(Ep.21) The Acquirers Podcast: Tim Melvin – Financial Value, Graham And Schloss Meets Kravis In Financials

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Summary

In this episode of The Acquirer’s Podcast Tobias chats with Tim Melvin who is a 31 year veteran of the financial services industry, as a broker, advisor, and a portfolio manager. During the interview Tim provided some great insights into:

– How Does A High School Drop-Out Get Started In The Finance Industry

– Why I Don’t Hate Leverage In Prospective Opportunities

– The Reason I Really Started Getting Interested In REITS

– How To Create A Private Equity Replication Strategy

– Why Small Bank Stocks Are So Attractive

– There’s Two Places In The Market Where Book Value Is Still The Best Metric For Valuation

– The Best Returns Can Be Found In Small Illiquid Value Stocks

– How To Construct An Insider Trading Strategy

– The Graham Two Factor Model Still Provides Great Returns Today

– The Best Way To Use Options In Your Value Investing Strategy

Other Studies/Papers Mentioned

Other studies/papers mentioned in the interview are;

Dan Rasmussen – Leveraged Small Value Equities

Roger Ibbotson – Liquidity As An Investment Style

The Acquirers Podcast

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Full Transcript

Tobias Carlisle: All right Tim, you ready?

Tim Melvin: I’m ready when you are.

Tobias Carlisle: All right, let’s do it.

Tim Melvin: Okay.

Tobias Carlisle: Hi, I’m Tobias Carlisle. This is the Acquirer’s Podcast. My special guest today is Tim Melvin. He’s a 31 year veteran of the financial services industry, as a broker, advisor, and a portfolio manager. He’s a strict practitioner of asset and cash flow based value, investing in the tradition of Graham, Schloss, and Whitman. He’s a prolific writer. He’s written for realmoney.com among other things and he’s also the ghost author of some of your favorite little books. Tim’s got a specialization in small bank stocks. I think financials are particularly undervalued at the moment. I’m looking forward to chatting with him right after this.

Speaker 3: Tobias Carlisle is the founder of Principle of Acquirers Funds. For regulatory reasons, he will not discuss any of the acquirers funds on this podcast. All opinions expressed by podcast participants are solely their own and do not reflect the opinions of acquirers funds or affiliates. For more information, visit acquirersfunds.com.

Tobias Carlisle: Hi, Tim. How are you?

Tim Melvin: I’m great Toby. Thanks for having me on today. I really appreciate it.

Tobias Carlisle: My absolute pleasure. We’ve known each other for quite a long time. You’re 31 years in the industry. How did you get into… You started out as a broker?

Tim Melvin: Yeah. Well, here’s the thing. I dropped out of high school. Okay? I took the state standard, the GED exam. It was in the 80s. A friend of my fathers had gotten me a job at John Hancock Financial Services in Baltimore. So, we’re selling life insurance, invariable life. We had that wonderful new sales system that had just been developed, called Financial Planning, so we’re really cutting edge on the financial planning sales process.

Tim Melvin: Eventually, I moved out to California because that’s where my then wife’s family was from, and we moved out there. Little town called Merced. In our little office complex, there was us, there was a fried chicken place and there was E.F. Hutton. I spent all my time over at the E.F. Hutton office reading research reports and driving the brokers nuts. They didn’t have a lot of money, so if I bought stock, or I was buying like 12 shares… This was before discount brokers were on every corner. I realized I wanted to be a stock broker.

Tim Melvin: I wanted to be a stock broker bad. I really did. I had some of the securities licenses, I had a six and the 22. I went to every brokerage office in the San Joaquin Valley. Okay? From Fresno all the way up to Sacramento and I stopped in every brokerage office. You would think in a mostly rural area, like the San Joaquin Valley, there wouldn’t be that many brokerage offices. There were a ton of them. They were everywhere. As soon as they heard GED, no college, nevermind an MBA, gone. Out the door. Except for one guy.

Tim Melvin: The manager of the Dean Witter office in Modesto, California. Was a bit of a maverick thinker. He put me through the aptitude test. I aced it. I crushed it. They put me through the co-calling test. They were like, you know, you did better than we expected. I was like, “Guys, I sold magazines and vacuum cleaners door to door as a kid for five years.” Nobody punched me. Nobody sicked their dog on me. It wasn’t raining on me. The worst thing that happened is a few folks hung up on me. That’s minor league. I can put up with that. Then, I took the securities’ knowledge aptitude test. Aced it. He wanted to hire me. The powers of [inaudible 00:03:54] came back and said, this is before the crash of 87, okay. We only hire MBA’s. We didn’t hire college graduates, you have to have an MBA to work for our brokerage firm.

Tim Melvin: Well, okay. So, you say, “Damn. There’s the dream I guess I can’t have without going back and getting a four year and an MBA.” Maybe we’ll do that someday, but I got babies coming along the way. I was a fairly young guy back then and put it aside. A few weeks after the crash of 87, this guy from Dean Witter Modesto called. He said, “Okay. All my MBA’s have quit, except for the guy who’s still in the hospital from passing out on the floor the day of the crash.” He said, “I need some guys in here that can sell. So, I’ve convinced them to give you a chance.” I went in. I took the series seven, had just an outstanding score. One of the highest in the firm for the year of 1988. I was off and running. I did very well, because I had just enough knowledge to be dangerous.

Tobias Carlisle: Sorry, excuse me.

Tim Melvin: That’s okay. That’s okay. The idea of making three, four hundred phone dials a day just didn’t scare me at all. Then, the rest, they say, was history. I was with Dean Witters, with Shearson for a while.

Tobias Carlisle: Got to give up the cigarettes. Sorry. Sorry, Tim. Keep going.

