An Open Letter to The Keihin Co., Ltd (9312.T)

English version

Japanese version

A Profitable Japanese Logistics Company at 0.52x Book Value and 3x EV/EBIT With Real Estate Greater Than The Market Cap; and a Position Sizing Thought

While going through the Tokyo Stock Exchange listings, the sheer amount of undervalued securities can sometimes leave you feeling overwhelmed. Because there are so many cheap stocks, I’ve taken a basket approach and want to share one today. This Japanese stock isn’t like a few in the portfolio with negative enterprise values or huge amounts of excess cash (although it does have some of that). It’s a strong, durable business that’s been around for almost 80 years trading at half of book value with a lot of M&A activity in the sector.

Then I talk about a position sizing thought I’ve come to appreciate.

Summary

Keihin (9312) is a ¥15.8B (CAD $152m) small cap Japanese logistics company trading at 0.52x book value, 0.43x adjusted book value, 3x EV/EBIT and 2x EV/EBITDA. It has almost half of it’s ¥15.8B market cap covered by net cash at ¥6.6B. As well as land and warehousing facilities with a fair market value approaching ¥30B, double the market cap and providing for significant downside protection. In a sector where buyouts are occurring regularly, Keihin makes for an interesting acquisition target as it’s operations have been extremely durable and profitable, with only one unprofitable year in the past 20 during the GFC. Management has even acknowledged that one of their priorities is to close the PBR discount in recent filings.

Extremely Durable Revenues & Profits

The company was started way back in 1947 with just ¥3 million yen to open a Yokohama port and today has a market value of ¥15.8 billion. The business of today consists of a domestic and international logistics business and operates through the whole logistics chain: warehousing facilities, port transportation, land transportation and ocean and air transportation. It is heavily influenced by how the global economy is performing and sales within Japan make up 90% of total sales. This is the revenue and profit breakdown of both segments for their fiscal 2025 year ending March 31:

Looking at the past 20 years of financial data, Keihin’s only loss was in 2009 during the GFC, which speaks to the durabilbity and consistency of the business. Over the past 10 years revenues have averaged ¥48.7B per year with EBIT ¥2.2B and EBITDA ¥4.2B.

On top of the predictable nature of the operations, there has been no share dilution with the share count steady at 6.53 million shares. With Japanese companies earning low ROEs due to their asset side of the balance sheet stuffed with cash and investments, Keihin has earned a respectable 10 year 7.6% ROE. This number would greatly improve if they didn’t hold half their current market cap in cash and investments.

The balance sheet is also in a strong position today as the past decade Keihin has used its free cash flow to pay down debt. It has gone from a net debt to a net cash position when including investment securities.

Cheap On Book, Even Cheaper Using Real Estate FMV

Overall land prices in Japan having been increasing in value the past 4 years since the end of the panedemic with commercial values increasing a bit faster than residential (see here, here and here). Land values in Tokyo’s 23 wards grew 11.8% last year. This should benefit Keihin Co. as they own ¥18,164 billion in buildings and land marked at cost, some located in the Tokyo port areas and others in the major ports of Japan. Some of this real estate has been on the books for decades. To get a current value of what the real estate could be worth, we can look at current prices per square meter of what the land is going for now. If you want to see the exact location and profiles of the buildings/land you can go to their corporate website where it lists each one. But keep in mind they lease some of these and you’ll have to use their Annual Report to get the total square meters owned.

The first piece of real estate is their head office. Located in Minato, a ward of Tokyo, right by the Tokyo Port, the size totals 2,097m². According to e-housing (a Tokyo real estate platform), the average commercial land price in Tokyo’s 23 wards is ¥3,590,800/m². Using the Hokushin pricing for the Minato ward in 2023 it is ¥2,149,700/m². To be conservative, I used the lower number from Hokushin which derives a value of ¥4.5 billion for the head office. About 4.5 times the amount it sits on the balance sheet for. Keep in mind this is using 2023 numbers and not adjusting for the increase in values that 2024 experienced.

The next piece of real estate they own is 18,979m² of land and warehousing facilities in the Koto ward of Tokyo, right on the Port of Tokyo. Using the the 2023 Hokushin pricing of ¥510,200m², these assets could potentially fetch ¥9.6B vs their book value of ¥3.6B.

Moving a bit down south to the Yokohama Port, one of the top 5 Japanese ports, Keihin owns 68,606m² of logistics facilities there. The value of these assets are carried at about ¥10B on the balance sheet. According to the city of Yokohama’s website, industrial land per square meter goes for ¥211,200m². This would put the value of Keihin’s Yokohama industrial assets at ¥14.4B.

The last piece of real estate Keihin owns is in Kobe City at the Port of Kobe. The industrial assets comprise of 21,105m² and have a book value of ¥3,466B. Trying to find industrial land value for these assets was a bit more of a challenge. Using the Utinokati website for land value in the Hyogo Prefecture, the land value would be about ¥1.3m² but I’m sure that includes residential and office/commercial value as well. Statista gives a value of ¥170,700m² which is what I used to be conservative. Using this amount values the Kobe Port assets at ¥3.6B.

If we then sum up all the real estate value, you get ¥32B. Almost double what it is carried at on the balance sheet and twice as much as the market cap of ¥15.8B!

Another way to look at their land value is to take some recent logistics/warehouse buyouts or the cost of building warehouse facilities and derive a value that way. Hong-Kong based PAG bought two warehouses near the Port of Nagoya in 2024 for ¥65.5B that totalled about 243,000m², which equates to ¥269,547/m². The Port of Nagoya is the busiest and largest port in Japan in terms of annual cargo volumes. Although Keihin doesn’t have assets right in this port, if I just assume a 10% discount to the other ports it gives a land value of ¥242,592/m²

At the beginning of 2025 Brookfield also purchased a stake in a Tokyo luxury hotel that came with a large 93,000m² plot of land on the outskirts of Nagoya that they are going to develop into a warehouse. The size of the warehouse is going to be 223,000m² and they’ll be investing ¥42.7B (US$300 million) to develop it which works out to ¥191,480/m². I would imagine this land, being away from the port, is a bit less valuable as evidenced by the PAG buyout numbers above right in the port. Applying a 20% bump to this number for by-the-port assets would come to ¥229,776/m².

Singapore’s sovereign wealth fund, GIC, purchased a logistics facility in August 2024 in Yokohama for ¥57B (US$400 million) that covered 126,000m² which works out to ¥452,380/m². And Nippon Life Insurance bought 3 logistics facilities in Osaka for ¥257,732/m² (¥50B / 194,000m²). Using these transactions and applying it to Keihin’s land size values it at ¥27.4B, not far from the ¥32B real estate value calculated above.

If we take the midpoint of these two values, ¥27.4B and ¥32.2B, and plug them into an adjusted net asset value calculation, Keihin is trading at 0.43x adjusted book value. Too cheap for a consistently profitable business with strategic assets in the major ports of Japan.

Takeout Multiples Lead to 100% Upside

The Japanese logistics industry has been an extremely fertile ground for takeovers and it doesn’t seem like it’s going to stop. Brookfield even said as much when they made their investment a few months ago. This is what one of their East Asian partners said after that deal happened:

Logisteed Ltd. (a subsidiary of KKR) also purchased Alps Logistics Co. last year and SG Holdings Co. (parent of Sagawa Express Co.) tendered for Chilled & Frozen Logistics.

One acquisition that jumps out was the most recent buyout of Nissin Corp. (9066) by Bain Capital just this month. Nissin is a larger, more profitable logistics company that operates on a global scale. Bain bought them out for ¥120B. Here are some of the buyout statistics I’ve compiled using their most recent financial statements and proxy filing:

I’m sure Bain got a pretty good deal and the land and buildings that Nissin owned are most likely extremely undervalued as well. After all, Nissin has been around for 80 years. There are probably costs that will be taken out of that business that would bring these multiples down too. Because Nissin is more profitable and operates on a global scale, when comparing to Keihin I discount the multiples by 20%. Even at the discounted multiples, Keihin could still offer 100% upside using different different valuation methodologies.

I don’t think it is a stretch that a company with a strong net cash balance sheet, significant real estate value that produces extremely durable profits could go for these kinds of multiples.

Management Acknowledges Low Stock Price

The company seems somewhat shareholder friendly so far as they have paid dividends, which were recently raised from ¥70/share to ¥80/share. On the current stock price this yields about 3%. They have also acknowledged in their most recent earnings forecast that returning profits to shareholders is important to them.

May 12, 2025 Earnings Forecast

On top of that, they stated in their 2024 Annual Report that their stock price is undervalued as well and one of their priorities is improving their PBR (price-to-book ratio) and ROE.

March 31, 2024 Annual Report

One way to obviously do this is to start using some of their excess cash and investments and buy back their stock. Buying at such a discount to book value would be extremely accretive to the remaining shareholders and would signal to the market that the company takes the new TSE guidelines and capital allocation seriously. I would be extremely supportive if Keihin goes this route, as I’m sure most investors would.

No Controlling Shareholder

There is also an opportunity for an activist to come in and make a bit of noise as no major shareholder owns over 10%. Some of these corporate shareholders might be friendly with one another and could vote for management friendly policies, but the whole point of the TSE guidelines is to get away from non-shareholder friendly corporate behaviour and to narrow the PBR discount.

Could This Be Another Perpetual Japanese Value Trap?

While historically Japanese stocks have been value traps, the Exchange’s guidelines are encouraging companies to take action to increase their share price and trade to at least 1x book. With Keihin, we have a company that pays out some profits to shareholders and just increased their dividend, a management team on record stating that improving the PBR is one of their priorities, and an industry that has been getting bought out left and right. Not to mention that the hard asset value provides strong downside protection.

Could the stock go no where and drift into value trap land? Yes, it’s possible. But I’ve learned that good things happen to cheap stocks over time.

Disclosure: long The Keihin Co., Ltd (9312)

Position Sizing Thought

The cream rises to the top.

That’s how I’ve been thinking about sizing positions recently. What I mean by that is letting the companies in your portfolio earn the right to be larger positions (h/t to Ian Cassel).

Don’t take a full sized position right away. Take a half sized position and see how the business plays out or if management does what they say they were going to do. If the stock goes up for good reasons, it deserves to be a larger part of your portfolio. It might be more beneficial to start adding then as clearly your thesis would be playing out.

If you buy a 5% position and it grows into a 20% position, I’d say that that company has absolutely earned the right to be a large part of your portfolio. While I get investors have different position limits they can take or risk tolerances, I would be perfectly fine not trimming that 20% position, provided if I could see more upside. Now if that position gets to 50% or more, that’s another story.

While I believe in concentrating in your best ideas, sometimes as investors (myself included), we tend to purchase a full sized position right away and look to add more as it goes down in value to keep the same allocation, hoping and believing that we’re right and the markets wrong. All the while, we might be better off purchasing a half sized position and watching it to see if the management team is executing like they said or if the business is performing like you anticipated. And then adding on the way up.

The counter to this is that if the stock has increased and you only made it a half sized position, you missed out on extra profits by not purchasing a full sized amount. But that seems like a good problem to have!

Of course if something ticks all of your boxes for your ideal investment you should load the boat. But coming across something like that doesn’t occur on a weekly or monthly basis and most investments probably deserve half sized positions at first. At least we shouldn’t be in such a rush to make everything so large a position right away.

Just a thought!

Leons: A Real Estate Co. Masquerading as a Furniture Retailer

Leon’s Furniture Ltd. (LNF.TO) is a dominant Canadian furniture retailer with leading market share that appears reasonably priced on the surface at 10x earnings. However, when taking into account their hidden real estate value that will eventually be IPO’d into a REIT, the stock appears deeply mispriced. With stable margins, consistent profits, a net cash balance sheet and other excess land value, I estimate nearly 100% upside to the stock price and limited downside due to the hard real estate assets that are more valuable than the retail business.

Capital Structure

Business background

Leon’s is the largest furniture retailer in Canada operating in every province under their main brands Leon’s Furniture (52 stores), The Brick (118 stores) and other smaller brands. They are ranked #1 in furniture and appliances and #2 in mattresses at roughly 20% market share of the total overall market. On top of the stores they corporately own and manage, they also franchise 35 Leon stores and 66 Brick stores which generated $33 million of revenues in 2024 out of a total $2.4 billion. The business has been around for over 100 years and was started in 1909 in the small town of Welland, Ontario. It was, and still is, a family-owned and run business and went public in 1969, which was followed by introducing the “big box” concept to Canada a few years later.

As the largest furniture retailer in Canada, Leon’s has an enormous scale over competitors in terms of sourcing inventory, advertising/marketing dollars spent and a wider selection over their large store footprint. When you think about a small mom & pop furniture retailer, they don’t have access to large volume purchasing discounts, they’ll have tiny advertising budgets compared to the big players that can’t be spread across multiple stores and their store spaces are smaller which means there are smaller selections of furniture available. Most retailers compete on price because when you are purchasing a couch, bed or stove you want good quality but you also want to buy at a good price. The brand you are purchasing is not really a factor you think about when shopping which helps Leon’s because they can offer a greater selection at affordable prices. You usually don’t go into a retailer with a particular brand in mind but go into the retailer looking for the best quality at the best price.

