Stocks You Can’t Buy

by Geoff Gannon


The always interesting Japanese stock blog (it’s written in English), Kenkyo Investing, has a post on a negative enterprise value stock called Hokuyaku Takeyama. The reason this stock is cheap is because it trades on the Sapporo Stock Exchange – not one of the more popular exchanges like Tokyo or Osaka. Very few stocks only trade on the Sapporo Stock Exchange. So, very few investors make the special effort to do business with a broker who will give them access to this exchange.

 

Watlington Waterworks (Bermuda Stock Exchange)

I wrote about a similar situation in March of 2011. That stock was called Watlington Waterworks. It’s a water company on the island of Bermuda. Because it’s on the island of Bermuda – a rich, densely populated remote island with no fresh water – the economics of Watlington Waterworks are generally superior to all other water companies around the world. And yet – in March of 2011 – the stock traded for lower multiples of earnings, book value, etc. than other water companies. In the 7 years since I wrote about Watlington Waterworks, the stock has risen in price by about 9% a year. It also paid a dividend. So, holders of the stock got 10%+ owning something that was a true diversifier in their portfolio (Watlington’s price doesn’t move based on how the Dow Jones, Nasdaq, or S&P 500 are doing). In fact, on many days, it doesn’t move. What’s more impressive is that Watlington returned more than 10% a year over 7 years while finishing that period with a P/E ratio less than 12, a price-to-book ratio less than 1, and a rock solid balance sheet.

Many stocks have returned more than 10% a year over the last 7 years. However, very few stocks that returned more than 10% a year now have a P/E under 12, a P/B under 1, and a solid balance sheet. Meanwhile, many companies that now have a P/E under 12 and a P/B under 1 have returned far worse than 10% a year over the last 7 years. In other words: Watlington is rare in the sense it combines a 7-year total return performance that has been adequate with a stock price that has always remained at an investment level rather than straying into speculative levels like most stocks. Basically, it’s been a decent “set it and forget it” investment. The business has never really performed badly. And the stock’s price has never really been anything but cheap.

Also worth mentioning is the way I presented Watlington Waterworks. I showed the company’s recent financial results on this blog – but didn’t give out the company’s name or business description. Readers then guessed where the stock traded. Back in 2011, almost everyone came up with a guess in the $20 to $30 price range. At the time, the stock traded at $14.

 

What Ben Graham Would Really Be Buying Today

These are the kinds of stocks you want to find – stocks like Hokuyaku Takeyama and Watlington Waterworks. They are stocks that just about everyone – if shown the company’s financials but not told the obscure exchange the stock trades on – would value at a price higher than where the stock actually trades.

In the U.S., these are usually OTC stocks. You can read blogs like Oddball Stocks to learn about some of these kinds of companies.

When people ask what would Ben Graham buy – this is it. He wouldn’t be buying the net-nets that turn up on screens (like Chinese reverse mergers). He would be opening an account in Japan, an account in Bermuda, etc. and putting 1%, 2%, or 3% into becoming a collector of little, illiquid, but clearly incorrectly priced stocks like these.

 

Bancinsurance

I’ve written about my experience in Bancinsurance many times before. Back in 2010, I bought into this stock. It was traded over-the-counter at the time. However, I was familiar with the company from years before when it was a listed stock. If you look at the second letter I wrote to the board of directors of Bancinsurance, you can see a graph showing that after the company de-listed, the stock started to consistently trade below book value even though (when it had been listed) the stock often traded above book value.

This is what we – as value investors – want to look for. The stock is priced differently because of factors like who owns it, what exchange it trades on, how it is categorized by investors, etc. rather than whether the balance sheet, the industry, the company, and the management team are solid or not.

In the case of Bancinsurance, it was priced differently than a “normal” stock in two ways:

1.       It was an insurance stock with a history of underwriting profits (the combined ratio was less than 100 in 28 of the last 30 years) and yet it traded at a discount to book value

2.       There was a $6 a share offer to take the company private from the CEO (and majority shareholder) and yet the stock consistently traded below the going-private offer

In other words: because of its obscurity, this stock wasn’t getting the attention of investors who specialized in insurance stocks or arbitrageurs who specialized in speculating on higher takeover offers. In this case, the deal was eventually done at $8.50 instead of $6. Normally, a deal that ends up being done at a 40% higher price within about six months to a year would attract special situations speculators. That didn’t happen here. Between the time the original $6 offer was made and the time the board accepted the $8.50 offer, I had very little competition buying as much of this stock as I could get my hands on. Honestly, I was my own competition for this stock. And it was only my reluctance to bid up the stock on myself that kept the price in check (and the number of shares I ended up getting lower than what I would have wished).

