Thursday, November 25, 2010

Oldie But Goodie Offering Encouragement to Young People Interested in Security Analysis

The University of Michigan Business School Dean's Seminar Lawrence J. Goldstein

The University of Michigan
School of Business Administration
Ann Arbor, Michigan

Dean's Seminar
February 8, 1988

Who is Lawrence J Goldstein? What makes him tick? How does go about making investments? Asked by the Dean of The University of Michigan Business School back in 1988 to speak to anassembly of MBA students and to tell them exactly “what he does, how he does it, and how he cameto do it, he delivered the following talk. We present it here because we believe it will provides youwith insight as to just who and what and why our founder is and what we may do for you.

Introduction
I founded Santa Monica Partners six years ago in order to seek long-term capital appreciation; build net worth for my partners and myself utilizing a single pool of capital; and, at the same time, have some fun.
What we have been doing is attempting to exploit what I call the "overlooked and/or ignored by otherwise intelligent investors" segment of the market.

What I want to do now is define this market for you, explain why it is the area of my prime focus, and then discuss my approach to investing.
Before going further, it might interest you to know something of my background. You will also see the genesis of and the basis for my views.
Background

Born, raised, and schooled in New York City - I attended New York University. Upon entering I knew what I did not want to be -- neither doctor, lawyer, Indian chief, nor engineer or teacher, which were the two most popular professions for boys and girls respectively in my era.
I took a freshman course in investments and liked it a lot more than anything else I was into and achieved a good grade to boot. I found my calling: Wall Street became my goal. The way I summed
it up, it had everything one could want.

There was no chance for boredom - one day you could be in the automobile business, the next day in the furniture business, the day after you could be in the brewing industry, and you could look into a variety of companies within the industries.

Moreover, one could wear many hats. That of a security analyst, trader, salesman, deal maker, arbitrageur and so on.

As a further attraction, Wall Street was where the money was.
Unlike today, when I understand college grads go out into the real world and obtain several years of work experience, I attended University of Michigan Business School immediately upon graduating from college. I got my MBA after being here for 12 straight months (two semesters and summer school), which I gather is not possible today. Then I did my time with the U.S. Army, which also is not required of young people today.
Late in 1959 I was ready to give myself to Wall Street.

I decided to aim at becoming a security analyst in the research department of a brokerage firm. At that time Wall Street firms did not recruit as they do today (or did until October 19, 1987). The road to the Street was typically through nepotism. You had to be related to either the partners or the firm's best customer. Falling into neither category, I got out the Manhattan yellow pages and wrote to every single brokerage firm listed - there must have been several hundred. I'll spare you the details of the months that followed my mailings.

In the last week of December 1959, I started work as the most junior person in the research department of Burnham and Company. I talked them into starting me at $80 a week. (Previously I managed to land a job at a tiny firm for $70 a week, but they bought my lunch each day which I figured came to almost $10 a week. Therefore, I incorporated $10 in my $80 per week request at Burnham.)

After three days on the job I received a check for a week’s salary as a bonus. If you worked for the firm, you got a bonus! On the fourth day, I got my salary for the week because they paid every Thursday. So after four days at Burnham and Company I had two weeks salary in my pocket. I figured it was a good place to work and stayed 23 years at which time I left to start my own business.

Burnham and Company in 1959 had a very large research department even by today's standards. Their analysts covered every important industry and their reports were aimed at the institutional investor. My initial job was answering wires from the branch offices. If the analysts covered the company, I had to read their pearls, or question them to obtain an opinion. If the company was not covered, I had to dig into the company myself. I lived in hopes of moving up to be a junior analyst/assistant to one of the senior analysts.

One day in 1960 I picked up a tabulation of revenue and profit comparisons for a list of some 50 trucking companies. I noticed all had revenue increases while all but four had profit declines or losses. They were: Overnite Transportation, Roadway Express, Merchants Fast Motor Lines and Denver Chicago Trucking.

My curiosity aroused, I investigated. Do you know that one stock, Overnite, which was growing annually, had a $5 P/S BV, $1.15 of EPS and a 40¢ dividend -- yet was available to be purchased at $3 P/S (about 2.67 times earnings, 60% of book and yielding 13%).