For being a furniture retailer that’s tied to 1) a cyclical industry while dealing with 2) high inflation and interest rates the past few years, Leon’s has enjoyed incredibly stable gross margins of 44% while remaining profitable during significant volatile periods over the past decade plus, which speaks to the quality of the operations.

Leon’s has averaged 25% ROIC the past decade with EBIT nearly doubling while compounding revenues at 3.5%. One of the reasons of increased revenues and profitability has been their 2013 purchase of The Brick. Leon’s purchased The Brick for $700m after they underwent a recapitalization a few years prior. They levered their balance sheet to finance the acquisition using $500m of debt and were able to pay it down over 5 years due to the large cash generation of the combined entities. Recently because of COVID, their e-commerce side of the business has grown substantially and now represents 10% of their revenues.

The company obtains all of their supply from 500 different suppliers and is therefore not beholden to any one supplier. They have wholly-owned subsidiaries based in Asia that helps them source their goods. 15% of their inventory comes from the US and with the Trump administration imposing tariffs on Canada, their vendors are potentially going to take the product and produce it offshore to avoid these tariffs or just hold the inventory until more clarity is given.

While I’m not expecting this business to grow revenues and earnings at large rates barring a large acquisition, a nice boost to Leon’s business in the current year could be that a large swath of Canadians are taking pride in purchasing Canadian made products as opposed to US made products as a result of the Trump admins stance on Canada. Q1 2025 results were just released and revenues were up 3%.

Why does this opportunity exist?

There are many reasons why the stock is currently mispriced:

• The Leon family owns about 70% of the shares outstanding. On a market cap of $1.5 billion, that means the total amount of publicly traded stock is really $450 million, hardly enough for large institutions to take a meaningful stake in the company or for any shareholder to gain any control.

• Low trading volumes. The average daily volume is typically 20K shares, and when you factor in a stock price of low 20’s, it results in daily dollar trading volume of just under half a million.

• The company is a furniture retailer. It doesn’t operate in the most exciting industry.

• Real estate has been hidden on the balance sheet. The real estate value has been recorded at the cost on the balance sheet and until the IPO of the REIT occurs, it will continue to be hidden.

• Limited investor outreach. There hasn’t been much outreach to the investment community in the past and the company doesn’t hold quarterly conferences calls.

• It’s been 2 years since announcing the IPO of REIT. May 2023 to today May 2025 marks 2 years of announcing their intention to form a REIT. Some investors could be losing a bit of patience with no given timeline of when it will actually occur.
  

Industry

The furniture industry is extremely competitive with low barriers to entry and high fragmentation. At the end of 2024, there were 3,151 furniture stores in Canada according to Statista with just over half of them in Quebec and Ontario. The total size of the market is about $20 billion with Leon’s at the top at about 20% and IKEA Canada around there as well based on their $2.8 billion in sales for 2024 (although 5% of that is food). Then there are smaller players like Structube (75 stores), Ashley’s Canada (60 stores) and then smaller regional players (BMTC Group - which is also developing its real estate) with a few mom and pop stores.

The past decade has seen many players leave the industry: Target left in 2015, Sears Canada left completely in 2018 and even handed some of their leases to Leon’s in the process, Bad Boy Industry went bankrupt in 2024 and shut down their 50 Canadian locations and Hudson’s Bay recently entered a restructuring process, although they are more a clothing retailer with a small amount of furniture. The result of this is that Leon’s has consolidated market share from ten years ago pre-Brick acquisition from 5%-6% to 20% now. While a couple of years old, as of 2021 81% of purchases in the furniture industry were made in stores which has probably increased a bit since as Leon’s just did $265m of their sales online, up quite a bit pre-COVID. If customers purchasing online continues to grow and make up a larger percentage of total industry volume, it could remove the need for large retail stores to do business and just operate distribution centers to deliver the products. However, currently most customers will look up online what they like, go in store to test it out, and then purchase.

Management

I view the board and management as extremely shareholder friendly. The current CEO who started in 2021, Mike Walsh, is the first CEO in Leon’s history who’s last name is not Leon. He used to be the President of Leon’s Furniture and then the COO prior to becoming the CEO and is very familiar with the business and industry. He also used to work for Canadian Tire when they were undergoing their REIT transaction. The Leon family clearly trusts him because not only is he the CEO who is an “outsider” to the family, but right after being hired he authorized a Substantial Issuer Bid and bought back $200m worth of shares at about where the shares trade today.

Leon’s also authorizes normal course issuer bids to buy back their stock and currently has one outstanding to repurchase 5% of their shares. On top of the buybacks, they also pay a regular dividend that yields 3.5%. The Leon family also owns 70% of the shares aligning our interest with theirs.

History Rhymes: The Canadian Tire/Loblaws Blueprint

The current path that Leon’s is following has been done before in the Canadian markets. 10 years ago Canadian Tire and Loblaws decided to IPO their real estate into a separate REIT, while maintaining a large majority stake. Canadian Tire sold 15% and kept 85% ownership and Loblaws sold 17% and kept 83%. This allowed Canadian Tire and Loblaws to highlight their underlying real estate value while receiving some cash for selling a minority stake. From when Canadian Tire announced in May 2013 to October 2013 IPO, the stock price was up 28% and one year after the announcement was up 78%, not taking the REIT value into account. Loblaws announced their intention to create a REIT in December 2012 when their stock was at $32. In July 2013 when the IPO occurred, their stock was at 42 for a 31% gain. Two years after announcing their intention the stock was up 66%, without accounting for the REIT value. One of the reasons Loblaws wanted to highlight their real estate value was so they could get their stock price up to make a bid for Shoppers Drug Mart using their stock as currency, which they did in the summer of 2013.

One worry about when companies sell their real estate or engage in some type of sale lease back transaction is that, well now they are going to have to make rent payments which will decrease earnings significantly. While true if you’re selling 100%, but if you are keeping a majority ownership initially, the effect should be minimal as the rental income you receive is offset by the rental expense going out. In their initial REIT presentations, both Canadian Tire and Loblaws showed the projected impact of a pro forma REIT on their financials (Canadian Tire presentation and Loblaws presentation)

Because they kept a large initial stake, there was a minimal effect on the EPS, while not only getting access to cash from selling a small percentage but also putting a mark on the real estate that was hidden in the balance sheet. By forming a REIT, it puts in team a place with experience running real estate and developing properties as Leon’s executives have experience in running retail operations, not developing real estate.

Valuing the REIT

On Leon’s balance sheet, there is $268 million in land and buildings recorded at historical cost sitting on the books that is worth multiples of that which will be transferred into the REIT. Right now Leon’s owns 50 owned properties that consists of 5.5 million square feet on 430 acres of land.

Their plan is to transfer the income producing properties into the REIT, IPO a stake while keeping a majority of the shares, and develop some of the land that they have that can be vended in over time. Based on just the 5.5m square feet, we can try to derive some type of value for the income producing portion of the real estate. While the value won’t be exact as the industrial and retail properties are located in different provinces that have different retail and industrial rental rates, we can come to a general view of the value. By using 1.2m of industrial square feet, 3.7m of retail square feet and 0.6m of other real estate and looking at rents per square feet for these types of assets, we can calculate a conservative total rental income, net operating income and then total value of the REIT.

Based on my estimates, total rental income would amount to $103m. I looked at CT REIT (Canadian Tire’s REIT) to give me a guide as to what additional expenses the REIT will incur. Assuming 21% of total income goes to property expenses and 3% to G&A for being publicly listed and corporate overhead, net operating income would be $78m. Putting a cap rate of 6.5% on that equates to $1.2B of value for the REIT. By selling 15% upon IPO, Leon’s can pocket $180m of cash.

Excess Land Value

In addition to the REIT value, Leon’s also owns excess acreage on their owned properties that they are currently looking to develop now and more potentially in the future. The most immediate development is where their headquarters sits at the intersection of the 401 and 400 highway in Toronto. The plan is to partner with developers who will construct a master planned community consisting of 4,000 residential units and also reconfigure their headquarters.

Valuing this development can be a bit tricky as we don’t know the agreement that will be in place on a potential split with the developers, financing involved, margins or timeline. We do know that the total buildable square footage will be 4.6m for this property. If we use the average 2024 $123 pbsf in the GTA, the total value of the land could be $565m. Using the higher range of sales that occurred in 2024 at $202 pbsf, the value could be $929m. Leon’s in still in the process of getting approvals from the City of Toronto for this piece of land and plan on submitting a Secondary Plan in mid-2025.

Of the 430 acres that Leon’s owns across Canada (mainly in Ontario), Toronto is just 40 acres of that. They also have 32 acres in Burlington that they could redevelop due to the dual zoning structure of the land. As well as their Missisauga location off the 401 amongst many others. Because a lot of their stores are classified as an industrial node, they can take the retail portion of the store and reconstruct it into more of a retail node, determine what the “highest and best use of the land is” other land is, and redevelop it. Management has said that if they go from 22 warehouses to 1 or 2 distribution centers, it could free up a lot of real estate. Only the Toronto master planned community development is factored into my valuation. I would imagine the other portions of the land would be worth millions if not hundreds of millions of dollars.

Retail Value

Predicting the value of the retail division is slightly less difficult than the real estate parts. Because the business has been so durable over the years with consistent margins and profitability, the value should not swing by much year to year. Assuming $2.5 billion in sales with 44% gross margins, SG&A amounting to 37% of revenue and incremental rent expense that needs to flow through the P/L due to the REIT IPO, we can arrive at a net income amount of $139m.

What multiple should this business trade at? Fairfax just bought Sleep Country in 2024 for $1.7B at about 17x earnings or 8-10 times EV/EBITDA according to the Proxy Circular. And Canadian Tire trades at a forward 2025 P/E of 12x today. To be conservative, I’ll use 10x earnings even though Leon’s is a larger company than Sleep Country with more product diversity but smaller than Canadian Tire with Canadian Tire retailing more auto and outdoor goods. Using these numbers gets to $1.3 billion for the retail business.

Putting it All Together

If we sum up the value of 1) the independent retailer, 2) the REIT, 3) the Toronto land, 4) the REIT sale proceeds and 5) the net cash on the balance sheet, the total value is $49/share, about 100% upside. This also doesn’t take into account the other land value that Leon’s could potentially develop, making the company even more valuable.

Catalysts

• Completion of the REIT IPO. While it has been two years since Leon’s announced their intention to complete their REIT transactions, we should be getting closer to when it actually comes to fruition. One thing to watch for is if they get approval to list on the Toronto Stock Exchange.

• Potential acquisitions. Management has mentioned that, due to the strong balance sheet, they have numerous avenues to deploy capital by potentially taking on debt. An acquisition could be one method if the price was right.

• Market share gains. Over the past decade the company has gone from single digit market share to about 20% and if current retailers keep going out of business, Leon’s would more than likely increase their market share.

• Accelerated stock repurchases. The company has shown that they aren’t afraid of repurchasing large blocks of stock in one transaction and if the price languishes in the low 20’s for some time, we might see another SIB.

• Canadian Gen Z FOMO. While this catalyst is a bit tongue in cheek, with the early Canadian generations of today effectively locked out of the real estate market due to rapid price appreciation the past few years, Leon’s stock could offer a way for Gen Z to buy Canadian real estate property at bargain prices and for them to realize that value via the REIT unlock.

Risks

While I believe the stock has minimal downside due to the stability of the retail business and hard real estate value, there are some risks to the idea not working out:

• Delayed or failed IPO. It’s been two years since they announced they were going to IPO the real estate. It took Canadian Tire and Loblaws months to go from announcement to IPO. There is still no given timeline as of there most recent Q1 2025 earnings press release.

• Downturn could delay retail purchases. If the Canadian consumer continues to get squeezed by higher inflation or higher rates, they could delay making furniture purchases until they have more disposable income. The nice thing about Leon’s is that they have survived and maintained profitability in pretty severe economic environments (COVID being one of the main ones).

• Reversal of Canadian immigration boom. Canada has experienced a large population increase in the past decade going from 35m to 40m, which many commentators point to the the large real estate boom. Any reversal of this could potentially lead to a decrease in all items related to housing spend. Recent polls show Canadians would prefer a more sensible immigration policy than has been shown in the past 10 years.

Disclosure: Long LNF.TO

Early Findings in the Tokyo Stock Exchange

Japan has been what is termed a “value trap” for years. The companies listed there had always traded a huge discounts to book/net asset value/ earnings while stock piling cash on their balance sheet. No real activism could take place because a lot of companies in Japan had “cross-shareholdings”, where different Japanese companies owned stakes in other Japanese companies, effectively blocking any potential activist from taking a position and agitating for better corporate governance or capital allocation policies.

However, the Japan of yesteryear is completely different from the Japan of today as the country has undergone a renaissance of corporate change the past few years. In 2022, the Tokyo Stock Exchange reorganized from 4 market sections into 3: the TSE Prime, Standard and Growth. The Prime market is for companies that have large market caps, investable to many institutional investors and good corporate governance with an open dialogue with investors.

You can read about the listing requirements for the other 2 segments here.

Then in 2023, the Tokyo Stock Exchange put out a paper titled “Action to Implement Management that is Conscious of Cost of Capital and Stock Price” for companies in the Prime and Standard markets that pushes the companies to disclose their cost of capital and if they are trading under 1x price-to-book, to discuss the reasons why and plans to get it up to 1x. The Japan Exchange Group has put out Case Studies for the Prime and Standard markets on companies that have disclosed their plans and what effective communication from companies should look like. And they even put out a list of companies that have disclosed or submitted their plans and update it monthly.

