Street Capitalist: Event Driven Value Investments

I had a chance to interview Zeke Ashton of Centaur Capital and manager of the Tilson Dividend Fund. I think you’ll enjoy the interview. Ashton is a generalist, he is willing to short stocks, and looks across all types of companies — from microcaps to large caps. Plus, he’s based out of Texas. I’ve been hoping to showcase more Texas-based fund managers to prove that we’re not all energy traders down here.

Please give me your thoughts on the interview in the comments section or feel free to e-mail me. I’m always looking for new investors to interview.

You can find more about the Tilson Dividend Fund here or learn more about the fund’s performance via Morningstar.

My questions are in bold.

Can you give us a brief bio of yourself and how you came to run Centaur Capital?

I started my career in the financial software business as a consultant deploying complex treasury and risk management systems for large banks and conglomerates, mostly in Europe. At the time, I thought that my natural career progression might be to become a risk manager for a large bank or insurance company.

Somewhere along the way I developed an interest in the stock market and discovered Warren Buffett’s Berkshire Hathaway letters and was immediately hooked. I also was a big fan of the Motley Fool website, and when I decided that I wanted to change careers to investing, I was fortunate enough to land a job there. I moved back to the States and started working for TMF as an investment writer in early 2000 – just in time for the bear market. I spent two years writing articles and research on investing for TMF, which enabled me to learn and refine my own investing approach.

In 2002, I decided that I was ready to start investing professionally, and moved to the Dallas area and started Centaur Capital Partners. I set up a private limited partnership and opened for business with less than $1 million under management, and it took several years to get to the point where Centaur Capital was a viable business. In 2005, we launched a mutual fund called the Tilson Dividend Fund (TILDX) in partnership with our good friends Whitney Tilson and Glenn Tongue at T2 Partners, and that has done well. We’ve now been in business for eight years, and while it’s not been without its challenges, overall I feel very fortunate to be where I am today.

A while back in 2007 at the Value Investors Congress, you gave a presentation (PDF) about how you think about asset allocation at Centaur. Is it largely the same today? Or has the financial crisis influenced your take on capital allocation?

That VIC presentation was primarily a discussion about portfolio construction, and it was really in reaction to what I thought was a growing pressure amongst value investors to run excessively concentrated portfolios. Keep in mind that this was 2007, and the market had produced a long stretch of good returns from 2003 to early 2007. The book “Fortune’s Formula” had become quite popular, and there were many discussions amongst investors about the potential for employing the Kelly Formula as some sort of secret sauce that would allow investors to increase returns by increasing concentration.

My own view is that most investors are better off running portfolios of 15-25 stocks because such a portfolio would ultimately be a truer reflection over time of an investor’s skill. In other words, a 15-25 stock portfolio has enough concentration to allow a skilled investor to really stand apart from the market, but is not so concentrated that bad luck, bad timing, or one or two mistakes can sink an otherwise competent investor. One of the points of emphasis in that presentation was that concentration shouldn’t be a constant, but rather should be idea and environment dependent. It has always seemed to me that each idea in the portfolio should be sized based on a careful assessment of the body of evidence available for that idea, with particular emphasis on risk factors. This would include factors such as how deeply the security appears to be under-valued, how predictable and reliable the business is, how it is capitalized, the quality and track record of the management team, and even how familiar the investor is with the idea. Also, it should be influenced by the presence of clearly correlated ideas in the portfolio.

I believed then and I believe now that using the flexible 20-stock model portfolio position sizing exercise that I described in the presentation is a very solid framework to start with. In looking back over that presentation today, I wouldn’t change a thing regarding the content of that discussion. But I’d sure like to have the stock picks back – I presented four ideas at that conference and three of the four performed very poorly in the bear market that followed.

How long do you study a potential investment before you decide to buy? After initiating the position, do you continue your research process on the name?

We generally produce a research document that covers all the important components of the investment, both qualitatively and quantitatively, prior to investing. For a simple idea, the document may well be five pages long. For a very complex idea, the report will be longer. But regardless of the complexity of the idea, writing a research document using a fairly standard template serves as both a form of checklist for us and ensures that we both understand the idea and can articulate why the idea meets our criteria for both value and safety. It also allows for a “quality check” in that it can be reviewed by a second analyst internally and even potentially by contacts outside of our shop that may be able to review our work and provide some insight back to us.

You have mentioned in the past that you are increasingly looking at macro data when making an investment. What kinds of macro indicators do you look at? Has there ever been a situation where a stock looked cheap but you did not invest because of the macro?

I wouldn’t say necessarily that we look at macro “data” when making an investment. It is more the recognition that an otherwise compelling idea can get overwhelmed if the larger forces surrounding that idea are negative enough. Going forward, we will probably be a little more cognizant of looking for the larger risks that could really hurt us as investors. As for an example, we basically decided in mid-2008 that we weren’t going to invest in any bank or other leveraged financial business given our concerns about the credit environment, and we sold the one stock he held at that time that qualified, which was American Express (NYSE:AXP). Granted, this was an extreme case, but it did help protect us from the worst of the permanent capital losses that many of our value investing peers suffered in banks and other leveraged financial stocks.

I suspect that our approach going forward when assessing ideas where we have identified a major industry or macro risk would be to use smaller position sizes, demand more compelling prices, or actively look for a way to hedge out any obvious macro risk that we identify if it can be done in a cost-effective way.

When you use valuation methods like DCFs, what kinds of factors do you look at when forecasting? Is it mostly things in the current-year, the past, or your own predictions? How far out do you model?

We use DCFs more as a sanity-check and to reverse engineer current market expectations than to try to produce any kind of precise valuation. When basing our views as far as what the future might look like, we try to look at a longer view of the company’s operating history (normally five to ten years) to see how the business has done over time. As an example, one of our larger current positions is Lab Corporation of America (NYSE:LH). Qualitatively, this is an outstanding business with tremendous barriers to entry. There is something of a Coke / Pepsi dynamic in the laboratory services industry, with competitor Quest Diagnostics (NYSE:DGX) the slightly larger company in the industry and LH being a strong number two in terms of revenues. LH has been a consistent but moderate grower over many years, with revenue growth in the high single digits and free cash flow growth at around 10% for the last five years. In looking at the recent stock price of around $72, when we plug the numbers into a DCF spreadsheet, we find that the market basically assumes that LH will never be able to grow its free cash flow at more than 2% annually going forward forever. Our view of the company’s growth prospects is significantly more optimistic than that.

