Not sure what else I can say that I haven’t already said about the company. There was noise in adjusted EBITDA. Wren’s tone on the call today was, finally, positive. The company’s main competitor, Peerless, appears desperate. Any company trading at five times cash flow is worthy of your attention. This one, doubly so. I continue to be okay waiting and averaging down.

It hasn’t even been near a full year that we’ve owned Tandem shares in Tarpon. I’m looking at two Post-It notes that have been stuck to my screen for longer. Some time ago, back when men were men and before boys ran hedge funds, it used to take time to make money when investing. TNDM will probably be no exception. I believe the wait will be worth it.

Investors can view this market’s casino mentality as the curse of our age, or treat certain days as if they were made to be taken advantage of. I basically did the latter today. I bought a ton of new TNDM shares in Tarpon, and I unloaded a ton that were at a higher cost basis, too. Fortunately, I can do this pretty efficiently and at zero cost through my custodian. So though our position size is the same, Tarpon investors now own a bushel of TNDM shares priced at all-time lows.

I can only hope it happens again tomorrow.

Where’s a good sovereign debt crisis when you need one?

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

The write-up below recently appeared on Value Investors Club. The author, who’d like to remain anonymous, reached out to me on some questions before he posted this. Although I believe TNDM is worth more than the author indicates, and have a few other comments I might add if time allowed, I nonetheless thought he did a solid job of analyzing the company. He gave me the okay to post the below here.

Ever since my interview on TNDM a few months back, I’ve had a pretty steady stream of emails and phone calls about the company from other portfolio managers, analysts, and individual investors. In short, while I cannot give specific investing advice here, I will say that I have been averaging down on TNDM in the Tarpon Folio over the past few months. The size of my position is a touch smaller than it was three months ago, but that’s much more a function of (a) other opportunities and (b) clearing out some higher cost-basis shares than being indicative of the company’s prospects in any way. I continue to maintain that the competitive threat from Peerless Networks is vastly overblown – it’s in a box canyon that the market doesn’t seem to recognize. I also continue to believe it is the number of switches and not per minute pricing that is the key variable when it comes to attracting new customers. At some point, the market will recognize this, and in the meantime, I continue to be okay just waiting.

The write-up follows. Please note that certain tables included in the original write-up weren’t translating well to HTML below, but you can download the entire write-up complete with those tables in PDF form here.

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Neutral Tandem (TNDM)

Neutral Tandem (TNDM) is a company whose stock has been oversold to all-time lows on fears of
slowing growth, increasing competition, and patent issues. This has driven shares to fall from a high of
$34.56 to $11.98 as of last close (7/12/2010). However, Neutral Tandem’s healthy free cash flows and
strong financial position (over $170M in cash and no debt) make the company an attractive investment
opportunity at these prices. Although headwinds such as competition are legitimate, I believe that TNDM
shares are currently priced for a worst-case scenario in the company’s future and should offer at least a
25-35% return at current prices.

Background

Some background is necessary to understand Neutral Tandem’s core business of interconnecting voice
carriers. Calls made from one voice carrier to a different voice carrier require either a tandem switch to
rout the call or a direct connection between the carriers in the relevant markets. Due to the high costs of
establishing direct connections, most voice carriers will choose to transit their calls with tandem switches.

Before Neutral Tandem entered the market, this meant most carriers used the network of tandem
switches owned by the “Baby Bells”, called the incumbent local exchange carriers (ILECs). By law, ILECs
were required to rout all traffic, including the calls of competing carriers, with their tandem switches.
ILECs charged competing carriers by the minute for calls requiring routing by their tandems at rates
regulated by state commissions and the FCC. Not only were the ILEC tandems inefficient for operating
with competing carriers since they had been designed by for a monopolistic carrier, but ILECs were in
general unhappy about having to give up use of their overburdened tandem networks to competitors and had an incentive to not “fully cooperate” in establishing the interconnections competing carriers required.

Neutral Tandem’s Operations

Neutral Tandem was founded in 2003 to provide an alternative to the ILEC tandem switching network. Over the course of 6-7 years, it has built its own national tandem switching network that offers three main advantages over the ILECs:

1. Neutrality. Its eponymous neutrality refers to the fact that it does not compete with voice carriers like an ILEC does, thus ensuring that carriers do not need to rout calls through their biggest competitors.

2. Cost savings. Since Neutral Tandem designed their tandem switch scheme to maximize efficiency for routing calls from many different carriers it is able to undercut the ILECs’ rates by 20-25%.

3. Quality and services. Finally, Neutral Tandem has built a higher quality product than the old ILEC tandems using new IP soft-switch tandems and offering features such as quality of service reporting,
traffic reports, and redundancies in the network to ensure more reliable service.

With its first mover advantage, Neutral Tandem has managed to grow its network into the largest
alternative tandem switching network in the US. Neutral Tandem routed 87.8 billion minutes of calls in
2009 and currently serves almost all of the major carriers, with the exception of the wireline ILECs such
as AT&T and Verizon wireline (although it does serve AT&T and Verizon wireless). Its network also
handles all types of voice carriers: wireline competitive local exchange carriers (CLECs), cable
companies, VoIP, wireless, and long-distance carriers interexchange carriers (IXC). Wireless carriers and
cable companies account for 65% of revenue, IXC carriers account for 20%, and the rest is from CLECs
and VoIP.

Like the ILECs, Neutral Tandem charges carriers on a per minute basis for calls that go through their
tandem switches. Revenue recognition is straightforward and is recorded each month based on the
number of minutes trafficked for each specific tandem switching service Neutral Tandem offers. The
tandem switching business is highly scalable and as Neutral Tandem’s network expands, operations
become more efficient, capex decreases as a percentage of sales, and margins increase. This had led to
rapid growth in the sales, profits, and margins in the past 3 years (see tables in original PDF here).

Future Growth

Neutral Tandem’s core business of voice tandem switching is benefiting from the secular trends of
consumers increasingly moving towards wireless, cable, and broadband carriers. As fewer consumers
use wireline ILEC services, more calls will be routed through Neutral Tandem’s network. Beyond these
secular trends, there are several services that are potential drivers of growth for Neutral Tandem (and
potential catalysts for the stock).

60-70% of Neutral Tandem’s revenues currently come from providing tandem routing services for local
calls. While Neutral Tandem is still expanding into new markets to grow its local call services, it is now
entering mainly smaller less profitable markets. Interconnections within larger existing markets also
provide room for Neutral Tandem’s local tandem services to grow. However, the drivers of Neutral
Tandem’s future growth in its core voice business are in two different areas: terminating switched access and originating services.

1. Terminating switched access. In the terminating switched access business, Neutral tandem uses its network to terminate long-distance calls for long-distance carriers, or interexchange carriers (IXC). This is currently 20% of Neutral Tandem’s revenue and management has stated that it may double within a year. Neutral Tandem is also seeking to grow its business by providing terminating services for international long-distance carriers. Neutral Tandem has recently solved the technology aspects of this international service, and is currently working to resolve the contractual aspects with international carriers.

