Stephan Company: A Very Interesting Nano-Cap Moving (farther) up the Quality Curve

Author's Note: This article was originally published on Seeking Alpha in January of 2018. I wrote it over the Christmas break in 2017.  Many of the steps have been small and a few required some charges and also cash conservation.

However, the latest quarterly results have largely proven the thesis, I believe. 

I have been meaning to publish this on this blog for some time, but for a long time, the article was exclusive to SA and afterwards I thought I might want to submit it for publication elsewhere. It deserves a revisit, as much has changed - there is a new CEO, there are many new brands, and of course, COVID has limited options for barber shops.

As a prelude to an updated article, I thought it was time to publish it here.

There's plenty wrong with many of the details (capital policy has changed significantly), but I want to be honest with myself and with you. I hope you enjoy it.

The Stephan Company: A very interesting nano-cap moving up the quality curve.

-          The Stephan Co is a nano-cap company with a recent history of poor performance

-          Recent BOD and management changes have come with a smart restructuring

-          Management and board are disciplined in capital allocation and very shareholder friendly

-          Business has moved from bloated and loss making to lean and profitable

-          Focus is now on growth which is happening organically and inorganically

 

The Stephan Company (PK:SPCO) has had articles written about it on SA before, in 2007 and 2011.  Given the long gap and significant recent changes to its operations, I thought it was time that a new article be published.

The Stephan Company is a nano-cap stock with a market capitalization of about $10mn (3.993mn shares out as of latest Q)[1] [i]and a recent history of operating challenges, but in spite of its size, it is quite an old company that is moving back up the quality curve.  Founded in 1897[2], the company is focused on the beauty segment, particularly the barber shop distribution segment.

The business is now run by some very smart people who are incredibly disciplined in their use of capital and also very shareholder friendly.  Indeed, much of the BOD is made of up financial investors who are making sure that the business uses its excess cash (substantially all of its operating cash flow, as required CapEx is negligible) to return capital to shareholders.  This is the sort of high return on capital business that you can be comfortable holding for very long periods which offers some effectively no cost (negative cost, perhaps) real options on growth and capital gains, and which pays you to wait while you sit on those options.  As such, for the non-institutional investor, this might be interesting.  This assumes that you can get shares; they are quite illiquid.

Risks:

Before we explore the business any further, I think I should point out that SPCO is a very small business with control shareholders who already possess over 50% of the 4mn shares outstanding.  Acquiring shares is very difficult to do, selling them no less so (though helpfully, management is committed to repurchases, so there is some liquidity in that regard).

As a small business in the distribution segment the business competes with many other businesses some of which have greater resources.   It is also a business that until recently had significant losses, though that was before the restructuring.  This is a very interesting business but Coca-Cola it is not.

Given the high level of Board / insider ownership, you have to recognize and be comfortable with the control team as stewards of the enterprise and capital.  Moreover, there is a risk that this business will be taken entirely private and stop reporting altogether.  Efforts to do just that have been made before (by other shareholders and management) and the closely held nature and size of the business could make this attractive to insiders.  Somewhat mitigating this risk, I believe, are the DTAs, the fact that at least one major shareholder is an RIA with separate client accounts, which accounts would be harmed by a go private transaction, and the fact that being a public company offers SPCO some unique benefits in doing deals.

Investors should consider this a PE sort of investment with a very long lockup.  In return, the business generates nice cash and high returns on equity, but typical strategies for avoiding losses (eg. stops) will not work with such a business.

Background:

As you can imagine with a 120 year old company, they have had multiple operating approaches over the years, but what matters are some recent changes, starting about five years ago.  At that time, the then CEO who had controlled the company since the early 2000s (and attempted, unsuccessfully, to take the company private in 2004, but who did delist the company in 2010) died suddenly.  At the same time, the performance of the branded product part of the company headed down quite rapidly, resulting in millions in losses.  The successor management team tried multiple strategies to preserve the business in tact, cutting expenses and staff, moving production to reduce costs, but could not align costs with revenue.  Revenue mostly declined but even investments in improved marketing that did stem the decline negated through the incremental costs the benefit of stable sales.

CEO compensation was out of line and there were multiple lawsuits with companies and brands that SPCO had acquired.  These lawsuits consistently resulted in unfavorable outcomes for the company.  (Most of the issues had occurred under previous management, but the road on these litigations only ended in 2012-2014). 

The challenges in the branded products segment masked a profitable distribution business.  This is surprising, most investors tend to expect the branded part of the business to carry the intellectual property and the high returns on capital with low reinvestment required.  But in this case, the distribution business, specialized on a small customer segment as it is, actually has quite high margins for a distribution business (30%) and requires almost no capital expenditure, whereas production in branded products had low margins and significant capital outlays required to fend off new entrants.

Restructuring:

As a result, the BOD took the strategic decision in 2015 to exit the branded segment to focus on the distribution business exclusively.  They sold off the brands, liquidated inventory, liquidated excess real estate and separated from about 20 employees.  Among those were the CEO and CFO who were earning significant salaries for a struggling small business.  Instead the COO was promoted to the top job and finance was outsourced to an accounting firm with one of its partners functioning as a part time controller and CFO.  With a smaller firm, the scope of audit was reduced and the audit contract rebid and won by a smaller audit firm, presumably at better rates.  Old outstanding litigation was settled and the company was able to make a fresh start with much lower operating costs and therefore a realistic breakeven point, stable sales, good margins, minimal investment required and lots of deferred tax assets (DTAs) from the $18mn in losses the previous management incurred trying to rescue the branded products business.

And look what resulted!  The figures for 2013 and 2014 left the business in a state which raised doubts about the company’s ability to continue as a going concern.   

Then, in 2015, the business was successfully restructured.  Revenues declined, but costs declined much more rapidly and therefore net loss narrowed.  Exiting 2015, structural costs were so much improved that in 2016 the company earned a profit for the first time in years.[3]

Moreover, a smaller operation required less capital, so that the balance sheet could be shortened and shareholders rewarded with cash dividends from asset sales and liquidation.  Returns on capital soared, with ROA at 16.5%.  ROE at 20% and RONE (effectively equity less cash) went to 26.5%. 

If you could invest at book value, most investors would be happy to have 20%-28% passive returns indefinitely.  Alas, at today’s prices, an investor is paying a multiple of book, and so trailing returns are somewhere in the 10-12% range.  Except, what if there were growth?  Might return on capital get even better?

 

Market opportunity:

To have a sense of what kind of growth might be possible, let’s get a sense of how big the end market is.  We estimate that Stephen Co has about 8% +/-2% of the market in which it competes.[4]  4Q results are trending to about $2.4mn, which would give the company an annual run rate of $10mn in revenue.  I believe that the addressable market is somewhere between $100-$230mn. 

