Value Investors, Value Collectors

I’ll be in Omaha May 5-7 for the Berkshire Hathaway shareholders’ meeting and the Markel brunch. I have a busy schedule, but it would be great to meet up with any readers who will be in attendance. E-mail me at dave.waters@alluvialcapital.com.

In my five years of writing on OTCAdventures, I have had the pleasure of interacting with hundreds of investors in micro-cap stocks and other market niches. I have found that people have different motivations for investing in these companies. Some simply want to make a lot of money. Others get a measure of pride and satisfaction out of owning things that few others do and discovering new treasures to add to their hoard. These I’ll dub “Collectors.” Collectors desire a good return, but delight in businesses that are unique in some way, or have some historical cachet.

I am one of these. I derive a great deal of satisfaction from owning the truly rare and unusual. Century-old community banks, the leftover husks of former corporate dynasties, industry pioneers now occupying some sleepy niche. Problem is, many of these “Collector Edition” securities are simply not good investments. Either the economics of the business are too challenging or management is out-matched or self-serving. Consequently, these are not often securities I buy for Alluvial’s clients and partners. But personally, I really enjoy owning stocks  like Ohio Art Company, which until recently was the owner of Etch-a-Sketch. Or St. John Knits, the venerable designer of  apparel for wealthy and powerful women.

One of these unusual companies I have never seen being discussed anywhere is Massachusetts Business Development Corp. I have been a shareholder for several years. “MBDC” is a strange quasi-governmental organization dedicated to providing business financing and venture capital in the New England region. MBDC is not government-owned, but it is very much government-supported via various lending and tax incentive programs. Founded in 1953, the company is the nation’s oldest Business Development Company. Over the course of its existence, MBDC has invested over $1 billion in small companies and startups, creating untold wealth for the economies of Massachusetts and the neighboring states. MBDC invests directly in companies, providing the full spectrum of financing from senior and mezzanine debt to working capital factoring or equity. MBDC also manages a handful of investment funds and invests in these funds.

MBDC operates as a sort of co-op. While shareholders are the nominal owners of the company, the true power rests with the company’s members, a large group of New England banks and insurers who provide the company with capital to deploy. There are 165,382 MBDC common shares outstanding, each with one vote. But, members receive 1 vote for every $1,000 of capital loaned to MBDC. There is presently $56 million in capital loaned to MBDC by members, resulting in 56,000 votes for those members. Shareholders are simply along for the ride.

The company is consistently profitable and does pay a small dividend. But one might expect that with the company’s economic growth mandate, it is not a profit maximizer. One would be correct. MBDC’s three year average return on equity is around 6%. At year-end, Massachusetts Business Development Corp.’s balance sheet reached $77 million, up from $67 million in 2014. The company has been focused on deploying more capital in support of economic growth in its service region. Book equity is currently $10.3 million, which makes the company appear highly leveraged. But remember that nearly all of MBDC’s financing is provided by member banks and insurers, at a very low cost. At year-end, the company’s cost of debt was just 1.4%, and the company had borrowing capacity of an additional $163 million. MBDC does experience loan losses typical for an investor in venture-stage and small enterprises, but these losses are easily surpassed by the loan fee income and investment management income the company generates.

Liquidity is extremely poor for MBDC shares, and the bid/ask spread frequently suggests no reasonable two-way market exists. At the most recent trade of $28, MBDC trades at a price to book ratio of 45% and a P/E of 8.2. I am not suggesting this is cheap. Remember that shareholders have effectively zero control over the company and should not expect any sort of meaningful dividend, share repurchases, a buyout or other value catalyzing event. I expect that MBDC will go about executing its mandate, not seeking to enrich a tiny number of voiceless shareholders. The only way I can foresee shareholders doing very well is if the business is for some reason placed into run-off and eventually liquidated. How could that happen? I suppose that like the controversy over the federally-chartered Export-Import Bank, conservative politicians could seek to nix MBDC in the name of opposing “crony capitalism.” But frankly, that’s pretty unlikely in New England. It’s much more likely that MBDC continues to operate for decades, and remains nothing more than a little oddity in my portfolio. And that is fine with me.

I personally own shares of Massachusetts Business Development Corp. I may buy or sell shares of MBDC at any time.

First National of Nebraska – FINN

I have long held that a prime hunting ground for value is in very high-priced stocks, especially those that are unlisted or trade in foreign markets. For whatever reason, investor appetite for shares really falls off once the price eclipses $1,000, especially for illiquid stocks. I suspect the wide bid/ask that often accompanies these shares is also a contributor. Those willing and able to purchase these high-priced shares may walk away with a bargain.

