Stig Brodersen 1:12

So David, we already had you on those back in Episode 93. And but what we really like about having you on is that you’ve been with The Investor’s Podcast even before it was The Investor’s Podcast. We got to know each other back whenever we were just a handful of people discussing stocks on a forum at Buffett’s Books. So now we’re back in 2013. And we didn’t have a podcast. We didn’t have the Academy. It was just this old forum looking like 1997. It was Preston and you and me talking about Warren Buffett and value investing. And you’re one of the most old-school value ambassadors I know, which, by the way, is a huge compliment. And you have this strategy where you invest in so called micro and nano cap stocks. Many of them only traded over-the-counter. And there’s very limited information, whenever you invest in these companies. So please talk to us about your investing strategy, and perhaps talk to us what it means when a stock is trading over-the-counter.

David Flood 2:18
Sure, so the over-the-counter markets are essentially a decentralized group of disparate markets. You could think of them as thousands of tiny little markets that are all kind of amalgamated together. And they’re run by broker dealers, who act as market makers, and they will typically carry the inventory of stocks on their balance sheet. And then, they will use those. But over-the-counter investors trade amongst one another. So these stocks that are traded on the over-the-counter markets are–they’re unlisted companies. They don’t meet the requirements of the New York Stock Exchange, so their cap may be too small, or they may have too fewer shareholders to be able to float on the major exchanges. So these companies will be traded amongst over-the-counter investors. And they’re typically tiny, little companies with low share accounts.

So my approach is to look at these tiny companies. I use a deep value approach; that, which is inspired by Benjamin Graham. I will typically start with a balance sheet, and I will look at the companies to see if I can find if they have any kind of undervalued assets on the balance sheet. I’m particularly interested in the current assets like cash and equivalents; accounts receivable; inventory; things like that. I’m also interested in undervalued real estate, which could be over-depreciated on the balance sheet. And I will combine with that another approach, which is to look at long-range charts; long-range price charts. I started doing this after I…found out that George Soros, Peter Lynch, and Walter Schloss have all used price charts, when they were looking at companies. So I’ve now begun to use price charts, so I can gauge where I think a stock may falter. Because often when you–when a value investor buys a stock based upon the numbers, they can find that the stock will continue to drop, and as if they also combine that with a reading of the price charts that can notice that sometimes the stock will fall, and then it will hit a level of support and begin to form what’s called a “base.” So I use that approach to try and find stocks, where they’ve kind of hit a rock-bottom price, and then I will buy-in at that point. Walter Slosh did something similar, where he would…he would look for stocks that were selling at three, five, or all time lows, and he would buy them, when they were basically extremely depressed, and all their investors had kind of given up with the stock. They were no longer interested in it.

So I, I look for tiny companies. I want them ideally to be a market cap of $10 million dollars or less. Although I will buy some up to maybe $50 million push if they look interesting. I want these companies to be highly liquid. So I want the shares outstanding to be 10 million or less, ideally. And then I also want the share price on an absolute basis to ideally be a dollar or less. Now, there’s a good reason for that. Purely because the investor psychology: investors are far more inclined to put money into lower priced stocks than they are higher priced stocks, irrespective of the intrinsic value of the stock. So you’re far more to see large price moves in stocks, which trade a dollar or less. It’s a very peculiar phenomenon that you see. It’s just a part of the psychology of the market that this–that happens. So I try and use that to my advantage. And then I also focus on looking at what are known as “dark companies.” These are companies which don’t file with the SEC. They’ve deregistered, and they may only provide financials to shareholders who request them if they email the company, or they mainly put them on their website. So I use this approach because there’s going to be less people looking at these stocks. And because there’s less people looking at them, there’s more chance that there’s going to be mispricings in these stocks. So that’s generally my approach.

Preston Pysh 6:12

So David, I have a confession here. You’re one of the investors that I follow closest. And I’m sure Stig will say the same thing. Because you write analysis for TIP, and you write on our forum here, and we obviously read your blog. And some of the stocks that are on your radar include Network One Technology, Inc, Pinelawn Cemetery, Beaver Coal Company, and Myriad Advertising PLC. It would be quite a stretch to call them household names. And we’re kind of curious, how do you find these companies? What are you doing?

David Flood 6:47

Well, I’ll use a combination of different approaches. I’ll use stock screeners sometimes and with the stock screeners, I’ll look for companies, which is selling below $50 million, and then I will also screen for negative enterprise value. So this generally will bring me a selection of companies, which may be trading below net cash. That would be if you sold off all our assets and basically selling for less than the cash they have on the balance sheet. The market cap would be lower than the cash on the balance sheet if you sold everything up. And so I like to look for companies like that because then when the share price is so depressed, and any kind of good news is likely to send the share price going up. I will do that. I will go manually through lists of stocks. I will get hold of stock manuals like the Walker’s Manuals, the Mergent Manuals, and then, I will go into the over-the-counter markets and just start with the A’s as Warren Buffett did with the old Moody’s Manuals, and just go stock by stock through thousands of stocks. It takes a long time, but it’s…it’s really good because you find a lot of interesting companies there that are hidden.