We make the following estimates of the market opportunity:[5]

Topic	Low		High
[1] Men in America		150,000,000
[2] Men who go to the barber (vs. salon, or DIY grooming)	60%		65%
[3] Barber visits per year for those who go	6		12
[4] Product usage (shop cost) per visit		$0.20
[5] Estimated Market	$108,000,000		$234,000,000

 

This makes Stephen Co, a tiny company you never heard of, a meaningful player in its market, but one that has plenty of scope for growth within its category.

Barber shops, I hasten to add, are not like salons.  When women go to the salon, they tend to spend much, much more money, not just on styling but also on product like coloring and product is a significant cost of a haircut.  Barber shop haircuts are almost entirely labor costs.  Mostly you get a cut, and there are some creams, powders, gels and disinfectants.  They come in the same jars and bottles we see everywhere, many of which are distributed by Stephen Co.  But in the end, it is a negligible cost of a haircut at the barber.  (Interestingly, this means that if you have a good distribution system, you can increase prices, because product costs do not drive customer spend barbers can more easily pass along those costs).

Growth:

As part of its 3Q17 quarterly report, management revealed several interesting things about 4Q in its discussion and analysis of the business.  An MDA that is so revealing about events after the date of the report is quite unusual.  I cannot recall ever seeing such a strong amount of color in Q, but the forthrightness is consistent with a BOD and management that want to be open and honest with minority shareholders.

To understand the impact let’s first understand the business through 3Q17.  Nearby you find the as reported figures for 2017

and adjusted figures that net the acquisition back out and then annualize figures for the year based on the “going concern” – ie. pre-acquisition - structure of the business. [6]  Returns on capital, assets and equity remain very strong.  In fact, 2017 looks like a near repeat of 2016.  But there have been some significant changes starting at the end of Q3, with the acquisition of MD Barber. 

MD Barber provides some attractive assets.  First off, it has some successful products, particularly LXIV (Louis XIV) Pomade, and it also has a successful website and online sales and distribution arm through which SPCO can market its products, so the business brings revenue, new products and new capabilities in going to market that make the existing business better.  Not only that, the acquisition involved no goodwill, suggesting that the price is quite fair.

What about the impact on the financials?  MD Barber is a business that had about $800k in revenue in 2016 (10% of SPCO).  It seems 2017 might have been similar through the first 9 months.  We can figure this as follows: given the relative size, we would expect MD Barber to increase revenue by 10%, in fact, it has increased it by 11% and management indicated this is an increase over last year.  Interestingly, it is in line with the organic SPCO business, which is also growing 9% YoY in 4Q, for a combined growth in revenue of 20%, with both units growing something like 10%.

What does this mean from a profitability standpoint?

One reason that SPCO earns strong returns on capital are the high gross margins available in the barber shop distribution business.  It is unusual for FMCG distribution companies to earn 30% gross margins, and yet SPCO manages.  I suspect that the high margins are available because barber shop distribution is expensive; each customer account is pretty small and not really eligible for a volume discount.  This means that larger distribution players who might be able to drive out cost mostly ignore the segment and the customers don’t expect to have pricing power, so discounting is minimal.  Also, if you look at the size of businesses that set themselves up as local distributors of barber shop products, you can see that they are themselves small (MD Barber looks pretty professional within its segment and it has less than $1mn in revenue), which means that each of them likely has considerable fixed costs that have to be amortized and limited reach, such that there simply is not much scope to cut prices and still make it worthwhile to stay in business.  Of course, if you could develop a platform that reduced fixed costs to serve and were able to go on adding revenue at or near historical margins, your operating margins could rise significantly towards your gross margins.

We assume that MD Barber, as an internet distributor, has lower gross margins (there have been no details on this yet).  We construct two scenarios, in both scenarios, we carry through the 9% organic growth with constant gross margins.  In scenario 1, we assume MD Barber has 20% margins.  For illustration, we then project a second scenario in which MD Barber has 30% margins, nearly those achieved by SPCO.  The impacts are to add $98 - $119k to gross profit.  But in both cases, there should be some incremental SGA, which offsets some of this benefit.  Still, due to other efforts by management, we believe this can be held to a much smaller increase.  We assume a small increase in D&A over the 20k per quarter that was running through 3Q as some of the intangible assets acquired get written off.  We then annualize this effect (straight-line multiplication as the quarters are pretty even) and get profits of $835-$921 per year.

In the lower scenario, the higher intangibles and increased balance sheet size keep ROA at a quite steady level, although in the more favorable scenario, they increase ROA by a few percentage points.  Returns on equity are higher in both cases.  What is really impressive, quite frankly, is that the organic growth was achieved with only $12k in CapEx into the legacy business OVER TWO YEARS.  That means that, to the extent that the organic growth is independent of the MD Barber business, the business was able to grow gross profit by about $200k (annualized) with just $12k of investment.  Long may it continue as it means that D&A costs will fall over time further enhancing profitability in the meantime, they shelter taxes.

Now, the question is, where will this money go?  We have seen already that very little needs to be reinvested, even if the past two years are a bit of an extreme example, likely no more than 30-80k need to be reinvested.  This leaves money for acquisitions on a similar scale and setup.  Assuming just maintenance capex and no further deals, the business could have $800-$900k for distribution.  With 4mn shares out, this would be a dividend of $0.20-0.225 per share.  If growth on the scale of the 4^th quarter could be sustained annually, good for about a 1-2% share pickup per year, half from organic and half from inorganic, and a deal required some $200k in cash, there would still be enough cash for a $0.15-$0.18 dividend, before counting the incremental sales and gross profit effects.

 

Now for a fun exercise – note that management also mentioned that they are working on a deal to monetize some of the trademark portfolio.  What if they struck a royalty deal for 4% of sales on their trademarks with a company that specializes in the retail channel?  Say those products could earn $5-$10mn in the retail channel.  This would generate $200-$400k in gross profit with substantially no incremental cost at all.  The impact would be to lift Net Profit by an equivalent amount and push it to $1-$1.3m against shares outstanding of 4mn, good for $0.25-$0.325 cents per share.  Moreover, margins would shoot might higher since the new revenue would have effectively 100% margin.  In such a case, we could expect a very nice incremental payout, likely an amount offering a 10% yield at today’s price, not to mention a revaluation of the entire business upward.  With ROE of 40% and solid growth it would not be unreasonable to see the stock trade at 6-10x book value.  At current prices, it would also offer shareholders something on the scale of 12-15% returns annually, plus the appreciation in the shares, which might be significant.  In a market environment with 2% yields and 4-5% expected returns on equities in general, you are being paid reasonably for the risks assumed.

Conclusion:

SPCO is a business that generates fantastic returns on capital.  The business is very well run by smart allocators who are pursuing a variety of strategies to grow the business and further improve company economics.  Prices have risen some, reflecting those improved economics, and yet, the company still yields attractive payouts and offers the potential for further growth in what is mostly a mature category.

Obtaining shares is difficult, but not impossible, and while current prices are not a “slam dunk” they offer considerably higher potential returns that the overall market while simultaneously avoiding the risks associated with herding into index products.

This management team has been quite intelligent in allocating capital and has required minimal reinvestment to nevertheless grow the top line and margins.  There are some hidden assets that might be able to be monetized in interesting ways.