So that’s our first sign that LH is a potential opportunity for us.

If I drop in even 5% average FCF growth for LH going out for ten years before dropping down to a terminal growth rate of 2% after that, my spreadsheet tells me the stock is worth $96. Because I’ve owned LH in the past and am extremely familiar with the business, I am very comfortable taking the view that the company will be able to grow its FCF much faster than the current market price is discounting. I don’t have to be super precise. When the stock gets to $85-90, it will be a closer call and I will probably respond by reducing our position size somewhat. So we try to use the full body of evidence we have available about a company, but in general we just don’t buy stocks that require heroic growth assumptions to justify the current price.

You operate largely as a generalist. Sometimes that entails investing in unfamiliar industries. Can you give an example of a case where this happened? What were some of the things you specifically did to learn the ins and outs of the business?

Yes, being a generalist means that one needs to have a framework for getting up to speed quickly when looking at a company or industry that is new for us. So we have learned to quickly identify the business model, which gives us a huge head start in terms of how to approach the research. There really probably aren’t more than a dozen or so basic business models in existence and most companies employ a variation of one of them. Then we start our study of the targeted business and some competitors, and we start reading annual reports, industry publications, and whatever we think we need until we feel we have a good handle on the business. One of the good things about this business is that knowledge is cumulative and the longer I’ve been investing, the more businesses and industries I’ve become familiar with and the faster I am able to get up to speed.

What is one company that you think you would be comfortable with buying and holding for 15 years? Why?

That’s an interesting question, and I’m going to have to answer it by changing your question a bit. We’ve come to believe that if your goal as an investor is to compound at high rates (our goal is 15-20%), that a “buy and hold” philosophy for 15 years simply isn’t likely to work except perhaps in very rare cases. To get that kind of return, you have to buy stocks when they are undervalued and sell them when they are fully valued. Therefore, to give you a stock that I’d be comfortable buying and holding for 15 years simply doesn’t reflect our philosophy, since over a 15-year period we’d expect to have the opportunity to buy a stock at discounted prices and sell it back at full prices multiple times. Of course we are prepared to wait a long time if necessary to get fair value for our holdings, and there are other cases where the performance of the company results in ever-increasing estimates of fair value such that we can hold on to the position for a long time. But we are usually hoping that we will be able to get full value for our stocks within 2-3 years of purchasing them.

So let me give you a list of companies that we admire and that we very much like to own when the stocks are cheap: Fairfax Financial (TSE:FFH), because we admire Prem Watsa. Berkshire Hathaway (NYSE:BRK.A / BRK.B) of course. In our current portfolio, I like Lab Corp (NYSE:LH), Dreamworks (NASDAQ:DWA), and a small Canadian company called Ag Growth International (TSE:AFN). In all of these, I either have a great deal of comfort and admiration for the management team, or else the business is extremely unique and enjoys a strong competitive advantage.

One of the things that value investors often talk about with shorting is how it gives you potentially unlimited losses. How do you manage risk with shorts?

Shorting is a very tough business, and we continue to learn new lessons every year. I have come to the belief from talking to several guys who are more experienced than myself on the short side that the best way to manage risk is to keep position sizes small and have a slightly more diversified short book. We also limit the size of our overall short exposure. Unlike the long side, where we have no individual position loss limits, we have historically used a position loss limit on short positions, though over time it has probably hurt us as much as it has helped us.

Can you give an example of a past investment mistake? What do you think happened? What did you learn?

Sure. Rather than give you a specific mistake, I’ll give you a category mistake that we’ve made more than once and that I therefore think is one that investors are extremely vulnerable to. The mistake is one of commitment bias, where for example we will decide that a given idea is very compelling but due to its potential risk is justifiable only as a small position. For example, every once in a while we find ideas where there is a very wide range of possible outcomes, but where either the potential magnitude of the return in the good case scenario is very high or we think the probabilities are favorably skewed in our favor. On balance, we’ve done OK with this kind of idea. The problems have come when we’ve initiated the position at an appropriate position size (say, 1% of the fund, or 2% or whatever) but then the stock declines either because of some new development or for another reason. We’ve often added to the stock and built them to inappropriately large position sizes simply due to the lower price, rather than sticking to our initial game plan of limiting our bet. Because of this, we’ve occasionally made what would have been a small loser into a bigger loser.

Another and similar mistake is reacting immediately to a sharp decline in an existing holding on negative news without taking adequate time to fully review the new information to ensure that making the additional deployment is justified by the new development. We try now to be rigorous in ensuring that each incremental add to an existing position is truly justified by the existence of a widening discount to our expected range of fair value and not due to some embedded commitment to the name.

What are some of your favorite books? Investing or non-investing related.

I kind of like to follow good writers around. For financial-related books, I always like to read anything by Roger Lowenstein, with particular nods to his biography of Warren Buffett as well as his book Origins of the Crash that described the causes of the tech and large cap bull market of the late 1990’s. I think Michael Lewis does fantastic work – his latest of course is The Big Short, but I also loved Liar’s Poker as well as his non-financial books The Blind Side and Moneyball.

How do you look at the market cap of a company? Are you less willing to invest in large caps? Do you see more opportunities in one than the other?

No, we don’t care what the market cap is. We are looking to get the best combination of value and safety out of our investment dollars as we possibly can. I do think that large cap, high quality stocks are as cheap now relative to the rest of the market as I’ve ever seen them, and that being the case our portfolio is more heavily weighted to large company stocks than it has been for most of our history.

Can you give us a company that you think is undervalued/attractive right now? What is your thesis there?

Sure. Lab Corp is our biggest position, and I’ve already explained our thinking there. Let me give you an esoteric one. This one is a small position for us, because the stock trades on the pink sheets and isn’t very liquid. Therefore, I’m not making a recommendation, only naming a stock that I personally think is undervalued and attractive. The company is Mass Financial Corp (PINK:MFCAF), and it trades in the U.S. on the pink sheets under the ticker MFCAF. MFC is a merchant bank specializing in a combination of traditional financing services and proprietary investing, primarily involving commodities and natural resources. The business is run by Michael Smith, who is also the chairman of the company formerly known as KHD Humboldt Wedag and is now called Terra Nova Royalty Corporation (NYSE:TTT).

