves like that of UBS to separate the bad assets into separate vehicles as this will create huge pools of underpriced and unloved mortgage assets that no one wants to own, reminiscent of the Texas bad Banks of the late 80s and early 90s. But that time is not now. Small community banks will thrive and benefit from the tighter credit conditions and steeper yield curve. But not yet. Patient investors will see one of the best buying opportunities of their lifetimes. But it is too soon. 

June 20,2008
Interest rates are starting to rise. I continue to think that only an illiterate deaf mute kamikaze could be aggressively long the US stock market. Of course there are lots of those around. We call them mutual fund managers.

As for the market itself there is a fortune to be made over the next several years. I see companies that are profitable trading for less than 3 times E/EBITDA. I see an ever growing list of companies that sell for less than cash in the bank. We are fast approaching the depths of an ugly bear market and there is money to be made. I am buying DAR, HDNG, DOW,ASH and other like a crack addict at a rock convention.


You can buy stocks like ADPT, TECD, and ESIO for less than the value of the company’s liquid assets. You can literally build a portfolio of 40-50 of these that have a good credit scores, viable businesses and excellent recovery prospects. That’s enough to make me salivate at the possibilities for gains over the next several years.

DIS trade for about two thirds of my appraisal value. That is provided we give no value at all to the film library or character rights and price the parks as raw land and put a 5 multiple on after tax earnings .DELL trade for less than two cash. HTH is a pile of cash in the hands of a proven investor in distressed banks and other financials. As a bonus the company landed a back door bank charter and will be able to bid on distressed assets and institutions. Southwest Airlines is stupid cheap, trading below tangible book value. Oil service companies like RDC and PTEN trade below net asset value at these levels. I like the idea of buying the Forest City senior debentures at a 30% YTM and what looks to be more than adequate asset coverage. Whitman has been a buyer and although struggled with everyone else last year, he is one of the best credit analysts and distressed guys around.  

This is the type of trade I am hoping begins to develop in earnest in the first half of 2010. As commercial and real estate woes continue to fall I am looking for the market to wake up to the problems facing the small banks. When it starts the stock market, being the bastion of irrational insanity that it is ,the baby will go out with the bathwater. This type of activity created a situation back in the early 1990s that allowed many people to literally get rich over the next decade. When the good get sold with the bad I am looking to buy up a portfolio of small banks below tangible book value that have low loan losses and adequate reserves. As real estate improves-and it will someday- we will start to see a wave of mergers and acquisitions in the banking community. These transactions will occur at multiples of book, not at a discount. Those solid bank stock bought in this next sell off will show tremendous gains for those bold enough to step up.

  August 8,2011

The current turmoil in the markets is creating some opportunities. Any type of corporate disappointments is leading to a steep and drastic sell off. Right now foreign banks are god-awful, point of maximum pessimism cheap. I like two of the larger Japanese banks, Mitsubishi UFJ (MTU) and Mizhou (MFG). Both sell at a fraction of tangible book value and for an investor with a time horizon of five years or more should be very profitable. The same is true for Royal Bank Of Scotland (RBS). The stock is at 40% of tangible book and management has a solid plan to de-risk the balance sheet and return to profitability. As a final foreign excursion the shares of Dutch insurer Aegon (AEG) are also very, very cheap. They have repaid the Dutch government for the emergency funding and should pay a dividend again starting next year.

Here at Home Hudson City Bancshares (HCBK) have sold off sharply. After the reorganization of the balance sheet the bank should do very well going forward and at a discount from tangible book and yield of 4.40% it’s an attractive long term investment. First Bancorp (FBNC) is also cheap and replacing the TARP funding with Treasury Small Business program funding will be an enormous boost to the bottom line. Locally Shore Bancshares(SHBI) has been a severe disappointment as loan losses have continued to mount. I am going to hold that name and add Severn Savings (SVBI) at this price. I have a lot of faith in the Hyatt families’ strong desire not to lose the millions they have invested in the bank. Insiders have been buying so it’s worth a shot at one third of book value.

Force Protection (FRPT) missed earnings and is now trading at very cheap prices. This company should have sold out last year and now I think it is just a matter of time. They have a decent business but will function better as a division of a larger defense contractor. LB Foster has decent earnings but there is a product liability claim with Union Pacific involving 1.6 million rail road ties. The question becomes is that worth the 50% of market cap the stock shed? They will be a huge winner when we finally get all this crap behind us and our economy is once again growing to the point that infrastructure spending resumes. Demand for computers and other tech products may be slow but it will come back when the economy does. That makes Micron Technology (MU) a screaming long term buy at 75% of book value in my opinion.

I like the idea of buying a small package of mortgage REITS here. I would buy a little Annaly (NLY) and a little Invesco Mortgage (IVR) here with the idea of building the position over an extended period of time. You are likely to get a chance to buy lower based on conditions and volatility in the bond markets going forward. However they are cheap and the yields of 15 and 20% respectively make them worth a shot here.