We believe that a fair price is likely between $3-$5 and possibly as much as $6-$8 in the right circumstances, plus a decent yield and little risk of capital loss.

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[1] https://www.otcmarkets.com/financialReportViewer?symbol=SPCO&id=184637; Balance Sheet, pg 3.

[2] http://thestephanco.com/

[3] Data from Annual reports from 2016 and 2014.  Calculations are author’s own work.

[4] This is the products market, although it supplies barber shops, it is not selling capital goods, like swivel chairs or other furniture.

[5] Source: author’s own estimates.

[6] Source: 3Q17 10-Q, pages 3, 5. 7 for the financials, and page 8 and 9 for the purchase accounting.  Adjustments and ratios, author’s own analysis. 

Adjustments reverse the purchase accounting and the $56 that was paid subsequent to close to reduce loans available.  These loans were acquired, but as of 30 September were only showing $70 as management already partially paid down the loans.  Walking through the adjustments:

-          Adjustments to Equity:

a.  Reverse out stock issued reducing common stock by $2

b. Reverse out paid in capital by $392

c. Reduce Accumulated Deficit by $33 for the costs associated with the acquisition

-          Adjustments to Liabilities:

d.       Reduce A/P by $50 for payables assumed and by $35 in purchase credit for inventory

e.       Reduce Loans payable by $70

-          Adjustments to Assets other than Cash

f.         Reverse Intangible Assets acquired by $645

g.       Reverse Inventories Acquired of $132

h.       Reverse Receivables Acquired by $21

-          Adjustments to Cash (i)

o   Reverse Cash received of $38,

o   Reverse Cash Paid to Seller of $231

o   Reverse Cash Paid to Loan Holder of $56

o   Reverse SGA Costs incurred for acquisition of $33

-          Adjustments to P&L

j.         Reverse $19 in SGA costs associated with acquisition

k.        Reverse $14 in Other Expense associated with one time acquisition costs

 

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[i]

A few good investing websites

I honestly am trying to spend less time on "newsy" investing sites and focus more on fundamentals and thinking as we approach a "4th Turning" crisis period.  Alas, crisis periods are nearly impossible to "invest" in in the normal sense - extrapolation and prediction are nearly impossible because there are so many macro factors that are likely to get resolved in one big cataclysm; the outcome of which is largely dispositive as it is really unknowable.  Inflation or deflation? Empire or tributary dependency? Heavy industry, physical assets, or intellectual property?  Legal, economic, environmental, political systems - all up for grabs.

Few strategies work well and unlike the later states of the prior crisis period, securities are not dirt cheap.  The right strategy in 1937-1938 was to buy net nets, which were plentiful.  Today, they are hens teeth, so the downside of being wrong is much much larger.

Anyway, some things you might want to check out:

- The writings of famous investors on Austin Value Capital

- The ideas on Clark Street Value

- The smart guys at Oddball Stocks

- The "cousins" at NoNameStocks

- Dave Waters at OTCAdventures

Not saying these are ways to invest, but they are places to think about the discipline AND get some stuff to sift through.

Recognize that most of the investors at Austin Value Cap were born in a fortuitous period from 1916-1930.  Most of the great generation of post war investor-allocators were from this period, because you had your early career largely after the war and could accumulate significant assets cheaply from the 1940s to the mid sixties (Graham style investing) then buy compounders with strong yields in the 1970s and then sit back and let the twin tailwinds of lower taxes and lower yields drive the portfolio value into the stratosphere.  Not saying these aren't smart people, just that Ben Graham, who was quite a bit older, did much less well because he was born at the wrong time to have the strategy truly work for him; he died before the really big revaluation could work it's magic.

What happens to Core Molding (CMT) from here?

Core Molding Technologies is an SME focused on plastics and structural foam molding that has emerged through a series of solid acquisitions, from the heavy trucking industry.  Starting in 2018, the company was hit with twin challenges of operational weakness and balance sheet weakness.  It has been fighting back ever since, but the stock price collapsed - barely exceeding $1 at the depths of the Covid-19 market panic in March.  The price has bounced back since, what is likely to happen now?

I will spare you the suspense - I believe that the price is likely to rise, and sharply, from here.  Why? Because of several cash generating levers that we are likely to see that will mitigate much of the "risk" to the lenders, who will therefore be likely willing to refinance the company, after they exact the pound of flesh that always attends distress guys.

Rarely do I take this view - almost always distress debt and NOLs lead to more distress and more NOLs until at some point, the business is sold, the assets or sold, or the whole thing is refinanced with debt being swapped with equity.  For much of the past 12 months, it has been hard to see which way this was likely to play out, but several recent developments have indicated that the business is likely to survive intact with the equity surviving as the successful fulcrum security.

There are multiple reasons for this - the first is that the company competes as part of an oligopoly in its core market segment: plastic and lightweight composites for transports, particularly heavy trucking.  The heavy trucking industry itself is quite concentrated - in North America there are four major players (Navistar/International, PACCAR, Volvo and Daimler Trucks); in Europe, you add Volkswagen/MAN and Fiat/Ivecco, but lose Navistar and in Asia you have a few other firms.  However, each of these geographies is actually quite separate as are many of the supply networks, because the physical transport costs are significant.  Sure, small parts like nuts and bolts are largely globally competitive, but air shields and panels and such are hugely expensive to ship if you have to pack them in containers and float them across an ocean; they take up too much space.  It is far more efficient to ship raw materials to a factory co-located or at least near to the final production facility.

Companies being what they are, three competitors are essential to pricing and development strategies.  Each of the four North American producers does business with each of the three suppliers (CMT and its competitors).  The ecosystem is balanced in this way, and so everyone can earn ok profits and returns on capital over time; it would be unhelpful to the manufacturers to drive bargains that push prices below economic returns, because starving your suppliers means that they cannot invest in your future.  This is how CMT managed to be profitable from 1996 to 2017 in all years except one (no credit for guessing that it was 2001, not 2008 or 2009 that was the unprofitable year).  This sort of stable business that allows for very careful planning of capex is a source of competitive advantage and allows for very solid returns on equity and capital (high teens) over a cycle.

Moreover, we know that CMT has historically been a solid operator - a few years back, CMT landed a huge increase in business when a competitor irked one of the big four producers and had some programs shifted to CMT.

CMT has also historically been quite conservative in finance.  I attribute much of this to the board - who are all old corporate operators with conservative corporate finance perspective.  CMT was actually a spinoff of Navistar (in 1998).  They have chosen to avoid balloon payments on debt (though the current debt does have a balloon, but it is many years out and CMT has adequate time to earn enough to meet the balloon).

Prior to COVID putting a hurt on operations, the company was earning solid returns; overall 1Q20 results were good, in spite of slow sales at the end of March. 2Q20 will be weaker, and yet, plants restarted in May and trucking has continued apace.  Moreover, several new lines of business from the acquisitions of CPI and Horizon actually were up in 1Q20 over 1Q19; so there is some buoyancy in their end markets. (I estimate that heavy trucking clients actually represented only about 50% of sales in 1Q20, so diversification is happening).