Tim Melvin: And eventually found my home at a firm in the mid atlantic region, I’d gone back to Maryland. A very small firm, really. All we did was municipal bonds and small bank stocks. That’s the whole story right there. So, yeah, started as a broker.

Tobias Carlisle: Oh, jeez.

Tim Melvin: That’s okay. Worked there as that for 20 years. Then, the guys at Real Money wanted me to write for them. The brokerage firm’s lawyers said no. I called them back and said, “I need to make this much.” They were like, “When can you start?” I’m like, “Tomorrow. I’m your guy. I’m in.”

Tobias Carlisle: So where did you become a value guy through there? What prompted you to become a value investor?

Tim Melvin: My first couple weeks on the job at Dean Witter out there in Modesto. Remember, they teach you enough in training, just enough to be truly dangerous. Most of the training is focused on the sales process, okay? I get back and I’m making my dials. I’m using Tax Rebound Funds to talk to people about. I’m like, “this is boring. Let’s find something exciting. Let’s get a stock idea. Something really exciting. Get people fired up.” So, I found one. Dean Witter had what they used to call the idea of the day. The research departments sent out there best idea that day. The best idea comes out the day I decided to try my stock experiment. It’s La Petite Academy. Right?

Tim Melvin: In the late 1980s, what a story. We were still in the fairly early stages of women back to work in two income households. This was really just gaining momentum. The need for daily child care was truly greater than it’s… I’m getting excited about this story just telling it now, 30 some years later, right? There was just going to be this tremendous earnings’ growth. They were located all over the country and plenty of room to grow. So, I was passionate about it. I’m calling up people and I’m selling them. I’m opening accounts like crazy. It’s a great story. They reported earnings. Yeah. They might of missed the number and maybe somebody touched somebody where they shouldn’t of touched that somebody. There was lawsuits and legals. The stock drops 50%. I don’t think I know as much as I thought I did.

Tim Melvin: There was a guy in the office and he runs a very large successful investment management firm today. Back then, he was a broker. It was the cleanest, most efficient way before the plethoration of hedge funds, when it was very easy to be an RA, to manage your family and friends money. So, that’s what he did. The guy was racking up phenomenal numbers. Incredible. I literally just pestered this poor guy. I mean, every day. How are you doing? What do I have to do? How do I learn? He’s like me, a little absent minded, forgets to get hair cuts, documents piled up about yea-high on the desk. He’s just down behind them, reading and studying. I’m like, “Look. You got to tell me. I’m not going away. You’ve got to teach me how you’re doing what you’re doing.” I want to make some money, feed my family and stay in this business. I don’t like selling life insurance. I don’t want to go back to it.

Tim Melvin: He finally took pity on me and he give me the intelligent investor, by Ben Graham of course and Marty Whitmans, the aggressive conservative investor. He says, “When you’ve read both these books, then I’ll talk to you.” What he didn’t realize. I’m a natural born speed reader. Okay. Those books were demolished in a weekend. I was back with questions from the books. That’s how it started. He really taught me and was an unwilling and reluctant mentor to me for the several years until I returned back to the east coast of Maryland. I just kept building the knowledge base from there.

Tobias Carlisle: So, that’s why you’re still a Graham, Schlost, Whitman guy?

Tim Melvin: Well, I think you really have to add some Henry Kravis in there. I really do think a lot more today, like a private equity investor, then I think some of the traditional Graham investors. I don’t hate leverage. Right? I read Dan Rasmussen’s study and [inaudible 00:09:24] companies. I said, “Aha. Somebody finally put this down in black and white.” If a company is reducing it’s debt load and that Altman Z-score’s over about 1.81 and I’m getting the assets or earning stream streak. I’m not scared.

Tim Melvin: I know a lot of guys like Builders First [inaudible 00:09:44] is in the building products business. I have such a favorable long term view of that business because of the housing shortage. I think eventually we figure out some of the affordability issues. We start to see a lot more of first time homes being built. I don’t think it’s going to happen tomorrow, but I think it’s going to happen over the next five years, which happens to be one of my favorite time frames. The debt to equity, Builders First [inaudible 00:10:07] is well over one. A lot of the traditional value guys like, “Whoa. I’m out. That’s a levered company and Ben and Warren said don’t buy those.” Warren’s saying don’t buy companies with debt is hysterical. He runs an insurance company with a huge float in his favorite investment is banked, the most levered companies on the planet. I’ve always gotten a kick out of that.

Tobias Carlisle: He’s saying don’t buy them so I can buy them.

Tim Melvin: Yeah. I think that’s pretty much it. Levered companies don’t scare me as long as we’ve got the pay down of the debt and the high Z-score that’s telling me, “Hey. Yeah. They got debt, but they got a lot of cash flow so they can pay the debt. Every dollar they pay of debt makes my equity another dollar more valuable.” It makes sense to me. If they’ve got the free cash flow generation, then I’ll tolerate the debt.

Tim Melvin: The other thing is, the reason I really started getting interested in reads and really studying, go what’s going on here. I was looking at what Blackstone and KKR and some of these other firms, particularly Blackstone though, were doing in the private equity space with real estate. They’re largest owner of real estate in the world right now, I believe. If not one, they’re two. They’re racking up huge returns just buying real estate at cheap prices. They’re not putting anything fancy on it, right? I was listening to Steve Schwarzman at the [inaudible 00:11:26] Conference up in New York City earlier this year. They’re like, “What’s the secret?” He says, “No secret. It’s the same thing the guys taught me when I first started. You’re looking to invest in real estate where you can grow the asset value and grow the free cash flow each and every year.” I’m like, “Damn. I think I can quantify that.”

Tobias Carlisle: So, that’s one of your strategies. You have this private equity replication strategy, so do you want to tell us a little bit about that one?

Tim Melvin: Yeah. I mean, it’s like a cross between what you do and what Dan Rasmussen… I think you’ve already interviewed him. [crosstalk 00:11:56].