MFC was spun out of KHD in January 2006, and had negligible book value at the time of its spin-off. The stock trades for $9 and change, and has a market cap of approximately $200 million. In the last four years, MFC has averaged over $40 million in net income and over $50 million in free cash flow. Here’s the book value per-share at the year-end each of the last four years, starting basically from zero at January 2006 (note that the book value per share figures are adjusted for a 9% stock dividend issued in late December 2009):

December 31, 2006 $2.43
December 31, 2007 $4.39
December 31, 2008 $5.71
December 31, 2009 $9.72

Going back further, prior to folding MFC into KHD, Michael Smith ran the company (then called MFC Bancorp) from 1984 to 1995, and during that stretch he grew book value from $1.49 per share to $17.09 per share, which is a pretty impressive performance. Overall, we think that MFC is a very intriguing investment at a discount to book value given the impressive track record.

The downside to an investment in MFC is that there is never really any way to know what Michael Smith is up to. Smith’s policy is to report financial results every six months, and only issues press releases when a material development occurs. In addition, the company’s disclosures are not as highly detailed as one might like regarding its merchant banking and direct investment activities. Nevertheless, the performance of the company speaks for itself, and MFC has an extremely strong and liquid balance sheet and uses very little leverage in its activities, making the historical performance that much more impressive. A couple months ago, MFC took over a majority interest in a micro-cap Canadian listed company called Canoro Resources (CVE:CNS), which has some very interesting oil and gas assets in India. As I mentioned, MFC is a small position for us, but I like having it in the portfolio.

Zeke, thank you for taking the time to interview with Street Capitalist

Unfortunately, the Bank Analyst must remain anonymous. I will say that he works at a large buy-side fund and comes from a value investing background. I think that this interview went really well and you’ll enjoy it. The interview just has a ton of concentrated information about how to look at banks and then perspectives on the sector. I transcribed this from a recording of our conversation, so I everything below is pretty close to word-for-word what was said. I tried to get all questions that were submitted to me answered. Questions and my comments are in bold.

How do you gain a circle of competence with banks? Where do you start?

Keep it very simple. Banks or financial institutions are based around borrowing money and then lending it. So that’s going to be masked by all different types of weird funding mechanisms and odd assets (securities and lending structures). The accounting treatment and regulation will be tricky.

The learning curve especially with the crisis means it’s hard and always evolving. With that giant pot of knowledge you want to keep it very simple. Start out be looking at small micro banks, there are banks trading that might only have 10 branches that operate out of one geography. You can learn that one particular geography and all the macro idiosyncrasies of it. Plus, you can probably talk to management. Keep it simple, find banks that focus on just mortgage lending or commercial and industrial (C&I) lending and master that. Then if you master it you can branch out. If you master mortgages you can branch out to commercial real estate (CRE), then C&I.

Then you could do something like read a Bank of America 10K. They own every type of business within financials. So it might look confusing as a whole but if you think about it individually they are like separate monolines that are operating as a whole.

But yeah definitely start with the simpler banks at first.

What ratios are you looking at the most when examining banks? Do you use the Texas ratio at all given how it has helped signal banks that will need to raise cash in the past?

We don’t really use the Texas ratio specifically. The general ratios that the banks provide you are ok but obviously you can’t just go off of that. There’s much more investigative work. It all starts with a detailed look of the loan/securities portfolios, so type of loans and where they were originated in terms of geography. We look at the different delinquency buckets, non-performing assets, charge-off numbers and make assumptions. It’s a very macro-economic driven process.

Non-Performing Asset (NPA) ratios and charge-off ratios and the rates of their change are important but ultimately it’s the capital relative to the banks assets that’s most important. If a bank has a 4% capital ratio (TCE / TA) and the bank has 5% losses the equity is wiped out assuming they don’t earn their way out. Texas Ratio basically says if all non-performers lead to charge-offs then what percentage of tangible equity would be wiped out, so sort of the same thing.

Do you use any different metrics for regional banks?

No. I wouldn’t say we use any different metrics. Regional banks may not have as many loan categories as the bigger guys. There can be less to look at and obviously its specific to the region. If there is a large discrepancy between the general macro and the regions macro it can make a major difference (meaning a Florida bank may relatively underperform a bank in NJ)

Thomas Brown of Bankstocks argued that the charge-offs to loan reserve ratio had no meaning due to variations in accounting treatment. Can the analyst describe a better criteria for measuring loan reserve adequacy?

There’s some merit to his argument. I’ll give you a simple example: When a bank makes a credit card loan, the reserve to the loan should be higher in theory because it’s an unsecured loan. If it’s a mortgage you can afford to charge off less because there’s collateral backing it up and you’ll have some of the loan recovered in a sale. Obviously the severity is dependent on the economy (if home prices go down). Generally simple reserve ratios may not tell the whole story but when they are headed in one direction quarter after quarter it’s telling you something. If I recall correctly from the specific article where Brown discusses the topic he talks about FHN and how based on reserve ratio, reserves look inadequate but if you look at how those reserves are allocated it seems sufficient. Now you can try to be a hero and pick names that way and claim its thorough analysis but it doesn’t work so well in a banking crisis environment similar to the one we went through.

So should capital adequacy ratios factor in black swan events then?

See – no one knows what that correct capital adequacy ratio (CAR) number is. You don’t know what the severity of the next crisis will be. I’m in favor of keeping the reserve requirements higher than they have historically been. One of the reasons we got in trouble is because the system got way too levered.

How important do you view the funding of deposits? How do you incorporate sources of funding into your investing decisions?

Some people value banks based on deposits — I don’t. I don’t think anyone uses it as the end all valuation. Deposits can make or break a bank. They generally tend to be the stickiest and lowest cost source of funding. With wholesale funding, you’re waking up in the morning praying that some institution is going to keep lending to you. With deposits, you don’t have to worry about that as much.

You want growth in savings loans versus high yield CDs right?

Yeah — the type of deposits is important. If a bank sets them up with hot money CDs, it’s really no different than wholesale funding. GMAC did this. You don’t want a banking institution that does that. You want a depository that people trust and are willing to give you money interest free.

How do you value a bank? Most traditional investors look at things like DCF valuations or try to come up with a Ben Graham style assets-based valuation, but banks are different right?

It’s rare to see a bank analyst use a DCF. We mostly use an earnings model. We then attach a multiple, so what a lot of analysts are doing is attaching the historical 10-12x multiple to normalized earnings.