In spite of what will be no doubt weaker sales and weaker profits from negative absorption of fixed assets and expenses, there might still be surprising cash generation in 2Q - lower sales in the past have been cash generative as receivables are collected and inventories are reduced.  The strong paydown of payables in 1Q20 means that working capital actually expanded, providing more scope for reduction to align with lower sales levels going forward.  If there is solid cash generation in 2Q, the receipt of $6m in tax refunds, it seems likely that the company can completely repay its $7.8m in revolver debt by 3Q20.  The large tax refund is a benefit from the CARES act, which provided the company with a farther "look back" period for applying operating losses; usually these can be applied back one year and forward 20, under CARES, I believe they can look back 3 years.  This allows the company to apply losses against profits from a period when corporate taxes were higher, as an added bonus.

Since it is clear that the company will be able to make its payments, there is little incentive for the lenders not to offer forbearance a bit longer, continue to benefit from a penalty default rate and get re-liquified in the inevitable refi, or agree to do the refi themselves and get the origination fees on top.  I need to be clear, the issue is actually not the repayment; I don't believe anyone can expect that the company cannot repay.  The issue is that the debt has covenants promising certain levels of profitabilty which, due to operating weakness, have been violated.

In any case, as I say, I expect that the debt will be refinanced and when an extension of the forebearance is announced, that the stock will rise further, and with a refi, that the stock will return to something approaching book value.  I make this assessment, because of the solid profitability that the company generated on an operating basis with a much lower level of revenue in 1Q20.  This is a strong sign that the operating improvements the new management have been putting in place are working, indeed, have worked, and that profitability in a normal operating environment, which should see revenue north of $70m a quarter will be incredibly strong.  Gross margins were nearly 17% with $64m in revenue.  With $72-75m they should exceed 19%.  If SGA return to 2019 levels for similar levels of revenue, operating profit would be somewhere around $6.5m a quarter (with 7,778k shares out).  Annualized, this is operating profit of around $26m, lower debt balances and lower interest rates could take interest costs down around 250 basis points, which could actually lower interest expense below $1m annually.  Allow $1m and you still have PBT of $25m and income tax expense of 21% puts profits a shade below $20m, vs let's call it 8m shares out (it is less).  $2.50 a share in profits.  For a cyclical, is that worth 10x? 12x?  As a firm with a solid history of good deals, increasing success at diversification from traditional verticals AND steady expansion of customers, products and manufacturing capabilities - could it be worth 15x?  Maybe that is a bridge too far, but a stock price approaching $30, call it $28 seems like a 7x return from here in say, 18 months?

Management and the BoD have persistently made open market purchases throughout the last several months and quarters in spite of - nee, because of - the market weakness.  They have been signalling, I think, that they are not worried about being able to be refinanced.  This has continued into COVID.  The CEO and COO filed form 4s earlier this month after 1Q earnings dropped and they had a window to make purchases.

There are risks, of course.

First off, there are the macro factors.  COVID could lead to some sort of permanent shutdown.  Also, I believe that we are likely to find tax rates being hiked to address the fiscal situation - a conflict, a military conflict, that is, likely with China, might be the proximate cause, but when it happens, it will be swift and sharp.  That would certainly change expected yields. 

Moreover, CMT, though an AMEX (NYSE MKT) stock and not a big board company, will still get hit.  I am old enough to remember when the Wiltshire 5000 actually had 7800 stocks (to represent the "total [listed] market".  Now I think it barely has 3300; so concentration in listed stocks has increased beta. Macro factors seem likely to persist.  On the other hand, trucking might have certain tailwinds in a conflict and CMT might benefit.

Also, there are macro tailwinds in the form of autonomy.  While the excitement and enthusiasm for self driving vehicles is overhyped, particularly in passenger cars, trucking is where much of the investment is among the majors.  This makes sense - in the early days of autonomy, much monitoring will be required; planned routes and logistics infrastructure will provide the means of that monitoring and the economics of lower operating costs will provide much of the investment dollars needed.  CMT doesn't have a huge spare parts business, but new truck programs and sustained high volumes as the fleet is turned over would provide a sustained tailwind enabling sustained high levels of utilization. The cash could be used to make further acquisitions that could provide diversification and reduced cyclicality when the secular tailwinds abate after say, a double long cycle.


The bigger risks are probably micro.  As I have noted, the firm itself has certain protections from existential competition given the need of all four manufacturers to have a reliable local supply chain. It is possible that some Asian or European firms could make a transplant; buying a competitor, for instance and potentially driving down certain R&D costs, or leveraging global purchasing arrangements - given the fact that Daimler and Volvo are both Europe-based and between them represent a majority of NAFTA production, this is always at the back of my mind.  On the other hand, if the economics of this were really that attractive, that sort of consolidation would likely have occurred.  Management at CMT does not seem to believe that geographic expansion makes any sense, given their specialties.

A bigger risk, perhaps is in some of the newly acquired business, because some important revenue lines derive from cases where CMT is a tier 2 supplier and not only at risk for their own performance, but also for that of the tier 1.  Horizon Plastics, the deal that nearly broke the company (in spite of a significant amount of equity used in the purchase in the form of cash on hand) has multiple business lines, among which are plastic fencing sold through big box home improvement stores.  You know it - the white, plastic 1/2 in or so, lattice fencing that is used mostly for cosmetic purposes.  This product is considered part of the "wood" category, so the category manager always has to find a supplier for it, as the category manager is sometimes booted from one of the stores.  In fact, CMT/Horizon benefitted from just such a situation - where the competitor was ejected and 100% of the business was awarded to the tier 1.  This situation is likely to reverse - given the situation there is considerably more tail risk that we might want.  Better for a firm like CMT to know that you will get between 40 and 60% of the business than 0 or 100%.

Operations could continue to be a challenge - although these really seem worked out and I have personally been impressed with David Duvall and Eric Palomaki (CEO and COO, respectively).  I believe they are earnest, hardworking and smart and full of integrity.  Ironically, COVID may again be a tailwind here.  The operational problems that were encountered late in 2018 stemmed from a set of misjudgments by management - misjudgments that were understandable.  Trucking usually operates on a 7 year cycle, with five great years and two crappy ones.  After what was a long up cycle into 2016 management and the industry anticipated weakness for 2-3 years.  They were right in 2017 and had already made adjustments to hiring, staffing and capital investment, adjustments that saw profitability remain strong in a down year.  They were caught off-guard when the truck market rebounded without sustained weakness, and, with unemployment at 20 years lows, were unable to recruit to staff up to meet demand, overtime and expensive contract labor were required, hurting margins.  Previous management had compounded this error by PPAPing a part that could not be manufactured reliably, requiring considerable rework and overtime and even so, delivery delays hurt production and clients - one client in particular - assessed penalties for failure to deliver which compounded the losses.

