I am happy to share another interview with you. This time with a seasoned investor and long-time investment writer Geoff Gannon. Geoff has been focused on value investing for the past 20 years. In that time, he wrote for different outlets as well as his own newsletters and his blog. He frequently ventured into the OTC land and most of the time focused on small-caps.
I hope you will enjoy the discussion, and if you have any questions that you feel were unanswered, do let me know, and I can send them to Geoff.
As a start, could you please share with us why you kept your focus on small/nano-caps for more than 13 years?
The main way I value a business is to imagine what the business will look like 5 years from now and then imagine what a private buyer would pay for 100% of that business. In normal times: I find more stocks among microcaps that meet this "private buyer" test than among big stocks. For example, I've found a decent business selling for less than net cash among stocks with market caps below $50 million but never above $1 billion.
I have bought big stocks, but almost always during a special situation, an industry downturn, or a stock market panic.
I don't really care about a stock's market cap, whether it is or isn't a special situation, etc. All I need is a stock where I think I can see 5 years into the future and know the stock's cheap today versus that future.
How would you describe your investment strategy, and what are the most important factors in it?
I need two things. One, a business I can have confidence in. And two, a low hurdle for that business to clear. Price is the hurdle it has to clear. I always go in thinking I'll own a stock for a minimum of 5 years even though I often sell before then. And then, I never want to buy anything where I don't think my return is going to be at least 10% a year. I don't think a lot about upside beyond that. I really just ask: "which stock is the one I'm most confident will manage to return 10% a year even if I was forced to hold it for the next 5 years."
Generally, this is a business with what I call "market power". It doesn't face a lot of price competition. Maybe it has a high customer retention rate. Maybe it dominates a niche. Warren Buffett would call what I'm looking for a "moat". So, the two factors I care most about are: 1) The business faces lower than normal competition and 2) I'm paying a lower-than-normal price for the business.
How do you form your 5-year 'future' outlook?
I don't project out macro things. I just expect them to be at their long-term trend and that it will take the full 5 years to get back to normal. So, for something like a bank, my assumption when the Fed Funds Rate was at 0.25% was that it would be at 3% in five years. A 3% Fed Funds Rate is at the low end of the historical norm. If you are in the middle of a bust in a cyclical industry right now, you'll probably be pretty close to a boom in 5 years. Frost (NYSE:CFR) makes energy loans. So, when I bought Frost, there was some concern as oil was at like $30 a barrel.
I assumed it'd be at $50 a barrel in 5 years. It got to $50 a barrel a lot faster. Actually, Frost is a good example of that because people were worried about two things - a very low Fed Funds Rate and a very low price per barrel of oil - that were both very out of line with the long-term historical trend and so were likely to correct over time.
I never assume any macro variable will get to normal faster than in 5 years, but I always assume it'll get back to normal. I don't take the risk that the price of oil will never rise, or the Fed Funds Rate will never rise seriously. When you're looking out 5 years, today's level isn't important. The average level of the last 50 to 100 years is what matters.
I do project out company-specific things. So, in the case of Frost, I'd project out that the bank would have maybe 33% more deposits in 5 years (about 5% to 6% annual deposit growth). With Tandy Leather (NASDAQ:TLF), I'd try to imagine how many new stores they might open per year. In fact, I passed on that stock personally when I realized they weren't having any success opening new stores. Without store growth, it's a less interesting stock.
But the question I ask is: "What will store count be in 5 years?" I don't really project out changes in the margins of anything. I try to focus on businesses and industries where margins don't move much. So, for BWX Technologies (NYSE:BWXT), I'd use the Navy's plan for taking carrier and submarine deliveries. For Omnicom (OTCQX:OMCM), I'd assume ad spending grows at least in line with inflation and maybe as fast as nominal GDP. I don't go any deeper than that usually.
Do you have projections that you repeat every time no matter which stock you are looking at?
No. Each case is unique.
How do you think about a stock that is trading above tangible book, and how do you treat the implied future cash flow expectations? Do you quantify cash flow in any way?
Well, if a stock is trading above tangible book value, it would need to have better returns on its tangible equity than the return you can expect in the stock market. So, let's say long-term stocks return maybe 8% to 10% on their market price - that means, you don't want to buy a stock at above book value unless you think it will return 11% a year on that book value.
How do you analyse a management team?
I don't talk to management. I read earnings call transcripts, interviews, etc. I can think of cases where I didn't invest in a stock because of management. But I can't think of any cases where I did invest because of management. It's not a topic I think much about.