A simple way of getting an earnings number is by taking a ROA (Return on Assets) percentage and assuming some type of asset growth (negative or positive) and then multiplying the ROA times assets times the growth number. Then, take that number and divide it up by the shares outstanding to get some kind of an EPS figure.

A more detailed model assumes some earnings asset level and net interest margin (NIM) to get net interest income. To get non-interest income you just assume some growth rate off of the fee line items. Then, assuming something on provisions and expenses to get a net income figure. Thats the basic idea and it incorporates a lot of assumptions on the macro and regulatory environment.

During this crisis I think people looked at banks in this manner:

There is a credit/capital concern > people start looking at banks based on tangible book > the concern becomes whether capital is enough. You make your own stress test. If banks pass that you might want to invest in them. Obviously you have to net that against how ouch they will earn too. But trying to earn your way out didn’t really work for Japan.

Ulimately, normalized earnings will depend on GDP and unemployment. If it ends up being robust (so GDP growth rates are high and the unemployment rate goes down) then banks will win but the biggest risk to bank earnings going forward is the level of earning assets. If earning assets decline, normalized earnings will not be as high. The decline in loan balances is something I’m paying particularly close attention to this quarter.

So if a bank has 14% capital and they currently have losses of 3% you are probably in good shape assuming they are not lying or pushing losses into the future. But a bank of that sort might not be cheap either, which can make it a waste to invest in.

What kinds of things do you usually ask management on calls and visits?

Ask whatever you can’t get out of the 10Q and 10K. Understand the intricacies of the business. Find out about specific accounting treatments and things like granular details on their loan portfolios.

Also, trying to gauge how they see the macro-economic environment. The best thing to ask management is to ask what they see in their locale. Look at Case Schiller and see what a specific housing market is doing and then ask a bank there about it. They might say that even if house prices are going up, the unemployment situation still sucks so there’s no improvement.

In Margin of Safety, Seth Klarman says that value investors don’t invest in banks often because their asset books are too opaque. How, when you’re analyzing a bank, do you make sure the assets have a credible margin of safety?

It depends on a lot of factors. 1. The types of loans and geography 2. How loans are performing. 3. Management’s track record in originating loans and honesty. 4. How the macro is performing and 5. How aggressive/conservative management is in working through problem loans.

So dealing with the transparency, that’s a good question. Investing in financials is more of a gamble than any other category. You will simply not have the transparency you have at other simpler businesses. In other sectors management on conference calls can give you line item guidance that you can just plug in your models to come out with next quarter EPS within a small range of error. How many financial management teams got it wrong or thought they wouldn’t be the last one’s holding the bag during the crisis? I remember hearing Ken Lewis (CEO of Bank of America) talking about how the recession will end in 2Q08. And this guy basically gets a real time update on the economy on a daily basis.

So you want a wider margin of safety. If you would buy a company at 6x P/E, you might want to aim for 4x P/E.

Financials are truly a different animal in my opinion. There is no advantage in investing in financials (meaning you are not getting superior moats or higher ROE businesses compared to other sectors) If you thought the market was dead cheap in march for example, there were plenty of businesses in plain vanilla sectors (retail) that had rises greater than or similar to financials and were much easier to understand. Assuming these stocks were undervalued and haven’t gone up for speculative purposes, you can see that car rental company Avis Budget Group (NYSE:CAR) is up 11 fold since its low compared to Bank of America which is up 6x. I would say Avis is a lot easier to understand than BoA.

So why did value investors get it wrong?

As a value investor, investing in a financial requires really getting comfortable with the macro-economic situation. So unless you’re doing some kind of arbitrage (market-neutral) play, you will have to look at the macro. If you want to ignore the macro because Warren Buffett says it is useless then you want to stay away, especially if you’re not benchmarked or don’t have a mandate to invest in financials.

I think that some value investors refused to believe that this time it is different. Also, they just didn’t understand the risks involved with some of the intricacies in financials. Bruce Berkowtiz talks about how he didn’t understand AIG when he read about their derivatives and said pass.

I think that other value investors, especially the ones who decided that AIG was cheap let those risks pass by them. Or they looked at history and said “Okay, this bank trades at 1/2 book and based on history its never been cheaper.” They were wrong.

What would happen to banks in a hyper-inflationary scenario in which the 30-year Treasury yield goes to 15-20% or higher, as Julian Robertson has suggested?

In a hyper or super high rate environment, it will not be good for financials and equities.

The first step would be that asset sensitive banks where loans/securities re-price faster than their liabilities would win temporarily. If you read what SCHW has said, for every 100 bps rise in rates they generate 600 million in net revenues, which pretty much fall straight to the bottom line.

Eventually the dynamic that would kick in would be that depositors would demand higher rates. If rates are 15% depositors wont want 3% CDs. So right there, funding costs would go up.

For a bank to make money, it’s usually an 80/20 split. So, 80% comes from interest income and 20% from fees. Since banks typically generate income from net interest income, they’re going to have to make loans that are higher than their funding costs. The argument is, what homeowner wants to pay a 15% mortgage in a 10% unemployment environment? Credit card rates have already gone up — you’ve seen Wells Fargo and others already do this to try to protect against potential regulatory changes, so that they can keep ROEs closer to a historical level.

I’d argue though that loan demand would collapse. Unless it’s a necessity but I don’t think anybody can raise prices high enough to match that kind of rate environment. Would you pay $20 for a Starbucks coffee? I don’t think so.

So the basic idea here is that nobody will be able to afford those loans and the demand for credit will fall?

So yeah, when funding costs become elevated it’s tough for them to make loans higher than the funding cost. A coffee shop isn’t going to take a loan to buy an espresso maker when the rate is 15%. To make money above their 15% cost you would have to raise prices to the point where no one would purchase a latte. Will that espresso machine make a 15% return to make that a viable expense? I doubt it. Initially, when rates start to rise, asset sensitive banks will win.

So let’s say a bank out there has locked in 5% funding base for the next 10 years. If rates go to 20%, they’re safe with their 5% and they’ll be able to price loans above that easily. Or a bank can become the lender to the government, but if all you’re doing is funding the government that wont work in the long term, as the economy would collapse.

The trade in financials has largely been long large money center and short regional banks. Do you see that trend continuing going forward?