I told my boss, the Director of Research, about the company. He pointed out the fact that the company only had 500,000 shares outstanding, half of them owned by the founder, Harwood Cochrane, and the stock wasn't "listed." It was in the Pink Sheets. No matter, this was a bargain. It wasn't of institutional quality according to my boss and this was an institutional research department. I was told to forget about it.
This was my first exposure to both the bargains in the Pink Sheets and also to the institutional mentality.

Overnite went on to earn $2.26 in 1961, and when the stock was at $15 per share (up five times) my boss relented some and allowed me to put out a research report. But it had to be on green bordered paper and reproduced in purple ditto rather than the regular photo offset black print on white letter head paper that regular research reports went out on. The company grew and grew and eventually in 1970 it listed on the New York Stock Exchange. On December 16, 1986, Overnite sold out to the Union Pacific Railroad at $43.25 per share. However, by this time, solely as a result of stock splits, there were 28 million shares outstanding. Adjusted, the 1960 $3 price and the 1961 $15 price worked out to $2,422, a not too shabby 31% and 23% compounded respectively over 25 years.

Soon, in addition to answering wires, I became the trucking analyst at Burnham and issued reports on the likes of Roadway and others. I even managed to round up four other analysts who specialized in this little, but key, industry and formed the Motor Carrier Analysts Group, one of the first splinter groups of the NYSSA.

In order to become a full fledged senior analyst, I, of necessity, sought out other niche areas so that I could have several groups to follow and thus be the analyst, on a level with the other seniors.

I discovered industries with four principal companies each, i.e. the brewing Industry, the Railroad Tank Car Leasing Industry, and also business service companies which permitted me to look at a whole host of companies that did not fall into a nice little industry niche. Included were cleaning and maintenance companies, advertising agencies, uniformed guard agencies and others. Finally I created enough industries and companies on which to provide reasonable coverage to become a full fledged senior analyst.

But always I was looking for ideas off the beaten path. Always I seemed to be looking for values that no one else had been interested in or even knew about. I think I came by my approach to investing honestly. Given the need to create my own niche in a research department covering the major industries, I simply had to look in the nooks and crannies of industries and the market if I were to become a regular member of the Burnham Research Department.

Other analysts were less interested in finding values and more interested in following the major industries and the major companies to the exclusion of all else - "maintenance research," as it came to be known. "Give the institutions what they want research" I called it. Filler for their files to support their belief that their growing funds should be invested in Fortune 500 type companies is what it really was.

I came to believe that the institutions were, contrary to popular belief, not interested in making money for their clients, not interested in income, not interested in beating inflation, and not interested in preserving capital. Rather they were bureaucrats behaving like bureaucrats. Their interest was in keeping their jobs. Thus, you buy IBM because if it goes down you say, "But it's IBM! You know IBM! Everyone owns IBM!"

On the other hand if you buy "I Never Heard Of It, Incorporated," and it goes down, you lose your customer. And if you lose your customer you lose your job.

Moreover, if "I Never Heard Of It, Incorporated" goes up tenfold in a year . . . . maybe, maybe at best you get a "thank you."

Therefore, mainstream investing, as opposed to "off the beaten path investing," has developed and flourishes among the entire institutional investment community.

Everyone focuses on relative value as opposed to absolute value. If the average company using some index is at 20 times, then the Blue Chip at only 15 times becomes undervalued in the institutional jargon and is a buy. Never mind that the index wasn't ever worth the 20 times. In my view the discount from the ever escalating index average method of justifying new investments is just the greater fool theory in operation.

More recently the institutions jumped on the latest bandwagon of conventional wisdom, the index fund. This hasn't made them money, only conventional, as they all knew when they lost 23.6% on October 19, 1987.
Now that you've got the flavor (and fervor of my views) you can see where I am coming from and you will better understand where I am leading you.
The Overlooked and/or Ignored Segment of the Market

There are some 2,200 stocks traded on the New York Stock Exchange, another 1,000 on the American Stock Exchange and about 5,200 traded OTC on NASDAQ. In all, 8,400 stocks for which the world can obtain instant price quotations. To my knowledge, fundamental information on most, but not all of these stocks, can be accessed and massaged via the various vendor data bases. And everyone does just that. Everyone has his criteria, sets up his screens and scrutinizes his list. But there is another large market segment for which this has not been possible. This is the Pink Sheet market. These are the less visible, nearly invisible stocks. The stocks in the shadows of Wall Street. The under-researched group or, more correctly, the not-researched group. This is the inefficient market. This is what I call the overlooked and/or ignored by otherwise intelligent investors segment of the market.