If I’m looking at things like Japan, I’ll get the Japan Company Handbook, which I think Warren is, Warren Buffett’s known to have on his desk, which he likes to look through from time to time. So I will use that as well. And I also follow a lot of investment blogs that cover these kind of obscure stocks. There’s a lot of really good investment blogs if you research around on the internet, you can find them. And then I’ll also look at the 13F filings of small value firms. So most investment firms can’t really look at these tiny companies just because they’re too small. Their corporate charter generally prohibits them from looking at them. But the small value firms that could be family offices, and things like that; limited partnerships. They will sometimes look at these much smaller companies. Then I will then go and look up their filings to see what they hold. And then I can look through those companies to see if I can find anything of interest. So I’m almost coat-tailing. I’m using those as my analysts much like Mohnish Pabrai does, when he looks at the 13 acts of other value firms. And they also network with other investors. So over time, I’ve built up a really good broad group of contacts–people that I can get in touch with, and I could run ideas by them on different companies that I’m looking at, or ask them for ideas. And once you start sharing ideas, you start to get more and more ideas sent to you. And another thing is to look for a mentor. I think it’s really important to try and find someone who has a lot of experience in this area, and then use them as a mentor to teach you how you would go about investing in the over-the-counter market space. So those are the things that I’ve applied to my own investment approach.

Stig Brodersen 9:33

You know, David, whenever I look at some of the numbers of the companies that we just talked about here, I mean, they look great. But like most investors, I’m concerned about the liquidity of the stocks that I’m nesting in. This might sound a bit weird to some investors out there, who primarily invest in companies like Apple or Google. There’s always liquidity in the market. I could just go in and buy these stocks, but these are very small stocks. They’re very liquid stocks. So could you please talk to us about how to use the illiquidity to your advantage, and how much money you can typically deploy in something like nano cap stock market? And whenever we’re saying nano cap, we’re talking about companies that has a market below $50 million, and sometimes much less than that.

David Flood 10:21
So a lot of investors that consider illiquidity to be a problem or an issue that they want to avoid. Charlie Munger famously quotes Pascal, who said, “Invert. Always invert.” So you can see a problem is actually something beneficial. So the illiquidity actually puts off a lot of investors from looking at these companies, which means that there’s going to be a lot less competition, and there’s more likely to be mispricings. The large firms just simply can’t invest in these small companies, which means that the only people who are going to be looking at them are going to be retail investors like myself. So that’s much less competition for me, and a higher chance of mispricings. So I typically will build a position in a company, and it may take me several weeks, or it could take several months. But I’m happy to wait. I’m not in a rush. I think patience is a virtue of value investing. But the interesting thing with these illiquid stocks is once you build a position, and then some positive news emerges, or some kind of catalyst occurs, so that the market reprices the stock.

When the demand increases for these very illiquid companies, the share price will move up dramatically. And then, that’s an opportunity for you to then sell out into heavier volume as they become slightly more liquid, when there’s more sellers in the market and buyers. And then you can profit from these rises in the share price. So it takes a bit of patience to build a position. But then to offload a position can generally be easier, when the share price starts to move up. And you can typically deploy maybe between $100,000 to a million dollars in the nano cap space. Maybe $10 to $100,000 per stock. So, this is a perfect strategy for the small investor; the small retail investor. So in order to build a position in these tiny companies, I will use good till cancelled limit orders, so these are orders that you can put in with your broker that will just sit until they get filled, and you may have to leave these orders sat there for months. Sometimes even over a year, but that’s fine because with my approach of deep value investing, I will buy a basket of stocks. I’m happy to have 10, 15, 20 good till cancel limit orders just sat, and I will just wait, and just be patient. I’m not in a rush to buy these companies.

I’m happy for the market to give me the price that I want to pay for these companies. And then, I will look at the, the offering from the ask, which is the person selling. I will look at the amount of stock that they’re offering, and I will keep my buying volume low because I don’t want to drive the price up. I want the price to be the price that I want to pay for the stock. So I will just buy in box. I will not try and buy my whole position in one go because that will, that will let other investors know that perhaps there’s some hidden value there. So I will use a little bit of caution and just build my position over time. So that no other market participants find out that I’ve discovered that there’s some hidden value there. If the stock does happen to fall down; below the price that I’ve paid, I’m happy to average down because I’m building a position over time. I can do that. So I can actually lower my average cost price over several weeks or several months if need be. And then as I say yes, I’ll buy a basket of stocks. I’m not looking to put all my net worth into five stocks. I’ll be buying maybe 20, 30 stocks. So I’m happy to have multiple orders out, and I won’t chase these companies. I’ll wait for the price to come to me.

Preston Pysh 13:43

So David, would those 20 or let’s say 30 stocks be the only ones in your portfolio? Or are you separating those picks from another batch that would be large cap companies?

David Flood 13:56

Yes, I only focus on small companies. I think I’ve got one large cap company left in my portfolio, which I’ll be selling at some point. I don’t really invest in ETFs, or bonds, or anything else. I just focus on tiny companies. Now, that isn’t to say that I won’t invest in these other companies. At some point, if the opportunity arises, where there’s a good price, I’ll happily invest in anything if I think there’s a good deal to be had. But at the moment where we are in the current market cycle, I’m finding the most value in the nano cap space, so that’s where I’m focusing my attention.

Stig Brodersen 14:31

It’s interesting that we both come from this background as value investors. And we are taught that we shouldn’t look too much at the price action. But we should look at the fundamentals. We should look at where the value really is. And you previously mentioned about, you know, looking at price action; being inspired, for instance, by George Soros. Now, I’m curious to hear whenever you do look at price action, is there a different approach or truth for over-the-counter illiquid stocks that, that are more beneficial for you, whenever you have to take a position say, in the long run, or perhaps even trade over-the-counter stocks from a technical perspective?