Here again we see what we – as value investors – should be looking for in a stock: a good asset traded in an inefficient market.

After all: how efficient is a market likely to be when there are days with no serious second bidder?

 

Warren Buffett (The Snowball): National American Fire Insurance and Blue Chip Stamps

In Warren Buffett’s pre-Berkshire investing days, he came across several stocks where the market for those stocks was inefficient for historical reasons.

Let’s talk about two.

The first is National American Fire Insurance. This was the holding company in which the Ahmanson family stashed some of their best assets. However, it was built out of an unrelated company that had done badly as a stock for many people in the local Omaha area.

You can read the full story in Alice Schroeder’s “The Snowball”. This is what I wrote in an article called “How Warren Buffett Made His First $100,000”:

“…it was a super illiquid stock that had once been worth a lot more. The shares ended up spread thinly across a lot of different individual investors. They remembered when the stock was worth $100 a share. That’s where a lot of them bought. And many of them didn’t want to sell until the stock got back to $100 and made them whole. But, because the stock had burned them so bad, they also had no interest in buying more shares. They just clung to what they had.

Now, what’s really fascinating about this story is what Warren Buffett did. So, the stock was last selling for about $27 a share. At first, he tried buying around $30 a share. Then he went to $35. He went to towns where he knew people owned the stock. He talked in person to people to try to get them to sell to him. 

Eventually, he offered some people $100 a share. Now, think about this for a minute. That’s still a very, very low price for this stock. At $100 a share, Buffett was paying 3.5 times earnings. And he was still only paying about 75% of book value for what he thought were some of the best insurance companies in America.”

Warren Buffett – and Charlie Munger – also bought into a company called Blue Chip Stamps. What attracted them to this business was its “float”. But, what attracted me to discussing it here in this post is the odd way that shares of Blue Chip stock had been distributed.

Blue Chip Stamps was a trading stamps company. It ran a multi-retailer loyalty program. A shopper would make purchases at participating grocery stores, gas stations, drug stores, etc. and would receive a certain number of Blue Chip Stamps in return. These stamps could then be exchanged for merchandise. This kind of loyalty alliance between a participating group of retailers encouraged households that already shopped at say a grocery store giving out Blue Chip Stamps to also seek out a gas station, a drug store, etc. that gave out Blue Chip Stamps instead of a competing location that gave out nothing, or gave out competing Sperry & Hutchison Green Stamps. Basically, it encouraged locking shoppers into a loop of retailers and encouraged locking retailers into that loop as well. The bigger the loop got in terms of attracting shoppers – the more it could attract retailers. And the bigger the loop got in terms of attracting retailers – the more it could attract shoppers. The company’s business would decline in the years after Buffett bought in (eventually disappearing altogether). But, it obviously had similarities to payment processing companies like American Express (AXP) charge cards.

What’s important for our purposes here is not how attractive Blue Chip Stamps was as a business. What we’re discussing here is the odd way that shares of the stock were allocated.

In 1963, the United States government opened an anti-trust case against Blue Chip Stamps. Four years later, Blue Chip Stamps settled with the U.S. government via a “consent decree”. (I’m simplifying here. In reality: first, it seemed like there was an agreement, then there wasn’t, then there was again, then there was one last court case, etc. – but the end result was that Blue Chip Stamps and the government came to an agreement over anti-trust issues).

You may have heard of “consent decrees” before. One of the most famous is the 1948 Paramount consent decree that spelled the beginning of the end for the “Hollywood System”. Consent decrees are of interest to investors because they often involve a company settling an anti-trust issue with the U.S. government.

Usually, this means two things.

One: the company has a lot of “market power”. It has some sort of monopoly, market dominance, etc. Otherwise, it wouldn’t sign a consent decree.

And two: the company is often agreeing to take some sort of extraordinary action – like separating a movie theater chain from a studio that makes movies (the Paramount case) or breaking up the various stages (or geographic regions) of oil distribution in the United States (the Standard Oil case) that may unlock the potential for investors to suddenly invest in pieces of a once dominant business. These pieces may be mispriced, they may end up in the hands of owners who didn’t originally intend to invest in just that one part of the parent alone, etc.