So what does this all mean?

It means in Japan there are currently hundred of companies trading at depressed valuations, with overcapitalized balance sheets on low earnings multiples that have the “largest activist” on their back to act as a catalyst to realize full value or near full value for their shares: the TSE and the Japanese government.

Not to mention that out of the top ten activist funds in 2024, a large portion of their activity was focused on Japan:

Strategic Capital, Oasis, Dalton Investments and Murakami Funds all have activist positions exclusively in Japan I believe. The number of Japanese activist engagements is at an all time high in 2024 as well:

You can see that the Tokyo Stock Exchange new guideline implementations and the activists are making real capital allocation changes as Japanese buybacks were at an all time high in 2024:

Management buyouts are also at the highest levels since 2011 and the Tokyo Stock Exchange is looking to change the Corporate Code of Conduct that will require firms to improve disclosures around the assumptions of how management teams arrive at their buyout prices. The companies are also being told to reduce and sell off their cross-shareholdings of other companies as these inter-company “investments” reduce the company’s overall capital efficiency and promote poor corporate governance as these friendly shareholders won’t hold the management team accountable.
I’ve started to do a bit of digging and some of the companies that I’ve looked at so far seem egregiously cheap (no position in any of these yet):

The Kaneshita Construction Co., Ltd. (1897)

The company is engaged in the construction industry and sells asphalt products and other construction materials as well as operates a conveyor belt sushi restaurant business. If I were to show you the balance sheet and income statement and had you guess what they were worth, I bet many would be off by a large percentage. This is the balance sheet:

And then the income statement:

If you just take the total cash of ¥8.8 billion plus the investment securities of ¥8 billion less all liabilities of ¥3 billion, you get ¥13.8 billion in value with out taking into account any other asset or the operations of the business. If you calculate the NCAV (current assets plus LT securities less all liabilities) your value would be about ¥17 billion. If you use true NCAV (CA - CL), the value is ¥9 billion. And just using book value, the value is ¥18.8 billion.

This company currently trades in the market for ¥5.6 billion (¥2,652 x 2.1m shares). Which means it’s trading a 0.3x book value, with that book value made up of mostly cash and securities. And oh ya, the company has been consistently profitable the past few years. At least 11% of the shares are owned by the Kanashita family with the remaining large chunks owned by Japanese financial institutions. The company pays a paltry 50/share dividend and has announced a 3% share buyback which is hugely accretive because the company trades so cheap.

Takahashi Curtain Wall Corporation (1994.T) - Takahashi has the number one market share in the Japanese precast concrete curtain wall industry. It has been profitable the last 5 years with various swings in income levels.

It’s stock is currently ¥470/share and there are are 9.55 million shares outstanding for a market cap of ¥4.48 billion. It has ¥1.028 billion in cash and ¥222 million of securities against total debt of ¥1.326 billion so EV is ¥4.556 billion. The past 6 year average EBIT is ¥790 million for a trailing 5 year average of 5.8x EV/EBIT. However, they have tons of other building, land and investment property value on the balance sheet for a total book value of ¥10.772 billion which means it’s trading at 0.41x book value. ¥98 million of the securities on the balance sheet is Sumitomo Realty Development which is currently being targeted by Elliot. About 30%-40% of the shares are held by the Takahashi family.

The Torigoe Co., Ltd. (2009.T) - Sells flours and other food products in Japan. With a share price of ¥825 and shares outstanding of 26m, the market cap is ¥21.5B. Torigoe has ¥10.3B in cash and ¥13.4 billion in short term & long term securities against total debt of ¥3.2B which implies an enterprise value of ¥1 billion. Meanwhile the company did ¥1B of operating income in each of the last 2 years. Are they overearning? I don’t currently know. But trading at trailing 1x EV/EBIT is absolutely dirt cheap and this doesn’t take into account the 10B in buildings and land. Of course there are some liabilities totalling ¥9 billion but book value is ¥35.9 billion so it’s trading at 60% of book. There doesn’t seem like there is a controlling shareholder as just 5% increments sit in certain Japanese financial institutional hands.

Heian Ceremony Service Co., Ltd (2344.T) - Has 4 different segments: 1) funeral services where it operates about 50 funeral halls and parlors, 2) two wedding facilities in their wedding segment, 3) a mutual aid business and 4) a nursing care business. Stock price is ¥800, shares outstanding of 12.3m for a market cap of ¥9.84 billion. For that price you get ¥7.4B in cash, ¥2.5B in securities with no real true debt (using the most recent 3Q report) so essentially nil or negative enterprise value. They did ¥1.5 billion in operating profit last year. Their total assets of ¥33.7 billion is made up of mainly land of ¥10 billion, cash of ¥7.4 billion and buildings of ¥6.3 billion. Against total liabilities of ¥12.69 billion, book value is ¥21 billion which means it’s trading at 0.47x book. Another ridiculously cheap stock.

What I’m Looking For

I am sure there are hundreds more like these which brings me to the point of what I’m going to look for when I build my basket up of these companies. I’ll be looking to add about 5-15 stocks based on the following factors/rankings:

1) Degree of cheapness/undervaluation

2) History of profitability

3) Open register/activist involvement

4) Liquidity

5) Business quality

6) Low debt levels

For companies that fit all of these criteria, they’ll represent a larger portion of the basket compared to other companies that don’t.

Some other good sources of material

Neuberger Berman 2023 White Paper

Dalton Investments - Price to Book is Back?

Japan’s Orphans

ACGA Open Letter: Strategic Shareholdings in Corporate Japan

Some Stocks Worth Monitoring

Thought I’d quickly share 2 stocks I’m adding to my watch list.

Fab-Form Industries ($FBF.V)

Why am I adding this one? 4 reasons:

• The company’s stock price has gotten cut in half the past year

• They created a niche product that could change the way construction sites pour concrete

• Rock solid balance sheet with no debt and 2/3rds of total assets in cash and short-term investments.

• High levels of insider ownership

Fab-Form was started in 1986 in Vancouver B.C. and became public in 1999. It operates in the construction industry and develops and manufactures certain concrete-forming products. For example, their Fastfoot product is a laid out mesh product that helps builders pour concrete footings in order for the concrete to properly form without using excess lumber to keep it in place. They also make insulated concrete forms (ICF), which uses styrofoam to reinforce the concrete walls. They build and supply these products within the region of Vancouver. They have a new product coming out called Fast-Tube that helps guide the pouring of circular concrete walls which the CEO thinks the TAM could be a billion dollars. It competes directly with Sonotube (made by Sonoco), which uses a cardboard like cyclinder to help the concrete stay in place. Instead of the cardboard cylinder of Sonotube, Fast-Tube is a mesh, which fills up as the concrete is poured and is a much better mouse trap as it is way more efficient from a storage and transportation aspect that Sonotube.

The stock has gotten cut in half in the past year due to the decline in sales and the increased capital expenditures as the company has been investing into new products.

It’s grown from a $2-$3m business pre-Covid to peak revenues of $6.1m in 2022 and has steadily declined since. With the business being in the construction industry, it is cyclical and is affected by local housing starts, the weather (as bad weather delays construction activity) and interest rates. For only having 10 employees, it is a nice little business that is aiming to grow a lot more. The gross margins have averaged mid 30% but the operating expenses have stayed somewhat fixed over the past few years which has given them nice operating leverage which you’ll see in their increased net margins. There has been no real dilution of the shares outstanding and the company has maintained great profitability as evidenced by their ROIC and profit margins.

The company has a cash-rich balance sheet with no debt and doesn’t need much capital to operate. Management has stated that some of that cash they want to use for R&D for new products and potentially use it for marketing dollars to get the word out about these products. It’s clear they don’t need that much capital as total net working capital and PP&E is only a couple hundred thousand a year.

Richard Fearn was the president and CEO from 1986 to 2023 until he stepped aside and now Joey Fearn (his son) runs the business. Joey has been in the business for years and obviously knows the company as well as anyone. Richard owns a stake of 3.8m shares and Joey owns 192K shares as of the most recent proxy. Total insider ownership I believe is about 40% as employees own some stakes as well which creates a tight share structure and limits liquidity.

The proxy itself is a good read as the company highlights that “compensation must be performance-based”, “at least 10% of all employees’ compensation should be at performance risk”, highlighting strong ownership culture with the main focus being on building shareholder value.

On a trailing earnings basis adjusted for cash, it’s trading at about an 8x P/E multiple, 5.3x FCF multiple and 6.5 EV/EBITDA multiple.

While somewhat cheap, it’s not egregisouly cheap and to make me a bit more interested I need to see an outlined plan of what they intend on doing with their excess capital (preferably M&A or tender offer) and a return to growth. The company discloses the sale of each of their products so we can track how their new product Fast-Tube is selling.

Reitmans Limited (RET.V, RET-A.V)

Retail is one of the toughest businesses to be in. There is a lot of operating leverage but it’s also next to impossible to predict fashion trends and guess what people will want to buy. You also have to invest large amounts into inventory to sell throughout the year based on what you think your customers will like and if it doesn’t sell, one or two bad years can potentially put you under. However, there is something to be said for retailers that have been around for almost 100 years (even if this one just went through a restructuring process).

They entered CCAA (which is the Canadian bankruptcy proceedings) in 2020 and emerged in 2022. During the restructuring process, they shut down 2 unprofitable brands and let go a bunch of employees. They went from an unprofitable business to a profitable one:

I’ll admit that one of the brands they own, RW & Co., is probably my favourite clothing place. Little did I know when I came across the stock how cheap it really is:

The company is basically trading at it’s cash balance or a negative EV when not taking the lease liabilities into account. It’s at about 2x EBITDA when we factor them in. It’s also trading at a discount to reported book value of $5.6/share. They own their corporate headquarters and distribution centre in Montreal. Ernst and Young performed a liquidation analysis during the CCAA process and valued the headquarters and distribution centre at $114 million, compared to the current $88 million cost on the balance sheet. If we performed an adjusted NAV calculation and bump the PP&E up to $114 million, the adjusted NAV/share would be $6.3/share. If you were to assume last year’s EBITDA margin of 5% against $780 million in total revenues, it gets you to $39 million (this is not adding back ROU and interest depreciation. The EBITDA in the above Valuation adds it back because leases are added on to the EV). Put any type of low multiple to that, say 5x, you are at $195 million or $3.7/share, without taking into account any of the excess cash or building value.

The problem is that the controlling family, the Reitman’s, don’t seem to want to take shareholder friendly actions regarding capital allocation and corporate governance. Out of the 13.4 million common voting shares, they own 56.5% and 8% of the 38.95 million Class A non-voting shares.

Right now they own three retail brands:

1) Reitmans which is a female retail brand with 223 stores across Canada

2) Penn Penningtons which does mens and womens retail in 86 stores

3) RW & Co. which does mens and womens fashion as well in 81 stores across Canada. It operates on a similar level of Banana Republic quality/price point, just a bit above H&M.

They don’t segment their financials between brands but between retail store sales and ecommerce so there is no real way to gauge how each brand is performing.

Donville Kent sent a letter to the board in 2023 asking to eliminate the dual-class share structure, initiate a stock buyback, uplist the shares back on the TSX and have an investor relations presence by holding conference calls and having better communication to the investment community.

The company has taken some of their recommendations so far by introducing a stock buyback in the summer of 2024 but the amount and pace of the buyback so far has been small. And they also hired an investor relations firm last May as well. These are steps in the right direction but the stock has not gone anywhere still and you can get a sense of shareholders fustration based on their last conference call. The below is from Parma Investments on the call:

I would go even one further than what Donville Kent outlined in their letter and ask the board to form a strategic comittee to see if it makes sense to complete a sale leaseback on either one or both of their owned distribution centre and corporate head office and do a tender offer. They also just hired an outside the family CEO and gave her options with a strike price right around where the stock is trading currently.

For now, I’ll be on the lookout for any type of change to capital allocation i.e. increased speed of buybacks or corporate governance. This stock strikes me as a potential MBO opportunity if the market continues to not value it properly.

Disclosure : Added to Watchlist

A Tetragon of Catalysts

Note: This write up was based on a $15.5 stock price and it is currently sitting at $15.05. Some of the numbers will have changed due to this but the thesis still remains.

Tetragon Financial is a closed-end investment fund that trades on the Euronext and LSE at a significant 57% discount to management’s NAV of 35.43/share with potential catalysts on the horizon to unlock this value. Tetragon has limited downside based on hard NAV and huge upside optionality depending on the event path that can range from 61% - 234%+. This is a low risk, highly uncertain bet, in my opinion, based on the range of options management can take this. Some highlights of the investment are:

• Potential sale of their largest holding, Equitix, that would equate to a $6 per share NAV uplift or $16/share in cash added to the balance sheet vs a current $15.5 stock price.

• Buyback/tender offer from proceeds of sale at significant discount to NAV.

• Ripple Labs IPO, where Tetragon holds a 2% investment and by my calculations, owns an indirect “look through” XRP token value of $23.46/share

• Other potential asset sales and returns of capital

This is one of the more interesting set ups I’ve seen recently. On top of the catalysts, you collect a 3% dividend while you wait.