David Flood 15:12

The over-the-counter markets, it tends to be predominantly retail investors that operate in this space. So there’s a lot less noise in the share price movement. When you’re looking at the much larger stock exchanges, where all the large companies at. There’s a lot more noise just simply because there’s so many institutional investors participating. So with the smaller companies, I like to use price charts and observe the price action, the volume, and then, the support and resistance. So I can watch a company, and I can watch it share price, and I will observe it. And then, it may fall and then hit a point of support and the stock no longer keeps drifting down. It just basically bounces along and support and that’s known as forming a long term base. That indicates to me that other participants in the market are beginning to buy that stock. They’re accumulating a position, and they’re supporting the share price. It’s no longer falling. That tells me that that’s a good entry point for the stock. So I will use that in combination with the numbers that I will look at the balance sheet to try and find some kind of discount to the tangible assets, and then use that as to find a good entry point for the stock.

Also, you’ll notice when a stock hits support and begins to form one of these long term basis, the volume will drop off completely. But as the stock has been drifting down, volume has been quite heavy. Because there’s been a number of investors that have been throwing in the towel. They’ve been selling the stock because perhaps things are going badly, or they’ve gone elsewhere in search of value. Once the stock hits the base, the volume dries up. And that’s the accumulation period where one can then go in and begin to buy; build a position over time without really attracting much attention. People have forgotten about the stock. They’ve essentially left it for dead. They’re ignoring it, and there’s no interest there. So in, in that period of quiet and darkness, you can then begin to build a position in the company without really attracting much interest. Because the problem with buying a stock purely on the numbers is that stock can look cheap based on the numbers, but it can keep falling. This is a major problem for a lot of value investors, when they first start. They will buy cyclical companies that appear cheap based on some of their…their numbers, but then, they can get much cheaper. They can get 50% cheaper. And then, they’re sat on a 50% paper locks, and it’s going to take them a while to break even before they make any money. So by using the charts, we can gauge where a suitable entry point would be for these kind of deep value plays and not get caught out where you’re going to have your purchase cut in half its value. So I like to use that approach. I look for companies that are selling at multiyear lows, and sometimes all time lows.

You know when a company is selling at such a depressed price, the entire market has essentially given up on the company. If you can then look through their companies, and find ones that have some kind of hidden value; awesome prospects for change, then you can really profit from that. So I will generally go through all these deep value companies, and then look for ones where there’s possibly some kind of catalyst present; where there’s some opportunity where I think there may be some kind of change which is going to unlock this value. Now value is in and of itself a catalyst. So over time, the market will reprice these stocks if they are undervalued. If they remain undervalued over time, the market, as Ben Graham says, is a weighing machine. And these companies will recorrect the price in time as they revert back to the main.

Stig Brodersen 18:33

So David, let’s do a case study, and be a bit more specific, and come up with examples of what you are looking at here for specific company. So back in March, you wrote a blog post about Pinelawn Cemetery. The stock picker is P-L-W-N. And I’ll make sure to link to that in our show notes. Now the stock was trading at $235 at a time. It paid $26 in dividend and today’s trading at 270. I find that to be a very interesting case study. Not so much for finding a stock that can be expected to compound for years and years to come, but more because of where we are in the market cycle. Perhaps you could please talk to us about how you see a potential investment in Pinelawn Cemetery.

David Flood 19:23

So Pinelawn Cemetery is a very interesting company. It’s, it’s one that I found when I was screening for companies, which had high dividend yields. And at the time, when I first initially found the company, it’s what’s known as dark. So financials aren’t readily available. You have to think of a novel way to try and get hold of the financials of the company, which I eventually managed to do. But at the time, I was just basically using the price chart and some other information that I’d found on the company. So I was looking at the, the price action of the company in relation to its dividend payments. Typically, you will find with a lot of companies that pay dividends, their share price will rise in anticipation of the dividend payments. Investors will buy into the stock and the share price will rise as they take a position to claim the dividend. Once the dividend is paid, share price will drift back down as people sell off the stock, and go elsewhere in search of value or other dividends.

With a company like Pinelawn, one can use the price charts to observe a suitable entry point. You would wait for the post dividend period, when the stock has been sold off, and it’s drifted down to form a new base, and then you would buy at that point. And then, you capture the highest dividend yield possible because the stock is selling you its lowest amount. And then, you will also capture capital appreciation as the stock goes up in value. I’ll put a good ’til cancelled lowball offer. So I’ll put a really low offer that could be…that could be below the bed, you know? I want to try and coax the price down as far as possible, and then buy a really cheap depressed price, and then I can capture a higher yield, and I can capture the capital appreciation of the stock. Pinelawn and Beaver Coal Company that pay high dividend yields. Another approach is to put in good ’til cancelled orders, which are extremely low. And one could go back and look at the long range price charts and look at where these companies fell to in the last financial crisis. So you can look at the price charts, and go back to say, 2008. And you can see that these companies dropped dramatically. There’s absolutely no reason why they should. Pinelawn Cemetery as a cemetery business. The recession means nothing to the cemetery business. The business will just continue as it has in the past, and it did. The one could place orders to buy these stocks at extremely depressed, cheap prices and capture very large dividend yields. And, and then also, a capital appreciation in stock. So that’s the approach that I will use with these companies.

Stig Brodersen 21:49

So I’m curious to hear your thoughts on the importance of dividends. And in this example, we just talked about Pinelawn, you know? Dividend yield of, call it, 10%-ish. You know, a very high dividend yield compared to what else that you see out there with the current valuations that we have. Now, again, as, as value investors, we are taught the dividends are only good thing if the management can redeploy that capital to say, buy back stocks that are really good price, or if it cannot, you know, put that back into the business and make some good investments. Now, I’m curious if high dividend payments are more important for over-the-counter stocks compared to bigger companies, as it might be perceived as taking some of the risk of your position without having to worry about the liquidity? Or does the principle behind dividend distributions still hold up for you as a value investor looking at these small obscure stocks?