Catalyst or valuation? Which one do you think is more important when it comes to an investment?
Valuation. I did once inadvertently buy a microcap with a catalyst. I started buying the stock around $5 a share only for the CEO to make an offer to take the company private at $6 a share. Some people were willing to sell out at an average of around $5.80 instead of holding till the deal went through. So, I bought up literally all the stock I could at that price. I wrote a couple letters to the board. The deal was eventually done at $8.50 a share. I'm sure I had nothing to do with the higher price. What got the board to that higher price was a low starting valuation. The initial going private offer was made at a price-to-book of 0.7 and a P/E of 6. That value was the real catalyst.
Who influenced your investing strategy the most, and what is your favourite book that left a significant 'mark' on you?
My favorite book is Joel Greenblatt's "You Can Be a Stock Market Genius".
I've certainly read as much as I could about Warren Buffett's career from the 1950s through the 1970s and Ben Graham's investments too. I have a copy of Graham's memoirs. I've tracked down contemporary newspaper articles discussing stocks he invested in. I have old Moody's Manuals from Graham's days and Buffett's early days. But I can't really say I'm sure they've influenced my investing strategy.
I started investing around age 14 before I ever heard of value investing. And, I thought mostly in the same terms I do today: what's a business I can understand, what will it look like in 5 years, is the price today cheap enough that I'm sure I can make 10% a year over those 5 years. So, I'd say I'm interested in Buffett and Graham, but I'm unsure how much of an influence I can trace back to them.
Did statistical investing ever appeal to you? Or were you always pure stock picker?
No. Statistical investing never appealed to me. I do screen for net-nets. I've done backtests myself, and I know that a pure microcap net-net strategy with just a minimum quality requirement (like you only buy stocks that have been profitable for a long time) would at least match my stock picking. There are mechanical strategies that could do 15% to 20% a year over the last 20 years. And, remember, the last 20 years were bad ones for the S&P 500. Basically, it's a net-net strategy. That's the one that works best nearly all the time in nearly all the world.
When I invested in Japan, I did it in a way I'd consider just statistical investing. I just said I'd buy every stock I came across that was trading for less than its net cash and had 10 straight years of profits. If a stock met those two criteria, I bought it. Once I had 40% to 50% of my portfolio in 5 of them, I stopped. But I never did any actual stock picking in Japan. And my Japanese net-nets worked out better than any other strategy I've ever used. Net-net investing works great. If investors want to do that without layering any human judgment on top of it, that's fine.
There's no way the S&P 500 is ever going to beat net-nets over a long stretch of years. So, net-net investing is a simple, statistical approach that ensures you'll beat the market. Not every year. It hasn't been good relative to the market for about the last 5 years. And it's maybe close to a wash versus the S&P 500 since this bull market started. But that's about as bad as it ever gets - you match the market in a long bull market. Not much of a risk. If you pretend the market doesn't exist and just do net-net investing for your whole career, you'll get a good result. So, I don't really see the point in any other kind of statistical investing. If you're not going to pick your own stocks, you should just buy net-nets.
If you had a book deal, what would the book be about?
The book would just be case studies. It would just be the story of an investment in a stock, what it looked like before I bought in, what it looked like when I sold it. So, you wouldn't talk about the idea of low price-to-book stocks, you write a chapter illustrating the purchase of a low price-to-book stock like the story of Bancinsurance I told where the majority owner and CEO wanted to take the company private and yet investors still made 40% more than his original offer in less than a year.
Instead of having a chapter about stock buybacks, you'd just analyse Warren Buffett's investment in the Washington Post, compared to other media companies of the time that did more acquisitions and fewer buybacks. The book would be all practical stuff, no theoretical stuff.
I'm always telling new investors to stop reading value investing books and start reading 10-Ks.
Is there any surprising source that you learned something about investing from?
Well, I invested in Village Supermarket when I was a teenager, because I worked at the company as a cashier. That's also why I invested in Coinstar. So, I got two good stock ideas from one summer job in high school. I made several times more money from those stock ideas than from my paychecks. It sounds silly to say that a high school job gives you the knowledge you need to invest. But, as a cashier, I had knowledge about customer behaviour regarding Coinstar that investors lacked.