2. Originating switched access. Originating switched access services essentially serve 800 number calls. 800 number calls need to be translated by a tandem to determine which carrier to send it to. Recently, TNDM has begun to offer originating services. However, management has said growth in this area is
currently stalled since Neutral Tandem cannot match the marketing fees often paid to carriers. Future
growth of originating services will depend on whether a number of current lawsuits filed by others will lead to the FCC restricting the marketing fee practice.

Neutral Tandem has also begun a service outside its core business of voice tandem switching in late
2009. It is a joint venture with TelX to launch an Ethernet exchange network. I won’t spend too much time describing this venture since it is a very new venture in a very young industry that will likely interest growth investors more than value investors. The basic concept of this service is to provide efficient interconnection services for companies using the Ethernet system. The Ethernet interconnection industry has been projected to be worth twice as much as the voice tandem business, but this remains to be seen.

Neutral Tandem is behind the main competitors in this new space, CENX and Equinix, by roughly 8
months. That being said, Neutral Tandem has two large advantages in the Ethernet interconnection
industry: 1) its existing network that it can leverage, and 2) existing business relationships with many of the potential Ethernet exchange customers. As a value investor, I would not necessarily invest in TNDM on the potential prospects of the Ethernet exchange network, but growth investors may, which I will discuss in the catalysts section.

Current Concerns

Three main concerns have been contributing to the recent sell-off of TNDM :

1. Competition. Over the past year, Neutral Tandem has seen increasing competitive pressure from firms such as Level 3 and Peerless Networks that has led to a large sell-off. While management has said
that they have retained all major customers, they have admitted that there has been increased price
pressure. This is reflected by the decreasing average rate per minute from 0.19c/minute in 2009 to
0.18c/minute in Q1 of 2010. (While this decrease is occurring partly because of competition, part of the
decrease can also be attributed to Neutral Tandem entering new smaller markets that generally yield
lower rates.) Management was quoted as saying that they had “seen some of the toughest pricing that I
pretty much expect to see”. Regardless of whether this is the case, management appears to be taking the competition seriously and stated that it is competing aggressively to retain customers and gain new ones with long-term contracts and leveraging its ability to provide comprehensive solutions to customers (e.g. broader geographic coverage, more capacity to handle call traffic).

Even with increasing competition, Neutral Tandem has several competitive advantages. First, no
competitor has a tandem network approaching Neutral Tandem’s network’s size. This means that
competitors can only offer a partial solution to carriers at best and makes it unlikely that Neutral Tandem will lose business with carriers that have a national presence (No major customers have been to competitors thus far). Second, Neutral Tandem has built a network with very few quality issues while it is reported that some competitors have had issues with their tandem switching quality. Therefore, large scale defections of Neutral Tandem’s customers are unlikely, and the main legitimate concern is margin compression in local markets.

However, as I’ll discuss in my valuation, even if the easy days of growth are over and margins decline, Neutral Tandem is priced so that in most scenarios is remains a compelling buy. Furthermore, as I discussed previously, the international long-distance, originating access services, and Ethernet exchange are both potential growth areas for Neutral Tandem that could counteract competition in the tandem market.

2. Patent Litigation. In June 2008, Neutral Tandem sued Peerless Networks for patent infringement of its tandem network design, but Peerless Network responded by questioning the validity of Neutral Tandem’s patent and calling for the USTPO to re-examine the patent. Initial action by the USTPO in
March 2010 has been to reject Neutral Tandem’s patent claims, although the USTPO’s final decision on
the re-examination and the Court’s final ruling will not likely be until this fall. This patent dispute and the unfavorable developments have contributed to the sell-off of TNDM in 2010. However, I believe that concerns regarding the patent are overblown.

First, remember that Peerless Networks and likely other competitors have already been infringing on
Neutral Tandem’s patent for over a year to date. An unfavorable ruling for Neutral Tandem would
therefore not materially alter the competitive environment. Second, the company’s balance sheet is
immune to an unfavorable ruling since the company does not appear to assign its patent any value on its books. (Or if they do, it is negligible and filed under “Other assets” which is valued at $511,000.) So while Neutral Tandem may lose its patent battle, it will not fundamentally change its competitive environment. Any favorable ruling on the patent case, while unlikely based on recent developments, will be a catalyst for TNDM and a deterrent against Neutral Tandem’s competition though.

3. Fear of Obsolescence. Similar to the issue of competition, I believe that growth investors have also steadily fallen out of favor with TNDM because of the fear of eventual obsolescence due to VoIP. VoIP
relies on IP-switching technology that greatly reduces the cost and complexity of creating direct
connections between carriers, thereby bypassing the need for tandem switches. However, even
assuming a constant high growth rate of 31.1% CAGR in residential VoIP lines, based on past growth in
VoIP lines, it will still be approximately 7-8 years before VoIP overtakes the number of current US
residential wirelines. This also assumes that there will be no slowdown in VoIP growth due to necessary
infrastructure investments or regulatory hurdles.

Even if adoption occurs at this high rate, it is important to remember that establishing direct connections between VoIP carriers will still take time and that tandem switching will still be necessary for connecting VoIP with wireless carriers and the remaining wireline carriers. Therefore, while the terminal value of Neutral Tandem’s core business of tandem switching should be discounted for the risks of VoIP adoption, an all-VoIP network that makes tandem switching obsolete is still years away.

Valuation

Based on 2009 results and today’s prices, TNDM is attractively valued with a 9.8% FCF yield, FCF/EV of
18.5%, and a low 2.6 EV/EBITDA multiple. (See tables here again.)

Note: EV and all following calculations use an adjusted cash measure that includes auction rate securities (ARS). Neutral Tandem currently has $171M in cash and cash equivalents and holds par value $12.9M of ARS. Beginning on 6/30/2010, it will have the right to sell these ARS back to UBS at par value. Therefore, I use an adjusted cash figure of $184M.

I consider two useful scenarios in valuing Neutral Tandem: 1.) “worst-case” scenario and 2.) a “normal”
scenario. Both scenarios use the low ends of management guidance given for FY2010. In the worst-case
scenario, I assume that revenue steadily declines and that EBITDA margins decline 17% by 2014
(compared to 2010) due to competition and pricing pressure. To approximate the risk of faster-than
expected VoIP adoption and competitive pressures I substantially discount the terminal value based on
2014 FCFs (as per the tables here).

After adding back cash to the DCFs, I estimate that this “worst-case” scenario implies a fair value for
TNDM at approximately $10.90-$11.20 per share. This implies a decent margin of safety with a 6%-9%
downside risk at current trading levels of $11.98.