If you start from the beginning, that trade has worked relatively. The best trade was to just long the whole sector. Now I would say that trade is worth holding onto. Ultimately, what I see on the long side is truly diminishing. On the short side there is some stuff but its primarily valuation related.

I want to make clear though that the idea to go long money center banks has had the margin of safety diminish by a lot. I’ll give an example:

Smart and dumb analysts think that Bank of America (NYSE:BAC) is going to earn around $2.50 to $3.00 in 2011 or 2012. What happens if they’re dead wrong? What happens if they earn $0.90 cents? Then you are clearly overpaying for the price it is at today, $17. But when the stock was available at about $3 it was either trading at 3x or 1x. It was very cheap at both of those multiples.

It’s scary because everyone is betting on Bank of America and I don’t like to bet on a horse that everyone else is betting on. If there is a chain reaction of sells on that name it can contract quite a bit.

How worried are you about regionals with large commercial real estate (CRE) exposure as we progress through what seems to be the next set of fundamental problems? And on that note, which regionals would you be most afraid of here?

In the beginning of the year people thought about banks specifically on the basis of what are the banks with early credit stage issues – housing, consumer type loans (credit cards) versus banks with later stage issues like CRE.

So for example: If you see people moving onto land, they’ll build houses. And if companies see houses, they’ll build commercial real estate and expand their businesses there. So in theory, it’s consumer loans that go bad and then goes CRE and C&I. So for regionals, later stage issues are a larger portion of their loan portfolios. We haven’t seen that hit as much as the early stage credit stuff.

CRE is an interesting animal. 1. There’s a lot of weird accounting 2. The structure of the loan itself. So there are these mini-perm loans for example where on the third or fifth year, the principle balance of the loan is due. A lot of these loans were made between 2005-2007. You still have 2009-2011 where things will come due. But a lot of these mini perm loans get extended out a year. So instead of going to non-performing they just get extended out and to all of us we continue to think they are performing.

Fifth Third (NASDAQ:FITB) is one regional that I’m kind of worried about. In general, right, if you’re going to look for CRE issues there’s a few categories: retail, lodging, industrial, and multi-family. Multi-family probably won’t do as bad as other ones because it’s harder to get loans to buy a mortgage. So more people are going to move into apartments in theory but it will still be hit. That might not do as bad as the other types of loans. Retail will obviously take a hit with consumer spending dropping and unemployment levels elevated. Here are some numbers: a basket of regionals – CMA 22.4%, MTB 25%, Regions 21%, Synovus 28%, Zion 35%. If you look at Wells Fargo 10%. Citigroup it is 2% and for BoA it’s 5.75% of loan portfolio. So those guys are pretty diversified versus the regionals that have a ton of CRE exposure. So you have to drill down and figure out the type of CRE they have the geography of it.

So basically it’s a way for management to hide delinquencies using weird accounting treatments?

Exactly. I’d point to the FDIC bank failures. A lot of the failed banks had 2-4% delinquencies in CRE and then a quarter later delinquencies shot up to 30%!. So you don’t really see that in other categories as the increase is gradual Q/Q.

Will majors participate in open market M&A or wait for the FDIC gain deposit share?

A lot of consolidation you saw with PNC (NYSE:PNC) taking over Nat City, Wells taking over Wachovia, I would argue that that type of M&A is less likely in the near term. More of the FDIC bank seizure type will be common

What about straight up mergers/takeovers?

Banks are still worrying about filling holes in their capital base. Even though equity markets have opened up, these guys would likely have to raise money to take over a large-scale bank. Look at Wells Fargo. Once they put on all their off-balance sheet exposure they’ll have a TCE ratio closer to 3%. They’re already in the 4%-ish range. Some of these guys are already too big — a single bank cannot own 10% of the depositor base of the US. You can only do that if you grow the deposit base organically. Not through takeovers, though I think that rule wasn’t considered last year

Can you talk about how you think regulatory / compliance changes that are on the horizon will affect banks? Any key things to watch out for?

One thing that’s known by the industry that everyone is expecting is rules on new capital adequacy ratios. Capital ratios will go up, the system cannot lever as much as it did before. That’s one thing. Fees are going to get hit (think deposit fees, credit card fees). Who knows what will happen if the Consumer Protection Agency goes forward.

I think normalized earnings will go down because of this. I think provisioning rules will change too. When times are good, banks can’t build reserves too high. FASB will argue that that they’re trying to dodge taxes. Do you know how that works?

No I don’t — let’s go into that a bit.

Okay so, when you have to build your allowances for loan losses, it comes through the provision expense. So banks have a reserve set aside, Bank A has $1000 in reserves with $100 in charge-offs. $100 comes out and the reserve is $900 now. If you want to replenish you need to add $100 but if you want to over provide for that you need to add $101 or more, which all comes out of net income.

In good times, some banks might want to provide for more if they think a crisis is coming. The less they provide the higher their earnings will be. The more they earn, the more they pay in taxes. FASB doesn’t want them to build reserves to an amount they think is unnecessary.

It goes back to what Japan was worried about. Their loans stayed in trouble for a long time. I think 25% of Japan’s tax receipts came from financial reserves. So the government didn’t want them to provide for bad loans.

So yeah — it would severely dent tax revenues. So that’s the dynamic here, there’s this quirk in the accounting and regulatory situation.

Exactly. If a bank had foreseen the crisis, they would have had pressure to actually lower reserves. So I think that will change for the better now and that banks will be able build reserves at a higher rate than before.

How do you deal with the government interference and its skewing of natural competition among banks? (i.e.: having the entire mortgage market in 3-4 banks)

Yeah, so there’s always a stigma with government. I think that’s why banks got so depressed in January and March lows. There were a lot of nationalization fears and the stress test looming. Nat City always boggles me because they had 8.7% TCE ratio, they were one of the highest among peers/large banks. For some reason that bank had to basically be sold to PNC. It could have been a depositor’s run.

So you think the government overreacted in cases?

I don’t think government is good at running businesses. So if they start telling banks whom to originate to I wouldn’t want to be a shareholder of that bank. I do think it will have some implications on the lending business going forward.

One thing to add to that, some people are definitely giving the banks that have excessive intervention less of a multiple. Bank X might be worth 8x but Bank Y that paid back TARP might be worth 10x.

Do you agree with that?