The market that I am talking about comprises some 14,000 stocks and accounts for 63% of all publicly traded equity issues. But it has a market value of $24 billion which represents less than 1% of the total available U.S. equity market value. The vast majority of these OTC issues are, as I say, overlooked and/or ignored. Many reasons exist for this situation; however, the principal contributing factor is the growth and concentration of substantial pools of funds under management by large banks and other institutions coupled with the trend toward fewer and larger brokerage firms servicing the investment community.

Large pools of money have consequently sought investment in larger companies with large market capitalizations. In addition to the economics of a company, the ability to move large dollar amounts in and out of stocks has become a key criterion in the decision to invest. Brokers, in turn, cater to this need to the exclusion of investments in most small capitalization companies. Both believe that it is more productive to put research man hours into a situation in which business can be done (i.e., significant amounts of shares and dollars can be traded) than into a situation in which profit potential may be substantially greater but volume transactions are not possible. Brokers, in particular, are reluctant to spend any time on a recommendation which cannot be disseminated to a very broad clientele without impacting the market. Of course, the need to generate commissions is also an important factor necessitating the dealing in securities with large capitalizations. This is particularly true since the advent of negotiated commissions which has further heightened the trend toward investing in big companies.
The effect of all this is to limit investing to only the largest companies. Some will consider investing in so-called small companies with market capitalizations as small as $100 million, while others will have special funds which consider $50 million and up, and on occasion a few institutional managers will go as small as $25 million.

The average OTC issue has a market value of $20 million (up from $6 million when I started my firm) or well below the size criterion of any institution worthy of the name. The average Pink Sheet stock is, of course, much less, having a market value of under $2 million. In effect, by ignoring the Pink Sheet stocks, investors are saying that about three-fifths of American management (of publicly held companies) are not worthwhile investments. However, it should be obvious that there are many smart managements among the approximately 14,000 - 19,000 issuers whose shares are eliminated from investment consideration. Furthermore, the excellent managements among the population of small companies eliminated from consideration are often available for investment at bargain prices.
What we have is a vicious cycle which has created a substantial pocket of opportunity in the aggregate for us to exploit. Stocks overlooked and/or ignored by otherwise intelligent investors. Stocks with market capitalizations which are small because they are ignored, and, in turn, stocks which are ignored because they are small.

It is important to note that we are not necessarily talking about small companies. Nor are we always thinking of small capitalization in dollar terms. Often it is just the number of shares outstanding that is small.
By way of example, Young's Market Company had 1987 sales of $500 million and market value of $87 million, but it had only 51,000 outstanding shares. Two years ago, Doubleday had sales of $500 million and market value of $56 million. Its outstanding shares totaled 139,000. You probably never heard of the former, and most investors never knew that the latter was public. A year ago Doubleday sold out to Bertelsmann for $500 million.

The Approach - How and What We Do
In order to find investment opportunities we had to have information. So we did the obvious thing. We wrote and telephoned companies until we built files on a large number of Pink Sheet trading companies.
By cross referencing the material with the Standard & Poor's Corporate Records and Moody's OTC Industrial Manual we were able to separate out those companies for which there is either no listing or only outdated summary data. Surprisingly our list includes hundreds of NASDAQ listed companies. All told, we have some sixteen thousand green file folders according to a Wall Street Journal reporter who counted them in 1979.
Because we maintain reports on thousands of non-reporting companies, our files are more comprehensive than those of the SEC. These non-reporting firms are probably among the most interesting bargain investments of all. They are companies with fewer than 300 shareholders that have elected not to report, i.e. not be 12G companies - they do not file 10-K's, 10-Q's or comply with proxy requirements.

I say that this group of firms may hold the most interesting bargains because these companies are hidden in the darkest shadow of Wall Street and there seems to be a very logical hierarchy of stock prices that exists.
Generally speaking, stocks trading in the non-NASDAQ segment of the market will sell at a discount from stocks trading over-the-counter on NASDAQ, and the latter, in turn, typically trade at a discount from comparable stocks listed on a stock exchange. The less visibility and the less information available to the investor, normally the larger the discount from "real worth." In short, when people don't know about a stock it usually sells for less than when many people do know about it. Consequently, there are far more opportunities for discovery in the inefficient markets than there are in the larger listed and NASDAQ markets. Furthermore, the degree of swing from undervaluation to overvaluation that is possible in the inefficient sectors makes for larger profit potentials than is generally available in the more efficient markets.