History

Tetragon invests in different asset classes and IPO’d in 2007 at $10 a share. The stock has pretty much traded sideways at that price since. It has a checkered history starting a couple of years after their IPO. In the early 2010’s hedge fund manager Leon Cooperman sued and released some letters to the board. If you want to read the lawsuit you can here. The gist of it was executive pay was too high, no high water mark on the performance fee calculation, disagreements on capital allocation and the main one: Tetragon founders sold Polygon Management LP, in which they were also founders in, to Tetragon for shares of Tetragon, only to have Tetragon than announce a $150 million buyback the same date. The valuation for the purchase of Polygon wasn’t released, shareholders didn’t get a vote and the whole process was done in the dark with related party conflicts. The lawsuit was eventually thrown out.

There is also the fact that during the GFC, management took down their NAV (as mostly everything was down then) but double dipped on performance fees on their way up as the NAV was written back up as a result of the no high water mark.

Both of these events have left a stain, in my view, on the company which is why it trades at such a large discount to the underlying NAV now and the past decade.

What’s changed vs what hasn’t?

For one, management has actually compounded NAV at a decent clip of about 11% at the same time earning ROEs at the same rate.

When Tetragon first started, the large majority of NAV was made up of a portfolio of CLO’s and bank loans. Today, the bank loan and CLO portion of the portfolio only make up 5%, with ownership of asset management, hedge funds and venture capital comprising over 50% of NAV now. This is a breakdown of their current NAV:

Insider ownership has gone from 11% a decade ago to now sitting at 40%. The lawsuits have all been settled and are now a thing of the past. The hurdle rate to earn their incentive fee is now a larger percentage as in years past it was based on LIBOR + 2.6% where LIBOR was under 1% or equal to it. Now it is based on SOFR + 2.7% but rates are a lot higher today so today the hurdle would be about 7% compared to 3%-3.5% a decade ago.

However, management is still paid a 1.5% of NAV fee and there is still no high water mark. The shares that any shareholder buys are also non-voting shares as in the past too.

Why does this opportunity exists?

If you mention Tetragon to most investors, I am sure they will roll their eyes. Many will remember the lack of a high water mark for the incentive fee or the fact that when you purchase shares, your shares are non-voting. Both are valid reasons and why there is such a large discrepancy between price and NAV. These two reasons are certainly enough to produce an “ick” factor associated with this investment. If you look at the Association of Investment Companies webpage (350 members of the closed-end investment industry in the UK), Tetragon is on the last page when sorted buy price to discount from NAV.

Some secondary reasons creating the opportunity are:

• The company reports in USD, trades on the Euronext and LSE and is Guernsey domiciled.

• Closed-end investment funds should trade at a discount to NAV

• The market doesn’t believe management’s stated asset value

There is a very fatigued shareholder base that has sat on dead money for the past decade and only until the past few months has the stock had a very positive reaction causing the current set up.

Current set up

Thesis #1 - Sale of Equitix

Reuters had a report out in October that Tetragon was in talks to sell Equitix, in which it has a 75% stake in and represents 26% of NAV i.e. their largest holding. The report went on to cite that the value could be 1.5 billion pounds based off of 11 billion pounds of AUM (US $13.8B). Equitix owns some unique infrastructure assets that should be highly coveted by large asset management firms like the contract to operate and maintain the M25, a major highway that surrounds London, or the High Speed 1 30-year contract to operate UK’s high speed rail plus many more.

How likely is the sale? I would give it greater than 50% odds as it was reported by a very creditable source and also confirmed by the company, amongst possibly other potential asset sales. The only reason the company confirms this is to let other bidders know that they are accepting offers or shopping the asset as generally companies don’t comment on press report speculation.

A sale price of 1.5 billion pounds converts into US $1.936 billion. Using a 75% ownership ratio as the 81.48% given in the financials is a little unclear exactly if they receive that full amount, Tetragon would receive US $1.452 billion, which means there would be a value uplift of US$529.6 million to NAV based off of reported NAV for Equitix of US$922.4 million on Dec. 31, 2024. This results in an extra $6/share in NAV uplift or brings on $16/share of cash on the balance sheet, which is just a bit more than where the stock trades today. Even though the company purchased their stake in Equitix for US $208 million, from my understanding of Guernsey tax law there are no capital gains tax and would therefore not have a taxable event.

The infrastructure space has been ripe for deals. BlackRock bought Global Infrastructure Partners for $12.5 billion, which held $100 billion in AUM, for a percentage of 12.5% AUM. CVC Capital Partners just bought infrastructure manager DIF and General Atlantic bought Actis. All these deals could have been a potential trigger for Tetragon to solicit bids and test the market

What could the potential value of Tetragon trade at if they sell Equitix? Based on using 60% price to NAV, it could be worth $25 for upside of 61%. The stock has historically traded at 50% of NAV for the past 10 years but I would argue that a company that’s compounded NAV at 11% since IPO and is willing to sell their largest component of NAV for cash , and maybe return that cash, could see a decrease in the discount from price to NAV. Even if you use 50% there is still a bit of upside.

Thesis #2 - Explore return of capital via tender or special dividend

If/once Equitix is sold, I believe Tetragon could look to make a tender offer using the proceeds at a significant discount to NAV. Management and Tetragon employees own about 40% of the company and would be highly incentivized to see the stock price increase now. What is the use of owning such a large chunk of a significantly undervalued company if you cannot sell your shares for their true fair value? I am assuming the tender occurs at $25 because that’s the value I have if Equitix is sold. It could, if it occurs, happen at levels below $25 which would be even more accretive to NAV. But assuming a tender is done at $25, it could result in 80% upside.

Thesis #3 - Potential IPO of Ripple Labs

This is where the thesis gets really interesting. I’ll preface by saying that I am in no way a crypto expert but I like situations with extreme optionality on the upside, even if there are different event paths that could occur. The late grate Michael Price called this the steak and sizzle approach. Focus on the steak and get the sizzle for free.

In 2019, Tetragon made a Series C preferred equity investment in Ripple Labs for $150 million with the option of Ripple redeeming their investment if it was ruled that XRP was a security on a go-forward basis. The SEC sued Ripple in 2020 stating they had been issuing unregistered securities from the sale of XRP, which led to Tetragon suing Ripple to redeem their investment as a result of the SEC lawsuit. Tetragon’s suit was dimissed and Ripple decided to buyout the Series C preferred back anyways in 2021. Tetragon then purchased Series A and B preferred of Ripple on the secondary market. While they have never disclosed the price paid or terms, there have been reports that they own about 2% of Ripple. Although not a perfect method, triangulating what Ripple is carried at on Tetragon’s balance sheet vs Ripple valuation in 2024 comes to roughly 2%:

What’s interesting about their Ripple investment though is that Ripple in January 2024 owned $25 billion worth of XRP tokens on their balance sheet at a rough price of $0.5/token when they did their tender offer for $11.3 billion last year. This meant they were buying back shares at under a 50% discount to net asset value and I believe they made another tender in 2024. And now one year later, the XRP price has gone vertical:

Sitting at just around $2.3, their XRP tokens are now worth more than $100 billion, thanks to a nearly 5-fold increase in price and the CEO of Ripple thinks the original $11.3 billion valuation of Ripple is “very outdated”. The drastic price increase is as a result of the friendly Trump administration coming into office, the resignation of Gary Gensler who was antagonistic to Ripple, Ripple only having to pay a $125 million dollar fine which was substantially below the $2 billion the SEC wanted from their lawsuit and the SEC recently approving bitcoin ETFs. Not to mention a potential US Strategic Reserve for purchasing cryptocurrencies that could come into affect.

Ripple’s balance sheet isn’t public so we can’t see exactly how many tokens of XRP it holds but its around 46 billion against a total supply of 100 billion according to various news outlets. At today’s price of $2.3, Ripple owns about $105 billion XRP on balance sheet. At Tetragon’s current stock price, the “look through” ownership of their XRP holdings are about $23.46 which means Tetragon’s implicit value less their holdings is negative 720 million. Stated another way, an investment in Tetragon today means you are receiving about 3B of assets for a negative $720 million.

GAM Global Special Situations Fund has noticed the same implicit value in SBI Holdings, which is a Japanese financial services company that owns 8%-9% of Ripple and based on their look-through holdings, is trading at a negative market cap as well. They recently sent a letter to SBI you can read here. They want SBI to publish a daily figure of SBI’s lookthrough XRP holdings and to establish a public XRP coin buying program buy purchasing the coins outright to close the gap to NAV, similar to what Microstrategy has done in the US.

And Ripple itself is essentially doing somewhat of a reverse Microstrategy approach. Microstrategy issues equity at a premium to NAV and buys bitcoin whereas Ripple is just tendering for shares at a severe discount to NAV and could/should possibly sell some on balance sheet XRP and use it to repurchase more shares.

So what is the likelihood of Ripple going public and potentially releasing all of this value? Last January Ripple was looking to go public outside the U.S. because of the hostile SEC and decided to put it on hold. Since then, Gary Gensler is no longer the SEC chairman and the Trump administration has been viewed as extremely favourable to the crypto industry. Trump even issued his own coin days before he entered the white house with the first lady following suit. The CEO of Ripple has stated that going public wasn’t prioritized previously because of the prior SEC administration. With that administration now gone, experts are predicting late 2025 to 2026, potentially once the lawsuit with the SEC is finalized. I have no unique insight into when this could occur but view it as extremely positive for this investment (maybe not for society overall) that the administration is very pro crypto. While Ripple does trade on certain private markets online, coming to a precise valuation is near impossible due to no real business numbers being available. Just using a valuation of $15B, almost a 50% increase from their tender, gets to an overall stock price of Tetragon up 84%.

While the above valuation is just valuing Ripple’s potential business based on a gain from their last tender of $11.3 billion, this investment can get a bit silly on potential upside optionality if/when Ripple comes public and the market chooses to value it based on their on balance sheet XRP holdings. If the market were to value it just at todays XRP value of $105B, the upside can be quite dramatic.

And if Ripple starts trading like how the market values Microstrategy, at a multiple of their bitcoin holdings, Ripple could be worth a multiple of the 105B on balance sheet crypto holdings. The scenario above doesn’t account for the fact that the XRP token price could increase in value, or that Ripple would most likely be a highly coveted IPO by a lot of retail traders and garner a huge valuation.

Thesis #4 - Other asset sales

There is the possibility of other asset sales on top of Equitix. One of the analysts covering Tetragon thinks the BGO asset could be disposed of in the near term. While this would be viewed favourably by the market (of course depending on price and uses of the cash), it is not a main point to the overall thesis but would be most welcomed.

Potential Value Creation

Management and other executives own about 40% of the company, with the two main founders Reade Griffith and Paddy Dear owning 27%. I think they have done a relatively good job of compounding NAV since inception at 11%. One thing that does bother me is management’s aloofness on how to close the discount to NAV. On the most recent call they said “they don’t think there is a clear silver bullet to closing the discount to NAV”. I lay out some options on what I would do to close the discount at the end of this write up but with the persistent discount to NAV ongoing, upper management have the option of collecting their combined $50-$100m incentive fees per year until they retire in 5-10 years, or they have the option of creating a ton of value right up front. Based on my valuations, this could be the potential value they can create for themselves:

Risks

In all potential deals, there is the possibility of the sale falling through. If the Equitix sale doesn’t occur, it is possible this trades back down a bit and is dead money. I don’t think it should trade back down to 10, it might go down to the 11-12 range based on the markets perception that the company is willing to entertain offers for some of its assets and turn at least some of their investment NAV into cash.

What if Equitix might not get as a high a price as reported? Anything at NAV or above and turning their investment into cash is a win in my opinion as they could still use that cash to repurchase at a significant discount to NAV.

Or what if the company chooses to reinvest any proceeds from asset sales into other investments? While a bit of risk, it wouldn’t be a terrible outcome as management has shown they can grow NAV at a decent clip. However, this wouldn’t allow for larger outsized returns as outlined above in my opinion.

There is also the risk that if a down turn occurs, management can write down NAV, write it back up and double dip like they did in the GFC. I give this situation occurring low odds. Back in the GFC, management owned just loans and CLO’s, assets that were heavily affected by the crisis and most likely deserved to be written down then. Now they own a more diverse set of assets. We’ve also seen during the COVID 2020 market that their NAV actually increased, which should dispel most of this risk. The company could also face a barrage of lawsuits from investors, tainting the investment in the stock even more and thereby increasing the price to NAV of where it trades, in which management owns 40% and not giving them a path to realize their holdings at fair value.

What if Ripple doesn’t IPO or the price of XRP drops? While a lot of the upside of the investment could be tied to a Ripple IPO and their significant holdings of XRP on balance sheet, you don’t need the Ripple IPO to occur to earn a decent return in the stock. While it would be nice for Ripple to IPO and be a highly coveted asset by retailer and institutional investors, if they stay private they can still grow their value without going public. And even if their value doesn’t increase, Tetragon the stock, can still earn a good return if management liquidates some assets and repurchases shares.

Event Path If I Were Management

The first step I would take is currently what mangement is doing. Putting one of your largest holdings on the block and trying to crystalize that value. I would also sell another asset as well for further NAV uplift. Once these sales occur, I would announce a larger tender at a significant discount to NAV in order for NAV/share to grow even further, increasing management’s and investors who choose to stick around ownership further.