In the more likely “normal scenario”, I model very modest growth occurring at declining rates until 2014 but that EBITDA margins will decline by 14% in 2014 (compared to 2010) from pricing pressure. Terminal value is increased from the worst-case scenario to approximate a more modest level of expected risk (again, as per the tables here):

After adding back cash to the DCFs, I conservatively estimate that under normal circumstances TNDM’s fair value should be at least $15-$16.20, representing a 25%-35% upside from the current price of $11.98.

Note that the 2010 guidance figures used in both valuations assume there is no sales contribution from
the Ethernet exchange project. These guidance figures do assume a $4M operations cost and $4M in
capex related to the Ethernet exchange project. Therefore, if the Ethernet exchange development is
stopped after 2010 (due to poor results or low revenue) actual EBITDA and FCFs will be higher than I
estimated. If the Ethernet exchange project is continued, one would hope that it provided enough FCF to
offset its costs though. Given the competent management of Neutral Tandem thus far, I feel the risk of a
serious capital budgeting mistake with respect to the Ethernet exchange is low though.

In summary, TNDM shares are oversold mainly due to fears of competition, lawsuits, and future growth.
These are all legitimate concerns, but TNDM shares are trading at worst-case scenario prices. Estimates
of the fair value of Neutral Tandem’s business suggest that TNDM shares are conservatively worth at
least $15-$16.20, representing a 25-35% upside from current prices.

Catalysts

1. Value/Activist investor attention. In a May 13, 2010 13D filing ValueAct Small Cap Partners
disclosed that they had purchased 6.2% of Neutral Tandem at an average price of $15.15. ValueAct has
a reputation for being long-term value-oriented investors with an activist bent. Barron’s reports that
ValueAct sits on roughly half of their holdings’ boards. While I do not know their exact plans for their
TNDM position, a potential board seat or further acquisitions of Neutral Tandem’s stock could be a
catalyst for the stock.

2. Growth in core business: Management has outlined how their terminating business and originating
businesses could see increased growth this year. Management has already set expectations low by
predicting results at the lower range of its guidance. If the core business can grow better than expected,
catalysts could include beating guidance expectations and analyst upgrades.

3. Positive Ethernet exchange news. There may be surprise revenues from the Ethernet exchange
being developed. Management has not factored in any potential Ethernet exchange revenue, but has
noted it is possible to see Ethernet revenue this year. Neutral Tandem has also been stressing the
exchange’s growth opportunities to growth investors recently, devoting an entire presentation and
conference call this May to the Ethernet exchange. If growth investors begin to buy TNDM based on
potentially favorable developments in this Ethernet venture, I believe that value investors could exit their
positions at share prices at or above the fair value of TNDM’s core tandem switching business.

4. Share buyback. With a mountain of cash, if TNDM decides not to aggressively pursue the Ethernet
exchange venture for whatever reason, another share buyback could occur. In the latest 10Q, the
company reported that $15.4M of shares was still available for repurchase as of 3/31/2010. Given the
high FCF and large cash position of Neutral Tandem, it is certainly possible that more buybacks could be
announced.

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This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

Background

Citizens Republic Bancorp, Inc (CRBC) is a regional bank in the midst of a turnaround, focused on growing its retail/consumer bank franchise in Michigan and neighboring Midwest states. In the latest quarter (Q1 of ’10), the bank posted an $85 million loss. So, you know, if the idea of owning a bank in Flint, Michigan, doesn’t do it for you, perhaps heavy losses might. More to the point, though – while plenty of investors are overlooking CRBC for obvious reasons, higher loan loss provisions and a strong capital base I believe help make a solid long-term investing case for CRBC at recent levels. More on this shortly.

CRBC offers banking and financial services through over 200 offices and 267 ATM locations throughout Michigan, Wisconsin, Ohio, Iowa, and Indiana. Ranked by assets, CRBC is the 49th largest bank holding company in the U.S.. containing year end 2009 assets of $11.7 billion assets and $8.5 billion in deposits. Citizens has no exposure to sub-prime loans, CDOs or CMOs.

The company offers these services:

Specialty Commercial – provides a wide range of lending and depository services to players in real estate market, middle-market companies and local government.

Regional Banking – provides banking and financial services to both commercial and retail clients with a focus towards consumer, residential mortgage, commercial and industrial, small business, private banking and treasury management.

Wealth Management – with $3 billion assets under administration the segment offers a broad array of asset management, financial planning, estate settlement and administration, credit and deposit products and services.

The company’s primary source of revenue is interest income, which constitutes 85% of total income, with the rest coming from non-interest revenue including fees and other charges related to financial services.

CRBC has a significant portion of loan portfolio tied up in commercial and residential real estate. About 70% of this portfolio comprises of borrowers located in Michigan, while the rest includes borrowers from Wisconsin and Northern Ohio. These states have, as you have probably heard, seen some tough times lately. Therefore CRBC on a precautionary basis recently increased its loan loss allowance to greater than 4%, almost double to the industry median of 2.2%.

The Investment Case

Consistent with the economic recovery, the bank’s credit quality and core earnings are improving. For instance, CRBC reported a 6.5% decline in total non-performing assets in the last quarter as well as lower delinquent loans. As the economy continues to improve, I expect CRBC to see an increase in lending. So one way to view CRBC is as a favorable bet on eventual credit recovery – providing you have a relatively high degree of confidence in its strategy to conserve capital, stabilize credit and return to profitability, as I do. Again, I believe the bank will become profitable again in Q1 of 2011, as per my model here.

Key Factors

Strong Capital Levels – CRBC has maintained approximately $400 million in capital above the minimum regulatory requirements. I view its strong capital base as not only a cushion but as having the potential to help CRBC better capitalize on an eventual increase in credit demand.

Improvement in Credit Quality – CRBC’s credit trends show continued signs of stability. As a percentage of loans, its reserve levels improved in Q1 ’10 by 500 bips. Delinquencies were down 7.3%, in line with an improvement in non-performing assets. While earnings losses will continue over the near term, I believe the improving macro environment will help the bank to cut down bad assets. CRBC also recently sold a portion of its nonperforming residential mortgages, which will further improve the company’s balance sheet.

CRBC trades at a significant discount to tangible common book value – Despite having an adequate capital base, CRBC is trading at one of the lowest price to book multiples in the sector. At around 0.6x TCBV, Citizens currently trades at a discount to peers, which trade closer to 1.25x TCBV. Short-hand relative valuations are always tricky, particular these days, but in conjunction with looking at core earnings, which I’ll mention later, they can nonetheless help underscore certain pricing discrepancies.

Returning to profitability early next year – As per the above, I believe the bank will become profitable in the first quarter of 2011 on the back of higher interest spreads and lower loan loss provisions. (For Q1 ’10 the bank earned an interest spread of 2.74%. All things being equal, I think the company will be able to post an improved interest spread of 3.09% by Q1 ’11.)