A textbook example of this phenomenon is First National of Nebraska, a large and well-run bank that nonetheless trades at a deep discount to the valuations its peers command.

Since this blog focuses on micro-cap stocks, one might assume that I mean “large” in a relative sense, as in a balance sheet of one billion dollars or so. But First National is a truly large bank holding company, with a balance sheet of $19 billion. Fewer than 50 other public US banks are larger. But you’ll never hear about First National of Nebraska’s shares on CNBC, because they have an eye-popping price tag of $7,500. A typical day’s trading volume is in the single digits, so it’s not exactly easy to acquire a huge position.

First National is well-run in the sense that it consistently generates a return on assets in excess of 1.0%, and a return on equity of 10-11%. The company maintains a strong capital position with common equity to total assets of >10%, a much lower leverage ratio than the company employed before the crisis. Speaking of the crisis, First National never had one. Profits suffered in 2008 and 2009, but the bank never recorded an annual loss. The recession was only a temporary setback in the bank’s continued expansion.

First National has 101 branches in seven states. Please excuse the poor image quality of the graphic I borrowed from the company’s annual report I received last week.

According to Northpoint mortgage lenders, some banks focus on residential mortgages, others on commercial real estate, others on agricultural or development loans. First National of Nebraska has carved out a very profitable niche in credit card lending. Thousands of different businesses and non-profits offer their own branded credit cards to customers and members. First National is the entity actually making these revolving unsecured consumer loans. First National counts Best Western and Ducks Unlimited among its customers, and has a nearly $6 billion portfolio of credit card loans. Credit card loans are riskier than other types of lending, but the bank has large reserves against expected loan losses and has proven itself a responsible lender in the sector. Credit card loans make up 43% of First National’s loan book. Commercial loans, real estate and otherwise, make up 29%. Agricultural loans are 11%, residential real estate 10%, and “other” 7%.

First National has a long history of steady if not spectacular growth. Since 1997, the bank’s balance sheet expanded at an annual rate of 4.3%. Loans grew at the same pace, while deposits expanded at 4.7% annually. Profits grew at a 5.4% rate. Profit growth on a per share basis has been higher recently, growing at 8% since 2012.

Despite its healthy balance sheet, good profitability and attractive niche business, First National of Nebraska trades at a large discount to other banks of similar size and quality. I generated a list of publicly-traded banks with $10-30 billion balance sheets and a five year average return on equity of at least 8%. I may have missed a few peers, but this exercise is to prove a point, not create academic-quality data.

The entire peer group trades at an average price-to-book ratio of 1.8 and a P/E ratio of 19.8. First National’s closest competitors in terms of average historical ROE trade slightly higher, at a P/BV of 1.9 and a P/E of 20.5. Whichever set of banks we look at, First National of Nebraska is far cheaper at just 1.1x book value and a P/E of 10.4.

Perhaps some of this discount is justifiable. First National may carry more risk than other banks in its size range because of its exposure to credit card and agricultural loans. Credit card loans are uncollateralized and agricultural is highly cyclical. And yet, First National of Nebraska remained profitable in the crisis when many traditional residential real estate lenders failed. Or, perhaps the market is concerned that First National may lose some of its credit card relationships. They did lose a large relationship in 2016. Maybe the market doesn’t believe that First National will benefit from rising rates the way its peers will.

However, I believe that nearly all of the valuation discount is due to First National of Nebraska’s lofty share price and minimal trading volume. This presents opportunity for long-term investors who care little about the day to day fluctuations and much about the long-term performance of the underlying business. Naively assuming the bank can earn its long-term return on equity of 11.0%, First National could earn almost $790 per share in 2017, for a forward P/E of 9.6. Of course, who knows what this year holds. A recession could arrive, or expected higher interests rates could fail to materialize. But I am sure that long-term holders of First National of Nebraska will be richly rewarded.

Alluvial Capital Management, LLC holds shares of First National of Nebraska, Inc. Alluvial may buy or sell shares of First National of Nebraska, Inc. at any time. 

Alluvial Capital Management, LLC may buy or sell securities mentioned on this blog for client accounts or for the accounts of principals. For a full accounting of Alluvial’s and Alluvial personnel’s holdings in any securities mentioned, contact Alluvial Capital Management, LLC at info@alluvialcapital.com.