Yeah I do. If government flexing their muscles influences operations, if it becomes very big, then yeah. I don’t think government will be as efficient although I don’t think management of banks themselves aren’t so competent or efficient.

Yeah I thought it was interesting that Citigroup had to sell Phibro, even though it’s a profitable and well-run business unit.

Yeah that’s one decent example. Another thing — if you have more programs or initiatives that relax loan standards. If you can’t pay 20% down you shouldn’t buy a house, no matter what the American dream entails. America’s sort of becoming one big bank. They’re doing subprime lending with the FHAs.

What’s your best long and short for the sector? Themes?

I currently ask two questions:
1. What financial institutions are pushing problems to the future?
2. What banks are trying to work through their issues right now and be prepared for an uncertain world?

So how do you tell that?

Find banks that are aggressive in marking down their books and aggressive in raising capital. Or banks that didn’t partake in this excess during the credit bubble. You’ll find these banks; they might not be very popular. Look for well-capitalized institutions that are ready to pick off credits from weaker institutions. It’s sad to say but look for well-connected management. Look at Goldman Sachs (NYSE:GS), a lot of people complain about Goldman, like with that Rolling Stones article. But if you think about it, all those negatives are reasons I’d want to own them at the right price.

So for management, look for guys that are liked by politicians and the public?

So if Warren Buffett were to fall tomorrow, a bunch of guys would be saying all these great things about the life he lived. Angelo Mozilo of Countrywide? Probably not so much. In banking, honesty is super important. It’s important everywhere but I mean — look at IndyMac’s CEO. He was so positive up till the bank collapsed. It’s very unfair and really tough. Some investors really relied on his word and it’s very sad. The good thing about having this period in history is that you can see what management teams handled it well. So if the problems get worse, you can use this period to see if they passed.

I would argue that future crises that come about are likely to be worse. With the way the US is acting these days, with the amount of debt they’re taking on, we’ll probably see more problems in the future.

Commerce Bancorp (formerly CBH) used to be a unique bank that had a different business model. If it were a standalone company now, would it have been affected the same way as most of the big banks? Also, would it have taken more market share from the likes of BoA and Citi.

The thing is, when you go through a system-wide crisis, even small banks are bound to be affected. People always praise Wells but I highly doubt that they picked off the best credits in California while Countrywide and IndyMac were left holding the crap. When you have that big of a loan portfolio, I doubt that whole number is good credits. Obviously it hasn’t been.

So Commerce, their model, Vernon Hill was definitely an innovator. Bank Atlantic tried to mimic it exactly, UMPQ is doing something similar. Ultimately though, it’s the type of loans you make that can bring you down. You can be the most innovative banker in the world but if you make bad loans you’ll go down. Commerce also benefited from having a geographic concentration in the Tri-state area.

Are there any banks in particular that stand out in doing new, innovative things? The future of banking will be different than it is today, which banks are going to be ready for that new future?

I’m sure people can disagree but I’d argue how innovative can you really get in a borrowing/lending model. The medium is changing. We’re seeing more Internet banking and maybe something happens in mobile. When is the last time you actually stepped into a bank branch? My parents do, but not so much the younger generations. There’s banks that offer iPhone apps, so that’s the type of innovation I see but nothing too big. You wont get credit for innovation when you’re in a banking crisis.

Mostly, innovations are used to get cheap deposits. If there is a bank that can innovate and do it correctly, then it can work well. Commerce is a great example of one that did achieve it. Their efficiency ratio was higher than most peers but that’s because they kept their bank open 7 days a week and they made it so you really wanted to visit their branches. They used nice colors, had super friendly tellers (they weren’t stuck behind bullet proof windows or a mini gate), and they didn’t make branches look like a post office or a jail cell.

Their whole idea was putting more money towards non-interest expense but they were able to charge less for deposits since they were more convenient. It definitely worked. If you could invest in safe assets you could earn a wider NIM than peers.

The thing about Vernon Hill was that he wasn’t in the banking business forever, he owned Burger King franchises so he brought over that customer-driven model to banking. But if you run into the storm like we did now, innovation is not a high priority on bank executives’ minds.

If you look at innovation from other areas, like tech, you’ll see guys in college who are really bright that are making websites trying to innovative banks.

Yeah I wanted to talk about that — I always see guys, especially from valley tech startups saying how we need to take the start up model to banking ad really innovate things on that end. Every time, I think this is a recipe for failure with all the regulatory hurdles and work involved.

That’s another good point. It’s a heavily regulated industry. So for someone in college or high school that has a bright idea for starting something in the financial sector, they’re going to go through more capital and regulatory barriers than someone trying to build something like Facebook or Twitter. The roadblocks are just a lot higher.

A lot of times when there’s innovation in financials, it usually comes from within the banking system itself. So it is some guy who has been there for 10 years who sees something and acts on it. But it’s almost never from guys on the outside that think of something one day while sitting in their college classroom.

I would argue that there’s simply a smaller number of brains devoted to thinking about new ideas in banking and it’s mostly limited to people who are already in the financial world because it is within their competence.

What about innovative companies within banking?

There’s definitely people like Dick Kovacevich of Wells Fargo who talks about cross selling at Wells Fargo. There are people who argue that it doesn’t work but to him it’s like the Holy Grail. I’d argue to some degree it has worked because Wells Fargo probably has the best funding out there. I don’t have much experience with their branches since I’m on the east coast but we’ll see how things go with this Wachovia integration.

One thing that a lot of value guys got wrong is that they focus too much on qualitative factors like culture and things on the surface of the business model too much. They focus so much on the positives that they aren’t looking at the risks looming. When you’re sitting there analyzing tech companies, a lot of tech companies have good balance sheets. You’re not trained to look at balance sheet risk. David Einhorn did better on financials than other guys, because they set themselves up to look more at downside. Tom Brown focused too much on culture / qualitative factors and didn’t consider the macro/quantitative reasons that could destroy a bank.

What are you reading right now?

I’m reading Just What I Said by Carrol Baum, a Bloomberg Economics columnist. It’s pretty basic. One thing I learned about banks is that macro matters so much more than you think with banks. You’re almost a macro investor, so on that note I’m also reading Alchemy of Finance by George Soros.

One more basic/beginners book that I really like is Peter Lynch’s One Up Wall Street, that was a book that had a big impact on how I looked at investing when I was younger.

Thank you very much for giving your time for this interview. I know that my readers are going to enjoy it.

