My approach to stock picking rests on a simple premise: The market capitalization of any given stock never equals the intrinsic value of the business. In other words, all stocks are mispriced. Some are mispriced by a lot, some by a little, but all are mispriced.
This particular approach naturally leads to a dual imperative: (1) Avoid stocks where price > value; and (2) Look for stocks where value > price, and by a wide margin. It goes without saying: The more that intrinsic value exceeds the stock price, the better.
It doesn't follow, though, that after I've identified and bought a stock at a fraction of its intrinsic value, my analysis will be vindicated by an immediate spurt in the stock price. All too often, the opposite happens. In December, 2008, for example, I recommended CarMax (NYSE:KMX) at $7.44 in a column for TheStreet.com, saying it was worth $20 per share. I even included it in my Top Ten List for 2009, but shortly thereafter the stock dropped 27%, to $5.44 per share.
The 27% downdraft in CarMax stock illustrates just how important your conviction level is as to intrinsic value. If you're shaky at all, such a decline is likely to get you to sell the stock. On the other hand, if you're highly confident in your valuation work, a 27% decline should make you downright giddy. Coincident with a decline in the stock to $5.44, the risk of owning CarMax declined. That's because the spread between price and intrinsic value ($20) was much wider with the stock at $5.44. Note that what I paid for the stock is irrelevant in this regard. When assessing risk, the variables that matter are the current price and your calculation of value.
In terms of prospective reward, if you liked owning CarMax at $7.44 with a $20 intrinsic value, you had to love it at $5.44. Of course, it's easier said than done. I've witnessed skilled stock-pickers - those who thoroughly understand price versus value - suddenly change mentality after they buy a stock. Before they invest, they get it: CarMax, at $7.44, is temporarily trading well below intrinsic value.
But once they have their hard-earned capital in the game and they have to endure wild price swings, they begin to doubt their analytical work. Other issues swell in importance: the threat of a double-dip recession, lingering issues in real estate, problems in Europe, etc. Rather than keep it simple - by focusing solely on price versus value - their thinking gets sidetracked and they end up making poor decisions.
It points to just how important your conviction level really is. If you're not highly confident in your valuation analysis, you won't know what to do when a stock moves against you. But if you're confident in your work, the decision is easy. You're certainly not going to sell CarMax simply because the price goes lower, and, depending on how your portfolio is constructed, you'll be looking to add to the position. In any event, the CarMax recommendation worked out nicely. It made it to $20 within one year of my column and now trades at $34, or just below my latest estimate of value.
BUY: Republic First Bancorp (NASDAQ:FRBK)
My recommendation of Republic First Bancorp, a regional bank based in Pennsylvania, is similar to my CarMax recommendation on a number of levels. Like CarMax in 2008, the stock of FRBK, at $2 per share, is priced as if it was teetering on the precipice of disaster. Like with CarMax, the reality is quite the opposite - the company has reinvented itself and is poised to thrive. And, as with CarMax, my position in Republic First Bancorp is not a short-term trade. Because of what I anticipate will be a healthy growth trajectory, I hope to own FRBK for a decade or more.
By the way, it's important to emphasize use of a limit order when buying this stock. With a market cap of only $50 million, trading in the stock is thin, so don't use a market order.
Republic First Bancorp has a remarkably similar model to a bank formerly known as Commerce Bank, which was taken over by Toronto-Dominion Bank (NYSE:TD) in 2008. Commerce was a deposit-gathering machine that benefited shareholders with ten-fold returns in a decade's time. Much of the former Commerce management team is now at First Republic, intent on creating the same deposit gathering magic that Commerce enjoyed.
A few of the FRBK positives worth noting:
1. The balance sheet, carrying a book value of $2.50 per share, is squeaky clean after being thoroughly restructured in the years since the credit crisis.
2. The growth plan is low-risk, built upon a foundation of organic growth and deposit gathering. Early signs are encouraging, as deposits grew organically by 22% (net of C.D.'s) year over year in the most recent quarter.
3. Book value is set up to grow strongly over the next several years, and should compound at a double-digit annual rate (think low- to mid-teens) catalyzed by a combination of branch growth, net interest margin expansion, and same-branch deposit growth.
So where is the stock of Republic First Bancorp headed over the next several years? Pre-2007, investors were all too willing to pay 1.5 to 2.5 times book value for financial stocks, back when balance sheets were excessively leveraged with suspect credits. If we take the low end of that range (1.5x book) and assume FRBK can grow book value by 15% per year (Commerce averaged about double that rate), then we can project a book value of $5 in five years, and a stock price of $7.50.
That said, if I'm right that FRBK is poised to deliver more than 15% book value growth over the next several years (based on their recent rapid growth in deposits, and how I think the model will evolve, this might be conservative), it will most certainly command a premium price (Commerce was priced at three times book when it traded publicly). A stock price based of two times book would be a reasonable target, suggesting a stock price of $10 per share in five years.