Tobias Carlisle: I have, yeah.

Tim Melvin: It’s kind of somewhere in the middle of what you guys are doing and then we wrap that with real estate. We add the real estate component. We’ve got the bank component, I call that the lending component. Business development companies would go in there if they were attractive. Right? Then, you’ve got special situations, which again, tracking private equities lead primarily infrastructure, although we do have a few holding companies in there like steel partners that own a mix of different companies or mini-private equity companies in and of themselves. We own a lot of infrastructure. Private equities really into infrastructure right now, because once you put it in place, be it a solar farm, an airport, whatever it is, right? The annual cost of maintenance are not that high and the cash flowing in the door is massive. It’s Bruce Flatt of Brookfield Asset Management calls it being a toll collector. We’re just collecting tolls in that section of the portfolio.

Tim Melvin: If you put all this together in an individual portfolio, all of a sudden, you don’t look like a mutual fund. You’ll look like Cundall, Kravis, and Roberts. Our work shows that your mutual funds don’t do all that great and KKR, they’ve done pretty good. That’s top quartile private equity funds consistently over that 20% line. That’s what we want to replicate and I have to say, I’m pleased and impressed with the results that we’ve had so far.

Tobias Carlisle: Why do you think that the private equity firms have directed themselves to these… why are they so good at sniffing out these areas?

Tim Melvin: Well, I think it evolves, right? You’re borrowing a lot of money, so you figure out how to be a pretty good lender. You begin to understand the value of permanent cash flow. You start looking for vehicles that can provide that permanent cash flow. The rents on, let’s say field solar panels, that rents coming in every year. There’s no variation like there might be in the operating accounts of one of your companies. You spend the money once, you’ve got a forever stream of free cash flow coming back. I really think it evolved from their core buy out strategy. Then, the real estate, I think Schwarzman at Blackstone just had an aha moment. He’s like, “I own all of these businesses all over the world. I’m paying everybody rent. Why in the hell am I doing that? I’ve got all this cash, all these investors. Let’s just go buy the building. We’ll pay ourselves rent.” Then, buy some more buildings and collect their rent. Other guys followed.

Tim Melvin: When you put it all together, they’re kind of not correlated, but they’re all very high returns. The same things that drive reads have nothing to do with the buy out part of the portfolio, which by the way is based really heavily on your work in quantitative value and deep value. One of the first discussion you and I ever had was which was more important? That enterprise multiple or the price to book value. We arrived at the conclusion that this, for non financials, your metric enterprise value, much more affective and important. For financials, this price to book value, probably much more important. I still view the world today based on that, what seven, eight year ago conversation.

Tobias Carlisle: Yeah, as do I. That’s exactly how I run my portfolio. For the industrials, I use my acquirers multiple and for the financials, price to book value. That’s what my portfolio looks like now.

Tim Melvin: Okay. Yeah. Mine as well. We’re still doing the newsletter business, so we’re putting out a bunch of articles. We run them out of portfolios. That’s exactly how we run it. We try to stay, I call buckets, we try to stay in those four buckets. Right now, not doing a lot in the lending bucket, particularly the BDC side of that. Not finding a lot in the buy out bucket. I mean, that’s very slim pickings right now, as you know. There’s not too many [inaudible 00:15:59] enterprise multiples, but we are finding some special situation infrastructure, holding companies in particular, and the real estate investment trusts are this, right now they’re the gift that keeps on giving.

Tobias Carlisle: Yes. Really love chatting to you, as we’ve done over the years, about small bank stocks. What attracts you to that area right now?

Tim Melvin: Well, it’s the same thing that always attracts me to them. Banks have been in a consolidation phase since the interstate banking laws started to change under Ronald Reagan. We had about 18,000 banks back then. We’re down to a little under 6,000 financial institutions, if I throw the thrifts in there. They’re very small, the ones I favor, anyway. Nobody on Wall Street cares about them, or really can buy them. There’s this small little hand full of activist funds that are active in this space, but nobody else is. If you want to see some of the more active traders and investors out there, you want to see their eyes glaze over, start talking to them about buying small bank stocks below book value. You can put a room to sleep quicker than anything else.

Tim Melvin: Here’s what happens. You get a small, well run bank. It’s trading below book value, because again, nobody really cares about it. Good things are going to happen, especially if you’ve paid a lot of attention to do they have enough capital, what is the loan book look like. If you get all three parts of that right. The loan book, the capital structure and the price to book. Toby, it’s hard to lose money. It may not happen overnight, but it’s very difficult to lose money. Sooner or later, odds are, somebody’s going to come along and buy that bank.

Tobias Carlisle: Well, let’s talk about a few of those things. How small are you talking about when you say small banks?

Tim Melvin: I think the average market cap in my portfolio is probably around 50 million. On the same token, I did suggest that we all try to buy shares a $10 million bank in Hawaii the other day. We’ll go small. That’s one of our biggest edges. We’ll go small, put a limit order in. I’ve been in situations where it took three, four months to get filled on the stock. That’s fine. If I get filled, odds are I’m going to make money.

Tobias Carlisle: Let’s talk about the banks themselves. When you say, well capitalized, what are you looking for there?

Tim Melvin: We want an equity that assets’ ratio over ten. Before the credit crisis, the average ratio in the country was probably down around seven. Back when Peter Lynch was executing a very similar strategy in the 70s, he thought the equity to asset ratio should be above five. Banks were much more levered machines back then. The leverage is down and we’re comfortable with that. Excess capital allows for acquisitions, it allows for buy backs, and it allows for dividends. I’m a huge fan of all three of those things. Go ahead.

Tobias Carlisle: I was just going to ask you a little… you keep going. I was going to ask you about the valuation, but let’s keep on going.