David Flood 22:44

I think in some cases, the dividend payment is…is beneficial because with some of these small companies, you’re going to be looking at limited partnerships or unit trusts, where as part of their corporate structure, they’re required to pay out the majority of their earnings as dividends. And I think investors can use those dividends; those large dividends as a form of cash flow, which then they can use to go and deploy into other stocks that they’re interested in. And the other interesting thing with the over-the-counter market companies is often they’ll have very, very low share prices, but then, they will pay special dividends. Now sometimes these special dividends can be 50% of the share price. Or they can sometimes even be in excess of the share price that could be 150% of the share price. You would never get this with larger companies. It’s just the law of large numbers prohibits it. But with these much smaller companies, they sell off…some assets. They may sell some real estate or they may sell off a division. They can then return that capital back to investors in the form of special dividends. Now, if you hold these companies in a tax-sheltered account, but that you’re receiving these dividends shouldn’t be too much of a problem. And I think that having that kind of stream of cash flows can be useful to then deploy that into other companies.

Stig Brodersen 24:01

So the ownership structure of these companies are typically different than what we see for bigger companies. They’re typically much more concentrated, meaning that might just be one owner, or a few owners, and then what might own a lot more of that company than what you see for S&P 500 companies. How do you deal with that? What is a good ownership structure for you as an investor?

David Flood 24:25

Ideally, I’d like to see quite a concentrated ownership by the people that run the companies because when insiders have skin in the game, they’re generally more inclined to run the company in a manner that benefits minority shareholders. Now, if they have majority control of the company, it can work the other way. They may be able to pass rules where they can pay themselves egregious salaries, or they can give themselves super voting rights, and essentially, use the company like a personal bank account for themselves. So you have to use a bit of discretion, when you’re looking at these companies, and look on a case-by-case basis. But typically, I do like to see companies where it’s a family-controlled company or a family-owned business because you know that they’ve built that business from the ground; that their heart and soul is in the company. And generally, they will have a lot of their own net worth in the company; their interest will be aligned with those of minority shareholders. So I typically like to look for those family-owned or operated businesses that held a significant position in the company.

Preston Pysh 25:25

So collecting information is super hard. I know that for one of your picks, Aqua Tech International Core, you even contacted the CEO about getting more financial data. Do you have a specific approach to getting that special information edge?

David Flood 25:40

Yes, I call it “information arbitrage.” With the, the much larger companies like Apple, there are armies, thousands and thousands of analysts and PhDs looking at these companies. So I’m deluding myself if I think I’m going to discover something about these companies that they haven’t found. So my approach is to look at companies that I know hardly anyone else is looking at. And the more hidden and opaque these companies are, the better because it requires me to put in the work to find that hidden value. I’ll use a different, a number of different approaches; try and discover the hidden value present in these companies, so I will contact management. I’ll email them, or I’ll set up a call with them, and I’ll ring them and have a, have a chat. And I will try and get financial statements that they can email them to me or mail them to me. I will check their website because often with some of these dark companies that deregistered with the SEC, they no longer file financial statements, but they will still provide them to shareholders. So they may put them on their own website, or they may mail them out to you if you contact them and request them. And then I will try and get creative, and do a bit of scuttlebutting.

So I’ll use Google Street View, and I’ll look up the headquarters of the company to go and see if it’s still there. I’ll count how many cars are parked outside to get an idea of how many employees I think the company has. I’ll check other websites to see if I can see there company’s products being sold. I’ll use land registry, so I can look up to see how much they paid for the real estate, and get an idea of whether the real estate is undervalued on their balance sheet. I could also use Google satellite images to get an idea of what I think the, the size of of the land that they own and the size of the buildings. And then, I can calculate what I think the commercial real estate value of those buildings might be. And then I’ll also use state websites to look at corporate info, so you can look up the, the corporate charters for the company; various things like web address changes, or changes in ownership, or legal counsel, things like that.

I’ve become more interested in bankruptcies recently, so I, I use a website called Pacer. And you can look up the court dockets for companies that are going through bankruptcy. So I will go through the court dockets and I’ll look to see if there’s any kind of hidden value, where I think that the common stock may receive the payout once all the debts have been paid on the company. And there, you can sometimes find some very interesting value plays that not many other people are going to be looking at. And then, finally, I’ll also use stock message boards. So I’ll, I’ll look at these boards, there boards where all these tiny companies are talked about. And it’s just generally a small handful of people like myself that are looking at these companies. That I can go onto these message boards, and then look at the research they’ve been conducting, and they’re almost acting as my analysts going out there and digging up information on these companies. So the approach in general is I tried to be like a private investigator, or a detective, and I will begin to try and hunt down information on these companies to see if I can find any hidden value.

Stig Brodersen 28:41

Talk to us more about this hidden value. You know, we previously talked about catalysts, and say that you would go in, and you make an assessment of, you know, the value of the buildings, which might be much higher than what you read in the financial statements right now. But I’d imagine for that to be recognized by the market that, oh, the buildings are listed at, you know, $10 million, but they’re probably worth you know $45 million, whatever it is. It might be a catalyst that takes a long time to materialize, and you said yes, value in itself is a driver. Talk to us more about which type of catalysts you see is more prevalent for these type of stocks. How long does it take for these catalysts to materialize?