The next step, however unlikely, would be to convert the non-voting shares into voting. If management doesn’t sell back into the tender, they could go above 50%, thereby making the newly proposed voting shares semantics as they would now control the voting shares and eliminate some of the discount to NAV. At the same time, instill a high water mark which would further erase some of the discount to NAV. Instead of the high water being just NAV, tie it to some type of performance based measurement of shareholder value like stock price. These two steps I would do after the tender to allow a larger price to NAV gap to exist during the buyback.

Once these are done, start highlighting the Ripple investment and the indirect “look through” XRP that Tetragon now holds. This could show the market that one of the ways to play the Ripple IPO would be by owning Tetragon, thereby increasing demand for the stock.

Disclosure: Long TFG.AS, TFG.LN

Investment Idea: Currency Exchange International

Currency Exchange International - Long

Note: this was written up based off a $15.93 stock price and it is now trading at $15.25.

Jerry Jones Outsized Returns; Interesting Reads

I was listening to the Founders podcast episode on Jerry Jones and wanted to jot down some key characteristics of what made some of his investments so great as well as a brief summary of the podcast. I highly recommend listening to it. I wasn’t aware that Jerry’s Cowboys purchase was a deep value turnaround.

Jerry Jones had always wanted to purchase an NFL team. He had told everybody all his life he wanted to. But first he had to make some money to finance it. He made a bit of money when his father sold his insurance company that Jerry helped build and which netted him about $500,000. Since he was extremely hungry to become rich, he then moved to Little Rock, Arkansas and wanted to get into the oil business. His first deal was when he met someone who was shopping an oil deal that everyone had turned down and had said no to. Jerry was the only person who had said yes, while at the time he was selling mobile homes.

The result?

The group hit their first well that was worth more than $4 million dollars. And they kept hitting wells each time they drilled for 15 consecutive times. He ended up selling 1 of his oil production companies in 1976 for $50 million.

What allowed him to make an outsized return on this investment that I think can apply to public markets or any type of investment is 1)When people turn their nose up at it and think it is dumb/crazy, 2) There is an ick factor associated with the investment and 3) Everyone doesn’t want to touch it and says no to it. When any of these characteristics apply to an investment you are being pitched, I believe it would pay to do more work. Or to look for investments that people think are dumb/crazy to invest in to. I don’t mean to go look for huge cash burning non-revenue generating businesses, but real businesses with downside protection that others don’t or can’t touch for whatever reason. A good example wold be General Growth Properties in 2008.

2nd and 3rd Investment

After his first success, in 1980 he decides to drill for natural gas with a partner and they take a shot drilling at 2 wells. One near San Francisco and one in South Eastern Oklahoma. Right away, the production was a disaster as an employee made a half a million-dollar mistake by accidentally dumping cement in the well ruining it at their Oklahoma location. They then invested another $500,000 and moved the drill bit 100 feet and the next day hit a natural gas well worth over $40 million. While this was happening, the San Francisco well was going to be worth $40 million over a two-year period. In total, they made $80 million on their first two natural gas drills.

The last deal he does before buying the Cowboys is extremely interesting. Jerry’s friend was the CEO of Arkansas-Louisiana Gas Company, which is the state regulated utility company. In 1981, Jones forms a new gas drilling company called Arkoma Production Company. He then enters into a deal with Arkansas-Louisana Gas Company (which people say is one of the greatest sweet heart deals of all time) that allows Jones’ company to sell gas to this utility company (which his friend is the CEO of) at a price much higher than what the utility company was currently paying other gas companies for their gas. The deal was for $4.50/thousand cubic feet, which meant Arkoma was getting more than 9x the price that other natural gas producers were selling their product for.

Then in 1985, the natural gas industry was deregulated and the price of natural gas went down significantly. But because of the terms of the agreement between Arkoma and the utility, the utility company had to purchase from Arkoma the most amount of gas it could produce at the maximum legal price. Jones then decides to purchase other natural gas producers that didn’t have this sweetheart deal because he has a guaranteed price he can sell to the utility company compared to what all the other natural gas producers could currently sell at. Thereby buying more supply and selling the gas at the inflated rate. The end result of all of this: the utility company was paying Arkoma $40 million a year for gas it didn’t need. Because this was a terrible deal for the utility company, it decided to purchase Arkoma in 1987 for $175 million. The total value to Jones and his partner based on money taken out of the business and sale price allowed them to pocket over $300 million. These articles here, here and here give a good background of the deal. This leaves Jones with about $90 million in cash at this point in his life.

Cowboys Purchase

The current owner of the Cowboys in 1988 was forced to sell the team because he had a severe cash crisis with all the businesses he owned. The owner was never really interested in owning the team but wanted to own it for the depreciation it threw off to cover his profitable oil business. When he decided to sell, he pitched 75 people who all had said no and financial advisors at the time had said buying the cowboys was “ridiculously overpriced, and financial suicide”. Enter Jerry, who buys the team in 1989 for $140 million. He used all of his $90 million in the bank and borrowed the remaining $50 million at high interest rates.

With that, he got a football team that just recently lost $9 million, couldn’t sell a majority of the luxury suites as only 6 of 188 were sold, attendance dropping 25% from the prior year, and only one home game had sold out.

Within a few years from taking over they were averaging more than $30 million in profits per year and are now doing over a billion in revenue. As of 2024 they were valued at $10.1 billion, earning 112 times his initial $90 million investment.

Here’s how he earned outsized returns on his Cowboys purchase:

• Purchased from a forced seller

• The owner had shopped the team to 75 other parties who all said no before Jones came into the picture and said yes.

• Took advantage of low hanging revenues opportunities.

  • If you sell the luxury suites in your stadium, you don’t have to share the revenues with other NFL owners as you do the typical ticket revenues. The suites could sell for $400,000 to $1.5 million and after a few years he had 95%-98% of them filled. This turned into $50 million profit just from selling these.

  • Moved the free press seats that were the best seats on the 50 yard line to the 5 yard line and sold these 50 yard line seats.

  • There were no ads inside the stadium. He placed ads inside the stadium and sold these ads to local businesses.

  • At the time they couldn’t sell beer and alcohol at the games. Jerry lobbied and wined and dined the city council to grant him a stadium license to sell alcohol. This turned into $1.5 million to $2 million per game in profit.

  • Hired sales and promotion people and cut positions that weren’t generating revenue.

His cowboy purchase can be boiled down to a few key characteristics: 1) There was a forced seller, 2) The cowboy franchise is a scarce asset as NFL franchises are rarely if ever expanded. This creates a lack of supply with all demand growth going to the limited franchises in existence and acts as a tailwind, 3) No one wanted it as it was shopped to 75 other parties, 4) Extremely low hanging revenue opportunities that were just common sense to implement.

These key characteristics in his investments are what everyone should be on the look out for and has made Jerry Jones one of the richest men in the world today.

Interesting Reads

A couple of interesting reads this past weekend:

1) Tom Murphy 2000 HBS Interview

2) Ben Graham 1955 testimony before congress

Gulf & Pacific Equities Corp.

An interesting stock I came across to put on my watchlist is Gulf & Pacific Equites Corp. (GUF.V). It’s not something I would invest in now but would need some sort of catalyst for this idea to work and don’t see it right yet.

Gulf owns 2 malls, a retail property and a piece of land in Western Canada. All of the assets are owned in small towns. One mall is located in St. Paul, Alberta and is 100% leased with good tenants (Tim Horton’s, Dollar Tree, Mark’s and more). The other mall is located in Cold Lake, Alberta and is not 100% leased but has good tenants as well (Pizza Hut, Sobeys, Taco Bell, etc.). The retail property is located in Three Hills, Alberta and is leased 100% to Dollarama long-term. And then there is a vacant land owned in Merritt, BC which management doesn’t give any value to.

The company began operations in 1999 and this is the income statement the past 2 years:

It looks extremely profitable but the profits the past two years are really as a result of the FV adjustments in the way they mark up or down their properties and run it through the income statement. It is essentially breakeven on an operating basis. But what got me more interested was the balance sheet:

The stock trades at $0.42 with fully diluted shares outstanding of 22,660,685 for a market cap of $9.5m. Right from the balance sheet you can see it is trading for 43% of book value. If you include the FV adjustments as real income (which I don’t) it would be trading at 8x last years earnings. In the notes, management states it recently had appraisals done for the 3 properties as well as completed their own appraisals and the two large malls were worth $48.35m and the smaller location was $2.01m.

The CEO owns 52% of the shares through his investment company Ceyx Properties Ltd. and insiders own a combined 55%. Two other shareholders own another another 28% so the shares are in just a few hands which leaves the remaining 17% shares to the public.

There is a pretty compelling case to be made that this should just be privatized to a larger retail/mall operator:

• Reduce public company and management costs. Management and the board are paid just over $400K a year which would drop straight to the acquiror’s bottom line as well as public company/audit costs not included in that $400K number.

• Access to lower costs of capital from merging with a larger entity.

• Become part of a larger mall portfolio which would reduce business risk as there would be many malls in the portfolio.

• The CEO is currently running this company as well as another publicly traded junior gold miner, Plato Gold Corporation and he is also the CEO of Ceyx Properties Ltd.

• Gulf & Pacific won’t ever get the appropriate earning/FFO/book value multiple because it is too small and illiquid.

In order for me to get real interested, I would need to see discount to book as well as cheap on an earnings/FFO/cash flow multiple. If the Cold Lake mall can get near or to 100% leased it might get there. Or management decides to liquidate and pay proceeds out to shareholders. Until then I am just going to add it to my watch list.

Disclosure: Stock watchlist

Liquidating Cannabis REIT with a Catch

Two posts ago I talked about “seasoned liquidations” and I just happened to have found exactly that. Nova Net Lease REIT is selling its main asset, Class A Units of an operating partnership, for $3.71m USD, or $0.50 per share, after undergoing a strategic review. This represents a 456-498% premium to the 30-day VWAP. Nova will then wind down its REIT and subsidiary corporation and make a liquidation distribution to shareholders relatively quickly in the next month or two in the amount of US $0.40-$0.43/unit. In the press release the distribution is to be expected in 30-60 days following the completion of the sale and in the circular it just says first quarter of 2025. This could provide upside of between 12% - 22%. Its trading OTC at $0.3526 as ticker NNLRF and on the Canadian Securities Exchange at $0.375 with ticker NNL.U. The only problem: I haven’t been able to get any order filled as the volume is dreadful so I thought I’d just share it anyways as a good case study for finding inefficient mis-pricings in the smaller market areas. And maybe someone reading this will be able to get a buy in before the distribution.

Nova owned a cannabis industrial investment property as well as a JV that held two cannabis investment properties. This is the organizational chart with what they sold.

From reading the documents, they effectively had a 35% economic interest in the LLC they sold. So after this sale, they are going to be left with Verdant Growth Properties Corp. and the REIT at the top, both of which are going to be wound down. If you look on page 74-75 on the circular PDF, you can see the financial advisor’s liquidation value calculations for the LLC which comes to roughly the distributable amount.

The transaction was announced in November and unitholders held a meeting to vote on the transaction December 20. The shareholders voted to complete the sale and it closed on January 9. Management stated $0.40-$0.43 in the press release was the estimated distribution and in the Fairness Opinion that amount is given as more precisely $0.42/share in US dollars.

Based on the net difference between $0.50 per share and expected payout of $0.42, the estimated liquidation costs are about $596,000, which seems about right for a relatively quick/small liquidation. They also released the CEO when the agreement was entered into and replaced him with the CFO with no additional compensation. Also, not that it matters much, but I don’t think I have seen the financial advisor, or someone who works for the financial advisor, provide a fairness opinion and they themselves own a stake in that company.

The spread is available because the liquidity is tiny. I am a little disappointed I haven’t been able to get my ordered filled but I know there will be plenty more of these to play and hopefully someone can take advantage of the spread.

A-Z on the Canadian Securities Exchange

This January I thought I’d go A-Z on a small backwater exchange here in Canada, the Canadian Securities Exchange. This is the exchange one tier below the TSX Venture, which itself is a tier below the TSX. I downloaded the excel list of companies from the CSE website and started at the top.

The game of investing is turning over the most rocks until you find something that seems extremely compelling. This could come from reading investor letters, investment pitches, running screens, following news flow, etc. But you aren’t going to see what truly are the best opportunities unless you go through every stock on each exchange. The beauty of looking at every stock is that you can than compare it to your existing portfolio as opposed to waiting for investments to come around.  The problem with this is it is extremely time consuming and you usually end up finding a lot of junk/unprofitable companies as you can see from my notes on the right below.

While there is no exact tell for what I was looking for when going through each company’s financial statements, I wanted to see actual businesses that were profitable or at least almost profitable with a strong balance sheet. Everything else was an immediate pass. How else can I value a business if there is no real business?

A couple observations

• For a country with vast natural resources, Canada has a TON of unprofitable mining companies.

• A lot of these companies should probably just be liquidated/not publicly traded.

• Going A-Z is never easy and I found myself thinking I should just skip the names that just seem like an obvious pass but if everyone thinks like that there might be some hidden gem.

• Once you get into the habit of starting, it can become a bit addicting trying to see each company everyday. At the end of each session I found myself wanting to look at “just one more” which would usually turn into 10 more.

• My goal was to do at least one letter of the alphabet each day and I would usually surpass that because some letters didn’t have many companies.