Tim Melvin: Also, when you have excess capital, if you go back to 2007 and you run some screens and you go, “Okay. Which banks in 2007 had equity to asset ratios over ten?” Well, those banks that show up on that list, they’re all still with us.

Tobias Carlisle: Right.

Tim Melvin: Not so many of those below ten are still with us. I want to be able to survive the shock.

Tobias Carlisle: Right.

Tim Melvin: If you were.

Tobias Carlisle: That’s spoken like a true deep value investor. The metric that you talked about then, it’s getting a lot of bad press lately, even though I think that that’s really the only metric that you can use for financials, is price to book value. Talk us through how you value one of these stocks.

Tim Melvin: It’s price to tangible book value. We only use tangible book value, by the way. I don’t really care about the intangibles in banks. They don’t amortize the same way they might in a tech company. Add up the loans, subtract out the deposits, divide by the number of shares, what do we got left? That’s what I want to pay for the bank. Richard Lashley at PL Capital runs a cost take out model of what it might be worth in a take out. I think it’s pretty cool and I play around with it. My core metric is price to tangible book.

Tim Melvin: Let me just digress for one second here. I know price to book value has become a very unpopular metric. The key saying is it doesn’t work. Here’s the truth. It still works in financials and it works very well. It also works on smaller stocks. We run models. We run them once a week. We back test them rigorously. One of the best performing models over the last year is a very small cap, hundred million and under, trading below book value with a strong balance sheet. Now, if I’m running a $5 billion fund, I can’t do anything with that. I can’t buy any of those companies. Unfortunately, I’m not running $5 billion. I can pile into those things and still do real well. The problem with price to book value is not that it doesn’t work, it’s that it doesn’t scale.

Tobias Carlisle: So, in the take out metric that you just discussed there before, do you view that as sort of an upper end of the valuation?

Tim Melvin: A midpoint really, because for instance, we had a bank taken over last week at a 70% premium for what we paid for it a few years ago. It was ridiculous. When I ran it through the take out model, it showed maybe a 20% upside. Clearly, that was understated, relying on price to book value, I think I was able to capture more of the extreme move then I would of if I’d relied heavily on that cost to take out model.

Tobias Carlisle: What’s interesting right now, do you have some unnamed that you can give us?

Tim Melvin: Let’s see. Glen Burnie Bancorp in Glen Burnie, Maryland. My own hometown. This is a relatively small bank, but it’s trading at about 87% of book value, plenty of capital on hand, great dividend, 3.74%. It’s just a small bank located between Anne Arundel county in Baltimore, which is a fantastic market, believe it or not. The economy doesn’t start going downhill until you actually cross that Baltimore city line. So, it’s in a great market, they have exposure to the D.C. market, could be a very attractive target it somebody wanted to take it out. Same token, the banks like a hundred years old. It’s been there for a long time, they’ve survived several crisis’, new management came in a few years ago and has done a fantastic job, cleaned out all the bad loans. You’ve just got this clean, pretty, dividend paying bank in a great market. I think no matter what happens to the stock market and economy, over time, that bank does very well.

Tobias Carlisle: How big is that bank?

Tim Melvin: Glen Burnie Bancorp is a whopping $28 million market cap. Folks, if you take any of my recommendations, limit orders are mandatory. Using a market order will ruin you’re whole day.

Tobias Carlisle: You mentioned the divided there. Is that something that you look for in bank stocks, in high yielding bank stocks?

Tim Melvin: Not in this particular strategy. Most of our banks are very small, I would say less than half of them actually pay a dividend. For as long as you brought it up, we have been working with some new stuff and running tests. That’s one of the things that you taught me, is always be testing your ideas. We found that if you combine price to earnings ratio with dividend yield, you end up with monstrous returns just by buying the 20 highest yielding banks with a low PE ratio. That test is clean all the way back through the credit crisis, all the way back to 1999. Yeah. You got hit in the credit crisis, no way you’re into portfolio banks and didn’t see some pain, for recover very quickly and none of the banks went out of business.

Tobias Carlisle: Where do you see the market for value… Are you wholly focused on bank stocks or are you looking outside?

Tim Melvin: I look outside banks as well. If I’m going to go second favorite area, real estate investment trusts. This is the most under owned asset on the planet by individual investors. I love it when you talk to the brokerage firms, they’re like, “Well, we’re going to add a 5% allocation to real estate investment trusts.” Seriously? Since they changed the tax laws in 1972, if you had just bought equity real estate investment trusts, you’ve outperformed the s and p 500 by a very considerable percentage. You’ve collected fat dividends along the way, and you’ve been backed, not by hopes and dreams of some technology company, but by actual real estate.

Tim Melvin: Most individuals should have a much higher allocation, in my opinion, to real estate investment trusts then they do at this or any other time.

Tobias Carlisle: What’s the aversion to real estate investment trusts?

Tim Melvin: I don’t know why the street has always had such an aversion to real estate investment trusts. I guess, you know, maybe they’re not exciting enough, they’re not sexy enough. Everybody wants the next Amazon or the next Facebook. What they forget is whoever the next Amazon and Facebook is, very hard to identify them looking forward. I’m old enough to remember in 2002, Amazon was on the Barron’s Death Watch List, because they were burning cash at such a rapid rate. If Amazon was such a sure thing and everybody knew it was going to happen, where are all the Amazon billionaires? There should be a bunch of them. I don’t know any.

Tobias Carlisle: Well, there’s one. There’s two now.

Tim Melvin: But I don’t know him or her. Whoever they are, they’re going to pay rent. The ones that don’t make it, going to pay rent. Everything good in science and technology and business, it happens inside. Most of them pay rent, so I’ll just collect rent checks.

Tobias Carlisle: Talk to us a little bit about business development companies. What is it and what’s attractive about it?