More importantly, though, I think improving asset quality will eventually provide CRBC with the ability to lower its provisioning requirement for bad assets (loan losses as a percent of NPL goes from the current 77.9% to 70% for Q1 ’11 in my model.) With an improving (read: slightly less horrific) real estate market, there should be a gradual decline in defaults, too, which translates into NPL as a percent of the loan portfolio dropping from the current levels of 5.56% to 4.75% by Q1 ’11.

And – more jargon coming – a note on TCBV. Generally, tangible book value is computed by deducting intangible assets, start-up expenses, and deferred financing costs from the firm’s normal book value (BV). Given the economic turmoil out there, though, I believe tangible common book value (TCBV) is a better measure to gauge what the common shareholders can expect to receive if the firm were to go bankrupt and all assets liquidated at book value. (This is strictly hypothetical and just to be conservative, mind you. I place a very low probability on this actually happening at CRBC.) So, I backed out preferred equity, intangible assets and all the assets from discontinued operations from book value to arrive at TCBV per share of approximately $1.60 for Q2 ’10E. We’ll see how that looks later today when Q2 earnings come out.

What’s it Worth?

The investment case for CRBC is fairly simple. That said, there is a high degree of uncertainty inherent in valuing CRBC shares.

Depending on your approach, values can range everywhere from $1.50 per share to $4.00 – though the latter seems to hinge on unrealistic assumptions. So what’s the real intrinsic value? Somewhere in between – and likely closer to the low end of that range.

Here’s a back-of-the-envelope approach to valuing shares that may ultimately be more useful than my earlier model:

If you annualize Q1 results, CRBC will produce $134M in pre-tax, pre-provision (“core”) earnings over the next twelve months. I believe (and Q2 results out later today should shed some light on this) that they’ll more realistically do $150M in core earnings over that same time.

So if you exclude loss provisions (and adjust for cash earnings and one-time expenses) then Citizens should earn $0.38 per share before tax.

Let’s say CRBC is unable to use its net operating loss as a tax shield and has to pay 35% tax on those earnings. On an after tax basis, then, CRBC would produce $0.25 per share in core earnings.

If the economy and real estate in particular recovers to a more normalized level, loan-loss provisions would probably decline to the adjusted average of $0.05 per share.

At that point, CRBC will be showing $0.20 per share in annualized after-tax, after-provision earnings. If we presume those shares deserve a P/E ratio of 11, then CRBC shares are worth $2.20 each.

Now, and this is an important point, management of the bank isn’t sitting around trying to figure out how they can someday reach $0.20 per share in after tax earnings. The bank is effectively already doing it – but it’s getting obscured by huge loan loss provisions. And what’s the right way to look at those?

I contend CRBC has been extremely conservative about classifying its loans, based on (1) the actions it has already taken, (2) comparisons with its peers, and (3) because its “swat team” approach to working with troubled borrowers appears to be working reasonably well. So while the Street appears to be assuming that most of the nonperforming loans on the company’s books won’t be recovered, the reality is that some will be. And that’s important to remember when considering this:

For the purposes of financial reporting, CRBC has already assumed the worst for its portfolio of nonperforming loans. In the first quarter, for instance, reserves for future loan losses stood at 4.3% of the bank’s total loan portfolio – more than two full percentage points above its peer group average. Since 5.6% percent of CRBC’s loans were classified as nonperforming, then before the 4.3% reserve becomes too light, nearly 80% of all loans currently classified as non-performing will have to become completely worthless – or new loans made during one of the best lending environments in recent history would have to suddenly go bad.

I believe either outcome is highly unlikely. In fact, the levels of non-performing assets, delinquent loans and watchlist loans have been decreasing sequentially at CRBC– trends I anticipate will continue.

In other words, CRBC should be through the worst of it in terms of impact to their earnings. The vast majority of those earnings are of good quality, mind you, as per the cash yield of 5.4% on its existing loan portfolio. And because the bank is asset-sensitive, earnings will improve further once interest rates start to rise.

And, yes, those back-of-the-envelope calcs above are a rough ballpark estimate based on assumptions that may or may not prove to be true. (Some could in fact be smashed to bits later this afternoon when Q2 earnings are released.) In conjunction with other valuations, however, including my semi-formal sell side model, peer analysis and plain old book value, I believe it’s safe to say that CRBC shares currently priced well below what they’re worth.

Then the question becomes:

Why are shares cheap?

For three years the price of CRBC shares could be pretty easily explained by business performance and the resulting negative sentiment. These days, however, performance is improving, albeit modestly, while poor sentiment remains. During the beginning of that three year snapshot, the stock’s price basically mimicked broad market and macroeconomic factors that resulted in, surprise, mounting bad loans and a deterioration in credit quality. The stock, which was trading at more than $10 per share until April of 2008, has been wallowing since, mostly for very good reason.

For instance, shares took it on the chin in early 2008 when management reiterated a weak outlook for the year. The broader sell-off, however, seemed to be triggered by Q2 2008 performance, which came in way below analysts’ estimates. Performance then was marked by lower than expected net interest income, higher expenses, flat fee income, and an approximate doubling in net charge-offs. At the same time, the company also suspended its quarterly cash dividends to preserve capital.

I think that was prudent, mind you, but management (and analyst) expectations nonetheless deteriorated materially as that year progressed – and which were brought to a head when management failed to meet its expectations to return to profitability later that year. In addition, the exit of Chairman and CEO Bill Hartman in February of 2009 seemed to go over like a fart in church on the Street.

Continued struggles with the loan book and a subsequent downgrade in CRBC’s long-term and short-term Issuer Default Ratings (IDRs) by Fitch in the second half of 2009 also added to the company’s woes.

That said, at this point in the cycle, and as mentioned above, things have changed and/or are in the process of changing for the positive. So why are shares still cheap right now, then?

Overblown Threat of Dilution

Of the rational concerns about the company’s shares floating around out there, I believe the most common is “the risk of dilution,” but I find even that a bit short-sighted. CRBC received TARP funding of $300 million in Q3 of 2008. So while the threat of dilution is certainly understandable, here’s why I don’t view it as an immediate concern:

Management has clearly stated in a recent analyst meeting that it does not anticipate repaying TARP funds in the near future. Further, they intend to “aggressively pursue” capital-enhancing opportunities that would be non-dilutive to its common shareholders. Like selling branches in Iowa, for instance. So, while the risk of dilution certainly exists, the risk of that dilution happening in 2010, for instance, is very low.

I’m not turning a blind eye to this issue, but I am trying to underscore that (1) dilution will most likely be much less severe that the Street currently believes and (2) trying to quantify the eventual impact right now is pointless. There is simply no rush to repay TARP over the next few years. Being able to capitalize on those funds during one of the best lending environments in recent memory is a very good thing for CRBC. I also happen to like that TARP shields the company from low-ball acquisition offers.

