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  • The Emperor Is Naked!

    Not a week goes by that we don't see a few articles on investment sites and stories on CNBC and Nightly Business Report where some well-known financial figure is justifying why the markets are overvalued, undervalued, or just right. Invariably, most of the justifications have some basis in corporate earnings and PE vs. historical levels of earnings and PE.

    The problem with these expert arguments is that they all tie back to EPS - company-reported EPS. This begs the question, what is "EPS"? We see two prevalent definitions of EPS these days:

    1. GAAP EPS - this is EPS based on "Generally Accepted Accounting Principles". If you read any company's income statement, this is what the bottom line EPS is.

    2. non-GAAP/adjusted/pro forma EPS and EBITDA - these are what we call "Whatever the company would really like their reported-EPS to be at this time". The company will start with the bottom line GAAP EPS, then add back common expenses that they prefer not to include - thereby giving the ability to boost their reported earnings. In discussing non-GAAP EPS in his book Financial Shenanigans, Howard Schilit provides the following:

    SEC Not Amused by Pro Forma Chicanery

    The SEC has taken note of these schemes. In a March 2001 speech, the agency's chief accountant, Lynn Turner, attacked company disclosures that appeared to "turn straw into gold." He described how the fixation on corporate profits has led companies to move from reporting EPS (earnings per share) to creating the turbo-charged pro forma EBS - Everything but the Bad Stuff.

    The company and analyst justification for reporting non-GAAP EPS is basically "these are one-time non-recurring expenses and don't give a true picture of the business operationally". Only problem is that these expenses occur every quarter and are in fact on-going/common/expected expenses that are part of the operations.

    Where we run into more problems is that historically, companies did not widely report non-GAAP EPS - EPS meant GAAP EPS. It really was not until Internet Bubble (IB) 1.0 that the use of non-GAAP measures began to infiltrate Wall St. and the financial markets. We all know that valuations donned on most internet stocks of the period were bogus, and the use of non-GAAP measures provided a means to inflate many and have some justification. Though we have gone through the purging of IB 1.0, and the sock puppet has died, non-GAAP EPS has not only lived on, but it's thrived and is now the norm. When discussing EPS these days, it is almost a given that what is being discussed is non-GAAP/adjusted/pro forma EPS - AND THIS IS BAD!

    What is bad is that analysts and financial "experts" are now using this concocted EPS in arriving at the proper PE ratio. If you have a bogus EPS, certainly you therefore have a bogus PE. Our contention is that across all the equity markets, we are looking at phony PE ratios and in actuality they are significantly higher. As a result, most of the US equity market is currently wildly overvalued and indexes deserve to be significantly lower.

    One company we follow, that has consistently abused non-GAAP reporting is Speed Commerce ($SPDC). Take a moment to read through SPDC's recent earnings announcement - notice the liberal use of non-GAAP metrics everywhere with only a single, almost hidden reference to the GAAP EPS numbers. At the end of the earnings announcement, the company includes the boilerplate "Use of Non-GAAP Information" statement and they've washed the blood from their hands.

    To summarize:

    • Use of non-GAAP EPS is now more prevalent than ever
    • Importance of GAAP EPS is being trivialized by the investment community
    • Barometers and historical metrics used for determining company and market valuations are now ineffective because of the ubiquitous use of non-GAAP EPS
    • As the economic recovery is maturing, financial engineering is becoming more widespread to mask weakening corporate performance
    • At some point, we believe there is going to be "The Emperor has no Clothes" revelation and it will be followed by a massive "reset". When this happens, things are going to become very ugly for those companies that rely upon and emphasize the use of non-GAAP/adjusted/pro forma EPS reporting.
    Apr 12 1:42 PM | Link | Comment!
  • It's Time To Pull Back

    To cut right to the chase, we're recommending extreme caution investing for the remainder of 2015. We see many red flags in the US and world economies, and believe the level of froth in the US equity markets is pushing the indexes into bubble territory.