Tim Melvin: Business development companies are investment for trusts basically, that make loans to middle market companies. These tend to be very higher yielding loans and it’s an area, frankly, that the banks stepped away from post cred crisis. They’re like, “Well, that’s riskier lending.” Lot of LBO lending, mezzanine financing. Here’s the thing, I do love them. I think they’re wonderful, especially those associated with the large private equity firms. Blackstone’s got one. Apollo’s got one. I think TPG’s got one. Right now, they’re not a buy. On paper they look good. They’re paying these fat double digit yields, but there’s too many people in this business. There’s over one trillion in the leverage loan market right now and an awful lot of it’s been lent by people that are new to the game.

Tim Melvin: Last year, I was at the leverage lending credit crisis in a private credit crisis conference, I’m sorry, in Chicago. As I looked around the room, a lot of guys there under 30. These guys have never seen a bad credit market. We’re seeing covenants, the restrictions on the loans themselves, pretty much nonexistent at this point. We’re seeing credits that should be an eight, nine, ten, 11% credit doing loans at five, five and a half, six. The funds themselves are levering that up three to one. There’s a lot of danger in the levered loan market right now. I would step back away from the business development companies, but they’re going to go boom. Okay? I don’t know when. Don’t have that kind of crystal ball. They’re going to go boom.

Tobias Carlisle: When you said boom, they’re going to go up or they’re going to go down? Which ways [crosstalk 00:27:40]

Tim Melvin: Oh, they’re going to go down. Eventually, if we get into a recession or rates start to go up, there’s just so much dumb money lent at unattractive rates with no convenance right now, that we’re going to have a meltdown in these things. The ones that survive the boom are going to be life changing investments. I expect they’ll be those with the closest and tightest relationships with the private equity firms.

Tim Melvin: The reason for that’s simple. If you look at KKR’s got one and I know Apollo’s got one. We’ll go with Apollo. Those guys came from Drexel Burnham, then went into the private equity business, borrowing tons of money to buy companies. I think they know a little bit something about who they should and should not loan to, because they’re had to pay back loans for better the three decades now. They structured a lot of those deals at Drexel Burnham that did blow up. They know what a blow up look like too. They’ve got more credit experience than anybody else in the market, besides possibly the bankers. Those BDC’s, they’ll see your prices get absolutely trashed, but if they survive, they’ve got that relationship, you’re going to be able to get into something that’s going to look like junk bonds back in the 90s with 15 to 20% yields and massive upside. I’m just kind of sitting here twiddling my thumbs waiting for it. I wish it would happen tomorrow. I’ve got some cash I’d love to put to work there, but we’ll wait because it will happen.

Tobias Carlisle: You’ve got a list and you’re just waiting patiently for the business development companies to get cheap?

Tim Melvin: Yup. Just waiting for the default rates to come up. It will be a problem. It will cost some messiness in the stock market. It’s not anything like, remember there’s a trillion dollars, big number, nowhere like the hundreds of trillions in the banking system that we put at risk back in 2008. The market won’t like it. It’ll cause a hiccup, but nothing that’s terribly value destructed from a broader perspective. A lot of these things are going to go by the wayside or get acquired by stronger competitors. From that point forward, these things will be a layup, much like junk bonds were in 1990.

Tobias Carlisle: A lot of the positions we’ve been discussing so far are going to be smaller and they’re likely quite a liquid, you said it would take several months in some cases or in one case to buy that.

Tim Melvin: Mm-hmm (affirmative)-

Tobias Carlisle: You’ve got some research on your liquid stocks.

Tim Melvin: Yeah. Actually Roger Ibbotson of Yale did this. It’s quite shocking and fascinating when he got into it. He diverged the world into liquidity and valuation. You had large liquid growth, you had small illiquid growth, large liquid value, and small illiquid value. Think about this for a second, because most people’s portfolio, what do they have? That large liquid growth stock. This study went all the way back into the 70s by the way and it was updated, I think, at the end of 2014. Down here, you’ve got your small illiquid value, they’re small banks, they’re companies nobodies ever heard of, the big firms can’t buy them. You would think all the money’s got to be up here in this large liquid growth because that’s what everybody tells us is the good spot. No. You got a return of like 2% annualized over this 30 year period. It was a study. Down here, these small illiquid value stocks have returned on average 18% a year. Illiquid, so what, I don’t care.

Tim Melvin: Most people will say, Warren Buffet says that if you can’t stand the stock market closing tomorrow for five years, you shouldn’t invest. You’ll hear that repeated all the time. None of them really mean it, because they’ve prized liquidity. I don’t really care. I have no intention when I buy a stock unless something goes horribly wrong in the financials, I’m not selling it for an extended period of time. I’m going to hold that until it’s at a premium valuation. Liquidity is not that big a concern for me. Again, I am unfortunately not running billions and billions of dollars at this point.

Tobias Carlisle: I always think there’s good logical reasons for liquidity being a pretty good indicator of something good that’s going to happen. It’s because when these stocks get beaten up, the people who own them know that they’re selling it way below value. The only reason they’re selling at that point is because they’re forced to, because they need some cash somewhere else in there portfolio. It’s all tightly held when it’s really deeply undervalued.

Tim Melvin: Yeah. The small stuff does tend to be tightly held. You find a lot of family run businesses down there. A lot of those, your exit is going to be because the family decided to sell or the kids don’t want anything to do with this company that dad and granddad started. They want to go out and do something else with their lives. Dad and granddad look around and say, “Well, we need to sell this, but we’re going to do it rational. We’re not going to sell it at this 70% of book valuation. We’re going to hire a banker.” It’s going to get sold at a proper price, which could be two and even three times book value. We’ve seen that happen more times than I can count.

Tobias Carlisle: Talk to me about your insider strategies.