I managed to make a list of at least some interesting companies to keep an eye on and thought I’d share the top 10 companies I thought were the most interesting.

1) ZTEST Electronics Inc.

Develops and assembles printed circuit boards and is currently undergoing a strategic review. Almost doubled revenues from 2023 to 2024 with net income going from $165K to $1.7m. Shares outstanding of 36.5 + 2.7m warrants +1.1m options with a stock price of $0.40 for a market cap of $16.12m. Trading at 9.5 times last years earnings and if they can grow again at the same rate this year, it seems really cheap. Strong balance sheet with cash balance of $2.7m against debt of just over $100K.

 2) BioHarvest Sciences

They synthesize plant based molecules and have a market cap of $110m with insiders owning 37.9% of the company. Their revenues and gross margins have exploded the past couple of years. In 2021 they did revenue of $2.1m and gross margins of 31.9%. In the TTM of Q3 2024, they’ve done revenue of $22.4m and gross margin of 54%. Huge growth that is hard to argue with.

The only downside is they are still losing money but on a lesser scale as a couple of years ago. Also, their shares outstanding have gone up as they have raised money to fund the growth. This is one I will be keeping my eye on for when 1) potential profitability will inflect, 2) no need to raise capital anymore, 3) if the valuation makes sense and 4) if I can get comfortable with the business/industry.

3) Eagle Royalties

A junior mining company but it holds 35 royalty interests in certain projects in Western Canada covering different commodities. It was spun off from Eagle Plains Resources in 2023 on a 3 for 1 ratio. Extremely strong balance sheet with total assets of $4.8m with cash comprising $3.5m of that and a note receivable of $1.25m against total liabilities of $303K. Market cap is $6.6m but they just diluted shares from 28m to 57m, with fully diluted 66m. Royalties seem lumpy as they just received one so far this year for $3.75m which turned into net income of $2.9m in the last 12 months. Insiders own 20-30%.

4) Happy Belly Food Group

Seems like an interesting small business. Has a bunch of different brand food locations/consulting and also earns royalty and franchise stream income. Sales have been growing as of September 30, 2024 as they have done 5.2m in past 9 months vs 3.8m last year same period. However, still burning money and diluting but looks like cash burn has come down. Total assets of $9.1m with cash making up $3.6m of it against $3.6m of convertible debt.

5) MTL Cannabis Corp.

One of the rare profitable cannabis companies I’ve seen, although they did lose money in 2023 but they under went a RTO mid 2023. With 117m shares outstanding, 7.7m warrants and 6.5 options, there is a market cap of $48.5m using a stock price of $0.37 (not using the treasury method). While I don’t love the balance sheet of $22.6m debt against $3.2m cash, there is $18.5m of PP&E backing that up as well. Sales have been growing, going from $32m September 2023 last 6 months to $42m September 2024 last 6 months. This takes into account $10m of excise taxes as well and if the government were to change this in the next few years, it could fall right to the bottom line.

Operates 2 segments: 1) Licensed producer that just did $11m in operating income and $8.5m net income past 6 months, 2) CHC segment that did $430K operating income and $100K net income past 6 months as well. On a consolidated basis when taking corporate expenses into account, its 9m operating income and $3.4m net income. Annualize that for the year could be $18m in operating income and $7m in net income against a market cap of $48.5m for 7 times earnings.

6) Namesilo Technologies Corp.

Nice little domain name business run by Paul Andreola. Holds 1.2m in bitcoin investments as well as some other of his investment picks (Atlas Engineered, Ceapro Inc.). Does just over $40m in revenues and is profitable on an operating basis of $3-4m. Only debt is 3.8m convertible and large amount of liabilities is the deferred revenue of almost $30m of a the total $43m in liabilities.

7) Nova Net Lease REIT

I will most likely be writing this up in a couple of days but it is a Cannabis REIT that owns one investment property and a JV that owns two other properties that are profitable. Just agreed to sell most of the assets and liquidate. Stock price of $0.36 with units outstanding at 7.4m, market cap is $2.6m. The book value without making any adjustments to the properties or JV is $12m, which means on my rough math it is trading at 22% of book value. But this could be as a result of them consolidating the JV onto their statements so their true economic ownership doesn’t show through. Granted it is losing some money and burning a bit of cash but the JV is profitable according to the notes in the financial statements.

8) Urbana Corporation

Investment company with a net asset value of $427m or 10.32/share. Currently trading at $6.19 which means it is valued at 60% of net asset value. Investments are made up of both public and private amounts. Public is $202m on balance sheet and private is $297m with some private debt investments of $6m. Management in September was granted by TSX to allow a NCIB to repurchase 10% of the company’s shares which means management agrees it is undervalued. Smart capital allocation to purchase below asset value which would bump up the NAV per share after the buyback. Reading past investment pitches on them, they have always traded at a large discount.

9) ICEsoft Technologies Canada Corp.

Licenses its technology and its SAAS product to businesses and government clients. They do the mass notifications that pop up on your phone if the government needs to let people know of certain emergencies. Seems like losses have come way down and they are near breakeven. Trades at a roughly $5m market cap when taking the warrants into consideration. Annualizing their current quarters revenue, trades for about 2.5 times revenue. The balance sheet isn’t the greatest with only $111K in cash against $1.2m of convertible debt. Not a buy to me as I need a clean balance sheet and profits but one to keep an eye on.

10) Victory Square Technologies Inc.

Investment company with investments made in the tech. sector and consilidates a bunch of their investments on to the financials. Has a market cap of $45.7m but they own a 64% stake in Hydreight Technologies (Ticker is NURS.V) that is worth roughly $60m as the stock has gone crazy the past year. They also own other investments that I am sure are worth more. Could be interesting if they ever try to unlock some of this value.

Honourable Mentions

—> Grown Rogue, Plaintree Systems Inc, Royalties Inc.

I am hoping to do the TSX Venture exchange in February/March. The CSE only has about 771 listings whereas the TSX Venture has I think triple that amount so it will take me a bit longer to do obviously.

Two Deep Value Special Situations Down Under; Seasoned Liquidations

I’ve recently come across two deep value situations in Australia. Both I own. The first one: 

Deep Value Situation #1 - Pacific Current Group (PAC.AX)

I first became aware of Pacific in July 2023 when major shareholders Regal Partners and River Capital offered to buy them at $11.12/share. Pacific owned 16 stakes in numerous tier 1 and tier 2 boutique asset managers, one of them being at the time GQG. This was then followed by GQG Inc. (who Pacific had an investment in and is itself publicly traded) indicating they would submit a bid as well. PAC then ran a strategic process and received multiple offers. Regal withdrew their offer in September 2023 and GQG Inc. submitted a bid for $11/share all cash in November 2023 without having obtained River Capital’s support. River Capital then got back in with a bid, but this time for $10.5/share in cash. Long story short, Pacific’s strategic committee disbanded in November 2023 as it wasn’t able to get any binding offers. 

What’s happened since then? Essentially a public liquidation, selling down to 11 boutiques as of August 2024.

The company has announced even more sales since August. All of these sales have changed the NAV percentage of the business dramatically:

Cash went from 2% of NAV last year to 43% as of June 2024 and this is still a growing amount. The company is now proposing to repurchase 25m shares in an off-market share buy-back, which equates to 47.9% of the shares outstanding. The shareholder vote is to take place January 30, 2025 with the 3 major shareholders representing 49% voting for it. However, they have not decided if they will tender their shares into it which creates a bit of a risk of the full buyback being used.

In order to determine potential returns, I’ve tried estimating the adjusted NAV as of this write up along with a scenario where all the shares are and aren’t bought back. There are a ton of moving pieces in the underlying NAV since last reported on June 30, 2024. Not only the recent sales but also some of the sale proceeds are to be collected over a period of a year or two. On top of that, the majority of the funds under management are reported in USD but the stock trades in AUD which must be accounted for.

Based on the assumptions above, I am getting to $14.38/share of adjusted NAV since the June 2024 NAV of $13.47/share. Below are the IRR estimates assuming a 2 month hold:

If the company is able to fulfill the full repurchase authorization, there is barely any downside with some upside depending where it trades after repurchase. The IRR on this, assuming a 2 month hold, could be a respectable 62% if it trades at a 20% discount after.

What happens if the tender is only able to be filled for half the amount allocated? Assuming only 12.5m shares can be repurchased, there is still a small IRR to be made if it trades at a 20% discount to adjusted NAV.

I’ll note that the stock is trading just below $12 so the IRRs on these numbers could be a bit greater than what I have from using the $12 beginning price. I didn’t account for any fair value uplift in potential sales as well that could provide a bit more return to the stock/NAV. Also, if the company isn’t able to get the full allocation, I imagine they could possibly do a special dividend or just sell it all/wind it down completely. The CEO is still listed as “Acting CEO” which makes you wonder what the end game is here. 

The real risk that could reduce the IRR is any delay in shareholder vote and rulings from the Australian Tax Office as these have caused a delay since May. But with the vote at the end of the month I would think this happens in March when scheduled.

I am long and see this as an extremely low downside bet with some upside and the chance of earning a high IRR. The opportunity is available because it’s a small company with 3 shareholders making up almost 50% of the shares which creates limited liquidity for larger funds to enter into.

Deep Value Situation #2 - Merchant House International Limited (MHI.AX)
Merchant is a textile manufacturer that makes boots, shoes and other home products. It is based in Hong Kong and listed on the ASX but domiciled in Bermuda. It has the “ick” factor in an investment that people turn their noses up at but I think this cigar butt has one last puff. They decided in August 2024 to liquidate the company, distribute the proceeds to shareholders and delist from the ASX once they sell their last remaining property. The liquidation announcement sent the stock from $0.04 to $0.15. As you can see, the business is of extremely low quality with declining sales and net tangible assets in the prior 5 years.

Merchant has 94.2m shares outstanding and currently trades at $0.15 for a market cap of $14.13m. The average volume for the shares is 100,000 shares or $15,000 a day.

The business consisted of 3 real main businesses with a couple other small/dormant subsidiaries:

1. Footwear Industries of Tennessee Inc. (FIT) which was sold in 2023 for gross proceeds of $3.28m USD and net proceeds of $2.63m for its fixed assets net of liabilities. The land and buildings in this sale had a book value $US 788K and sold for profit in the sale of $1.965m USD, amongst some other small assets. The main thing to note is the property sold above book value here.

2. Forsan Limited (Forsan) was a 33.79% ownership in a JV with Mr. Wu Shu Xin for Tianjin Tianxing Kesheng Leather Products Company Limited based in China. This was sold on May 30, 2024 for $8.3m AUD before taxes, costs and other payments. The company completed the sale on January 9 2025 for $4.9m USD. 

3. American Merchant Inc. Most of the value of the overall company is in this subsidiary as it holds a large piece of textile PP&E located in Bristol,VA. It was recently shut down as of September 30, 2024 and to be put up for sale. According to their website they have invested more than $24m in state-of-the-art equipment in the plant. This article also gives some background of the facility, equipment owned and its sale. Below is a picture of the plant:

And a location of the factory from google earth:

4. Various subsidiaries -  Pacific Bridges Enterprises Inc and Loretta Lee Limited. I am assuming Pacific Bridges is not worth anything. Loretta Lee Limited currently has a contingent liability of US$994,996 that must be returned plus interest owing from a court case.

The company has recently stated in their September 2024 Half-Year report release in late November that they have received expressions of interest from potential buyers and expects the sale process to be complete within 12 months.

Liquidation Proceeds 

So what can you expect to get in the liquidation? I lay out a bear, base and bull case with various assumptions on the amount the plant will sell for. Even in a draconian scenario where it only goes for 50% of stated book value, you would still get a decent return.

I haven’t been able to really find any precedent transactions for this type of asset in the area. But as stated earlier they were able to sell their FIT division for above book value. In 2022 they sold their 30% interest in Jiahua for $AUD 3.3m and it was carried on their books at $AUD 1.9m. And in April 2021 they disposed of their subsidiary Carsan for net proceeds of $AUD 21m for roughly 1x revenues and 3.8x book value based off my calculations from the segment’s book value of $AUD 5.5m as disclosed on page 20-21 of the 2021 annual report. In my model I have 4 boards of directors but one resigned in August but I left 4 in to be conservative.

The CEO owns 61.2m shares or 65% of the company and should be highly incentivized to get the best price and the company liquidated as quick as possible.

Many things can go wrong with this investment:

• The sale process can drag out which will eat into your IRR.

• The plant may not sell for 50% above book or might not be able to find a buyer thereby wiping out your downside. These are not very “attractive” assets but they have garnered some interest as per the release and the company has a history of selling these types of assets.

• The company might have to sell off pieces of equipment each before they can sell the entire plant. This would prolong the amount of time it takes to liquidate.

• Management can change their mind about liquidating and hoard the cash for an acquisition.

• Management can pilfer the company by paying out large salaries leaving shareholders left with nothing. This risk is the one that I worry about the most because you are always on the outside looking in in non-control liquidations like these in foreign jurisdictions. However, the release did state they wish to distribute the proceeds out to shareholders so hopefully there is no pound of flesh taken before that occurs.

I have a small position in this because while I don’t love the asset they have to sell, their history of getting north of book provides such a large discount to fair market value that you are well compensated for that risk. It also helps that this situation is uncorrelated with the overall market.