David Flood 29:23

So a company I looked at recently which is Microwave Filter Co, which is ticker symbol: MFCO. I, when I was looking through the financial statements for that company, I looked at the real estate, and it was being valued at around $70,000. And they have pictures of the real estate on the website. And I looked at the pictures and I thought this there’s no way that this warehouse is worth $70,000. And then I was reading through the footnotes to the financial statements, which I recommend all value investors. Pay attention to the footnotes of the financial statements. That’s often where you can find hidden value. And I found out that a bank called Key Bank has extended credit of $500,000 against the property.

Now, there’s no way that, that the mortgage broker would have valued that warehouse at $70,000, and then offered to extend $500,000 in credit against it. I realized clearly that this building must be undervalued. So then, I used…a bit of research on Google and figured out that the building’s probably worth roughly a couple of million dollars, so it’s massively undervalued on the balance sheet. So how will that value get unlocked? Now, there’s a number of different ways that the value could become unlocked. One of those is that small value firms may find these companies, and they may find them because they read your blog, or they may find them on their own. And they may up make an offer to buy out that company. They could buy out that company to unlock the value. They may decide to just liquidate the company. They may decide to sell off assets. They may decide to move, and then distribute the earnings; the proceed from the sale of the warehouse back to shareholders in the form of dividends or share buybacks.

But also, what can happen is there can be shareholder activism. So a number of shareholders may get together and decide to get someone appointed on the board, which can then push to unlock this hidden value within the company. And that’s far easy to do with these much smaller companies that are just a couple of million dollars in value. You obviously can’t do this with much larger companies because the amount of capital required is too great. But then often with these companies as well, they will be…they’ll be companies that have been around for decades and decades, and that family-owned companies, and you may find that the director or the CEO is quite elderly. And they may decide to pass on the reins to someone else; their son or another member of the family. And when they take control, they may decide to change things up. They may decide to unlock some of that value for shareholders. So an instance recently that I saw with the company was the son took over as CEO from the father, and he decided to sell off their warehouse, and then lease it back. And then, he paid out a special dividend to shareholders, which was in excess of the share price. So there’s a lot of ways that the value can be unlocked with these companies. Sometimes it will take years. Other times, it may literally be a few weeks or a few months. But with a deep value approach, it doesn’t really matter about the performance of an individual stock. You’re more interested in the performance of the portfolio. If you hold a basket of say, 20 to 30 stocks, generally, there’s always going to be something happening with one of the companies that will keep you occupied with your attention focusing on that company. There’s always some kind of reversion to the mean taking place, where these mispricings are correcting themselves.

Stig Brodersen 32:43

So whenever you talked about this net cash approach and how to read the balance sheet, it’s a very old-school, Benjamin Graham type of looking at a stock. So you can sell up all your assets, and you could pay off all your debt, and you will still be sitting there with, with cash even if you, you know, paid the full price for the company. Now, I’m curious to hear how you value the assets. We already talked about some of the real estate and how you can look more into that. But how do you look at valuation of the assets? Both in the sense that some of the assets might be worth more, which is a bit more rep. Also, that a lot of the assets, call it for instance, inventory. They might not be worth as much if you have to sell it right away. How do you value assets; both current assets, so meaning, it’s typically liquidated within 12 months, but also longer term assets?

David Flood 33:36

So I like to use the Ben Graham approach. So Ben Graham would look at a company and would look at its net cash position. He would look at its net current asset value, which would be the the value of the company minus total liabilities, and all fixed assets. What do you have in value in terms of the current assets? And can you find companies that are selling below that value? We’d also use what’s known as net-net working capital. And here, he would be more aggressive with his discounts. So he would only value the inventory about 50% of its stated value. The accounts receivable, he would typically only value at about a naught point eighty-five times its stated value. So by looking at these companies that are selling at net-net working capital or below net cash, you were essentially disregarding most of the assets and saying they have no value whatsoever to me. And if you find companies where the market cap is below net cash, you’re essentially getting the entire business for free; all the fixed assets; and all the other current assets. You’re looking at it from a very, very conservative manner. So it doesn’t really take much positive improvement to see the share price really move up on these companies.

So with a company like Myriad, when I bought it, it was selling at by six, two times net cash. Several months after I bought it, the stock price shot up 300% because they announced that they signed a contract with Tencent to implement their technology. So with these tiny, tiny companies, you can see huge share price moves upward. But just because there the market sentiment towards the company is so depressed, and people have really given up on the company, and the discount is so huge to their assets that one positive amount of news, or some catalyst emerging can really send the share price up dramatically.

Stig Brodersen 35:21

So many of our listeners have read about the net-net approach that you just mentioned before. Perhaps they haven’t practiced it yet. They, they might have read security analysis and, you know, spent months and months of their life trying to get through that book. It’s an amazing book, but it can be a little rough to, to get through. I’m sure you read that book, too. And we talked about it and about this net-net approach on the forum before, David. How have you found the foundation, you know, the net-net foundation; the old school approach, working today? How much is directly applicable today? How profitable is it? What has changed, if anything?

David Flood 35:57

The net-net approach, I think, still will works particularly with smaller companies. I mean, you generally you’re not going to find net-nets. You’re not going to find companies that are so–at selling below net current asset value with larger companies. You are going to be looking at these much smaller companies that tend to sell on the over-the-counter markets. And because there’s less people looking at these companies, the mispricings generally are much greater. Now, things have changed somewhat in the fact that many more companies now are service-based rather than product-based. And they will have much less in terms of fixed assets. They may be much lighter than their structure. But there’s still plenty of manufacturing firms, traditional companies that will hold a lot of…assets like inventory. They will still have accounts receivable. They’ll still have cash on the balance sheet. This approach with the net-nets will still work today.