That mercifully seems to all be in the past.  But CMT's specialty is in developing custom solutions, as when a part requires a custom fit and the integration of say a metal rod or component into the plastic.  Problems with manufacturing could happen again.

Another question mark remains the CFO.  He is clearly not dumb, but I sometimes wonder if he is wise.  Back when the company had an IR team, I was told that he was brought in with three objectives: reduce costs, improve IR and complete deals.  He has achieved these things to some extent, but not always in the best way.

He certainly helped reduce costs and raise profitabilty in the 2014-2017 period.  I was genuinely pleased with the level of cash generation, though much of that sat fallow for years only to still prove insufficient to his ambitions.  Thing is, I ask myself if those cuts weren't the real reason the company found itself so unprepared in the rebound of 2018.  Some of htis might have been poor operating decisions by the former CEO, but how much of that was finance pushing for particular margin targets and forcing corners to be cut?

IR has certainly improved in certain ways.  There is a good investor presentation on the website (link here).  Moreover, Zimmer has always responded to my inquiries, for which I am appreciative.  Moreover, he managed, through the operating difficulties, to provoke shareholders to attend the annual meeting for the first time in years in 2019.  But not sure if that is really a good thing.  He prefers to have individual calls rather than investor meetings or conference calls.  The company does not present at any major conferences.  This is in spite of doing deals that should have investors looking at the company less as a heavy truck supplier and more as a custom lightweight composites solution provider.

Finally, there are the deals.  I actually liked both deals he did at the time he did them.  CPI was a deal that was entirely debt financed, though, I am not sure that it earns an equity rate of return.  It is hard to say because much of the margin there (quite a bit of the revenue for Bombardier - BRP - is from CPI but some is also from Horizon) is hard to estimate.  Moreover, that goodwill was impaired a few years later when management had to review goodwill as part of their normal process of looking at low P/B in market multiples.  At least it was conservatively financed.  At $15m, the purchase price was small relative to the cash generation of the legacy business.  Moreover, the legacy business was largely unencumbered by the time of that acquisition and so cash built up.  It brought them not only new customers and new verticals, it brought them manufacturing processes that were - we have been told - helpful in expanding significance with customers of the legacy firm.

That cash may have burned a hole in their pocket, because the Horizon deal seems now to have been a bit expensive.  It achieved several objectives, but also left no balance sheet flexibility.  I have a sense that having failed to do small deals in the three years between CPI and Horizon, management and the board felt a need to do something "big" and almost sank the firm in the process.

So, if we evaluate them as operators, investors and financiers, we can say that the old management turned out to be poor operators, but the new crew seems top notch, EXCEPT that perhaps the CFO also was to aggressive in optimizing cost aspects of operations and investment, both internal and from acquisition seem to have been either too parsimonious or two generous.  Finally, as financiers, he has not been great. The folks who ran the company for the first two decades, who were holdovers from the corporate parent that spun the company, approached finance like typical corporate guys - conservatively.  Wanting full amortization each month.  One could argue that this was "aggressive" in the sense that it is inflexible to have monthly principal payments (as compared with balloons) but, it is disciplined and avoids the need to refinance or to keep large amounts of cash on hand waiting for the payoff date and earning returns well below the interest cost of the debt that the cash offsets.

But in the Horizon deal, management should have demanded a different structure - knowing that the owner who built Horizon was selling to retire, they should have demanded that he take at least some of his payment in equity in the new business.  This would have reduced the debt load and made it easier to meet covenants and would have made the former owner more invested in the success of the merged firm.  CMT could have repurchased shares to offset dilution over time.

They might have also considered some preferred or convertible debt.  Rates were low, conversion provisions could have been set to ensure a premium to book and again, they would have had much more financial flexiblity. In the end, the CFO failed to imagine how bad the situation could be.

On the other hand - he has managed, so far, to avoid issuing additional equity as they have worked through this, which is actually fairly impressive, tho it probably has been a reason the problems have gone on for so long.  Will he get wiser? Who knows? The BoD is turning over some, and I expect that there will be a more muscular and aggressive board more focused on accountability.  We shall see, but I believe that this firm has some great characteristics and offers a superior risk / return.

Two types of Value Investors and Why Value has Underperformed

The structure of the modern company – indeed of modern business operations – represents a big challenge in the frameworks that value investors use to think about company values and in particular risk, reward and safety.  Two structural factors: the impact of intangible assets – and asset-light business and operating models - on business value and quality AND the consolidation of industries into global players, are making the calculus more difficult, particularly for one type of value investor.

Value investing, properly understood, is an approach to taking financial risks that seeks to minimize the risk of loss while allowing for reasonable expectations of upside gains at rates of return that allow you to get rich (and not just stay rich. “Get rich” returns have to be MUCH higher). Value investing therefore is primarily focused on “safety first”.  That safety is usually thought about through looking at worst case scenarios and trying to buy at a price so low that it offers a positive return even if that outcome occurs, or at least, only a very low probability of loss, and near certainty that the loss cannot be very large, not more than a few percentage points of the capital at risk.

Value investing as a mindset comes in two flavors: quality and cheapness.  Both concerns are important.  Quality matters, because crappy assets, or even decent assets trapped inside of a crappy operation, tend to diffuse over time and become impaired.  They don’t compound – or do so at very low rates - and so even if they are distributed at some point in the future, the returns over time are modest. Worse, distribution often happens at times of stress when the assets yield the lowest values. Without quality there can be very limited expectation of upside, unless the investor can wrest control of the assets and force some sort of asset conversion – a liquidation, a merger, a recap, a new line of operation or business.

But paying too much for even a quality asset can produce the same outcome.  Needing an asset to “grow” into its valuation embeds years of low or modest INTERNAL returns (market returns can be robust) while waiting for the value to catch up to the price paid.

Value investors debate these two poles frequently – and often bitterly.  I often find myself debating with other investors (and sometimes with myself) about the relative merits of the two in the case of a potential investment, or in comparison of a few investments. At issue is really a question of margin of safety, which, I believe is the true hallmark of value investing (the estimation of which I am working hard at improving).  A big part of this divide now, I think, is tied to the dominance of intangible assets in (post)modern business: they have much greater tail outcomes than physical assets do.

Low price seems to offer a much more straightforward route. It has a lot of appeal, in part because it is so quantitative.  You can look at the market values of the assets of the firm and if you can purchase them at a significant discount, then even if they are producing modest, perhaps non-economic returns or just barely earning their costs of capital, you still feel you have a margin of safety.  In the event of liquidation, the securities/interests you hold expect to receive a payout sufficient to at least return the capital invested if not more.  That is having a margin of safety.

Consider, tho, what sort of things this investor wants to buy – if the focus is on liquidation value, then the investor wants many, ideally liquid, SEVERABLE assets.  These are the sorts of things that are easy to auction to many bidders: receivables and rights to payment, inventories (in some cases, quick inventories at least), assignable leases, real estate (esp cash flow real estate), even property plant and equipment has value, especially to strategic buyers who may take a portion of the operations and may pay for some of that business value.