It was obvious to me that people who used Coinstar machines saw that Coinstar receipt as found money, they would still use it if the commission was higher, and that having a Coinstar machine was a plus for the store too. As far as living near Village stores and working in one, I knew you couldn't open competing stores near them. Every investor comment I read in the late 1990s about Village mentioned the threat of Walmart (NYSE:WMT), Whole Foods, and online groceries.
I could see online groceries wouldn't take off at all. I could also see there was literally no place to site a large competing store nearby. You couldn't build a big enough parking lot. At peak times, the store I was working in had cars "circling" waiting for a spot to open.
On paper, investors assume it's always possible for competition to enter a market. They don't realize that without the ability to build a large parking lot, no supermarket can enter the local market.
What is the one thing you feel many value investors are missing out when investing or researching?
They don't think of the stock as a business. They know they're supposed to. But they really don't. They think of the stock as a stock. So, they don't use logic, common sense, etc. the way they would if looking at a local business they wanted to buy in its entirety. The question I always try to get people to answer is - let's say you're looking at a $30 million market cap company, "If you had control of a $100 million family fortune, would you put 30% of that into owning all of this business".
Like, I mentioned Village and Coinstar. I would have absolutely answered yes to that question. If all of Coinstar was for sale, I'd buy it. If all of Village was for sale, I'd buy it. Investors think a lot about everything else and not enough about that one thing that really matters. Basically, if a public company would work as something you'd buy all of - it'll work as a stock. You just have to have faith it'll somehow work as a stock.
The reverse - thinking that a business you wouldn't buy 100% of at today's price will work as a stock despite that - makes no sense. But because of sort of statistical thinking about what value investing is and also focusing on the catalyst and things like that, people drift into doing something other than just imagining the board is offering them 100% of this public company at today's market cap. That's always the fantasy you should be playing out in your head.
Well, I mentioned Activision because it's an example of how by doing a lot I got a worse result than if I'd done nothing. In 2001, I owned just one stock: Activision and I had a pile of cash. I would have been 16 at the time. Right after the markets opened following the September 11th attacks, I put all my cash in Activision. So, I had 100% of my net worth in one stock. Well, that one stock went on to compound at like 20% a year for the last 16-17 years now. Instead of holding on to Activision for all those years, I bought a lot of stocks and sold a lot of stocks. I did fine. But it was more work for less of a return. The main learning is something I say to people all the time.
The best way for you to invest is probably to spend all year thinking about which stock to buy. Then, you should buy just that one stock. And then, you should just forget you own it. So, in 2001, you buy Activision. In 2002, you buy a different stock with the money you save in 2002. But it's not really worth it to second-guess your original purchase and decide which stock to sell now to make room for your new idea. Always focus on coming up with another great idea. Think only about buying the right stock at the right price. Don't think about selling at all.
How did you invest during the financial crisis?
I sold everything I owned and bought the highest quality companies I could find. So, I loaded up on companies like Omnicom (NYSE:OMC) and IMS Health. I also bought Berkshire Hathaway (NYSE:BRK.A) for the first and almost certainly last time in my life.
Why certainly the last?
Like I said, I'll buy a stock when it's trading at less than two-thirds of my appraisal value. Berkshire is not a stock that's likely to do that in the future. Generally, stocks that are big and liquid and well-known aren't stocks that trade at big discounts to what they're clearly worth. So, I'd be amazed if I ever bought Berkshire Hathaway stock again. It's just unlikely to ever be cheap enough to interest me.
What is your experience with the OTC stocks? Do you have (or had) any favourite OTC stocks?
Well, I mentioned two already. George Risk (OTCPK:RSKIA) was the "decent business selling for less than net cash" I bought in 2010 and sold in 2017. I owned it for about six and a half years. It didn't beat the S&P 500 during that time. So, you could call it a failure. But it worked out exactly as I expected - I just didn't expect the market to go up so much too. I bought it below net cash. The company's after-tax return on its non-cash (that is, invested) capital was probably 30% a year normally. It doesn't grow. But it's extremely high quality for a net-net.
Bancinsurance was a stock I knew back when it was listed and then it had a scandal, got dropped by its auditor, de-listed, etc. So, it was an OTC stock when I actually bought it. I put over 20% of my portfolio in George Risk while I owned that. I had more than 40% of my portfolio in Bancinsurance.