Now obviously, with the net-net approach, you’re looking at buying a basket of stocks. You’re not going to invest all your money in maybe two companies because the non market risk is too great. She would spread that risk over maybe 20 or 30 companies as Ben Graham suggested that one should do. And typically the returns on these kind of the net-net approach is gonna fire out the general market. My benchmark is to try and aim for a 12% return minimum because the S&P 500 returns say, on average, long term 9%. And then, the long range inflation rate in the United States is around 3 to 3.25%. I want to try and earn something that’s going to be an excess of that. Now, it’s going to be very difficult to try and earn those kind of market beating returns, when you’re investing in very large companies. People can do it, obviously. I mean momentum stocks have done very well recently. But that, I don’t think that’s going to last. But with the kind of deep value approach, you are going to be earning returns, which are probably going to be in the high teams. Maybe the low 20s, or maybe higher, depending on how conservative you are with your analysis of the companies. I think this approach works very well for small investors; small retail investors. And this approach can be applied across the entire world.

This is the  edge that the small investor has is that they can invest anywhere in the world, and invest in pretty much anything they want. So Japan is famous for having a lot of these net-net companies, where they’re selling at deep discounts to their tangible assets. South Korea is another one, where you’ll find some of these interesting companies. Hong Kong, there’ll likely be some companies with what’s going on at the minute. The share prices of these companies are falling, and the over- the- counter markets in the United States as well. And also the A market, which is the alternative investment market on the London Stock Exchange. A lot of these kind of net-nets tend to crop up there as well. So if you’re willing to put in the work, you can find these companies, and it can be a very successful strategy.

Stig Brodersen 38:43

So David, I really like the way that you introduce these companies and your process. And this is very different than the vast majority of our listeners are used to hear here on the show, and, and I’m sure what they used to do themselves. Now, usually whenever we invest in stocks, we always make a comparison with a competitor. For instance, if we buy stocks with Delta Airlines, we might want to compare that to Southwest Airlines first to learn more about industry metrics, and which company that has a competitive advantage. Now, it might be difficult enough to find financial statements for a company like Pinelawn Cemetery for instance. And you might end up comparing the company to a competitor that is say, thousand times as big because these companies just so small. How do you conduct a appropriate competitive analysis?

David Flood 39:36
I tend to approach each company on a case-by-case basis. And I will use, I guess, you would call it a, a micro economic approach. So I will maybe say, figure out how, how many employees does the company have? And then can I find out how much revenue the company is generating? Can I find out what earnings the company is generating? And then I’ll calculate, what is it earning in terms of sales and earnings per employee? And then, I could perhaps compare that to another company that doesn’t necessarily have to be in a similar market cap range. But I can still get an idea of roughly how competitive the company is; what its margins are gonna be like. But we’ll also look for companies that may have geographical moats, so these could be gravel pits; they could be toll bridges; they could be racing tracks; all kinds of strange, esoteric investments.

Now, these companies by their very nature will have a moat because they occupy a geographical space. So if we take maybe a quarry or a gravel pit, the owner of that gravel pit or quarry has a geographical moat because the competitor that’s based in another county, it’s not economical for them to ship over their produce; their aggregate to a different county. Just wouldn’t work out on a basic micro economic sense. So because of that, we know that within a certain catchment area around this gravel pit, all this…quarry, they will have a geographical moat. And the same could go for railways. No one’s going to spend huge amounts of money to lay down a railway track, where a railway track already exists. So by looking at these small companies, you don’t necessarily have to do a direct competitor analysis because you can find those that operate with some kind of geographical moat, or there may be some kind of niche business. They may specialize in producing some kind of very unique product. And they may have long term contracts with military, or the Defense Department, or various other government agencies.

These long term contracts are locked in and they provide some kind of competitive advantage for the company. Because it’s a very niche product, there’s unlikely to be many competitors attracted just because the, the market share is, is so small in terms of dollar terms. It’s not going to attract large numbers of competitors. That acts as a barrier to entry, so these companies can then build up these relationships with the government and other private sector operators, and then continue to produce margin results over prolonged periods of time.

Preston Pysh 42:02

So David, I’m kind of curious what you think the best advice would be for somebody who’s listening to this; somebody who may be wants to invest in a smaller company and an over-the-counter traded business. What would you tell that person knowing all the things that we previously discussed? What would be your best piece of guidance for them?

David Flood 42:20

The first thing would be to say, “Caveat emptor, buyer beware.” So proceed with caution, when you’re investing in the over-the-counter space because you will come across frauds there. But if you conduct due diligence, it’s very easy to spot these and to avoid them. So personally, I will generally avoid resource stocks like miners. The old saying is that, “A mine is a hole in the ground with a liar standing next to it.” These things, they tend to eat a lot of money and not really producing much of a return, so avoid those. Avoid biotech. And I suggest that the people do so, unless they’re experts in that kind of area. Biotech stocks tend to just burn through a lot of cash in research and development.

Crypto, I will generally avoid as well. I have no problem with cryptocurrencies. I think they’re a good thing. But I think there’s a lot of small companies that have sprung up in the crypto space because they think that is a quick way to make money. I will also buy Chinese reverse takeover merges. These are companies. where a Chinese company is found a United States company, which is maybe a shell company. It doesn’t have a business, and they will then merge with that company to get access to the markets in the United States. Now, I will generally avoid those companies because there’s a much higher chance of fraud with those kind of companies. So anything that really has operations in China, where I have some suspicions, I will avoid it. Well, I wouldn’t avoid some of the much larger companies in China or Hong Kong. Generally the small companies, I will avoid. I will also avoid companies that are very high share accounts.