    Below are some of those red flags we see. We leave the thought and investigative process to the reader. Our belief is that each on its own requires caution. When taken together as a whole, it screams for extreme caution.

    1. The entire world is now following the US lead of economic stimulus, taking actions similar to the QE and bond buying the Fed has done over the past few years and is now ending.

    2. Most of the world also has a near-zero (or negative) interest rate policy attempting to drive domestic investment.

    3. The Fed will give an interest rate increase by the end of 2015. The amount and timing of it is really of little importance, just that it will happen and signal that further rate increases will be following.

    4. Oil will remain below $75 for an extended period, possibly years.

    5. Earnings quality is falling, being bolstered by share repurchases and a good deal of financial engineering.

    6. PEs are rising and there is not good justification for it.

    7. Volatility has been increasing and we've been seeing wild swings in the US indexes.

    8. Apple is now worth over $700 billion, is a holding of most mutual fund and professional investment portfolios, and has been added to the DJIA.

    9. We have concerns about continued/blind money flows into index mutual funds.

    The investor should read each of the above points and objectively consider what the implications are for the equity markets and individual companies he/she has invested in?

    Yesterday, our concerns continued to be bolstered as we read the following article:

    We've been trimming our portfolio over the past few weeks into market rallies because of our concerns. Our plan for the remainder of 2015 is to remain with a heavy cash bias while making select investments based on our approach of letting insider purchases guide us. We still see bargains in many small regional and community banks and believe the banking sector will be beneficiaries of the coming interest rate increases.

    In conclusion, we believe that it's time to trim your portfolio and build cash. It's not a call to exit the market and it's not yelling fire in a crowded theater. It's a recommendation for each investor to take a look around, consider the gains you've taken out of the market over the past 6 years (have you taken gains or are they all paper gains?), and be extremely cautious in the near to intermediate term.

    Mar 24 8:44 AM | Link | Comment!
  • Century Bancorp - 50% Undervalued

    Over the past year, we've become extremely bullish on smaller community and regional banks for a number of reasons. While the markets have rallied and provided excellent gains, shares of these banks have been left out. During this period where their valuations have stagnated, they have gotten to the point where many are now posting record profits - even in the current near zero interest rate environment. As most readers who follow us know, we are guided by insider purchasing patterns. This has served us well through the bull market, and continues to give us solid investments going forward.

    Century Bancorp ($CNBKA) is a small (based on market cap) family founded/operated regional bank based in Massachusetts. It operates 27 branches in the Greater Boston area. It is one of these banks mentioned above that is producing record earnings, yet finds its shares extremely undervalued at this time.

    I could go into all the details of the bank, its history, and operations, but that's simply minutiae that would bore most readers. If you're into that, the company's website provides all of that and more ( My objective is to simply make the case that the shares are extremely undervalued today, we see consistent insider purchasing of shares, and we have every reason to believe that the consistent, steady, measured growth shown historically will continue.

    1. Valuation

    a. Price/Earnings - today, having just posted FY2014 earnings of $3.93/share, at a share price of $39, the P/E is just a smidge under 10. Contrast this to what we see in most other regional banks with PE in the 13 to 15 range, and Century is well below that level.

    b. Price/Deposits - when we look at banks, P/D is a favorite ratio we like to look at. Deposits drive assets, and it provides a metric of how much bang you get for your buck. The more deposits a bank has, the more loans it can make, and the more earnings it can drive. With $2.87 billion in deposits and a market cap of about $217 million we have a P/D ratio of 0.076. To gain an understanding of just how out of line this is, most all of the banks on our radar in the community/regional sector have P/D ratios in the 0.10 to 0.20 range. We consider those below 0.13 to be undervalued, in the 0.13 to 0.16 range to reasonably valued, in the 0.17 to 0.19 range overvalued, and above 0.19 wildly overvalued. Now, there can always be logical reasons why the ratio would be above 0.19 and not be wildly overvalued - maybe strong earnings as a result of higher margin business the bank does, or paying an oversized dividend. Similarly, a very low P/D below 0.10 can indicate other issues - like low or deteriorating earnings. However, in general, the ratios and ranges we note have served us well. In the case of Century, we see no reasons for the extremely low P/D when taken in conjunction with the growth and record level of earnings.