More to the point, though – one of the major factors that all banks keep in mind while evaluating when to repay TARP funds is the expectation of profitability going forward. Until CRBC reaches sustainable profitability again, the bank’s focus is on maintaining strong capital levels – to basically be on the lookout for ways to preserve cash and enhance liquidity. The company already suspended dividend payments for its trust-preferred securities and TARP-preferred stock, despite having the cash to pay for both on its books (saving about $5.0 million each quarter.) So it seems pretty clear that the company’s game plan is to make it through this downturn safely, and then look for conversion options once it is more obviously on the road to recovery – and presumably at what I believe should be a much higher stock price.

As a result, I don’t lose much sleep worrying about the risk of dilution at current price levels. Let’s see where we are this time next year. And while I can understand the short’s case for CRBC, which seems to hang on that risk of dilution, I suspect that issue will resolve itself as improved performance begins to become more evident.

Next in this series – why the Michigan economy is not as bad as you might think.

Supporting Charts & Graphs

Delinquency Rates by Loan Portfolio - click to enlarge

NPLs and Allowances - click to enlarge

NPAs and Delinquency Rates - click to enlarge

Capitalization Ratios and Notable Events - click to enlarge

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

Buying shares in a bank at the right price can be almost as good as a license to print money. In more normal times, the average bank in the U.S. produces returns on equity of about 15%, a level of profitability mostly associated with the top sliver of businesses in other industries.

I also like the fact that even small banks have moats – barriers to entry – around their businesses. The average turnover rate for deposits is usually well under 20% at a well-run bank, meaning folks tend to keep an account with a bank for at least five years. The secret? High switching costs. For most customers, it’s simply too much of a pain in the tuckus to switch banks once an account has been set up. Habit and inconvenience can be a good thing for the long-term investor. Add regulatory hurdles and the benefits of scale and owning a bank can become pretty downright attractive.

That said, it is not easy for banks to grow – at least, not at rates that those attractive returns on equity would imply. A level of internal growth tied to the regional economy is almost a given, but above that can be a challenge. That’s not necessarily a bad thing for shareholders, though. Most banks pay out the profits they didn’t use to grow as dividends. Or, at least they did in the days before TARP.

In general, most banks try to grow in one of two ways – by gathering as many deposits as they can, or by making as many loans as possible. To an investor, deposit-driven growth is generally more desirable, if for no other reason than only banks can take deposits. As a result, the profitability of that line of business is higher. If a bank can’t fund operations by aggregating deposits, it has to turn to more costly ways of funding itself. Unfortunately, just about anyone can make a loan, and as we saw a few years ago, just about everyone did. This can result in a double whammy to banks, as margins can suffer due to competition and creditworthiness can suffer due to bad loans.

Just how bad that double whammy can get depends on a few things. Let’s review the business model of a bank to frame them.

If you have a checking account or a car loan, you probably already know the basics: a bank takes in money from one group of people, depositors, lends it to another group, borrowers, and profits from the difference. If a bank borrows money from a depositor at 3 percent and lends it out at 6 percent, the bank has earned a 3 percent spread, or net interest income.

Most banks also make money from fees and other services, typically called noninterest income, which when combined with net interest income comprises the bank’s net revenues.

Much more than other businesses, a bank’s revenue and profits are tied to its balance sheet. You’ll recall a balance sheet is the financial statement that summarizes a company’s assets, liabilities and equity at a specific point in time. The balance sheet shows what is owned, what is owed, and what is left over.

On the asset side of a bank’s balance sheet, you’ll find loans and investments, and on the liabilities side you’ll see deposits and borrowings. One important point to understand about a balance sheet is that while the value of assets may change, liabilities are fixed. Since the amount of assets is always equal to liabilities plus equity, any change in the bank’s assets will be reflected in its equity, too.

If the Bank of Margaritaville had $50 million in both assets and liabilities, but no equity, then a small decline in the value of those assets would mean that the bank could not meet its debts. The bank would become insolvent.

So a bank’s equity is a critical cushion for both depositors and bank shareholders.

What sorts of things would cause that equity cushion to disappear? Bad loans, which effectively reduce the amount of assets on a bank’s balance sheet and therefore its equity, too. A constant barrage of bad loans could eventually drain the equity right out of a bank – if the regulators don’t step in and seize the bank first. And that would be bad for investors. Like, drive-off-a-bridge bad.

Banks are unique, too, in that by investing in them you are by definition going to have to tolerate a higher level of uncertainty when it comes to the financials than in any other industry. The books simply reflect a much higher degree of management discretion when it comes to the timing, categorization and/or classification of a wider range of variables. How can you compensate? A margin of safety, as usual, and by placing an extra level of scrutiny on management.

At this point I should note that among the many intangible factors I like about Citizens Republic and its CEO Cathleen Nash are these:

1 – The CEO leading the bank out of its crisis is not the same one who led the bank into it.

The CEO of any bank that would have failed if not for TARP should be canned. If that person remains at the helm, it’s probably a sign of a passive board, complacent shareholders, and/or an executive who is dug in like a tick. None are good.

2 – The CEO has been buying shares in the bank on the open market.

I believe this speaks of leadership. While it’s not a material amount of buying in Ms. Nash’s case, I can nonetheless count on one hand the number of bank CEOs who have bought their own shares recently.

3 – Finally – let’s just acknowledge the elephant in the room here – the CEO of Citizens Republic is from the South. Or at the very least she’s spent a lot of time down here.

So here’s the deal, yankees:

We’ll trade you C-Nash for LeBron – but the clam chowder stays exactly where it is.

Deal?

Kidding. I am a yankee. A yankee named after a race car driver.

Anyway – almost ready to start drilling down. More in a bit.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

First – much more than most publicly traded business, a bank’s fate is tied to the local economy (or economies) in which it operates. Because of the amounts a bank borrows, its results are uniquely leveraged to the conditions in its immediate surroundings. To invest in a bank solely because it’s statistically cheap is unwise.

When it comes to investing in small banks in particular, it’s a good idea to have a solid grasp of the main drivers of economic growth and all potential headwinds in that particular area. Since local economies on balance will mirror the national economy, having some knowledge of broader macroeconomic trends won’t hurt, either. As I blabbed on about here, I believe the strength of our current economic recovery, though not great, is not as bad as many pundits seem to think, either. I’ll talk more about Michigan’s economy as relates to Citizens Republic later in this series.

Second, there is no investing in regional banks these days without assuming what could be significant risk in terms of commercial real estate (CRE). Commercial real estate loans simply represent a ton of regional banks’ business. So at the risk of greatly understating this: it’s important to do all your worrying about the loan book upfront, before you buy shares.

One of the reasons I’m looking at banks is that I believe we’re already through the worst in the commercial real estate market. Regardless of my opinion, however, by buying shares in a bank that is already priced for the CRE apocalypse but which has enough capital to absorb it, I can be wrong about CRE and still do well as a long-term investor. I’ll write more about construction and development loans a bit later, too.