If I see a company, and it has billions of shares, I’m not interested in that company because that suggests to me that the company has to keep issuing equity to keep the lights on. They keep–are having to keep issuing equity. That’s a bad thing for me because I’m going to see my position diluted over time. Whereas if I find a company that’s got a share count that maybe 10 million or less, and it’s been around for several decades, that indicates to me that the company has been able to continue its operations without having to dilute shareholders. I would also suggest that investors diversify, so then they can limit non market risk. They can read about this in You Can Be a Stock Market Genius by Joel Greenblatt. He talks about how one should diversify to avoid non market risk: the risk that if when one of your stocks blows up, and wipes out your portfolio.

So don’t just put all your money into like a couple of stocks like Charlie Munger does. His approach is very different. He’s looking for companies with moats. The deep value approach is very different to that. And then another thing I’d say is to put the work in. The more work you do, the more likely you are to get market beating returns. If you work harder than everyone else that will pay off. I see that in all walks of life, whether it’s athletics, or business, or anything really. And again, I would suggest people look for a mentor. See if you can find someone that’s experienced in this area. And perhaps email them, contact them, and discuss ideas. Maybe share ideas and companies you found, and ask them what their opinion is before you buy the company. That can be very useful as well.

Stig Brodersen 42:25

So I think that’s a nice segue into my next question. Aside from your own blog, what are the best resources if our listeners would like to learn more about the OTC stock market?

David Flood 45:28

I would recommend that listeners can try and get hold of some over-the-counter market stock manuals. There are a number that are around. You can buy this: the Mergent over-the-counter manuals, and there is the Walker’s over-the-counter manuals. Now, you can pick these up on the cheap, generally on Amazon from time to time. I actually ended up ordering an old Mergent over-the-counter manual from the United States. I gen–generally don’t buy the most recent edition because it’s nearly a thousand dollars. So I will buy ones that are maybe a couple of years old, and…but generally a lot of the information is still quite relevant. And then, I will also follow a number of different over-the-counter value blogs, so there’s some such as No Name Stocks run by Dan Showm; Over-the-counter Adventures, which is run by Dave Walters; Oddball Stocks, which is run by Nate Tobik. I will follow these blogs and then look at the companies that they’re talking about. And use that as a kind of a springboard to then go and conduct research into these companies myself. And I think by reading through all these blogs, you start to get a, a knowledge of the different companies that operate within this space. And you start to learn about all the different nuances that there are in the over-the-counter investing space.

Stig Brodersen 46:41

David, thank you so much for coming here on the show. And yeah, I’m sure that our listeners would love to learn more about you. As mentioned before, I’ll make sure to link to Episode 93. The last time you were on the podcast, where you joined a mastermind group discussion. They can also read some of your analysis on our Intrinsic Value Index. It’s completely free. And they can also sign up at tipemail. com. Whenever we have a new analysis that we send out, a lot of them are written together with David, it will go directly to the inbox. But aside from that, David, I know that you’re on Twitter, and I know that you have a great blog, too. Where can the audience learn more about you?

David Flood 47:19

If people want to connect with me, they can connect to me on twitter @ElementaryValue, I’m always on there, generally, so if people want to contact me or respond, that’s fine, they can do that. And I’ll, I’ll get back to them. You can also follow me on my blog, which is at elementaryvalue.com. I generally try and post the write up on a new company every couple of weeks to every month if I can. I’ve got a lot of ideas, so there’s probably gonna be a lot more posts coming. And on that website, there’s also a lot of other information for value investors; how to look for ideas and different resources that they can use. You can find me there, and you can contact me there, and I’ll get back to you.

Stig Brodersen 47:57

Fantastic! And again, David, thank you so much for taking time out to speak with Preston and me here today. Thank you so much.

David Flood 48:04

Thanks for having me.

Stig Brodersen 48:06

Alright, guys! So at this point in time of the show, we will play a question from the audience. And this question comes from Sebastian.

Sebastian 48:13

Hi, Preston and Stig. Thank you so much for this show. I’m a big fan, and I’ve been learning a lot. My question is regarding passive investing. Warren Buffett and a lot of other value investors recommend index funds for most people. But this week, Bloomberg published an article that index funds have more money than actively managed funds. And famous investor Michael Burry recently claimed to have identified the latest bubble, which is passive investing, and neglecting all the other stocks. So my question is: What are your thoughts about passive investing and what else can one do to protect the downside? Thank you.

Stig Brodersen 48:53

Now, Sebastian, I think that’s a great question. So Michael Burry, who you refer to became famous for being the “hero” in the movie, The Big Short, that I’m sure many audience have already watched. And in that movie that takes place up to the crash in 2008, he made a very profitable investment betting against CEOs. And right now, he’s comparing passive men’s index funds, meaning if you buy, for instance, ETF tracking the S&P 500. And he’s comparing that with CDOs before the great financial crisis. Now, if you’re not too familiar with CDOs, it’s short for collateralized debt obligations, which was really a lot of bad debt bundled together and sold as high quality debt, and often roll into so called subprime mortgages that blew up back in 2008. And yes, we have tried multiple times to get Michael Burry to come on the podcast to talk not just about what he saw back then, but also his view on passive index funds. And he even recently took a stake in Bed, Bath, & Beyond, so definitely a lot of things to talk about. And we will definitely still try to see if we can get him on.