This investment brings me to a topic I’ve read about and think is extremely interesting in liquidation scenarios.

Seasoned liquidations

I read about a technique called “seasoned liquidations” in the book Merger Masters: Tales of Arbitrage. In the chapter about John Bader from Halycon Capital Management, he explains that a seasoned liquidation is one where the assets have actually been sold and are just sitting in cash waiting to be distributed to shareholders. All that needs to be accounted for in this situation is claims the company still has to pay out and the timeline. I think this technique is extremely smart, especially in situations where the assets have not been sold yet and it can be hard to put a value on the assets. There might not be as much upside using a seasoned liquidation approach, but your risk decreases dramatically because you are not relying on valuing the remaining asset to be sold. Just the cash in the register essentially.

This situation can be applied in the Merchant House pitch above due to the nature of the remaining asset. Once the price of that asset is sold, your risk of capital impairment would go dramatically down as you will be in a better position to see all the cash less payments to be made, the timeline of receiving your capital back and the stock price. Of course the stock will move before you are able to purchase it but the idea is to squeak out a few percentage points of return with minimal downside as it will most likely trade at a discount to full value. It is a very valid approach to liquidation investing and can be used in your special situation arsenal.

Investment Idea: Citizens Bancshares Corporation (CZBS)

Please see attached write up here as a PDF. Or read the blog post below.

Thesis

Citizens Bancshares Corporation (CZBS) is a small $93m market cap bank that is extremely overcapitalized with a strong deposit franchise trading at an estimated 2025 7x P/E, 2025 0.62x Adjusted TBV with the potential to earn 17% adjusted ROE in 2025. As a result of the $95.7m ECIP funding received a couple years ago, I believe they are poised for large increases in EPS either through M&A or buybacks that will rerate the stock to reflect its underlying value. On top of that, there are also potential catalysts such as a stock exchange uplifting or more communication with the investment community to increase investor awareness in the stock.

I believe CZBS should trade at 11x - 13x 2025 earnings, offering a potential upside of 53% - 102% or 1x - 1.48x 2025 TBV offering upside of 61% - 140% with limited downside. These upside projections don’t take into account any potential M&A or stock buybacks to increase earnings even more.

Business overview

Citizens Bancshares Corporation (CZBS) is the bank holding company for its subsidiary bank Citizens Trust Bank. Citizens Trust Bank operates 5 branches in Atlanta, 1 in Birmingham, Alabama and 1 in Eutaw, Alabama. The bank operates as your standard bank: checking and savings accounts, home mortgages and business/auto/personal loans with a focus on commercial loans. The bank operates as a Minority Depository Institution (MDI) and is a member of the Community Development Institutions Fund (CDFI) which means it services low-income communities and neighbourhoods. Here is a picture of their branch locations:

Why this opportunity exists

• Low liquidity. The stock trades on the OTC pink sheets and the 30 day average volume is 1,552 shares. For total dollar value, it works out to under $100K a day and is tough to build a position for large funds. Not to mention insiders as of Dec. 31, 2023 owned just over 30% of the shares.

• No analysts. There are no analysts covering the bank and no projections on what the bank could earn in any year which provides an information vacuum.

• Limited company releases. The company, until last year, would release just the annual report with no quarterly press releases.

• Recent bank failures in the news. The bank failures from 2023 could be weighing on investors' minds. People were scared about any deposit over the FDIC $250K threshold in any institution that was not a large money center bank.

• Banks are black boxes, commodity businesses that are highly regulated and have inherent operating and financial leverage. Take your pick.

History

The bank was started in 1921 by Heman Perry, an African-American businessman, as a result of when he was denied a fitting for a pair of socks by a white business owner in Atlanta. Because of that experience, Perry and 4 other men then formed Citizens Trust Bank. Soon after the great depression, the bank was the first black-owned bank to become a part of the FDIC and the first black-owned bank to join the Federal Reserve Bank in 1948. 

CZBS went public in 1999 and has made a couple of acquisitions since being public: Mutual Federal Savings Bank in 2000, Citizens Federal Savings Bank in 2003 and Peoples Bank (a branch based in Lithonia) in 2009. They were profitable during the GFC and from the data I have seen the past 20 years at least.

ECIP

The main part of the thesis is the ECIP. The Emergency Capital Investment Program (ECIP) was established in the 2021 Consolidated Appropriations Act as a way of helping low-income areas that were impacted by the COVID pandemic. Treasury injects capital into the banks in the form of preferred stock with the banks then loaning this money out to small-businesses and consumers. This program has allowed the Treasury Department to provide up to $9B of funds to CDFIs and MDIs with Ctizens’ taking on $95.7m. Bill Ackman in an interview once talked about the single greatest liability to have as a form of financing: non-cumulative, perpetual preferred stock. Below are the key financing terms of this preferred stock from my understanding of the document:

• The dividend rate for the first 10 years cannot exceed 2% per year and is non-cumulative

• No dividends/interest on the preferred are payable in the first 24 months

• The preferred is perpetual

• Annual rate won’t exceed 1.25% if loans to low/moderate borrowers have exceeded 200%-400% of the capital received. If over 400%, won’t exceed 0.5%.

• The bank can buy back the preferred from Treasury under a right of first refusal based on the value determined by a third-party valuation.

• Treated as Tier 1 Capital

• If a bank wishes to participate in M&A, Treasury will transfer it’s preferred as long as the purchaser is another CDFI member or MDI. If not a CDFI or MDI, Treasury approval has to be given before the buy/sale can proceed.

This financing is perpetual, non-cumulative preferred stock. Which is exactly the type Bill Ackman described as the greatest liability to have. Why’s it great? Because if you miss a payment the amounts don’t add up over time and it can remain outstanding forever. If the par value is $100 once injected, I would imagine there would be a large discount to this face value as any rational investor will not purchase it for $100 for no potential dividend return and no ability to call it back. Recent transactions in this space would support that the preferred should be valued at a significant discount. 

Bank First Capital Corporation (who received $175m ECIP) purchased Mechanics Bank Holding Company (who also received $43.5m ECIP) on January 1, 2023. When you make any type of acquisition you are required to adjust the acquiree’s balance sheet to fair market value. If you go to page 59 of Bank First’s annual report you will see the following:

They valued the ECIP preferred that Mechanics received at $9.2m for 21% of face value or a discount of 79%. Using that same discount for CZBS would result in the preferred having a true value of only $20.1m. This would mean that Treasury essentially gave CZBS $75.6m of free money (95.7 - 20.1).

Treasury also put out a release this fall that details ECIP disposition guidelines. Any bank who received ECIP funding can repurchase it back from treasury if certain lending or dividend repayment thresholds were met. Based on the formula given, CZBS could buy back the preferred stock from 7-29 cents on the dollar, depending on what dividend rate they will pay out.

There has also been a ton of M&A in the space over the past two years from banks that have received ECIP. Merchants and Marine Bancorp received $50m and went out and bought Mississippi River bank (who didn’t get any funds). Guarantee Capital Corporation got $184m and went and bought Lafayette Bancorp. who got $31m of ECIP. Both of these corporations are private so there haven’t been disclosures on how their ECIP was valued in the merger. I reached out to the firm advising to determine how the ECIP was valued on the transaction but have yet to receive a response. Capital Bancorp Inc. got $37.5m and bought Integrated Financial Holdings (who didn’t receive funding) for about $66.5m. And Southern Bancorp. got $250m in funding and is looking to buy other banks as discussed in this article here. The point is this creates a catalyst rich environment for banks who have received ECIP funding.

If you want to read more about the terms, you can click here and go to page 898. And here is a list of banks that received ECIP funds with the totals.

Deposits

CZBS has a strong deposit franchise as can be seen in the image below:

With non-interest bearing deposits making up 44% and core deposits of 86%, it allows CZBS to have an extremely low cost of deposits of 0.36% in 2023 and a 4 year average of 0.2%. This will most likely go up as rates have gone up over this period as there is usually a lag from when rates increase to when interest bearing deposits expire to be renewed at higher rates. But according to the FDIC’s Q3 2024 banking report, the cost of deposits for banks with $100m - $1B had a cost of 2.16%, which is significantly more than where CZBS deposit costs were. Even in 2022 and 2023, the FDIC report had the cost of deposits for CZBS’ competitors in the same dollar asset at 0.39% and 1.42%, respectively, which CZBS clearly beats. It also helps that a small portion of the deposits are time deposits which have gone down as a percentage of overall deposits over the past few years.

Core deposits have gone from 79% in 2020 to 86% in 2023 which is a good sign. These core deposits represent a stable source of funding and shouldn’t flee when there is turbulence in the markets. Further to this point, the bank only has one relationship that totals 5.9% of all deposits.

Going over their deposit market share, in Eutaw, Alabama, there are only two banks that operate. CZBS has 16% deposit market share and Merchant and Farmers Bank of Greene County has the remaining 84%.  There has been no growth in market share for either company when compared to 5 years ago in 2019. Even if you were to go back 10 years there have been no real gains in market share or any departures or entries from other banks over the past 10 years.

CBZS' only branch in Birmingham has 0.2% deposit market share which is more expected as you move into the larger cities. Regions Bank, PNC Bank, ServisFirst and Wells Fargo make up the large majority of market share there. The 5 CZBS branches in Atlanta and the surrounding areas have the same market share, at roughly 0.24%. Deposits have fluctuated a bit over the past few years but have been range bound between $500m-$600m and sit at $576m as of Q3 2024’s press release.

Securities

CZBS classifies their entire securities portfolio as available for sale (AFS). There are no HTM or trading securities. Because their entire security portfolio is held as AFS, any unrealized gains or losses flows through the equity statement as accumulated other comprehensive income. The securities portfolio is $199m with just over half of that consisting of MBS and the rest agencies, treasuries and municipals.

Of the portfolio that isn’t in MBS, about 20% of it will have gotten repriced in 2024 with roughly another 20% repriced in the next few years. It is key for a bank’s securities portfolio to not only make up one type of security, but to have different durations of the securities that they hold. This lessens the bet on interest rate movements because if a bank purchases all of their securities at just one rate, it could take on potential unrealized losses should rates move against you (see Silicon Valley Bank) and lead to needing to raise financing. There is a total 16m unrealized loss in the securities portfolio as a result of the large increases in rates the past few years. But when you compare that to 176m of equity capital at the bank subsidiary, it does not seem like anything to worry about, especially since these will be most likely held until maturity.

The yield on the security portfolio is obviously not great in 2023 and 2022 at 2.8% and 1.78%. This should have gone up a bit in 2024 with rates up.

Loans

A large portion of CBZS loan portfolio is commercial loans in the Atlanta and Birmingham areas. These are more risky than plain vanilla residential mortgage loans but come with higher yields. They make up 71% of the total loan portfolio. This also comes with some upside as focusing on the commercial aspect really allows the bank to develop strong relationships as can be seen with the amount of core deposits.

As a barometer for the end markets that CZBS operates in, here are some demographics of the two main cities. Birmingham has a population of 201,068  with an average income of $70,418 and average home value of $283,377.  Followed by Atlanta and surrounding metro area of a population of 6,399,274 with Atlanta one of the top 15 fastest growing MSAs in the US and having 14 of the Fortune 500 companies residing there, which ranks as the 4th highest city with Fortune 500 companies. The average income is $123,829 with an average home value of $445,077. Atlanta’s population has increased from 2020 to 2023 by 3%.  The unemployment rate in Atlanta is 3.9%. 

The yield on the loan portfolio in 2023 was 6%, up from the prior years as rates have gone up.

While we don’t know the loan yields in 2024, the company has provided the total number of loans outstanding at Q3, 2024 to be $417m.

The quality of the loans is something to keep an eye on as the NPL ratio (non-performing loans over 90 days to gross loans) has gone from 0.36% in 2022 to 2.04% as of Dec. 31, 2023. The loan loss reserve ratio (which is the allowance for loan losses as a % of total loans) has gone from 0.88% to 2%. CZBS is currently adequately reserved for the amount of their non-performing loans with a reserve coverage ratio of 98%. If non-performing loans increase when the numbers from 2024 are released, they may need to reserve a bit more, decreasing future earnings.

Capital & Liquidity

As of the most recent Q3 2024 press release, CZBS has a robust capital position with a Tier 1 capital ratio of 40% and a CET1 of 15%. This provides the bank with a large equity cushion should there be volatility in the banking sector or their end markets that causes losses.

CZBS’ liquidity should be the envy of every bank. On Dec. 31, 2023, they had access to cash of $142m and could sell their security portfolio for $199m (assuming no security portfolio growth since then) for combined liquidity of $341m. This would fund 59% of their current deposit base, if there was a potential run. Not to mention that the bank has a $138.2m remaining availability LOC from the FHLB and $92.2m borrowing availability from the Fed discount window. Taking these borrowings into account as well, this would fund 99% of the deposits. Not sure many banks are able to say they can fund almost all of their potential deposit withdrawals like that.

Management/Board/Shareholders

CZBS is led by CEO Cynthia Day who became CEO in 2012 and has been with the bank since 2003. When she took over as CEO the stock was roughly $4/share and she has delivered a 22% CAGR price performance since. A lot of that has come from the most recent few years. She owns 3.25% of the bank and also sits on the board of Aaron’s Inc. and Primerica. Ray Robinson has been the chairman of the board since 2003. He owns 0.76% of the company which is a little low for being on the board for over 20 years but it almost represents 1% of the company. The Herman Russell Estate and several of his children own roughly 24% of the company combined. Herman Russell was an entrepreneur and big in the Atlanta real estate space and bought a stake in the bank a few decades ago. The CFO Samuel Cox owns 2.81%

Overall there is good skin in the game from top insiders and the board. They control a combined 31% of the company and there are also other board members that own 0.5%-3% stakes.