    2. Earnings/Growth

    Century has posted diluted EPS just above $1.00/share the past two quarters. Being extremely conservative and only applying a 3% growth rate, we see 2015 EPS between $4.10 and $4.20/share - at the low end. For comparison, EPS growth from 2013 to 2014 was closer to 10% rising from $3.61 to $3.93. If we go back to the P/E of 13 to 15 for most similar banks, we get to a share price of $54 to $62 based on our conservative 3% growth.

    3. Tangible Book Value

    Century's TBV is $34.09 up from $31.27 a year earlier. We like seeing a share price close to TBV when we make a bank investment. Like our other metrics, it gives us a sense of the value. With community and regional banks, it serves as a safety net for the investor. Another of our metrics for value is what another bank would pay to acquire. In general, through 2014, we have seen buyouts take place in the range of 1.4 to 1.5 times TBV. So once again, Century shows to be a very good value with shares below $40.

    4. Efficiency Ratio

    For banks, the Efficiency Ratio is an important metric as it is a measure of how tight the banks cost structure is. The lower this ratio, the better as it shows lower cost (i.e. higher operating margins). Century currently has an efficiency ratio of 62%, which is very low and this is down from 63% a year earlier - which is also very low. If you compare with other bank efficiency ratios, you can see very quickly how well run Century is.

    5. Asset Quality

    Century has a very strong asset base. At December 31, 2014, non-performing assets totaled $4.6 million vs. $2.5 million a year earlier, while assets have grown to $3.6 billion from $3.4 billion.

    6. Interest rates

    In general, we like community and regional banks at this time because we know in the future interest rates will rise. Whether that happens at some time during 2015 may be up for debate, but we do not believe that we will continue to see rates near zero for eternity. Most economists are saying we are likely no more than 6 to 9 months away at most from the first rate increase. When interest rates rise, so too do earnings at banks - because their interest rate margin (spread) increases. The fact that these banks are turning in record earnings at this time, when interest rates are still near zero is a testament to how well they are performing.

    7. Insider ownership/purchasing

    Century has a dual class share structure, with 3.6 million Class A shares being publicly traded and 2 million Class B non-public shares which are likely primarily held by the family owners.

    James J. Filler is a 10% owner (of the Class A shares) with just under 400,000 shares. The filing for his most recent purchase of shares on March 4 is here:

    Mr. Filler has been steadily buying up Century shares, acquiring an additional 40,000 shares over the past 6 months. He is a director at ServisFirst Bancshares ($SFBS) and holds over 600,000 shares valued at over $20 million. The ServisFirst website indicates his career was in metals and recycling, and today he is just a private investor. Checking the residential address on the Form 4, Mr. Filler's 20,000 square foot mansion shows he's done quite well.


    Based on a number of metrics that we track for community/regional banks, Century is significantly undervalued at this time. The recent/frequent purchases by James Filler additionally raises our level of interest. Conservatively, based on conservative multiples, we believe shares would be appropriately valued at something closer to $60/share as opposed to the $39 they fetch today.

    Note, that there are only 3.6 million Class A shares outstanding, and 2.4 million in the float. On an average day, 2500 shares will trade and the bid/ask spread is generally between 25 and 50 cents. If you intend to purchase shares, be prepared to either wait a while (possibly days) to get your bid filled or pay a bit more and buy at the ask. Under no circumstances should a market order be placed - only limit orders should be used on both the buy side and the sell side.

    Mar 05 11:21 AM | Link | 16 Comments
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