 

A Brief Aside: Northern Pipeline

Ben Graham invested in Northern Pipeline. Northern Pipeline was a stock that had a more valuable investment portfolio than it did a stock price. Northern Pipeline was part of the Standard Oil system broken up by that anti-trust case.  

For more details on Ben Graham’s investment in Northern Pipeline, read my 2007 GuruFocus article on the subject.

 

Back to Blue Chip

In the case of Blue Chip Stamps, the participating retailers (actually, past participating retailers) ended up with a little over half the shares of Blue Chip Stamps stock.

To give you some idea of the inefficiency likely to result from this kind of distribution, I will quote from a later (mid-1970s) case involving Blue Chip Stamps where a U.S. court (actually the Supreme Court) included a description of the consent decree as background in that court’s opinion:

“…Old Blue Chip was to be merged into a newly formed corporation, Blue Chip Stamps (New Blue Chip). The holdings of the majority shareholders of Old Blue Chip were to be reduced, and New Blue Chip…was required under the plan to offer a substantial number of its shares of common stock to retailers who had used the stamp service in the past but who were not shareholders in the old company. Under the terms of the plan, the offering to non-shareholder users was to be proportional to past stamp usage, and the shares were to be offered in units consisting of common stock and debentures. The reorganization plan was carried out…Somewhat more than 50% of the offered units were actually purchased. In 1970, two years after the offering…a former user of the stamp service and therefore an offeree of the 1968 offering, filed this suit in the United States District Court for the Central District of California…(alleging, among other things) that the prospectus prepared and distributed by Blue Chip in connection with the offering was materially misleading in its overly pessimistic appraisal of Blue Chip's status and future prospects. It alleged that Blue Chip intentionally made the prospectus overly pessimistic in order to discourage (the) respondent and other members of the allegedly large class whom it represents from accepting what was intended to be a bargain offer, so that the rejected shares might later be offered to the public at a higher price. The complaint alleged that class members, because of and in reliance on the false and misleading prospectus, failed to purchase the offered units.”

Think of all the ways that distributing Blue Chip Stamps shares in this manner was likely to lead to an inefficient market in the stock (a mispriced stock). One, Blue Chip – which knew the most about its own business – had incentives to discourage people from buying the stock. Two, the stock was offered in proportion to past stamp usage and specifically to past stamp users who were retailers but not investors in Blue Chip. In other words, the stock was being offered specifically to entities that were likely to be businesses but not investors. So, the well-informed entity here (Blue Chip) had incentives to make itself look bad when offering to sell itself to what were essentially potential investors who had no experience investing in anything (these were businesses not investors). Furthermore, Blue Chip was offering combined units of both stocks and bonds to retailers who had no experience dealing in either stocks or bonds. So, you’re asking someone who has never been a buyer of stocks or bonds – only sometimes an issuer of their own stocks and bonds – to suddenly make a decision about the attractiveness of units that combine both stocks and bonds.  

Think about this for a second. For value investors: the Blue Chip Stamps consent decree resulted in something even better than a spin-off.

 

Why Spin-Offs Can Sometimes Be Unusually Attractive to Value Investors

In a spin-off, a group of investors – both institutions and individuals – is given stock in a company that might not be related to their original reason for buying into the parent. For example, I bought into a company called NACCO (NC) the day after it spun-off Hamilton Beach Brands (HBB). Hamilton Beach is a maker of small appliances like crockpots, slow cookers, microwaves, toasters, etc. The remaining business at NACCO – NACoal – is a cost-plus miner of lignite (brown) coal for power plants sited very near the mine. The two businesses have nothing in common. So, some investors may have originally bought NACCO stock because they liked Hamilton Beach Brands. Other investors may have originally bought the stock precisely because it was a “special situation”. Once Hamilton Beach was spun-off from NACCO, these investors were no longer invested in a conglomerate/special situation type investment. So, the folks who just wanted Hamilton Beach might want to unload NACCO. And the folks who were just invested in the combined company as a special situation might want to unload NACCO too, because now it was just a pure play coal company (there was no longer anything special about the situation). That’s usually how a spin-off works. Investors might not be interested in one of the two parts post break-up.

But – even in a spin-off – all these supposedly lazy investors are still investors who are used to analyzing public companies, deciding whether or not to hold a stock, etc. So, while they may not want a coal company – they certainly don’t mind holding a share of stock in something. Even if the people selling to me didn’t want to own a standalone coal company at (almost) any price – they were still investors who knew full well how to analyze NC stock as a stock. Even in the strangest of spin-offs, you usually still have to buy the stock you want from investors who have spent years analyzing stocks.