I am cautiously optimistic about CRE in that vacancy rates appear to have peaked, hotel occupancy is up, and credit, though not great, is starting to flow again. It also seems highly probable that the CMBS market (which packages and sells CRE loans to big investors) will be up and running in time to absorb the loans coming due over the next two to three years. And while there is no way to prove this, I would suspect that most of the really bad CRE loans were already packaged and sold off to CMBS investors. So, to me, and assuming you’re not sitting on a great big pile of crappy securitized loans, the plumbing in the commercial real estate world looks okay – it’s general confidence that is the issue. Plenty of others disagree with me on this point, however, and they could be right. I simply contend that as long as there is a big enough margin of safety in the shares you buy, in the end it should not matter who is more right.

Lastly – jargon alert! – I’d advise investors tread carefully around banks that don’t consider modified or restructured loans to be non-performing. This practice is also referred to as “extend and pretend.” Just this week the Wall Street Journal finally brought this issue the attention it deserves in the popular press.

Banks can reduce the number of defaulted loans they have to recognize by modifying those loans – extending terms or offering low interest rates. However, history has shown that 50% of all modified loans eventually default. It also can be nearly impossible for investors to identify which banks are extending or restructuring loans which management believes are one day going to fail anyway.

So, loan modifications can make a banks’ books look good in the short-term, but there is a fair chance those problems are really being kicked down the road.

Now I can certainly understand the business case for a bank to hold off on foreclosing on a property. It makes all the sense in the world to extend a loan if it increases the chances that it will be repaid – plus, then the bank can avoid having to sell the property in a deeply depressed market. And I don’t believe all banks are systematically restructuring or modifying loans in an attempt to hide the bad ones. But to not consider restructured or modified loans as non-performing in spite of that historically high level of eventual default seems, mmmm, a bit too conveniently optimistic.

So, I am on you like white on rice, SunTrust Bank.

And good on you, CRBC, for doing the right thing – even if only a few of us are watching.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

For the analysts and PMs in the crowd, however, here is a link to my spreadsheet containing various analyses and valuation hacks at CRBC. I think this will go without saying, but in case it does not: that spreadsheet is neither comprehensive nor authoritative. For instance, you’ll note it doesn’t contain much of what a proper bank analysis should (i.e. tangible common equity calcs, book value per share estimates, Texas ratio, etc. ) because, well, those things don’t require a spreadsheet. Evernote is great to store those notes, though.

So the invisible assumption behind my spreadsheet is that the bank has already passed some key initial screens. If you begin analyzing other banks by starting to plug your own numbers into this, and ignore those initial screens, it will probably not end well. And if you’re looking for a great resource on how to quickly recognize viable banks as potential investments these days, I highly recommend Plan Maestro’s blog Variant Perceptions. Plan put CRBC on my watch list back in December. Also, the Above Average Odds blog recently featured an excellent write-up on a bank that should be a great reference for more experienced investors.

In any case, my goals in that spreadsheet were a bit more wide-ranging – everything from gauging when the bank would be profitable again to trying to reverse-engineer certain sell-side assumptions to ballparking core earnings power if, magically, all provisioning went away. That file is also an amalgamation of several different spreadsheets, and I broke the links off in this version so parts could be clunky.

In any case – all of this means:

I think that spreadsheet will be helpful to others, but use it at your own risk.

Cool?

Next up: two critical things to understand about regional banks, plus one other tip for potential bank investors.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

First, though, a handful of points:

1. Discussing CRBC here is certainly akin to “talking my book.” So be it. However, to be clear, nothing in this series should in any way be confused with a formal recommendation of any sort. I enjoy educating my investors about the companies we own. Fortunately, they seem to appreciate it, too. These posts are intended for them.

2. In most of my communications with my investors I try to explain my rationale using as little jargon as possible. I feel like anything else comes across as annoying or arrogant. Unfortunately, there is no way to talk about banks without sounding like an alien. So, I will apologize in advance if parts of this series make anyone’s eyes glaze over.

3. If you’re considering investing in CRBC, please do your own homework. I don’t intend to publicly notify anyone when I sell our shares, nor why. I also originally started buying shares in CRBC at prices not insignificantly higher than where they are now. Should the price continue to drop, then all things being equal, I would continue to buy. However, I have the luxury of being able to average down very efficiently. You may not. I also am willing to endure short-term discomfort in order to realize a long-term gain – whether we’re talking about investing, teeth cleanings or rooting for the Dolphins. Again, your circumstances may differ.

Next up – I’ll throw a bone to the stock jockeys, point out a couple more things to be wary of as a bank investor, and then get more into Citizens Republic.

This site and the above are for educational and informational purposes only. Nothing contained here should be construed by anyone as an invitation or solicitation to buy or sell any security. This site does not contain personalized legal, tax, investment, or financial advice. Users of this site should consult with a qualified adviser to obtain advice suited to their personal circumstances. Any links provided here to other web sites are for informational purposes only.

In Case It’s All Making You Nuts

So what can you do to ease the stress of investing in such a volatile market?

I’ve got five suggestions.

1 – Just know that I’m on it. All day, every day. Should I see any data come out over the coming weeks and months that gets me truly alarmed about the future of our companies, the stock market, or the country, I will not hesitate to move some or all of the portfolio to cash. But this is not one of those times.

2 – Prepare yourself for media reports that will harp on whatever sells the most ads. In a weak recovery like this one, economic headlines won’t be sunshine and puppy dogs every time – particularly when it comes to unemployment. Correspondingly…

3 – Don’t get too carried away when things do turn positive, either. The biggest mistake you can make as an investor is to buy crappy companies near market peaks. Be cool.

4 – Consider making investments at regular intervals, rather than all at once. Among Tarpon investors with the highest returns to date are several people who contribute money regularly to their accounts every month. It’s easy to set up, takes emotion out of the equation, and in times like these, will allow you to improve your long-term returns.

5 – If you’re investing over a short time horizon that I don’t already know about it, or if you may need money earlier than you might think, call or email me. The sooner you need to withdraw any money, the more stress market volatility will cause – whether you’re invested in Tarpon or elsewhere. If I’m aware of any deadlines ahead of time, though, then we can take advantage of any big market upswings, or perhaps park some money in the lower-return but less-volatile Gecko Folio. Whatever works best. The point is just to make sure we’re on the same page when we each say “long-term.”

Please let me know if you have any questions. And thanks as usual for investing with us.

- Cale

A Qualifier of Sorts

The burden of proof in macroeconomics seems to be, essentially, on those who argue the consensus is wrong. In that light, I should point out two things.

1 – The consensus among the vast majority of professional economists is still that we are in a recovery. So, I am not being particularly subversive or original in any of my previous conclusions.

2 – None of my prior posts should be interpreted as predictions or forecasts of my own design. I review macroeconomic news and opinions to confirm or dispute the implicit assumptions the stock market makes when pricing in that news. If I knew the next recession was to begin tomorrow at 8 a.m., it would not change how I invest in the slightest.