You mentioned catalysts. I can think of a few OTC stocks with catalysts. But depending on when this interview is released, one or both of these may be out of date. The two that come to mind right now are Keweenaw Land Association (OTCPK:KEWL) where Jamie Mai of Cornwall Capital is trying to win 3 board seats thus giving him a majority of the board. It's a timber company that recently announced it has about 25% more actual timber on its land then its models predicted. There's also a chance someone starts building a mine on their land this year. The catalysts is a proxy battle that will be decided on April 12th I think.
The other catalyst situation that comes to mind is a now dark stock called Pendrell (OTCPK:PCOA). The CEO is Lee Mikles who ran FutureFuel, which was like a blank check company that acquired a chemical business. Here, he'll have to do the same thing: acquire something. Pendrell has cash. The stock is trading at about 90% of net cash. It also has patents. It was cash flow positive last year. But the other big asset is net operating loss carryforwards. The company carries the NOLs at zero dollars (which is the correct way to do it for GAAP, but misleading in terms of what'll really happen here). They'll eventually use the cash to buy something and pay no taxes for the next 7-14 years or so.
Note by Jan: All stocks are in the OTC database.
Did you have any losers in the OTC space?
Actually, I can't think of a single loser I've had in the OTC space. I have lost plenty of money on listed stocks. And I'm sure I've written about, talked about, etc. OTC stocks that didn't perform (I write about lots of stocks but only actually buy a very few). But, no, I can't think of any time I had an actual realized loss in an OTC stock. I may be forgetting something.
Was this tied to the nature of the OTC market or due to something else?
Stocks bounce around due to fear, greed, and boredom.
You can make a lot of money being greedy when others are fearful. But you can make at least as much money being bored when others refuse to be bored. There are a lot of boring stocks in the OTC market. They're not cheap because people are afraid of them. They're cheap because the people who own them are tired of them always being cheap.
So, you can buy things like George Risk and Opt Sciences (OTCPK:OPST) and such at net cash sometimes, because people are just tired of nothing happening with those stocks. There's no way to buy a listed stock at net cash when it's profitable. It just doesn't happen. It happens every year with OTC stocks. So, there are more sure bets among OTC stocks. And, I try to focus on the surest bets I can find. OTC stocks are interesting, because even the investors I know who focus on net-nets eventually sell stocks like George Risk for no reason other than they got tired of holding it, and it got a little more expensive over time.
Even I sold George Risk not out of fear but just because I had owned it for over 6 years and thought I might have another idea I liked better. I don't think you can find sure looking bets in listed stocks except during recessions, panics, down markets, etc. The prices I got on IMS Health in 2009 were as good as any prices I've gotten on an OTC stock, but it was 2009. There had been a financial panic, Obamacare was coming, etc. People were scared.
In listed stocks, you get bargains when people are scared. In OTC stocks, you get bargains when people are bored.
Have you ever encountered a particularly bad example(s) of corporate governance in the OTC space?
I've encountered bad corporate governance in stocks of all sizes. Among very, very small OTC stocks I've seen cases where management owns about 50% of the company and then also pays themselves a salary that sometimes approaches 50% of what net income would be before their salary. In their defence, the salary wouldn't be excessive for a professional manager at a large company. But it's big relative to the company's size, and it's in addition to their ownership in the company already.
Many of the best OTC stocks are controlled companies of some kind. Controlled companies are more likely to have unusual corporate governance - unusually good or unusually bad, depending on the management - when compared to non-controlled companies.
You ran a newsletter alongside Tobias Carlisle and Quan Hoang called Singular Diligence which was aimed at producing incredibly detailed reports. What did you learn from working on this newsletter?
Writing the newsletter was the most fun I ever had doing investment writing. Each month, I just wrote about 10,000 words on some stock that Quan, and I had talked about in great depth. For 30 days, I got to focus on just one stock. It was the closest I've come to doing investing writing that really just replicates what I do in my own investing.
From an investing perspective, the lesson is you can't have 12 good ideas a year. I knew that going in. I actually only bought 4 of the 26 or so stocks we wrote up for myself. And only 2 of those worked out. It just reinforced for me that you should aim for one good idea a year. That's all an investor needs.
What do you think of market efficiency? Do you believe it has decreased or increased over the time you have been investing?
There's no difference in market efficiency from the time I started investing in the late 1990s until today. Prices are generally higher. And, companies that would otherwise be attractive - especially small stocks - often go private.
But that's really an issue of competition from private equity for the stocks I like rather than competition from other minority investors. There's no difference in market efficiency day to day. But there's more competition from private equity.
Great insight Geoff, I really appreciate you taking the time to do this interview.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.