The Blue Chip Stamps case involved the creation of shareholders – the participating retailers – who didn’t want to own stocks at all. They weren’t investors. They were retailers. So, naturally, they were going to be too eager to unload as much stock as possible as quickly as possible without much regard to what that stock was worth.

You can compare this to situations where a government owns some stock in a public company and is now showing a profit on that position. If the government has political reasons why it might rather not own the stock – as soon as it shows the slightest profit, it’s going to be very tempted to sell that stock and just wash its hands of the matter.

In the case of Blue Chip Stamps: Warren Buffett obviously saw the potential to get a lot of shares from unusually motivated sellers. In fact, he even started buying the shares of publicly traded retailers that received Blue Chip Stamps shares – not because he was interested in these retailers as businesses, but purely because he believed he could get the retailers to agree to swap their shares in Blue Chip Stamps for his shares in them. Basically, he was betting he could get a company to give him Blue Chip Stamps to make him go away (as a shareholder).

 

 

Dealing in Illiquid Stocks: You Can’t Know Till You Try – George Risk and NACCO

Finally, I need to discuss the two ways in which something may be thought of as “a stock you can’t buy”.

Really, there are 3 ways. However, one is so odd most of you will never come across it.

So, reason #1 is legitimate but extremely rare. There are a few stocks around the world that have special rules which may literally prohibit you from buying the stock purely for investment purposes. These are often some kind of club that needed capital (a town, a housing development, etc.) and so issued stock to raise capital but never really intended to be operated purely for profit-seeking purposes. This is so rare you’re likely to never come across such a case. They do exist though. And in such cases, it may literally be true that you “can’t buy the stock”.

What are the other two cases?

The two cases you’ll actually run into are: 1) Your current broker won’t buy the stock for you or 2) You think the stock is too illiquid.

In reality, #2 is almost never a real problem for a small investor. But, I stress both those words: small and investor. Illiquid stocks are obviously un-buyable for a big trader. But, for a small investor – these stocks aren’t really “stocks you can’t buy”.

One, your portfolio must be small: thousands, tens of thousands, hundreds of thousands, or millions. But, not tens of millions or hundreds of millions. However, provided you are investing less than $10 million total – it will almost never be the case that you literally can’t get enough shares of a publicly traded company to matter to you. For example, say you are managing $10 million. A 5% position would be $500,000. Assume you buy one-third of the volume of a stock (I’ve bought more) for a period of six months. If the stock trades about $15,000 worth of stock per day – you’ll have no problem buying into it. And a lot of people reading this are managing less than $1 million. Buying illiquid stocks will be more than 10 times easier for you. That means many people reading this blog can invest in stocks trading as little as $1,000 to $2,000 a day. And some of you can invest in stocks trading much less than that.

So, illiquidity is almost never an excuse in terms of getting in.

Illiquidity may be an excuse in terms of getting in quickly or getting out quickly – or feeling you can get out at a price reasonably close to the last trade price. However, those are all trading concerns. Not investing concerns.

I know that sounds glib of me. But, the ability to get out of a stock at a price close to the last trade price is 100% a trading concern and 0% an investing concern. It has become so conventional to think in terms of liquidity that many people who consider themselves investors assume that the ability to get out of a stock at near the last trade price is some kind of necessity.

That’s not even a legitimate concern for an investor to have.

When you invest in a house, a small business, a farm, etc. you don’t have any expectation you can get out either 1) quickly or 2) at a price similar to some “last trade”. All you are betting on – as an investor – is that you’ll be able to eventually unload the asset in a way that gets you an adequate annual return over the period you owned it. There are many stocks out there that promise adequate annual returns without promising the ability to get out reasonably quickly or reasonably close to the last price someone else paid for the stock.

Now, let’s move from the theoretical argument of why illiquid stocks are worth your attention to a couple practical examples of the difficulties involved in buying enough of these stocks to move the needle in your portfolio.