Tim Melvin: Okay. These, we really do a lot of work on, because that’s so intuitively makes sense. If an insider’s buying a company, then something good should happen. After all, they’re in the best condition to know. Here’s a couple that we found. This first one I’m going to admit, I ripped this one off from the guys at WhaleWisdom. They did an article on it. I ran my own test, and I’m like, “Hey this works.” The toughest area of the market for value orient investors like us is biotech. It’s intellectually frustrating because we know biotech really is changing the world. biotech is going to make us live longer, live better, but they never trade at valuations that can attract us.

Tim Melvin: This strategies real simple. We’re going to go in, we’re going to follow the biotech insiders. When they buy more than $100,000 worth of stock, C-Suite executives, we’re simply going to buy that stock right there and sell it in 30 days. The numbers are shocking, how high. Shocking is the only word I have. I’m not even going to quote them because they’re just mind blowing. That’s a little more trading oriented, but it works. It’s worked for over ten years now. It does give you a clue as to which of these little clinical biotech stocks might be about to make a move.

Tobias Carlisle: Which makes sense, so insiders have some view on the way that the stocks going to trade post some announcement. They try to just front run it.

Tim Melvin: Sure. If you wrote a six figure check, unless you are Mr.Bezos and bought your own stock, you’ve got some conviction behind that. You’re not too worried about what’s going to happen at the FDA trials and that type of thing. The next strategy is really just, again, $100,000 check, open market purchase, no options, no stock awards, purchase. By any C-Suite executive and on this one, we’re just going to hold it until we find a better idea. Put 10% of your portfolio into each new idea. If a new one comes up and you’re fully invested, you sell the bottom performer, right? We just hang onto them until we find a better idea. Some of these stocks can be in the portfolio quite some time. Again, you easily climb what I call the 20% hurdle, using that strategy. Annualized returns and back testing and rolling back tests are north of 20%. We’ve been doing it recently and it’s working. We started implementing it real time with real money and you’re seeing almost immediate returns from these stocks.

Tobias Carlisle: How is that different from the first one you mentioned there?

Tim Melvin: Oh, that’s right. There is a difference in that one. I forgot. They’re 20% below the 200 day moving average. I knew I was forgetting something. This is a beaten up stock that nobody wants. Of course, the thing on Wall Street is, 200 day moving average matters. Never buy anything below the 200 day moving average. If there is a consensus on Wall Street that says never do something, I am immediately going to start testing what happens if I do that.

Tobias Carlisle: That works very well. So, you’re looking for something that it’s below it’s 200 day moving average, at least 20% below.

Tim Melvin: At least, yeah. It’s quite a bit below. This is a really beaten up stock. It’s kind of the ultimate contrarian strategy, really.

Tobias Carlisle: Somebody in the C-Suite has written a big check, $100,000 check in order to-

Tim Melvin: Yes. It has to be C-Suite. It can’t just be any officer or director. It has to be a C-Suite officer. So, CEO, CFO, COO.

Tobias Carlisle: Right. Got it. Talk to us about the Graham two factor model.

Tim Melvin: Well, you covered that one in quantitative value. Graham had that real simple model that he started working on in the 70s. He back tested it for 50 years. It did right around 15% a year. You and Wes back tested it for quantitative value, it was doing around 17% a year. I back tested it back to when you published the book and it’s still doing right around 15% a year. These are god awful boring companies, right? There’s nothing exciting about any of the stocks in this portfolio, just dividend paying stocks at less than 12 times earning, if I recall was the cut off that was used. You just rebalance that once a year. It’s kind of a set it and forget it investment strategy. You buy these stocks, you walk away. If something goes up 50%, you sell it. Otherwise, you sell it in two years. That’s ridiculously simple.

Tobias Carlisle: My recollection of that one is we might of struggled to find enough stocks in the universe that we were looking, but we might have been looking at a bigger universe. I think it might have been concentrated in a handful of stocks at any given time.

Tim Melvin: It does not produce a lot of [inaudible 00:37:32] and again, I’m going to pull the screen up right now. It doesn’t, but you should be able to get a 25 to 30 stock portfolio. Let’s see what we got here. I’ve got this one set for 20 stocks. If I remove the restriction. It’s a sure guarantee, American national insurance company, they sell annuities. Could there be a more boring business? These aren’t even variable annuities, they’re fixed annuities. Dillards. Just all kinds of just very boring companies. Insurance companies.

Tobias Carlisle: I like the short guarantee.

Tim Melvin: What’s that?

Tobias Carlisle: I like a short guarantee.

Tim Melvin: That’s a great company. I remember when Ross was buying that after the credit crisis. It was so ugly back then with all the potential losses. Of course, how everybody’s worried about their exposure to Puerto Rico.

Tobias Carlisle: Puerto Rico.

Tim Melvin: That seems to be working itself out. Okay, now if I remove my restrictions and rerun this. We actually got about 50 names that would fit that grand screen today, which is pretty good given that we’re ten years into a bull market.

Tobias Carlisle: There’s no market cap cut off in that screen, right? There’s no-

Tim Melvin: There’s no what?

Tobias Carlisle: There’s no minimum market capitalization there?

Tim Melvin: No. No. What’s the smallest capital? The smallest one in here is about 545 million and they go all the way up to, well, billions. Some of the really large companies.

Tobias Carlisle: That’s big enough.

Tim Melvin: Yes. Some MetLife’ is in there, Lincoln National. Those are all huge, multi billion dollar companies. They tend to be larger cap, dividend paying stocks. It’s a sleep real good and do better than average portfolio. Ever since you back tested it and updated it in the book, I’ve kept it pretty much updated every year.

Tobias Carlisle: It’s a great strategy. I’m a big fan of it. It’s just that I was under the impression that they weren’t around a great deal, but I haven’t really looked at it that closely over the recent period.