Tuesday, September 10, 2013

Stealing Ideas

Originally published as a series on
Special offer for my Deep Value Letter at bottom

As the 13f filings piled in  like everyone else I reviewed some of the bigger ones just to see how was doing what. The Whole street was reading them at pretty much the same time so there was no information advantage to be gained but the information on the buying and selling of David Einhorn, Daniel Loeb and other heavyweights is useful background information. However the fact that Einhorn sold Microsoft (MSFT), Loeb bought Disney (DIS) and John Paulson still likes Gold is not really actionable research worthy information for me.

That’s not the case with Paul Isaac of Arbiter Partners. I find some useful investable information in his portfolio every quarter. I enjoy reading his portfolio filings and to be honest its really good for my ego. Mr. Isaac is one of the most successful hedge fund managers of the last decade and learned the craft from his father and legendary Uncle Walter Schloss. He owns and has been buying many of the same stocks that I have in the past year and that really increases my comfort level with stocks s like Calamos Asset Management (CLMS), Cowen Group (COWN), National Western Life Insurance (NWLI) and a host of small cap banks that we both own right now.

The fund opened some interesting new positions in the second quarter. Arbiter bought shares of oil and gas company Apache (APA) in the quarter. The stock has traded right around book value in recent months. The company is selling its Gulf of Mexico assets to focus on onshore operations in the  Permian/Anadarko basins. They also have operations in Egypt which is a concern for many investors right now. The large cap company is on my buy in a big decline list of stocks as the stock could easily move back over the $100 a share mark in the next couple of years.

The fund was also a buyer of the recent spin off from Brookfield Asset management (BAM). Brookfield Property Partners (BPY) was formed to hold the commercial real estate operations of Brookfield and owns shopping malls, multi-family housing, office properties and have been buying industrial properties of late. The shares trade at about 80% of the equity value as reported at the end of the second quarter and yields a little over 4%. I am a huge fan of Brookfield deals and will be reading further on this one over the weekend.

The filing also shows a large new holding in AMBAC  Financial Group (AMBC) that I suspect was gained through participation in the bankruptcy process. The bond insurance company emerged from bankruptcy back in May of this year. There is a lot of stock in the hands of distressed funds who will be looking to sell strength so I am not really interested in this one right now. The recent developments in the municipal market may make the stock more interesting should vulture fund selling push the stock back below the $20 area later this year.

The fund was also buying some of the battered technology stocks that have underperformed the market in the past few years. The fund added to its stake in Amkor Technologies (AMKR) the semiconductor equipment company in the quarter. The stock is pretty cheap trading at just around tangible book value and earnings should gain some momentum in the future driven by increasing demand form the smart phone and table computing markets. The company is working to restructure its debt load and success in this endeavor could help unlock the value of the stock in the next year.

Mr. Isaacs fund also opened a new position in shares of Emulex (ELX) the network solutions company. As the economy eventually improves and corporations and governments begin to spend on IT infrastructure again the company should see revenues and earnings begin to grow at a decent pace. The company has made acquisitions that broaden its product line and should also help drive future growth. This one is not really my cup of tea as it trades well above tangible book value but investors should note that Mr. Isaac is a lot smarter than I am.

The fund held firm on most of its small bank positions in the quarter but they did add to two banks that had outstanding earnings reports this month and showed strong improvements. Both Intervest Bancshares (IBCA) and Eastern Virginia Bancshares (EVBS) are in my trade of the decade portfolio and I am happy to see that a smart and successful fund manager is in agreement.

The reports from the larger fund managers have turned into just more market noise the past few years. However the smaller higher returning mangers like Arbiter are still a source of great ideas worthy of further investigation and investment.

 Last month as 13F filings were coming fast and furious I sat a couple aside with the intention of reviewing and reporting the information to viewers. They are two managers I respect enormously and as proof their all-around intelligence and stock picking prowess we often own many of the same stocks. As with everything else that gets set aside for later here at Chez Melvin the reports fell into the black hole of Tim’s desk and went unreported. Today I will begin to fix that.

EJF Capital was started back in 2005 by Emmanuel Friedman one of the co-founders of Freidman Billings the broker dealer and asset manager. The firm made a name of itself with its research and investment banking success in the finance and real estate fields. Mr Friedman partnered with the former head of FBR’s Alternative Investment and Wealth Management divisions Neal Wilson to start EJF and they have more than $4 billion under management.

The firm is doing some interesting stuff in both the banking and real estate fields. That of course is right in wheel house as I am a huge fan if both sectors when you can buy the securities cheap. EJF has been finding some opportunities in both that are cheap and appear to have significant long term potential.
They have been big buyers of little banks and the second quarter of the year saw the buying streak continue. EJF opened new positions in shares of Fidelity Southern (LION), Charter Financial (CHFN), VantageSouth Bancshares (VSB), Newbridge Bancorp (NBBC),Heritage Financial (HBOS), and ConnectOne Bancsshares (CNOB) as well as a few much smaller banks. Of these listed here, only Charters Tim cheap trading below book value as the rest have moved up in recent months. I continue to be big believer in the small bank trade of the decade and it appears Mr. Friedman also likes the sector.