As an example: I bought stock in George Risk (RSKIA). The stock supposedly averages a little over $5,000 in daily volume. I owned the stock for about 6.5 years. When entering the stock, I put in a lot more than $5,000 and I did most of it in a single trade. When exiting the stock, I sold a lot more than $5,000 and I again did most of it in a single trade. In neither case did I bid for stock or offer stock at a price that was less advantageous to me than simply using the last trade price (what most people used to dealing in liquid stocks simply call the “market” price). As it turned out, the illiquidity of this stock never mattered to me. Both going into this stock and going out of it – I was prepared to wait a month or more and get a price that was a lot different than the last trade. It didn’t turn out that way. It turned out to be way easier to get in and out of George Risk than I ever would have dreamt.

NACCO was a different story. So far, I’ve only gone into this stock. I still have 50% of my portfolio in the stock. I planned to buy once it was trading separately from Hamilton Beach Brands. Because the stock’s market cap – as a combined company – had been several hundred million dollars and because my buying was to be done on the day the two stocks started trading separately (thus attracting a lot of attention including from special situations folks, etc.) I expected it to be very easy to get all the shares I wanted in this stock right away at very close to the last trade price.

It didn’t work out that way. I only checked the stock price several hours after the open – I don’t place orders when the market first opens – and by that point in the late morning there was a lot of volume. But, there was no one interested in doing one big trade near the last trade price. So, I had to make the decision to accept dozens of smaller trades – each of which might move the price a little – to fill my order rather than insisting on one all-or-nothing deal. Like I said, there was a lot of volume. So, I don’t think it made much difference to the average price I got over the entire day. You could have bought any time in the late morning through to the close of that day and probably gotten a very similar average cost for your shares whether you did it in one trade, ten trades, or a hundred trades.

But, it definitely wasn’t easier for me to get into NACCO than it had been to get into George Risk. And you wouldn’t have predicted that from looking at the average daily volume in those two stocks.

So, never assume you can’t get a stock just because it hasn’t traded a lot of shares in the past. Always make an effort. Put a bid out there and see what you can get.

 

Inconvenience Yourself

The other reason you might not buy a stock is because your broker doesn’t offer you access to the exchange on which that stock trades. This is a very common reason for why individual investors don’t buy some stocks. In fact, I’ve written several newsletters, did a report on Japanese net-nets, etc. and this is the most common complaint given whenever you mention foreign stocks to someone. They’d need to open another brokerage account with someone else.

I’ve gotten a lot of emails from investors saying they’d love to buy some specific stock but they can’t.

Eh…

Can’t or won’t?

They could open another brokerage account. They just won’t.

Do it.

This is a good illustration of how the concept of “switching costs” doesn’t mean what it appears to mean. It’s not expensive to find a broker to buy the stock you want to buy. What is it?

It’s inconvenient.

When we say “switching costs” we often just mean “inconvenience”.

All I can say about the cost of this kind of inconvenience is to consider how much you’d put into the stock and how much more you’d likely make on this stock rather than something your broker will buy for you.

If you’re the kind of person who would choose to fly coach rather than first class when crossing the Atlantic but won’t open a brokerage account to buy that stock you want so badly in Japan – you’re probably doing something wrong.

It may feel like it’s reasonable to prefer coach over first class for financial reasons but unreasonable to open another brokerage account just to buy some obscure stock.

From your net worth’s perspective though: those are equally reasonable actions.

It’s very likely that giving up on buying some obscure stock because your broker says he can’t buy it for you is costing you more than a first class plane ticket would.

So, you’re actually spending thousands on avoiding an inconvenience.

 

I Don’t Use an Online Broker

To be fair, most people reading this use an online discount broker of some kind.

I don’t.

My reason for not using something like Interactive Brokers isn’t that I want access to more exchanges around the world than that broker would give me.

My reason for not using an online broker is that I specifically don’t want the ability to place trades myself.

If you want to focus on investing – the first thing to do is prevent yourself from having the ability to trade. So, I leave trading to someone else entirely. This works very well for me.

But, I understand it is potentially more expensive and certainly less convenient than the approach others take.

Personally, I think it’s much easier on the mind and potentially more profitable in the long-run to go the old fashioned route and call your broker on the phone instead of placing a trade with your mouse.

I promise you you’ll make less trades this way.

But, I know I’m not going to win any converts to my side here.  

In fact, nothing I say is going to get you to switch brokers. This is what we really mean when we say “switching costs”. I can change people’s minds about a lot of things. But, it’s very hard to convince someone to do anything that’s both: 1) inconvenient and 2) a break from their established habits.

In some sense that’s probably why there will always be some oddly mispriced stocks out there. We’d have to break our habits and put in some extra effort to track them down and buy them.

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