Management has done a good job of receiving a bunch of low cost capital at once and not immediately just loaning it out or spending it on acquisitions. It shows that they are thoughtful and have a good culture in place which is extremely important for a bank.

Financials

CZBS, as of the most recent quarter, had an efficiency ratio of 50%, NIM of 4.81% and net income of $911K. There isn’t a ton of disclosure in the earnings releases. The last 9 months CZBS has earned $8.4m with results of Q4 2024 not yet reported and EPS has gone from 4.5/share in 2022 to 6.1/share in 2023. From a free cash flow perspective, in 2023 the company did $16.2m (NI + deprec. + loss provisions - capex) which works out to $8/share. Removing loss provisions from the equation, free cash flow per share was $6.4/share. 

The bank operated as a mediocre bank at best the past few years earning low ROE averages of 7% and ROA of 1%, which is decent but not great. Recently, the bank has seen earnings inflect as a result of the ECIP funding from Treasury as well as +$20m of other low cost preferred stock from big money banks that came in the past couple of years. Book value per share was just under $30/share as of Dec. 31, 2023 but that is not accounting for if the preferred is marked at fair value (see valuation section below).

Management has been buying back stock the past few years rather aggressively. They’ve reduced share count by 12% just from 2022 with more shares to most likely be repurchased in the future. Every share repurchase below intrinsic value is extremely accretive to the remaining shareholders.

Valuation

The great thing with all of the acquisitions in the banking sector is that the public companies have to release merger proxies and do shareholder presentations outlining multiples paid for similar banks which means you can see relevant bank comps. I mentioned earlier that Capital Bancorp Inc. bought Integrated Financial Holdings in 2024 and we can see in their shareholder presentation and merger proxy relevant comps for CZBS. Relevant bank comparables who have between $200m and $800m in assets on average trade at 0.89x TBV and 7.3x LTM earnings. However, higher quality comps are at 1.00x TBV and 10x earnings. If you look at the recent transactions page for similar banks, the median banks are bought for 1.48x TBV, 14 times earnings and 5.5x core deposit premiums. I would argue CZBS is now an above average bank based on profitability, ROE’s (when adjusting for FMV of preferred), ROA’s and their efficiency ratio and should trade in line with at least the median recent transaction comps. So what is CZBS worth? Based on earnings, tangible book and core deposit premiums, a whole lot more than where they trade today.

Earnings Multiple

Below are my earnings projections for 2025. It is extremely conservative in my opinion and doesn’t take into consideration any potential merger or share buybacks. The returns would increase should any of those two occur.

In a base case it should trade up 61% and a more bullish 111% if given an appropriate multiple, while downside is protected in a bear scenario. On a base case today it is trading at 7x 2025 earnings.

Tangible Book Value

Looking at TBVs, I believe the investment is strongly protected to the downside. The low range of using adjusted tangible book value when marking the preferred to fair market value is 49% upside while on the higher end projecting out to 2025 gives upside of 140%.

Core Deposits Premium

Using a core deposit premium approach and a standard 10% premium while keeping shares outstanding the same, the value is $105. Just more than a double using today's numbers.

All three methods show the asymmetry in the stock price today compared to where it should be trading.

Catalysts

Buybacks - Buying back shares below intrinsic value from where the bank should trade and is worth is extremely accretive and a good use of capital.

M&A - Purchasing another bank to drive increased earnings growth will force the market to eventually value the bank to fair value. 

Share uplisting - Relisting the shares from the pink sheets onto a recognizable exchange would allow for greater share volume and price discovery to occur. It would also reduce the restrictions placed on the company when investors are looking to purchase CBZS on the pink sheets.

Increased dividends - Any increase in return of capital should increase the stock price, provided it's a smart use of the capital.
Using excess liquidity to fund more loan growth and expand - This would potentially increase earnings if loaned conservatively.

Retiring the ECIP preferred below par - Crystallizing the gain on the money received would see dramatically improved tangible book values in the financials as well as ROE/ROA visibility. 

Risks/Bear Thesis
Recession could cause losses on loans.  - This is true for any bank and we can take solace from the fact that CZBS was profitable during the GFC and has been for years. Although they are bigger now with more loans, they are currently adequately provisioned. Atlanta is also growing its population and has a great demographic in terms of jobs and unemployment rates which support future real estate price increases. If we take their current loans of 459m and assume 10% have problems with 30% loss of principal, this would mean a $14m loss. Based on the current projected earnings power in 2025 of $18.8m, the company would still clear a few million in profit. Not to mention the current equity position of $176m.

Large increases/decreases in rates could shock the bank - CZBS has withstood a large shock already. The Fed raised rates in 2022 from zero to 5% in 17 months. CZBS remained and remains profitable. Their security portfolio has proper duration less the MBS portion and the portfolio only took a hit of $16m in 2023 and that loss should be reduced some by the current decreases in rates. 

Run on the bank or banks - While the odds are extremely low, CZBS is EXTREMELY liquid and would be able to fund almost all withdrawals if there was a run.

Continues to languish in the pink sheets. - While possible, CZBS management and board seem to be shareholder friendly with large stakes in the company so I trust they will do what is right for all shareholders if it means uplisting or not. Your downside is well protected in this case anyways.

Recent earnings inflection is not sustainable. - They received extremely low cost of capital at a fixed rate for as long as they want. This new injection is what will and continue to allow them to increase their earnings. Even if it is all put into treasuries yielding greater than 2%.

Management destroys value by buying a bank. - While any investment carries the risk of management doing something foolish with a bunch of cash, CZBS has made a couple of acquisitions before in its history. Insiders also have skin in the game which means the alignment with outside shareholders is there.

The stocks have already run up a ton, the trade is over. - While true they have run up a bunch, it doesn’t mean they are not undervalued today and looking forward. CZBS has yet to deploy the capital they received in a large manner. Based on my analysis, the bank still remains undervalued today.

Conclusion

Purchasing CBZS today provides an opportunity to buy a bank that is overcapitalized and undervalued, with a strong management team that has many options to significantly increase shareholder value. If it were to trade at recent comparable transactions of 10x - 13x earnings the upside would be 53% - 102% and on similar TBV multiples of 1x - 1.48x upside would be 49% - 140%.

Highlights from Reading Trinity Bank’s CEO Letters

I was scrolling twitter and came across a tweet by Turtle Bay (who might be one of my favourite accounts on twitter) who had a link to shareholder letters from Trinity Bank. I clicked the link and have been hooked, as I have read them all this past week. I thought I’d share some interesting things from the letters. I have been looking at a potential investment in a bank recently and these letters helped explain some of the inter-workings.

Trinity was founded in 2003 by Jeff Harp. They raised about $11m from shareholders and have been growing ever since. What’s amazing about Trinity is that they didn’t have one bad loan through the 07-08 crisis. Not until 2010 did they have their first problem loan of $1.78m. Their underwriting was so good that their accountants told them that they didn’t have to provision for loan losses for a period of time. Their first actual loss/charge off was in August 2012, almost 10 years after founding the bank. They focus more on commercial and industrial loans and don’t take on transactional deposits but want to develop relationships with their customers. Today they have a $300m loan book and $429m deposits. You can read the letters here at this link which I highly recommend.

First, from there 2008 Q1 press release:

$51m loans into the crisis and not a single nonperforming loan. That is remarkable based on the number of loans that went bad during this period.

From Q1 2012 shareholder letter:

Here is the CEO doing an acquisition analysis of other banks based on their current loan books. His reasoning for not purchasing another bank that he was pitched by an investment banker is is 1) He doesn’t want to go outside the banks circle of competence or core focus area of commercial and industrial vs non-owner occupied real estate lending and 2) For less costs, he can just hire 2-3 lenders to develop their own book and not have to pay millions of dollars above book value for loans he doesn’t really want. Both of these reasons seem extremely simple and logical but a lot of CEOs are willing to do M&A to empire build without thinking through the actual ramifications of acquisitions.

From the Q1 2014 letter:
The CEO talks about what a bank’s performance boils down to: 1) Volume, 2) Margin, 3) Asset Quality and 4) Efficiency.

 The volume of loans is key to a bank as that is where they get their highest return, followed by security investments and then short-term investments.

 Margin is vital for assessing a banks performance (the net interest margin) because it measures the rate the bank is earning on its money less the difference it is paying to hold the deposits. Obviously asset quality is important because if the loans are bad, the bank won’t exist for long. The problem with banks is that you won’t know the loans are bad for a few years. The efficiency ratio measures how well the bank is at managing its costs.

Near the end of this letter the CEO also talks about what can go wrong in banking: having problem loans or a rapid rise in interest rates (very prescient to Spring 2023 that caught some banks off guard).

From Q2 2014 Letter:

Here the CEO lays out the bank’s securities portfolio analysis and goes over what a bank usually buys in this portfolio. It can consist of US Treasuries, Federal agency securities, corporate bonds or tax-exempt securities. These are ordered from least to most risky.

From Q2 2015 letter:

 In this letter the CEO goes over an M&A analysis of why he doesn’t think it’s a good idea to sell the bank. Banks can be valued on a book value basis, earnings basis, or percentage of assets basis. There is no real perfect answer but he prefers percentage of assets and explains why as well as using precedent transactions to determine the value of Trinity.

From Q2 2019 letter:

 This letter explains why it is hard to make money in a flat yield curve environment. If you are paying depositors 3% and the 5 and 10-year is sitting at roughly 3%, it is hard to loan that money out on a long term-basis because you’re going to be loaning at roughly 3% as well. You won’t make any money and will probably break-even or lose a bit of money.

From Q1 2022 letter:

Explains how their bank mitigates interest rate risk. If a customer enters into a long-dated loan, Trinity puts interest-rate adjustment clauses into the loan so as not to have a negative carry on their loan book. For example, if Trinity loans out a 10-year loan at 2% and their cost of deposits are 1% and assume in 5 years that rates are now sitting at 4%. If they don’t enter into those rate adjustment loans, they will be receiving income at 2% but paying interest at 4% which is not sustainable. But by entering the rate adjustments, this 2% long term rate will adjust up in a few years so as to not sit below the rate that they are paying depositors.

The key thing here is that they are not betting on where interest rates will go but preparing for if they move in an adverse way.

From Q3 2022 Letter:

 Determining a banks liquidity is adding the amount of “overnight money” held at the federal reserve bank plus the marked-to-market of the securities portfolio. You can then compare this amount to the total deposits a bank has to determine how quick the bank could meet potential deposit withdrawals in a crisis. You could also add any LOCs the bank has from other banks as well.

One of the reasons they stay away from investor or speculative lending (NOORE – Non-Owner-Occupied Real Estate loans) is because the repayment of the loans relies on rental rates and occupancy levels. When rates rise rapidly, the interest cost obviously increases rapidly but the rent/lease income from those properties won’t be able to increase as fast. This leaves the owner of the property potentially burning money each month as financing costs are now greater than the income and the loan could turn non-performing. We are currently potentially seeing this at Bancorp Inc’s loan book.

From Q3 2023 Letter:

Managing a banks interest rate risk is the one of the most important aspects of banking. Trinity manages this risk by not only stress testing their loan book but by also having 49% of the loans floating rate and 51% fixed, pretty much 50/50. And the fixed portion has rate adjustments every 3-5 years as seen from the Q1 2022 letter. This allows them to keep their income on par with where rates move in a cycle and not to be stuck at a certain rate.

In terms of the nature of their deposits, this is a source of their competitive advantage. They don’t take fast money by offering higher rates for deposits. They want to develop the relationship with each customer so they have access to all of the customers accounts.

If a bank doesn’t have that type of relationship with the customer and needs deposits, they can just offer a higher rate, borrow from the FHLB or purchase brokered deposits. Since Trinity doesn’t have to do that but relies on the relationship, 98% of their total deposits are “core” deposits, which is exceptional.

Some ways they explain on how to improve banking services and other tidbits in the letters:

• Instead of charging overdraft fees right away, call the customer to let them know that their bank is in overdraft. And give them several overdrafts free each year. However, no one should abuse the service.

• “No voicemail unless customer asks for it. During banking hours, someone must answer the phone.”

• When a mistake is made on the account, usually have to call a toll-free number. Jeff gave his direct line out to customers for them to call him to fix the mistake and make sure it is not systemic.

• Focus on growth, profitability and quality rather than just focusing on growth.

• The key is not having problem loans but how much of your money you get back when you have one (a problem loan).

• Of the banks that perform poorly or are closed by the regulators, 99% of them do so because of bad loans. The other 1% is usually some kind of fraud or liquidity issue (In later years he says 95% and 5% but you get the picture).

Reading these letters leaves you feeling like you have an MBA in banking. I am hoping to increase my banking knowledge this year and am looking to read all of Jamie Dimon’s, Robert Wilmer’s, Richard Davis’, and Frost Bank shareholder letters. If anyone has any other recommendations please let me know. Hopefully I’ll get a few banking books in as well.