In the meantime, let’s go back to your question here, Sebastian. If you look closer at the S&P 500, you have as many as 266 stocks. That was Michael Burry’s count. More than half that was traded under 150 million dollars, and why this sounds like a lot–it’s not a lot if you compare it to the trillions. Trillions with a T of dollars in assets globally; their index to these stocks. Now there are many opinions on whether we are in the bubble or not. But here on the show, we multiple times talked about that we found the stock market overvalued, and I really haven’t changed my opinion about that. But regardless, if we are in a bubble or not. One thing is certain, if we are in a bubble, the longer it goes on, the worse it will be, whenever the music stops. So you asked how do we protect ourselves if we think that Michael Burry has a point. First, you don’t buy passive index funds, of course. Instead, you can have individual stocks. And yes, that stock could be in the S&P 500. But also consider if you can find stocks outside of the index. For instance, many value stocks are not included in those power indices. And know I’m talking my position, but I’m pretty bold on value to perform well compared to the markets the next few years. So, if you agree with Michael Burry about a bubble being built on passive index funds, I think that’s worth consideration.

Now, also to your other points, Sebastian. Does that mean that Warren Buffett is wrong, whenever he suggest investors to buy passive (*inaudible*) ETFs tracking the market? What he’s saying is that unless you’re qualified to make investment decisions and know how to value both the market and individual stocks, you should just invest in the market using a cheap investment vehicle such as ETF. Because in the long run, whether we’re in the bubble or not, you will get the market return. And yes, the market return won’t give you a fantastic Warren Buffett type of return, but a decent return without the stress about whether we in the bubble or not. And also keep in mind that we had very smart people before the crash in 2008. The boss said that the market would go higher and lower. And in March 2009, when the market bought on out, we still had some very smart people arguing that it will go in either way, you know? It could go higher or lower. So I still think Warren Buffett’s advice is very solid for the vast majority of investors, who can’t or won’t make investment decisions away from the stock market, or, or who do not pay attention to what Michael Burry is saying, or if we are indeed in a bubble. Long term, we will just do fine with that investment approach that Warren Buffett suggests.

Preston Pysh 52:46

Hey, Sebastian! So I love the question, and to be quite honest with you, I, I thought the same thing as you. I was kind of, you know, kind of raising an eyebrow saying, “Well, that’s an interesting take.” And it’s not a new take. You had Carl Icahn that was saying something similar back in 2015, I want to say. And it was funny because the CEO of BlackRock, Larry Fink, he came out and slammed the Ichan saying, you know, “That’s a bunch of crap. And here’s all the reasons why.” And I’m sure if you did a little bit of digging, you could uncover a few videos of that exchange, which happened well before Michael Burry’s comment here recently. And I just don’t know that I have a good answer for you. Where I think that there’s more systematic risk…with what’s going on is much more in the bond market and in the currency markets. So my point of view is that you can continue to do quantitative easing.

You can continue to do all these things that central bankers are doing, but where I think you start to hit a backstop, and where you start to hit a wall is in the fixed income bond market. And so, as that–as they continue, as central banks continue to push those interest rates lower and lower through quantitative easing, and now they’re doing it through–on the shorter end of the bond yield curve, in the repo market. It’s all quantitative easing, and all it’s doing is it’s continuing to push the yield of the bonds down to zero percent. Now, over in Europe, over in Japan, all these different spots in the world; major economies, you’re starting to see the interest rates bottom out at zero percent. They can’t go any lower. They’re trying to push them negative and it’s, it’s not looking pretty, whenever they do. Here in the United States, you still have some positive interest rate. So where I think that this is playing out much more so than maybe the ETF market. I think all the thing that the that’s going to happen with the ETFs is that you’re just going to see the movements be that much more abrupt, whenever they do occur. I don’t see the ETF being the cause, though. I see the central bank interaction pushing interest rates down to zero percent and trying to make them go negative becoming much more of the issue because you start to hit a limitation on how much Ray Dalio calls it “pushing on a string.”

So when you get to a position where currencies are going to have to be devalued in a major way in order to account for this. And that’s how I see this playing out, and you’re going to have to see–and, and if they do that with currencies that means interest rates on fixed income bonds have to go up, which would then drive equities down–I think that what you’re going to see the ETFs being this vehicle that provides a massive push to that more fundamental problem or more systematic problem that’s playing out. So really hard to say…(*inaudible*), I just–we keep on trying to find good undervalued picks; stuff that we were talking about with David today; good undervalued picks that have good fundamentals that would be able to weather something like that because they have a good strong competitive advantage, and they’re adding value in the marketplace. We’re just trying to find those kind of companies and highlight them to, you know, to all of our listeners, but then also talk about these macro factors, so that everyone’s aware as to what’s happening, or in, in the market. So Sebastian, really love the question! And for asking such a great question, we have an online course called our Intrinsic Value Course that we’re gonna give you completely for free. Additionally, we have a filtering and momentum tool which we call TIP Finance. We’re going to give you a year-long subscription to TIP Finance completely for free. Leave us a question at asktheinvestors.com. That’s asktheinvestors.com. If you’re interested in these tools, simply go to our website: theinvestorspodcast.com, and you can see right there in our top level navigation, there’s links to TIP Finance and also the TIP Academy, where you’d find the Intrinsic Value Course.

Stig Brodersen 56:35

All right, guys! That was all that Preston and I had for this week’s episode of The Investor’s Podcast. We see each other again next week.

Extro 56:42

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