This investor likes things like banks, old line industrial firms, asset heavy companies with lots of liquidation value. His problem is that in a world heavy on intangible, asset light models, what does he have on liquidation?  Often not much in the way of safety.  Intangible assets have much fatter tails.  If they retain their quality; then the strong operating characteristics of the business – which often require little or no reinvestment – mean that returns on capital will be genuinely wealth creating, but in the event of impairment, they are often worth next to nothing.  These assets can be goodwill, which is great while it is in place, but often worth nothing if customers flee. Even the most “severable” of intangible assets, brand names, can often have huge tail risks.  Other intangibles, like tax NOLs, are impaired upon transfer – by rule!

You can see the dilemma this poses for the value investor: he sees a Facebook and can only think about MySpace and he is not wrong to think this way.  But – at least in my case – I think the tendency is to *assume* no moat for Facebook; that it can fall out of fashion and be yesterdays news in a matter of months.  The implosions can be spectacular.

In cutting himself off from that left side of the distribution, though, our price and liquidation value focused investor is cutting himself off from many investments on the right side of the distribution set.  These businesses produce a very disproportionate amount of the value and so he underperforms.  Constantly. As he waits for asset heavy models to return to favor.

Worse, in a world with fewer competitors, the liquidation value of many of the assets is also lower.  There are simply fewer strategic buyers in nearly any traditional business line to purchase the operating assets AS OPERATIONS, which always command a higher price.  So the discount that has to be applied is larger.

Instead, the value investor has to focus more on paying up for quality – which is harder and more “qualitative” which is also more subjective. It requires thinking differently about what value means – that it is possible for a person and a webcam to generate some incredible content and a following that produces (if it remains topical) the potential for residual income streams in the form of the modern form of “syndication” – the YouTube suggestion set.  These residuals can go on for years. They can also disappear either from audience preference changes, or from decisions by the platforms on which many of these businesses depend.

Quality – and being able to assess that quality – is more important.  Moreover, it may be necessary to think differently about “quality” – that it is not always a permanent annuity.  Perhaps it is something in which the investor can realistically get a significant return in the near term – and thinking differently about how manage that position (he will need a market outcome in most cases, and will have to manage the position to capture and retain that gain.  This, tho, might be thought of as sepcuatlive and not value investing at all), in order to earn a solid return.  Is it so bad to know that you are “guaranteed” a solid return – enough to recover your capital and more – over a two to three year cycle, so long as you make sure to sell, because the long term prospect is the business is a $0.  This might be like investing in newspapers.

I think this paradigm really is a tough one for value.  Value works because of cheapness and protection, but it also assumed that financial capital would have considerable power in the structure of the firm – that financial capital controlled the purse.  But in an asset light world – very little financial capital is required.  Financial capital is going cap in hand and begging entrepreneurs to let them put money into their ventures.  What is the likelihood that this changes? The value investor is going to need to rethink the frameworks for investment, I think.  To find a different way of seeing margin of safety and perhaps to change thinking around how to provide / ensure that margin of safety.

Your Tax Assets are Worth Less (than management says)

Among the most interesting holdco justifications is the need to protect the realizable value of tax assets, often in plentiful supply at diversified holdcos, as the argument for diversification is often an escape from the awful economics of the legacy business, the source of the NOLs that gave rise to the tax assets.



At first blush, this might seem prudent – avoiding asset impairment is a good practice.  And yet, tax assets seem a curious rationale for a holdco, let alone a diversified one.  It seems to be a case of making a mistake by forgetting the objecitve, which is to earn high returns on capital.



Tax assets, it must be said, come in many forms.  Those that arise from differences between tax and financial account treatment of depreciation or similar „timing“ differences are pretty solid assets.  Like the cash cycle they are basically short term in nature and can be expected to be realized in the near term, and no later than the useful life of the operating assets that gave rise to them.  NOL tax assets are a horse of another color.  These tend to pile up in operations that are consistently loss making and which have few prospects for earning enough to recover those tax assets in the future.  In holdcos, the operations have often been shut down or sold, leaving behind some capital of the cash box sort and a pile of „assets we would like to find a use for“.



The problem is that the IRS makes this rather difficult.  Internal Revenue Code Section 382, which sets the rules that have to be followed in order to realize tax assets explicitly limits several actions, like selliing or merging the firm as well as some other complex rules.  The point of the IRC is to prevent people from selling defunct businesses as tax shelters.  You have to continue to operate a business yourself.



Finding a use for these assets is actually remarkably tough in a world in which there is no inflation and asset prices are sky high.  Think about it this way.  Imagine you are a firm, like Hudson RPO (HSON), and you have $300mn in NOLs, supporting $60m or so in DTAs.  (Pretty good if your market cap is $35m).   Now, NOLs usually expire, so you have to earn offsetting income within 20-25 years.  But even if you had 30 years, you would need to earn $10m a year every year for those 30 years.  But you don’t have operations that can generate this sort of profit, certainly not consistently.  If you did, you wouldn’t have $300m in NOLs, you would have a balance sheet comprised of operating assets. 



Therefore, you need to BUY a business that has that earning power and you are going to pay a going concern multiple to do so.  It will take something between 100-200mn probably to do this deal.  You cannot offer stock, because that would give the new firm too much ownership and limit the DTAs.  You have to pay cash.  But your box isn’t big enough for that.  So you have to try and purchase lots of little firms – you can see why diversified holdco structure seems to be the best way to go – it is the only way to get all the looks you need.  But then you have to operate lots of subscale oddballs under one umbrella, or you try and rollup an industry – like HVAC firms in Arizona.



Sure you can seed a business – but then you probably don’t need to be a diversifed holdco, what you want is to become a dominant operating company, which means you need someone who is not a financier, probably; you need someone with a passion for solving a specific human problem.



There are some reasonably probable ways to turn small piles of capital into profits – buying cashflow real estate at low cap rates will create a stream of earnings.  Except that in most cases, it will be more efficient to hold the real estate outside of the holdco.  So really what is the point?  Buy some land and become a land trust?



Similarly, you could buy securities that pay interest or dividends, but pretty soon you become an investment company, which limits the sorts of investors you can have and forces you to go private or become a CEF with a licensed management company.  Either way, an investment company isn’t taxed directly, so the benefits of the tax assets disappear.



I find the DTA thing strange for another reason: taxes on corporate profits aren’t that high.  During periods of high taxation and high inflation, DTAs can be great – you can almost always expect that rising revenue and rising nominal profits will enable you to use fixed value NOLs and shelter significant tax.  In the 1960-1980s, those tax rates were about 50%.  But along with the reforms that made it harder to take deductions like NOLs, tax rates were dropped significantly.  At the 21% we have now, a dollar of NOLs is only worth 21 cents.  And only once.  A dollar invested in a good business is worth considerably more than that – every year.