The firm is also a big believer in the mortgage servicing story as they have large positions in leading servicers and added to several of them in the quarter. To my discredit I totally missed this story and left a lot of money on the table the past few years. They hold shares of Nationstar Mortgage Holdings, PHH Corp (PHH) and Ocwen Financial (OCN). They added to Nationstar and PHH Corporation in the quarter and they are now the largest positions at EJF Capital. At this year’s Ira Sohn Conference Steve Eisman gave a very bullish presentation of mortgage servicing companies and EJF appears to share his enthusiasm.

They bought a lot more of Colony Financial   (CLNY)in the quarter as well. The hybrid REIT is involved in several segments of the real estate market place as they have been buying troubled real estate related loans with an eye towards working them out at a profit. They have originated higher yielding loans on properties such as hotels and offices. They also invested heavily in a related company, Colony American Homes, that was created to invest in single family homes and rent them. There are a lot of moving parts to this company and I am going to have to spend a little time on it but it is cheap at 90% of tangible book value right now.

They were also big buyers of Silver Bay Real Estate (SBY) in the quarter. Silver Bay also owns and rents single family homes. Silver Bay Silver Bay currently owns single-family properties in Arizona, California, Florida, Georgia, Nevada, North Carolina, Ohio and Texas. They currently have more than 3400 homes for rent. Investors have not received the company well since its IPO as it has taken some time to get the homes rehabbed and rented but now the company is starting to see progress. The stock trades at 90% of tangible book and about 80% of managements estimate of current net asset value.  I have been watching this one closely since the IPO and am going to pull the trigger on the stock very shortly.

Small banks, real estate financing and single family homes all offer significant upside over the next decade. Tacking the holdings of investors like EJF Capital that have been earnings outstanding results in the sectors for decades is a solid way to uncover ideas. These guys are now on my must read list and if you are a long term investor they should be on yours as well.

I have one other 13F mea culpa file to share with you. This one also made its way to the bottom of the stack after being reviewed and marked up. It is also one of the probably the top 5 filings I follow every quarter simply because following this manger has made me quite a bit of money over the years. Joseph Stilwell is a value and activist investor who has been active in community bank stocks. He usually keeps a pretty low media profile but I have run across him in so many bank stocks that I have learned to pay attention to his buying and selling activity.

He is not afraid to take an activist stake, engage in proxy fights or do whatever else it takes to unlock the value of one his holdings. Since that process is going to make money for investors who get in early it makes sense to pay attention to his 13D and 13F filings. He also writes one of better letters to management when he takes an activist stake with a very blunt fix it, sell it or go home.

Looking at his latest filings Mr. Stilwell was fairly quiet during the second quarter. Smaller bank stocks were stronger in the quarter and there were not a lot of new opportunities to buy stocks at cheaper levels. The story thought out the sector continues to be improved credit conditions, weak loan demand and lower net interest margins. Most of us who invest in the space have our positions and saw little opportunity to add new names or buy more of existing stocks.

The fund did take a position in shares of Charter Financial (CHFN), joining  EJF Capital in owing shares of the recently converted thrift.  The bank has been around since 1954 and has 16 branches in Georgia, Alabama and the Florida Panhandle. Total assets are $1.1 billion. At first glance it looks like the bank has an asset quality program as nonperforming assets stand at more than 4%. A little deeper digging shows that most of those loans are covered by loss sharing agreements and assets not covered by such an arrangement are just 1.08% of total assets.

Like all recently converted thrifts the company has a lot of excess capital after completion of the stock offering and the equity to capital ratio right now is a little over 24. Eventually we hope to see that capital used to pay dividends and buy back shares when permitted. The stock trades at 85% of tangible book value and yields a little under 2%. As the Southeast region of the US continues to slowly recover this bank should see its stock price do very well over time.

Westbury Bancorp (WBB) is a Wisconsin based bank that also completed a thrift conversion offering earlier this year and Mr. Stilwell purchased shares in the bank. Westbury is a 12 branches bank with a little over $500 million in assets and serves the area just north of Milwaukee and is the largest bank in their service area. Post offering the bank has excess capital with equity to assets ratio of more than 15. Nonperforming assets have been steadily improving and are now just 1.72% of total assets. At the current price the stock is trading at less than 75% of book value.

Mr. Stilwell invests in these little bank stocks in much the same manner I do. The filing reports a total of 75 stocks owned and all of home are little banks. We have common ownership in about 10 tiny little banks that cannot be written about here for liquidity reason. Most of them trade at significant discounts to tangible book value and should provide enormous returns as conditions continue to improve. The difference between us is that he is willing to take an activist stake and push management o get the stock price higher, fix operating difficulties or simply sell the bank.  As passive investors we can sit back and benefit from his more aggressive approach. I probably owe him lunch after seeing several holdings improve substantially as a result of his efforts over the years.

Investors with an interest in the Trade of the Decade in small bank stocks would be well served to download and read his filings very carefully.

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