Paul Sonkin, manager of the Hummingbird Value Fund, is an awesome investor and a great guy. I’m extremely grateful that Sonkin was willing to contribute his time to this interview (the first interview here at Street Capitalist). I wanted to interview Sonkin in particular because his fund employs a strategy accessible to all of us small investors. Some of the companies are absolutely tiny on a market cap basis and he goes after arbitrage situations that most investors will never hear of. This style of investing embraces the advantages of a small investor and allows you to exploit greater inefficiencies in the market, as many of these neglected companies are too small for the big Wall Street firms to cover or invest in. I hope you enjoy the interview and let me know if you think I should do more of these.

Flickr / Peasap

Tariq Ali: Could you give us your brief career history?

Paul Sonkin: I bought my first stock with my bar mitzvah money. I went to college and when I graduated it was when Drexel had just went belly up and I was looking for sell side research positions. I couldn’t really find any because all the assistant positions got taken up by those ex-Drexel people, so I worked at the Securities and Exchange Commission. It was a lot of fun spending a year and a half there and spending a year and half at Goldman Sachs. My career was going in one direction and my interests were going in another, so I went back to business school and I graduated in 1995. I worked for Chuck Royce for 3 years and then worked for First Manhattan which is Sandy Gottesman’s firm for a year and then I started Hummingbird about 10 years ago. That’s sort of a nutshell.

Tariq Ali: You often hunt in the nano-cap space, how do you find out about these companies? Is it like Buffett said, that you need to just “Start with the A’s” or do you use things like screens or local news periodicals?

Paul Sonkin: You know I’d say that most of my ideas come off of the new lows list. I take that that’s sort of the best hunting ground. And then the other thing that I do is I have these lists of companies i’ve owned before or am interested in. And then I get the news headlines for them on a daily basis and then I do a lot of keyword searches for like spinoffs, liquidations, merger arbitrage, stuff like that. And then I go to conferences I source my ideas pretty much from everywhere. The only place where I don’t source my ideas from is Wall Street. Not a lot of Wall Street research at all.

Tariq Ali: Yeah, that 52 weeks low list really exploded a few months ago.

Paul Sonkin: Yeah. And I guess that in times like that there’s so much to look at you can almost close your eyes and buy anything.

Tariq Ali: A lot of the companies you invest in are pretty small. Do you ever interact with the management of companies you invest in? How receptive are they to your ideas? Many of these companies have small shareholder bases, do you ever have to work with them to help promote changes in these companies?

Paul Sonkin: I guess. Yes and no. Sometimes they are very receptive sometimes they’re not receptive. I would say that we always talk to management over the phone and we’ll sort of have them walk us through the story and we’ll discuss their capital allocation decisions and just you know, go through various things like that.

Tariq Ali: And one thing I noticed is that some of the companies in this size range may have an incredibly small shareholder base. Do you ever work with these shareholder bases?

Paul Sonkin: Yeah, it’s very common.

Tariq Ali: And the other thing I noticed with some of them is they don’t register with the SEC, is this ever a problem for you? Do you ever have issues trusting their financial statements?

Paul Sonkin: No, I’d say that usually the financial statements are pretty good with the ones that don’t file. Sometimes they just file once a year. But it’s sort of like how the old pink sheets used to be.

Tariq Ali: You teach students value investing at Columbia Business School. When analyzing securities in the micro-cap/nano-cap space, are the methods different than researching mid-caps / large caps?

Paul Sonkin: Well yeah. You know it’s always easier to analyze something that’s simpler than something thats more complicated. So think of it as if you were dissecting a human body as opposed to an amoeba. You know when you have a company where there are just fewer moving parts it’s just easier to do the analysis. So that’s why we’ll keep track of 100 different companies and it’s pretty easy to do that because there’s just less to analyze.

Tariq Ali: I saw in another interview, you mentioned how the portfolio works at Hummingbird where you almost allocate 50% of the portfolio to arbitrage situations. Could you talk a little bit about position sizing — does your firm put limits, do you have a hard formula for that kind of thing?

Paul Sonkin: You know I’d say that we used to have much more stringent limits but what we’ve found is that lately there aren’t that many interesting arbitrage deals. So we have allocated a lot more money to the general portfolio. So its become a little bit overweighted in that respect.

Tariq Ali: About the arbitrage part of the portfolio, with my own portfolio I’ve participated in a few small, odd-lot tender kinds of things. Does your firm deviate from small micro-caps/nanocaps for arbitrage or do you stick in the same space?

Paul Sonkin: We do a lot of small odd-lots and other forms of arbitrage. We really don’t deviate because the competition there are the big arb funds and they have a mandate to put a lot of capital to work so the spreads and risk/reward scenarios aren’t appealing. With these larger deals you can do these odd-lots, like if they’re tender but they’re going to do it on a pro-forma basis if you own less than 99 shares usually you can tender into that. So it’s possible to do odd-lots with larger tender offers but it’s not an area of our focus.

Tariq Ali: In another interview, you mentioned Seth Klarman as an investment hero. Reading Margin of Safety, he talks a lot about looking at investments with potential catalysts. Is this a case for you to, do you look out for certain catalysts or is it more of buying low and eventually the market will figure it out?

Paul Sonkin: You always want to look for a catalyst but sometimes there is no catalyst. So with Steinway (NYSE:LVB) there’s no real catalyst there. Earnings will recover and that will be the catalyst but the catalyst isn’t obvious and when it is obvious it’s too late.

Tariq Ali: Do you think you could walk us through a failed past investment?

Paul Sonkin: I guess like other value investors, we’ve paid homage to newspaper stocks. We had one called American Community Newspapers (OTC:ACNIQ) which we thought they had a little bit of a different business model because while they were dependent upon advertising they weren’t really dependent on subscription revenue. What happened was that business just completely imploded. So I think that all value investors have paid homage to old media companies and that was one failed investment that we had.

Occasionally we’re going to get caught in other situations where you get involved and the problems are more than you thought. So a company like that was Meade Instruments (NASDAQ:MEAD) where we were an activist and got a board seat. By the time we got inside we realized that the business was in much worse shape than we would have thought. We would have done fine except the economy was the kind of nail in the coffin.

Tariq Ali: Could you talk a little bit then about shareholder activism. Is it a strategy you actively utilize at Hummingbird or is it more of a strategy of last resort?