It seems silly to trap capital inside of such a structure in service to a tax optimization strategy at the expense of reinvesting it in better opportunities that happen to limit the ability to claim and shelter taxes.  It is putting the tax shelter ahead of the objective – which is to earn high returns on capital.  This is the sort of thinking that arrogant retail investor commenters on Seeking Alpha employed to explain the brilliance of their investments in MLPs, until they blew up.  „Look at my yield! And I get to shaft the tax man, too!  I am so smart!“.  Then Kinder Morgan blows up and … crickets.  Why copy them?



So why then do managements work so hard to defend these assets, when they should be focused on improving the capital base and the operations of the holdco?  Well, here Whitman’s discussion of communities of interest and communities of conflict come into play.  DTAs are a great excuse for management to entrench itself and add poison pills like rights offerings ostensibly to protect DTAs from being limited by a change in control, which ensures that THEY remain in control.

What I like and hate about Dividend Growth Investing

Dividend growth investing, or DGI as it is often known, is a popular strategy for investing in stocks that receives immense digital ink on investment websites like Seeking Alpha and other places retail investors congregate.  I think the main reason that it is so popular is that it is a strategy that works for retail investors in that it can be put into practice without too much effort and without requiring huge amounts of research.  I have generally found it sort of lazy, even as I have considered the importance of dividends in my own investing.  I realize that there is much value in the approach, it is the writing that is lazy - a source of poorly researched clickbait.  So, I want to give it a fuller and fairer treatment here on my own personal blog.

Depending on how you count them, DGI has three (four) major virtues as an investment strategy.
The first is that it is long term.  I have heard several investors argue that in spite of considerable efforts by folks like AQR to reduce alpha to the impact of a set of factors, that duration - a willingness to simply let an investment strategy compound for long periods, cannot be deconstructed in this way.  At a minimum, long term as in any form of buy and hold, minimizes transactions and therefore minimizes fees, which is always helpful.

A second factor, which is related to the first is that having a long term orientation of this kind pushes the investor towards QUALITY.  Dividend paying firms - particularly those that are able to raise dividends regularly, are firms that are going to generate stable and recurring cash flow far in excess of reinvestment requirements.  They will generally have considerable ability to apply leverage to goose returns and to do deals, minimizing the amount of equity that has to be held on the balance sheet - capitalizing on the (often unrecognized) goodwill.

Third, I think dividends, and particularly dividend growth, enables the investor to ride out periods of market volatility, or indeed just the normal up and down of the price cycle, because of a psychological "stabilizer" that is the history of rising dividends.  It is so much easier to ignore the current price of a stock when looking at your gain / loss or cost basis, you get to watch a history of rising dividend payments stretching back unbroken to your first purchase.  For myself, I can say that one of my long term holdings, Colgate (CL) does this for me.  It was a large position when I started, and has gotten smaller as some other investments have grown faster, and as contributions have been allocated to other things, and yet, the value has increased dramatically since I bought it 15 years ago, with the dividend stream rising 5x (I DRIP dividends on CL).  It is so much easier to look at THAT trend and ignore the "noise" in the price signals in the daily market moves of the stock.  If CL is able to increase dividends by another 5x over the next 15 years and 5x in the 15 years after that, I will have dividends 125x my first dividend payment and will receive quarterly about 75% of what I invested.  Sure, that will have taken 45 years, but so what?  Would $4k invested in Social Security be worth $12k in annual pensions 45 years later?  This is the power of long term thinking.  There is no guarantee of course, that CL can continue to extrapolate dividends at this rate.  For one thing, dividend growth there has slowed considerably in the last few years as slow top line growth has caught up with the company.  The former CEO used financial leverage and engineering to keep the dividend rising, but the new CEO wants to derisk and is slowing dividend growth.  Anyway, the previous CEO found that he had to do the same in the end, lest the payout ratio rise too high.

This sort of equanimity is possible because of the fourth factor, which is that dividends are valuable not so much because of the change in the duration of returns (which is the way that most academic financial writers talk about it: as risk reduction.  The real benefit is that you have a source of return other than the market itself which makes you less dependent and less interested in the market volatility.  Receiving your return internally - paid by the operations of the business - makes your stock much more akin to a bond.  One without a fixed maturity, admittedly, but a perpetual bond is an attractive investment in many cases, particularly if there is an inflation kicker.  It tends to moderate the market swings, too.

Given this, I think there is no reason to discourage this approach.  In fact, I think it is an entirely reasonable way to build a portfolio of above average quality businesses while reducing market sensitivity over time and experiencing solid compounding as one gets the chance to reinvest dividends to acquire more shares.

Particularly if one pays especial attention to the price paid, some dividend stocks can offer truly excellent rates of return and the ability to purchase a long term income stream at very attractive prices and thereby lock in considerable retirement (or extra investing) income for prices that could not be purchased any other way.  I wrote about this in an article about BAC, answering a comment from a Seeking Alpha article.  A commenter was trying to understand why so many BAC shareholders were rooting for continued low prices (enabling faster and larger buybacks and therefore faster long term dividend hikes).

WHAT I DISLIKE

My problem with this approach has less to do with the theory or even the mechanics than with the commentariat on the topic.  All too often dividends history serves as a substitute for fundamental research necessary to estimate the sustainability of those same dividends.  In this way, it focuses its adherents on the capital account, rather than business fundamentals, as a means of evaluating the investment and this is not a good way to think.

The most common way of doing this is to have people look at questions of sustained dividend increases by selecting names from a list of Dividend Aristocrats.  To the extent that this is a list that identifies quality (you have to have a good business to be able to raise dividends consistently over very long periods) and a management priority to provide a return via dividends, it is a good place to start.  But when the discussion is about how many years the investor "require" to be a good investment I think it overlooks the not small probability that some long-running dividend payers can suddenly find themselves in tough going.  Often these are mature tech companies, but we see it in other firms as well.

The worst sort of articles are those that focus on the yield.  All to often these are really retiree clickbait, like discussions of REITs or MLPs.  The emphasis all to often is on the tax implications of dividends - low taxes, or almost always issued with smugness, an idea that "return of capital" accounting provides the owner with some way to screw over the tax man.  These sorts of discussions, where the author is putting the cart before the horse, focusing the reader on easy to understand things, make me crazy.

In few cases are they writing about how DGI darlings are capitalized - how many articles were written by the DGI crowd explaining how the large yields they were receiving were an indication of the instability of the firm's capital structure, analyzing how it sought new investment through net share issuance while sustaining a high yield because that yield provided access to capital markets in the form of yield hungry investors?

My problem, in short is less DGI itself - though it tends to put the investor into mature firms, these can still produce excellent returns (look at SPGI, which I purchased in Feb of 2012) - the problem is with the way that the writing inevitably ignores or elides important considerations, aimed as it is on retail "investors" with limited experience or skill evaluating business quality or prospects.