In the last decade, in each stock market cycle the amplitude of movement has been telescoped into shorter and shorter spans of time. This is the result of the increasing institutionalization and over-professionalization of markets. The odd lotter is no longer around to sell to. The continuing trend toward what today must be the maximum institutionalization of stocks has also led to the greatest stock volatility of all time. Exclusive of all the derivative products and program and insurance trading, institutions tend to want to buy their positions "now" and to sell "now," all at once. The less visible markets we prefer to deal in continue to exhibit long cycles and low volatility. So if you are patient and willing to do research, you can gather information while others gather stock, and you can do some real investing.

You know the age-old philosophical question: If a tree falls in the forest and no one is there to hear it, did the tree fall? Well, we geared up to listen hard while wandering around in a forest full of falling trees while everyone else was looking for needles in the haystack of the New York Stock Exchange or, more realistically these days, simply playing musical chairs.
At the heart of our approach are three tenets:
1. Avoid loss.
2. Diversify.
3. Believe in yourself, i.e., have the courage of your convictions.

Any damn fool can buy a stock and make money. My experience is that most who win big also lose big. The key to making and keeping money is avoiding loss. Therefore, I am not interested in hitting a grand slam home run at the risk of striking out.

I am not looking for the next Xerox, nor am I very interested in speculating in a company that will be worth a lot more if this, that or the other thing happens. Because if this, that or the other thing does not occur, then the stock probably goes down a lot because it wasn't worth what it was selling at in the first place.

For much the same reason I avoid investing in New York Stock Exchange stocks. Look, the minute you buy a stock on the Big Board it can go down on the next trade. Furthermore, if the earnings are only up 50% and the army of analysts following the company held expectations of a 55% or 60% gain, they all rush to sell. You see examples of this regularly.
This is exactly what happened a few weeks ago with IBM. In fact in that one, the analysts not only didn't get what they wanted, a more than 50% earnings gain; they also didn't like the factors that went into the increase, i.e., lower tax rate, currency translation benefits, etc. Everyone had what to say.

Now when we buy a Pink Sheet stock there is no immediate trade that follows. More likely it trades by appointment and we hope to have the next appointment and likely at the same price no matter what is going on. Furthermore, there are no other analysts with expectations to be shattered.

1. Avoid Loss

So, how do we avoid loss, you ask?
Well, the quick answer is that we look for stocks with low risk characteristics. The ingredients for this include the following.
As a general proposition, you must accept and agree that we are looking at a population of securities from which risk has often been drained out of their prices. This is by virtue of having been ruled out of consideration for investment as well as years of investor neglect during which the companies continued to grow and prosper.

Next we search out stocks with characteristics such as very low price/earnings ratio (such as two, three, four or five times current earnings), market price less than cash per share, market price less than current assets minus all liabilities, solid free cash flow at very low multiples, say two or three times, and high rates of earnings growth.

We look for firms which are top heavy on the top left side of the balance sheet and bottom heavy on the bottom right side of the statement.

In addition we see opportunities, exclusive to this sector, to reduce risk by making initial purchases at old, stable prices which haven't changed in months or years. Such stability is highly beneficial in avoiding loss. For example, if we discover a neglected stock which has been selling at $2 per share for two years and which we would agree might be worth $8 or $10 if it were "out in the open," and we purchase shares at $2, we probably could also agree that our risk is nil. Were we to buy the stock at $3 per share, while our risk would probably be considered very small, we could argue that we now have risk of about $1 because our own buying pushed the price up. If we remained convinced of the stock's value being at least $8, we then might conclude that we should accept the additional $1 risk because the potential is so large . . . . and we might do that. We might also consider paying, say, $4 for stock in "size" if it became available. Thus, we could limit our purchases to the $2 per share price in the interest of accepting what is deemed to be nil amount of risk or we could decide to take a certain amount of additional risk. The overriding factor determining our decision would be our judgment, after taking into consideration such factors as near and long-term appreciation potential, degree of our confidence in the potential for appreciation, amount of money we can invest, market environment and the available supply of alternative investment opportunities. Each situation is judged on its own merits.