Paul Sonkin: We don’t go into any situations with the intention of being activists. There are some people who do that and it’s just not a focus for us. I guess there are cases where we felt as though they weren’t being fair for shareholders and we stuck up for our rights but I don’t see us going on boards in the future.

Tariq Ali: Since you told us about a failed/disappointing past investment, could you walk us through one you’ve been pleased with?

Paul Sonkin: There are some we have now that we think will do quite well going forward. Rand Logistics (NASDAQ:RAND) is a large position for us. The interesting thing about Rand is they’re embarking on doing an acquistion of a company that’s in bankruptcy. So we expect that acquisition, if they complete it, will be an accretive acquistion even though they’re going to have to issue quite a few shares. But just looking at the business on a standalone basis you figure that they’re projected to do $16M of EBITDA this year. They’ll have $6M of CapEx, $4M of interest, and $1M of preferred dividends, which leaves you with about $5M dollars. If you take that and divide that by 12.7 million shares you get about $.40 per share of FCF for March 2010. For March of 2011 we think they’ll do $0.75 of FCF and for March of 2012 we think they’ll do about $1.00 of FCF and the stock is currently trading below $3.00 so we think that’s extremely attractive.

Another company we have a significant investment in is Southpeak Interactive (OTC:SOPK). I think the video gaming companies have had a lot of pressure because some believe that people may just download video games off the internet for free but they can’t get the same kind of experience on a game played online as they can on a CD that they buy. That company is trading at $0.60 and they have about 51 million shares outstanding so figures about a $31M market value with about $5M of interest bearing debt. So you’re talking about $36M, this is a company that could easily do north of $100M in sales at 8% operating margins. So we think that that is a pretty attractive situation. It’s in a very sexy niche and they just brought on the ex-CEO of Take Two Paul Eibeler Interactive as a board member which gives added credibility to the company. Terry Phillips is a very good manager who is very well known in the industry. They’re executing very well and we feel like we’ll make a multiple on our investment going forward.

Tariq Ali: Could you talk a little about Fortress International (NASDAQ:FIGI) with your take on the situation there?

Paul Sonkin: I think it’s a very very well run company. I think that they had some challenges with some of their customers getting financing but I think that long term it’s going to be a great investment because it’s a play on server farms and on these data processing facilities. Even though near term they may not put up great numbers. I think that long term they’re capable of some meaningful earnings growth and generating a lot of free cash flow. I was sitting with the CEO of the company about a month ago and if you just look at the companies that they’ve done initial build outs for I think they can get about $400M of revenue just by building out the facilities that they’ve already started to work on. Because when you put up a facility if they put up a 150,000 facility, they may only build out 20,000 feet but as more tenants come in they get that add on work.

Tariq Ali: As a teacher, do you have any advice for students of value investing right now?

Paul Sonkin: I think that it’s a great time for young people to be getting into the business. If you look, a lot of the firms were created after the aftermath of the 20′s and there were a lot of firms created after the 70′s. I think that there are a lot of firms that will be created out of the aftermath of 2008. So I think that it’s a good time to be getting into the business. Usually, the advice that I give my students is to keep your eyes open and your mouth shut. One of the pearls of wisdom that I give them is if your boss asks you for a red umbrella, don’t bring him a blue one and explain how it’s going to keep him dry. Just give your boss what he wants. I think that there are a lot of people who start working that get off on the wrong foot.

Tariq Ali: Do you have any book recommendations?

Paul Sonkin: There are several books that I really like. I like Hidden Champions by Hermann Simon. David Dreman wrote a book back in the 70′s called Psychology and the Stock Market. Another one I really like is Style Investing by Richard Bernstein. And all of the classics.

Tariq Ali: Thank you so much Paul for taking the time to do our interview.  We wish you the best of luck!

I really enjoyed having the opportunity to interview Sonkin. During the interview, I learned quite a bit about his process and I hope you did too. Here are some thoughts:

For his search strategy, It looks like following the 52 Week Lows is your best bet. In addition though, Sonkin mentions that he employs keyword searches to find things like liquidations and other special situations. There’s a few ways to do this. One, you can set up alerts with the SEC database to send you a message whenever a particular company has filed a document you’re looking out for. Different SEC filings correspond to different corporate events, there are filings for spinoffs, material events, tender offers, and so on. Or, you could rig up your own Yahoo! News Alert so that whenever a story comes with a particular trigger word, such as liquidation, you’d get notified so you can quickly act. Other things are more simple. For example, Sonkin mentioned that he keeps a list of companies that they watch. These are things you just have to do on your own, it becomes easier after you’ve analyzed more and more companies. Right now I’m throwing a number of companies in the too expensive pile, but I look at how they perform over time. Eventually maybe something will happen to cause a company to fall below its intrinsic value and because you’ve already done work on it, you’ll be able to act quickly.

I hope you noticed that when I said small companies, I meant it. Fortress International only has a market cap $13.67M, Southpeak Interactive trades at a $24.78M, Rand Logistics at $37.13M, and Steinway at about $102M. My guess is that most of these companies will have little by way of analyst coverage or attention on Wall Street or CNBC. The advantage is simple: less coverage means there’s less eyes on them and produces greater opportunities for you, the small investor. The market in these area is generally less efficient and the businesses are actually rather simple. I think that companies of this size are better for newer investors because like Sonkin says, they’re much easier to analyze. Steinway is going to have less moving parts than a company like Kraft and it means you can hone in on your analysis better.

I also thought it was interesting that Sonkin sees some of these companies as ones with great long term prospects to grow as business. I know that other investors only venture into companies of this size range in order to find net-nets or special situations, but it seems like Sokin is taking a much comprehensive approach. To find these kinds of companies you’re probably going to have to broaden your search a bit in order to find them, since they may not come up on an ordinary screen. Sonkin’s Fortress International investment is probably the best example of this.

I haven’t read any of the books that Sonkin mentioned but Hidden Champions looks to be very interesting. The book is a study on small companies (that most people may never have heard of) that are market leaders in their respective areas. Such a book could probably prove helpful for analyzing some of these tiny companies from a qualitative perspective.

Hopefully you enjoyed my first interview here at Street Capitalist, I plan on doing more of these in the near future but with readership participation. I think that they’re great learning tools for students of investing because you’re able to pick the brains of people with more experience in the field. I already know that I’ve learned a lot from this interview with Paul Sonkin.