Mostly, I fear this is a result of two or three factors: first, there is an element of the blind leading the blind in this area.  The analysis is superficial because it is written for people with limited knowledge and understanding by people with only slightly less knowledge and understanding.  (The Dunning Krüger effect runs deep in this set).  Second, the audience is one that lacks a more sophisticated toolset for some of the more important analysis - introducing lots of information that requires frameworks the reader lacks to be intelligible is basically unhelpful.  At best it leads them to conclude they don't know what to make of it.  This is not popular, though which leads to the third factor.  Many of these articles are written not to be thoughtful and thorough, but to fast and provide lots of clicks.  Quantity is much more important in building audience (brevity, at which I am hopeless, also helps), and so the nature and content of these things is set up to get people reading the material.

DGI then, is a solid strategy I believe that can help an investor focus on the strategy - the long term approach that they are taking and helps tune out the noise associated with stocks of "infinite" duration.  In the end, the basic problem is that it is a hermeneutic that is too often used as a shortcut that short circuits the more difficult analysis that are required for fundamentals investing.

Why so many BAC shareholders are ok with a low share price

After Bank of America (BAC) reported 19Q3 earnings this week, there were some discussions on Seeking Alpha by commenters arguing for the benefits of sustained low share price for the bank.  Naturally, this seemed to confuse at least one poster, and this topic has been running in the background on several online conversations.

On the surface, it seems sort of odd, doesn't it, for shareholders to actually desire LOWER prices for their portfolio positions?  Don't investors want the shares to rise?  Ultimately, probably yes, but I think what this discussion shows is the heterogeneity of shareholder objectives in a public company.  Marty Whitman talked about this idea at length, and expressed a view that one of the biggest mistakes that academic finance has made (and reflected in law and regulation) is the substantial consolidation of the firm and the shareholders.  He had a rather intelligent understanding of the various stakeholders in a firm and a Venn Diagramm-like view of overlapping communities of interest and opposition (and presumably indifference, although he didn't explore this to my knowledge).

So what is the deal with BAC and shareholders happy to have lower prices?  Well, I think it depends heavily on when you bought your shares and what you think you are doing with that investment.  There are many retail investors - the sort of people who post comments on SA - who purchased these shares some time ago.  Many purchased them in the 4th quarter of 2011, after Warren Buffett got 700mn options at $7.14 and the share price, after a brief spike, subsequently crashed to a low of $5 in early December of that year.  Much of this 4th quarter move appears to this writer to have been tax loss selling, as the minute 2012 came rolling around, the shares went on a run to $12 in a matter of weeks.  I digress.

The point is, if you loaded up as a retail investor in late 2011, you were probably thinking that the bank was not on death's door, although it was price as though this was the case, and that eventually the business would be capable of generating solid profits per share and paying large dividends.  Eight years later, that reality has come to pass.

At this point, if you are that sort of retail investor, you may be doing this sort of math: this stock is a cheap pension.  Let's say you purchased 10,000 shares of BAC at an average cost of $7.  You might have done much better than this, but let's not push the envelope too far.  Looking out to 2021, you can reasonably expect the dividend to reach $1 and rise from there.  If 50% of the 2019 shares can be bought in by 2031, not unreasonable if the company gets a few more years of being able to net repurchase 10% of the shares out and then steadily works at a mid single digit net repurchase rate, EPS should rise to something on the order of $6 a share without any organic growth.  If the dividend rate were to rise to around 50%, you could be looking at a $30k pension 20 years after the investment of $70k.  Moreover, just taking the expected returns from 2021 (of $10k - $1 per share on 10k in shares), you would have expected to receive $100k back on your initial investment BEFORE getting at $30k rising annuity pension.  This probably understates the capital return because it is unlike to remain at $1 for ten years before rising to $3.  If it advanced linearly over the 10 year period, the average would be $2 per share, good for a $200k return, or 3x the initial investment while STILL holding that investment and being entitled to the same $30k rising annuity pension.

This ignores the dividends likely to be paid between 2016 and 2021, which are good for a couple dollars per share in total.

Moreover, if the bank is able to increase earnings through cost control and a slow growth of the balance sheet and a slow shift toward greater tangible value (assuming intangibles remain stable) perhaps total earnings might grow 50% over the period, enabling EPS of $9 per share (good for an earnings yield on cost of well over 100% per annum) and a payout closer to $45k.

Compare that to Social Security, where an upper middle class earner can be expected to contribute over $12k per year (don't forget, employees pay the employer half of the the 12.4%) for 40 years ($480k) to have a similar pension.  The difference is, the BAC investor, who might have been a typical GenX 35 year old in 2011, paid MUCH less, doesn't have to wait to 67 to collect - his 30k BAC "pension" is available at 55 after returning 2-3x his initial investment.  He gets to collect for 12 more years - worth a stunning $400-$500k more, not to mention the ongoing rise in his income thereafter (his annuity at 67 will be much much higher than Social Security).  Finally, unlike an insurance annuity, this investor retains ownership over the principal which is likely to be capitalized at some 20x-25x the dividend payout.  $700k-$1.2m in 2031 will be worth less than at present, but this is a simply massive return.

But a not considerable amount of this return is based on teh ability of the bank to repurchase shares cheaply, which, so far, the market has allowed for.

I get that it is frustrating.  If a significant portion of your portfolio is invested in BAC, then you have not seen that portion of your brokerage statement drive a result since 2017.  If you are being paid to manage money and have promised investors that you will beat the market over certain time periods, you may find it difficult to hold BAC even as it gets objectively cheaper.

There are also risks, not least of which is credit quality and other macro factors like interest rates.  Then there are the fintech firms that are looking for ways to reduce the dependence on the centralized ledgers of banks and the permissioned system of transaction verification.  These could be near mortal threats to the fees that banks are able to charge for operating the payments system.  Though in the end someone has to perform the underwriting functions associated with credit and banks are likely to continue to do that better than most other firms.

BAC has several other attractive features - among them the fact that it cannot do acquisitions for additional US deposits. When I first purchased BAC shares, this was a major highlight for me.  Alas, it did not prevent the acquisition of Countrywide.  Inasmuch as countrywide was an effort to get more control over the creation and marketing of mortgage backed securities to improve the position of BAC investment banking (the old Credit Suisse First Boston securities business that BAC acquired with BankBoston, but which they struggled to grow into a bulge bracket bank - not for lack of trying), it was also a deal that could be done that avoided the deposits question.  Such a deal could be done again (let us hope that it will not be).  BAC has the option to enter foreign markets with retaail banking, but they can wait for a very favorable time.

For these reasons, I have not sold BAC shares in some time, although obve $30 and in particular above $35 I think that the price to tangible book suggest that it might be time to trim.  But then I think, hold onto your shares (I have trimmed from my 2011 position becuase BAC was getting to be too large and becuase there were other things to purchase and finally because I perhaps lost sight of some of this along the way.  I believe that a few stocks like this are the key aspects of having a strong portfolio.  Knowing, as an investor, that you will not be destitute, provides you with much more leeway to pursue more speculative positions that have high risk reward characteristics.

The longer the stock remains cheap - so long as management remains committed to repurchases - the faster and more likely it is that the scenario outlined here will be a success.