Tim Melvin: There seems to be more than enough, although you are going to be very industry concentrated. I’m looking at it right now and I see a lot of insurance companies, I see some energy companies. If you’re trying to diversify a cross sectors or industries, that’s going to be a little tricky. You’re going to be very industry concentrated.

Tobias Carlisle: I think that, you know, that’s not something that necessarily bothers me. I like industry concentration, because I think that that’s how you outperform. That’s a double edged sword, too.

Tim Melvin: Yeah. Can be, yes.

Tobias Carlisle: One other strategy that you follow that I particularly love is the liquidation value strategy. One of the things that I’ve noticed too, I always say, is they’re a little bit like cicadas, they come around every seven years or so in quantity. You have some tweaks that you make to the liquidation value that helps you out.

Tim Melvin: First thing in the liquidation value, I do it more like Peter Cundall then Ben Graham. We assign a little bit of asset value to the stuff that the company owns. Not a lot, but a little bit. Some of the stuff, like real estate obviously, can be converted to relatively quickly. So can a lot of the machinery. My son works as a CNC machine seller and reseller, there’s a really robust liquid market for that stuff. We just kind of try to figure out what that stuff is worth. Then the most important thing, A: always avoid the biotech’s because the cash burn in those things is phenomenal. Just because it looks like it’s trading less than liquidation value, it’s probably not actually doing that. And then, we just run the simple credit checks. Altman Z score and Piotroski F-Score and only buy those with the highest scores. This is a killer strategy. It’s more trading oriented. Right? You’re going to rebalance that about every 13 weeks. If you bought something at 70% of liquidation value and it’s gone up the liquidation value, you’re going to go ahead and sell that.

Tobias Carlisle: It’s a little bit about Marty Whitman. He has a great quote where he says, he likes to include real estate as well, and he said a first class office building is much more liquid then, depending on the inventory, but it could be fashion or something like that, that’s not going to be able to sell easily.

Tim Melvin: Right. Yeah, I mean I don’t think you want to put a whole lot of weight on inventory, particularly if it’s a dress maker. Right? The reason this companies trading cheap is because nobody likes their dresses. I don’t think I want to value that inventory very highly.

Tobias Carlisle: Joseph A. Bank was a stock I followed for a long time, because it was trading at a discount of their current asset value. That current asset value had an enormous chunk of their suit inventory in it. John Hampton, who’s the Australian guy whose known for shorting, he gave a presentation at a value investing congress. His observation was often in many frauds, not saying that Joseph A. Bank was a fraud, but often [inaudible 00:42:41] of fraud is that they have a very large asset sitting on their balance sheet. It’s out sized relative to everything else in it that’s in a crawl from the double entry book keeping accounting requires you to grow an asset if there’s a difference between your reported income and your cash flow.

Tim Melvin: Yeah. We try to avoid companies with larger crawls, because he’s right. They tend to be a little time bombs in the making. If I see that in something that appears to be trading below liquidation value, I’m going to lose interest pretty quick. We’re looking for that little handful. There’s only ten right now. In a bad market, they’ll be hundreds. Just those little tiny companies that are worth more dead than alive, but they have the financial strength to survive. Again, can I put my whole portfolio in these. No, that’s usually not enough. In 2009, there were enough. You could have done it then. It’s going to add incremental return, because there’s only a few of them. You can’t manage a billion dollars. It doesn’t scale, but for individual investors, you can put some kick to your returns using that strategy.

Tobias Carlisle: The argument the other way on Joseph A. Bank’s was that when guys go to buy suits, they must have the suit that they want immediately. They won’t wait around for it to be made, so it was sensible for them to carry enormous amount of inventory. Apparently, suit styles don’t change very quickly.

Tim Melvin: I mean, I’m guilty of that. I hate waiting for a suit and having it tailored and all that. Inventory in a retailer, it’s always going to be a fire sale. I don’t care if it is something that’s going to sell. Everybody in the room knows that these guys are bankrupt and the creditors want the cash and they want it today. Nobody’s paying anything close to even cost. If you overvalue inventory in a liquidation situation, I learned this the very, very hard way back in the 90s, you’re going to lose money. I don’t do that anymore.

Tobias Carlisle: What was Graham’s recommendation for the haircut that you should give to liquidation value? Do you remember? was it 75%?

Tim Melvin: Two thirds.

Tobias Carlisle: Two thirds.

Tim Melvin: Yeah. He wanted to buy it at two thirds of the net current asset value. I’m not quite that strict. I’m just looking for a discount large enough to provide me with a big return. If I buy it at 80% and it trades at 100, that’s a 25% gain. It’s usually going to take me less than a year to get that gain. Again, it’s an incremental strategy. I love it because it’s just ridiculously intellectually satisfying. It does add a very nice kick to your overall returns.

Tobias Carlisle: Options in value. Talk to me about how you use options in a value investment context.

Tim Melvin: You and I had a long talk about this if you recall.

Tobias Carlisle: We didn’t record it though.

Tim Melvin: No, we didn’t. I was kind of uncomfortable putting this out in the newsletter format, which is where I live and breathe these days, because I’m too lazy to get a job. You kind of talked me through that. The biggest way to do it, I’ve always done this. I don’t know why I was reluctant to send this out to subscribers and readers, but if the VIX, volatility index is high, it just makes sense to sell cash secured puts on an undervalued company.

Tim Melvin: If you think about it, you’ve got a $12 stock that you love. It’s trading with an enterprise value to [inaudible 00:46:10] multiple of seven or maybe it’s trading at a discount to tangible book value and the credits good. You’re looking at this and the stock’s okay, 11, 12 bucks. Why not sell that ten put and collect four, five, six percent for a month or two? It’s as close as you’re going to get as a win-win on Wall Street. If it goes down, you’re going to buy it and it’s at ten bucks minus the premium. Okay? You’ve bought this stock that you like at a lower price then it’s currently trading for. If it doesn’t go down, you get to keep the premium and do it again and again and again.