I am in no way qualified to independently and accurately forecast any macroeconomic trends of significance. Fortunately, all I am trying to point out here is that it is highly likely that the market is temporarily confused about the macroeconomic data that has been released lately – and for good reason.

As the fear of a double dip recession begins to diminish, as I believe it soon will, then market prices will move to accurately reflect underlying values. And in the case of our companies, that move should be significant.

While there are near-term risks to the economy, I believe they are overblown. I would put the probability of the U.S. slipping into a double dip recession at most at 20%. Recent economic data is less confusing when taken in historical context and after acknowledging the psychological effects of numerous systemic shocks to investors over the last few years. The Deepwater Horizon oil spill in particular comes at a critical time in the recovery.

Nonetheless, to expect 2.5% to 3.0% growth in the economy this year seems both objective and reasonable, and if credit conditions improve, it seems likely we’ll see considerably more growth next year. Despite the wild daily swings in the market the last few months, the data does not indicate any trends that would cause me to move any significant portions of the portfolio to cash. To the contrary – eventually we should begin to see positive economic news that will help underscore the depressed valuations of our companies.

And while I would not underestimate the ability of our esteemed political leaders to screw this recovery up, I would also caution against underestimating the desire of businesses to grow when given the chance. Right now is one of those opportunities.

As mentioned earlier, economics is BOGSAT. I love that. Therefore, when attempting to track economic news, it’s important to keep in mind the real-work-to-regurgitation ratio. The number of people who, when talking about the economy, actually parse data compared to those who regurgitate others’ opinions is remarkably close to zero. It’s almost all noise in the echo chamber.

To be clear, I am in the regurgitation camp when it comes to macroeconomics. I feel like I’ve got my hands full doing real work when it comes to analyzing companies. But if you’re not going to track, say, core capital goods shipments yourself, it’s important to find sources you can trust to keep you up to speed.

By someone you can trust, I mean a source who will (1) clearly articulate the nuances of macroeconomics, (2) present, reference or link to the data from which conclusions are derived, (3) have either a very transparent political or ideological bias, or none at all, (4) distinguish between opinion and fact, (5) try hard to be insightful, (6) avoid attempts to be clever, (7) learn from past mistakes and (8) possess at least some gray hair.

Also, that source should be thoroughly screened for Stopped Clock Syndrome. Making the same consistently dire or permanently rosy predictions at every point in the economic cycle is grounds for having your house TP’d.

For what it’s worth, these sites meet those criteria and have RSS feeds that I subscribe to:

The Big Picture. Barry Ritholz summarizes the best stuff that crosses his desk – including other economic research that costs a ton.

The Dismal Scientist. From the folks at Economy.com. The best, most professional online economic analysis for your dollar.

Briefing.com. More specifically – the “Our View” section. Just the facts, ma’am.

Calculated Risk. Educational and broader than just investing.

Macroblog. A blog from the Altanta Fed. Posts show up about once a week.

Real Time Economics. From the WSJ. Good to understand consensus, and why it may be wrong.

Some of the above are subscription-based, but they’re worth every penny. I also habitually read a number of other sources outside of my RSS feeds and the usual daily scans, including Bob Johnson at Morningstar and Jim Grant of Grant’s Interest Rate Observer.

And the Market?

The stock market is down more than 15% from its peak earlier in the year. This sell-off began, you’ll recall, when those men in Greece reminded us that debt is bad. That brought back bad memories of the 08-09 stock market drop(s). Some stocks are very cheap again now, although risk is high, too. The probability of continued wild market moves is much higher than normal. But barring any other large shocks to the system, an improving economy and increasing credit will begin to show up as higher company earnings. That will cause the stock market to rise – all things being equal.

If I am wrong, then, again, we should have limited downside, both due to the mild nature of a second recession, and the margin of safety that exists in the securities we own. The price to fair value ratio of Tarpon is notably higher now than it was a year ago.

This next part may sound hopelessly optimistic, but it’s essential to understanding what I’m doing in the portfolio lately:

If the country manages to plod through these current economic headwinds, and I believe it will, then the next few weeks and months will be a terrific long-term buying opportunity. (By long-term, I mean years, not months.)

We can make quite a bit of money without impressive economic growth, and even in the face of stubbornly high unemployment. For one, we’re getting great prices on some wonderful businesses. Soon, macroeconomic factors could be a wind in our sails, too. Here’s what I mean:

The U.S. economy has over the long-term grown at about a 3% annual rate. This is due to 1% growth in employment and 2% growth in productivity. So even if employment growth struggles, the economy can still grow at an annual 2% rate due to productivity gains – meaning the ability to make more with less.

That 2% real economic growth might not sound like much, but given all the cost cutting done by businesses to survive the Great Recession, even modest gains in revenue will lead to outsized gains in profits. And when it comes to our already undervalued companies, any excessive earnings growth should cause the gap between their market prices and intrinsic values to close that much quicker. All things being equal, of course.

Recent history lends some support to this idea. In 2003, for instance, payrolls were basically flat all year, rising just 87,000 total, or about 7,000 per month. Nonetheless, the S&P 500 rose over 26% in 2003 as the economy recovered from the recession that began in 2001.

That doesn’t mean a similar rise going to happen – only that it is within the realm of possibilities.

What Happens Next

The manufacturing sector of this country is improving faster than the rest of the economy, and in the macroeconomic sense, it is buying time for everything else to catch up. It, too, produces confusing economic data points, and it certainly won’t go straight up forever, but core capital goods data (riveting!) indicates that businesses will continue to invest strongly the rest of this year. In the aggregate, corporate profits right now are high – and increasing. This gives firms the ability to invest and hire. That will eventually improve job growth, which will, in turn, improve “consumer confidence” – a slightly more pleasant turn of phrase than “people will go to the mall,” but basically meaning the same thing.

Because the Federal Reserve will continue to keep interest rates very low, access to credit for small businesses will improve as banks earn their way out of their past sins. Once housing prices truly hit bottom, even more credit will flow. The recovery will then be able to sustain itself without being dependent on government stimulus. Then, we’ll be really growing. No training wheels or nothin’.

This will take time, though perhaps not as long as you might think. And it won’t be the kind of recovery that will knock your socks off. Again, job growth will probably be anemic, and housing will remain ugly for a few more quarters. But things should soon start to feel better than they do right now.

Some of the facts which lead me to believe that fears of a double dip recession are overblown:

- Quarterly GDP growth rates moderated after the recessions in 1990 and 2001, too.

- There is only one historical precedent for a double dip recession in the modern U.S. economy, back in 1980, and that one is somewhat debatable. The National Bureau of Economic Research actually considers it to have been two separate recessions.

- In Q2, ‘employee hours worked’ grew at a faster rate than at any point in the previous ten years. Next step? Hiring, because people can only work so hard until new help must be hired.