Another risk reducing factor we take advantage of is conventional wisdom.
The way I see it, conventional wisdom won't make you money, only conventional.

Example 1: The Conventional Wisdom Regarding Low Priced Shares
Most investors assume that because a stock is low in price, i.e., under $10 or under $5, it is more speculative, riskier or, plainly put, junk. Moreover, if a stock should sell below a dollar, such folks will assume that stock to be in the category of garbage. While this may of course be a correct assumption at times, research shows it to be an incorrect generalization very far from the truth.

For example, is a company with an $8 book value per share, $6 per share of cash, no debt whatever, a long-term record of annual profits, in a steady to rising pattern (currently earning 70¢), and shares which can be purchased at $1.75, speculative junk? We think not, and this is a real situation.

Is a shell corporation with 2 million shares outstanding, one asset, namely $400 million in cash ($200 per share), no liabilities and a $400 million net worth ($200 per share), selling at $100 per share, a high grade security? If you agree with us that it is high quality at a bargain price, then perhaps you will also agree with us that a company with the same 2 million shares but which is only a hundredth the size, i.e., $4 million in cash ($2 per share) and a $4 million net worth ($2 per share), selling at $1 per share, is also quality at a bargain price. The former was a mythical company while the latter is real. It was at $1 for months and traded in volume (we bought lots of it). It was there only because it was a "dollar stock" and therefore a "garbage stock" to most investors. Most investors simply won't bother to look into the "dollar stocks."

Consider still another real case study with the following set of facts: The company operates in a growth industry. Earnings have risen six fold in six years with gains having occurred annually. Current net earnings are about $2 per share. Cash equals $9 per share and book value is $11 per share. Equity is four times debt while others in the industry all have more debt than equity. Is this stock speculative, risk laden or low in quality because its shares have traded under $6 in the past year? We think not. You can't, indeed you shouldn't, judge a book (a stock) by its cover (low price). But others do.

Example 2: The Conventional Wisdom Regarding Inactive or Thinly Traded Stocks

Closely held stocks are of great interest to us because others will not even consider them for investment.

We like to be invested along with major owners of a company. This is especially important when it comes to takeovers as I'll explain in a few moments. When we hear others who have looked at an inactive stock ask, "How are you going to buy enough stock?" and "What is going to make it go up?" and "How will you get out?’ we know we have the makings of a winner.

It has long been our experience that investing in hard-to-buy stocks makes lots of sense because you are forced to be sure you want to own the darn thing for the long haul; you do not buy such stocks in order to sell them quickly.

We think in terms of being willing to buy the whole company at the price at which we initially are willing to buy some shares.
If you buy a good company at a good discount from real value and you are willing to hold indefinitely, you make money and you've avoided loss. If you have a "good" company and it is regularly increasing its net worth, it is going to go right on building value. So even if its stock price doesn't change for a long period of time it matters little.

After buying shares at more or less the same price for years, you eventually reach a point where the nth share can only be purchased, and, in fact, does trade at a price which rewards you handsomely for years of patient waiting.

Being willing, ready and able to perform thorough research, even though we may only be able to purchase an initial position of modest size, works. If we believe risk is low and profit potential very large, we would do all the work necessary and would willingly buy just a few hundred shares if that was all that was available at our price. No one else is willing to do this. By exercising extreme patience, we are able to acquire worthwhile positions gradually over weeks, months and sometimes years. As I mentioned earlier all too many professional investors want to get in only in a hurry and/or only in a big way. They won't even be bothered to consider what even they agree is an otherwise very attractive investment. Of course, there are also many occasions when blocks of stock become available to us.

Frequently, we find our largest haul of shares can be made at year-end when people sell for tax purposes or houseclean what they consider to be cluttered portfolios. We are willing to patiently wait, maintaining a bid should anyone care to sell during the year or at year-end. Seldom do we find a need to chase after stocks. After all, there is usually no need to hurry if we are fishing in neglected waters. When there is a hurry, as there may be on a rare occasion, then we might consider reaching up for
stock and taking offerings in a particular situation.