Tim Melvin: What’s the risk? Well, that the stock takes off or gets taken over and runs up, but you’ve still at least collected some premium along the way. The other risk with all put selling strategies, and this is where the individual investor tends to have one of their mental breakdowns. If I put up all the cash and do this, I’ve got 6%. If I put up half the cash, well now it’s 12%. If I just put up the exchange minimum margin, it’s a 30% two month return. This is the best thing ever. Until that stock moves against you and you’ve used all the cash in your account and done too many and you can’t meet the calling by the stock. That’s how you go from having money to not having money.

Tim Melvin: If you do this strategy, it’s fantastic, but if you’re doing a thousand shares of a $10 stock, put up the entire ten grand. Okay? Take the smaller incremental return. Don’t get crazy about it. The other thing, and this is something I’m going to give you full credit for this, because I’ve never really used it until recently. That’s buying in the money long term options on stocks that you like a whole lot. It’s really only going to work with larger cap stocks. It can give you four or five, six times leverage over the next year on a stock that you have a high conviction is going to go up.

Tobias Carlisle: I use it too, particularly when I think the stocks very undervalued but I’m not super confident about… it could be a zero. If there’s a risk of a zero, then I like the leaps on those things, because I know how much money I can lose. This is when we’re buying a call. I buy them at the money, because I think if you think they’re undervalued, I hate to be right and have bought them out of the money and have it not hit the strike and be [crosstalk 00:48:29].

Tim Melvin: That’s the worse.

Tobias Carlisle: So, I buy them at the money.

Tim Melvin: Okay. One other strategy that my son-in-law and I have been doing a lot of work on, we’re both big fans of [inaudible 00:48:40], The Black Swan. We’re looking and we actually did this, it’s the perfect way to describe it. I think Tesla is a zero. If we evaluated Tesla as a junk bond, it’s a C-rated bond at best. Elon Musk is the P.T. Barnum of the modern age. He’s gotten tax payers and investors to pay for all his very cool toys, which in my mind makes him very, very smart, but I don’t want to own his stock. Fiat Chrysler’s coming, Ford’s coming, Mercedes is coming, you know. He’s not going to have the driverless car market for very much longer as the dominant player. He could go to zero.

Tim Melvin: I looked at it 2021, back in February, when the stock was over 300. I saw that you could do a 150, 125 put spread for like two bucks, because the premiums were just enormous. I’m buying two full years, I’m on paying a couple bucks and I’m betting that something bad is going to happen at Tesla in two years. I think that’s a fantastic bet. We made it. Of course the stock went all the way back down, a little bit under 200. The option spread blew out to, you know, it was like four or five times what was paid for it. It’s come back a little bit now. I have no intention of closing that position until 2021.

Tim Melvin: Then, on the long side, I look at Fiat Chrysler. Here you’ve got [inaudible 00:50:09] telling us they’re going to make eight, nine bucks in 2021 a share. The stocks 14. Why not buy a 2021, $20 call for a dollar and just sit back and see what happens. Lower probability events with enormous payoffs if they happen by selecting very undervalued, good companies like Fiat Chrysler and really overvalued dumb companies like Tesla as your targets. I think you can inch the probabilities a little bit further up the scale in your favor. Wouldn’t do it with my entire net worth. It’s better than going to the race track. My wife doesn’t get quite as angry as she does when I go to the track and just as much fun. Again, intellectually very stimulating and exciting. Again, I think you can add a little bit of incremental return doing that.

Tobias Carlisle: I agree completely about all of those stocks that you just mentioned there. Tell us a little bit about your, what’s the newsletter business, what are you doing there?

Tim Melvin: Well, primarily to find out more, to keep track of what we’re doing is going to be at maxwealth.com. That will serve as a gateway to any further that you may wish to go down the road. Obviously, we have paid products. That one happens to be free. Three or four articles a week. What am I thinking about? I do throw out the occasional, well, the frequent stock idea that are in larger cap companies and things that might not make it into our more focused portfolios, but still use those core value and private equity replication principles. It’s a good place to start if you want to find out more and it doesn’t cost you a nickel. That’s just maxwealth.com.

Tobias Carlisle: You’re on Twitter as well, Tim. What’s your Twitter handle?

Tim Melvin: Oh, it’s real fancy. Tim Melvin. Just @timmelvin.

Tobias Carlisle: I think you’ve got snoopy on it’s house as your-

Tim Melvin: I have snoopy on his house, my dad was a snoopy addict. He always had a snoopy t-shirt on underneath his business suit. He passed that down to me, so if we were to pull back, there’s a snoopy sitting up here. There’s a snoopy in an Oriole’s uniform over here on the bookcase. Yeah. I inherited the love of snoopy, so he’s my Twitter Avatar.

Tobias Carlisle: You’re an Oriole’s guy?

Tim Melvin: I am an Oriole’s fan. It’s fascinating. We’re going to find out if Money Ball actually works or the Houston Astros were a fluke. Okay? We’ve got the same guys that did the Astros rebuild. It’s almost comical to watch this baseball team in action. You shouldn’t be able to be this consistently bad. It’s the first year of rebuild. It’s kind of fun to watch and I’ve been loyal to this team since I was six years old, which is longer than many nations around the world have been in existence. I’m not going to abandon them now.

Tobias Carlisle: Well, Tim. That’s time for us. Thank you very much for joining us today. Tim Melvin.

Tim Melvin: Toby, thanks so much for having me on. I look forward to the next time.

Tobias Carlisle: My pleasure.

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