2. Diversify

By being willing to own a very large number of individual issues with low risk characteristics, we believe we can further mitigate risk and yet not reduce the potential for unusual profit. We do not have any magical number of companies we would be willing to own. We do have positions in hundreds of stocks and are ready to own still more. The greater the supply of "nil risk" stocks of the ilk described earlier, the larger the list of companies which we think it is desirable to own.

We also see no advantage to having a rigid requirement for minimum size position. If a stock has a great deal of attraction and a limited amount of risk, we want to own it even if we are able to buy only 100 shares at our price. Conversely, we have also bought as much as 20% of an attractive investment when that was possible.

Given the vast number of investment opportunities with moderate risk to choose from we have built a broadly diversified portfolio. Again, it has been our experience that we only need a few stars to help us to a pleasant annual result and to achieve the goal of long-term substantial gains overall.

Buying inactive or closely held stock is very much like investing in private companies. Even though you do not see the price every day or see it changing, you know the value is growing. So you need a different mind set and a different mentality from most other stock market players.

Takeovers
I would like to say a few words about takeovers with regard to our market.
The acquisition and merger technique of growth has become an established fact of corporate life. We have, of course, been living in an age of competitive tender offers.
Unlike the typical stock exchange listed target company where key management players generally are not significant owners of the business but rather just hired hands, management of many over-the-counter companies and particularly the non-NASDAQ Pink Sheet segment own either the majority or a very substantial portion of the corporation. Consequently, the former are motivated to make a deal to keep their jobs while the latter only want the best price. Where management doesn't control much stock, the premiums paid by acquirers have typically ranged between 40% and 70% over market (occasionally as much as 100%). The more closely held over-the counter companies, on the other hand, usually sell out only for "real worth." As a result they have been able to obtain premiums of several hundred percent with 200% or 300% being more typical, and as much as 1,000% being paid on occasion.

While friendly deals can be made in the arena of the larger, more widely held company, the number of unfriendly takeovers or attempts at takeover is significant and apparently growing. Acquisitions of smaller, more closely held firms more often must take the form of negotiated transactions. You can buy them but you generally can't "steal" them near their unrealistically low market quotes where you can buy some shares. Consequently, potential for profit is larger.
In addition to large appreciation potential from takeovers, there are simply more companies in the over-the-counter markets to consider taking over. Non-NASDAQ companies are particularly alluring candidates to big companies because it is easier to do a deal out of the limelight. The scrutiny of government, competition and the press may well be much less. To fill in a product line it is less of a big deal and, in fact, there is even a willingness for a Fortune 500 company to overpay where a small obscure company is the takeover target. They will often pay more because they can make their very large or special capabilities available to rapidly expand the company's product or operational base. Often they decide that buying a "peewee" company is easier and faster than building a new plant.

3. Believe in Yourself, i.e., Have the Courage of Your Convictions

While I am talking about investing, I have got to tell you I think this also applies to all you do in life. I can't be sure that what has worked for me will work for everyone else, but I do believe that there is nothing you can't do if you really want to do it and you put your mind to it. There is no such thing as impossible. Cross out the word in your dictionary.

I mentioned early that when people say, "How are you going to buy enough shares?" and "What is going to make it go up?" and "How will you get out?", then I know that I have a winner. It means you will have that investment opportunity all to yourself until the day comes that the stock breaks out into the open territory of the visible efficient market. A good example of this is Oshkosh B'Gosh, which a year or two ago split 20-for-1, sold some shares in a public offering and listed on NASDAQ. To top things off, it was even included in the S & P 500.

I have professionally encountered three main types of people. Glib salesmen who only tell you all the attributes, hard nosed analysts who tell you all the reasons why something won't work. and salesmen-analysts and money managers who won't even bother to look or listen.
So believe in your own abilities -- they are probably no worse than others and possible a lot greater than others. Don't get turned off just because others don't agree with you.

In my investing, as in life, I have found:
1. Sometimes following the crowd doesn't get you where you want to go!
2. Sometimes it pays to be different!

And I said it before, but I'll say it again . . . .
3. Conventional wisdom won't make you - fill in the blank, in this case, money - only conventional!
4. Don't be afraid to go it alone and see if anyone follows!

Finally, I think one of my most successful business friends said it best when he said --
5. "Do what you like and do it well."

Thanks for listening.

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