- Assuming some gain in productivity in that last bullet, GDP growth in Q2 may prove to be better than in Q1.

- In Q2, monthly gains in private sector employment averaged 119,000, up from 79,000 in Q1. Yes, the June number was a bit unimpressive, but it was nonetheless positive – and any analysis based on just a one month snapshot is, well, bad analysis.

- The Institute for Supply Management indices, though down slightly, are still indicating the economy is in expansion mode. Anything above 50% is considered good. We were at 56.2% in June.

- The U.S. Treasury yield curve continues to be steep.

- World trade is now back to pre-Great Recession levels.

- Credit markets bounced right back from that whole Greece scare.

- Consumer confidence, though down for what I believe are explanatory reasons (it’s the oil spill, stupid!) will likely increase considerably if it does nothing more than revert to the mean.

- GDP growth looks like this. If you did nothing but look at the three bars at right, you’d intuitively grasp that the probability of a double dip is quite low. We’re doing okay, all things considered.

Because of the above, I also think it’s safe to say that the odds of being spectacularly wrong about the course of the economy over the next twelve months are much higher right now on the double-dip side of the debate. I don’t consider myself a permanent bear or a bull, mind you, but it’s seems considerably more likely the bears are wrong here. So, label me what you may.

To be clear, it’s also relatively easy to come up with a list of things to be concerned about in the economy these days. Some are significant, and all are worth keeping an eye on. In a nutshell, though, I believe that list is shorter and less relevant than the one above.

The Big Picture

Here is my attempt to frame the current macroeconomic angst the country is experiencing:

Our economy, compared to a year ago, is in good shape. Compared to what it was before the Great Recession, however, it’s still in rough shape. Pundits, armchair economists and politicians from both ends of the ideological spectrum have abnormally high levels of confidence about how to best fix this problems. Some are still peeved they were ignored last year. All tend to broadcast their opinions loudly. Their approaches vary dramatically. None can be tested empirically, though, because economics is not a real science. Thus, there is much noise.

Our economy is recovering weakly from a brutal recession. Numerous risks remain that demand watching closely. We have a huge long-term challenge ahead of us in terms of our federal deficit. Nonetheless, the economy is in a recovery. It’s important to distinguish between the slowing of a previously high rate, and a definitive downward trend. And right now, no data supports that latter conclusion. In fact, if you look at each of the significant macro data trails over quarters instead of months, the recovery becomes much clearer.

Many stocks are cheap again – if nothing else, than at least in the relative sense. As I write, the yield on the Dow Jones Index is higher than on Treasury bonds. This is good for long-term investors.

It doesn’t feel like we’re in a recovery yet, however, and that is the problem. Behavioral economists (the cool ones) call this ‘recency bias.’ People systematically and predictably project their current circumstances into the future. We put too much weight on recent events. Think of the gambler doubling down after winning the last two hands. The odds have not changed, but the perception of them has.

Recency bias played a key role in the recent housing bubble. The vast majority of the population of this country believed home prices would keep going up, simply because they had been going up. Recency bias also probably has a good deal to do with the long run-up in stock prices last year. I believe it’s affecting the stock market today, too, in the opposite direction. The jarring market drops of 2008 and early 2009 will forever be etched in the minds of anyone who was paying attention. The uncertainty created by recent economic data is leading many people to jump to premature conclusions based on some very unpleasant recent experiences.

When it comes to the economy lately, high unemployment and poor housing data are the numbers most of us tend to latch on to. Although we’re probably through the worst of it, housing will likely continue to be a drag on the economy the rest of the year. Unemployment will stay uncomfortably high. This oil spill is going to seem like it will go on forever. Each of these will cause continued angst. None should be confused, however, with things that will derail the ongoing recovery. That’s because big business is going to save us.

You’re welcome, economists.

The Downside

This next point in particular seems to be getting lost in all the noise.

Let’s assume for the sake of the argument that I am horribly wrong, and that the economy continues to dive right into a double dip recession. Let’s tack on other assumptions, too, including a double dip in Europe (which does seems likely, though no one is talking about it), persistently high unemployment and a bleak outlook for home prices. Let’s also assume our political leaders remain reasonably rational in their response to this scenario – or at least that they fake it for a while.

Should a double dip occur, even under those circumstances, it’s hard to see it being anything other than a mild recession.

Housing is already near a bottom, banks have already been re-booting themselves with new capital, and big companies have already gone through rounds of deep layoffs – and they’re sitting on historically high piles of cash. And whether you’re a supply-sider or a Keynesian, that we’re coming up on election season means that a double dip will certainly not go unaddressed in D.C.

So even if I’m wrong, I believe the downside is limited – at least in terms of investing. You are on your own if you quit your job to flip condos in Vegas again.

This, by the way, is also why you need a margin of safety in the companies you buy shares in, too – in case things go south for reasons you don’t originally contemplate.

Lastly, pundits calling for the end of America and/or a great depression are being, in the strictly academic sense of the word, asinine. You feelin’ me, Krugman? How about you, Elliott Wave guy? No more crazy talk outta either of you. We are America, dammit – the land that brings you moments like this:

(Wait for it….wait for it… and watch the guy in the lower right.)

Five Crises At a Time, Please

The long-term economic threats this country faces – from our federal deficit to inflation to the rise of China – concern me both as an investor and an American. We unequivocally need to get thrifty again. High inflation should be avoided at all costs. And I find it unsettling that the Chinese government is run by driven engineers, while ours is run by bickering lawyers.

But those threats are better discussed another day. If the markets aren’t concerned about them, then it seems more appropriate for me to stay focused on what is more immediately in front of us – our portfolio.

I know. Some portfolio manager in Greece probably wrote the same thing to his investors six months ago. The difference, though, is that our country actually has time to solve these issues.

I say that because right now the bond markets are not at all worried about U.S. deficits. The rates on U.S. bonds have dropped through the floor, meaning bond traders are remarkably unconcerned about our spending. The Greek government makes ours look Amish, I suppose. The spread between inflation protected Treasury bonds and regular bonds is currently low, too, implying that inflation is not a serious risk to be concerned about yet, either. Far be it from me to speak for bond traders – do you all still eat onion cheeseburgers for breakfast? – but my point is that the bond market is not telling me to figure out how to fix social security prior to buying more shares of Google.

Cale Smith
Islamorada Investment Management
Letter to Tarpon Folio Investors
June 2010

Since you’re all out of perspective and no one else seems to have it in this bloody town, I’ll make you a deal: you provide the food, I’ll provide the perspective.
- Anton Ego, Restaurant Critic

Like many value investors, my skepticism of economic predictions and forecasts runs fairly high. There was a time when I rarely devoted any serious time to thinking about GDP growth, unemployment levels, or our government’s fiscal policies. Not because such things aren’t important, but because they are so difficult to accurately predict. Successful investing is much more about solid bottoms-up analysis than accurate top-down forecasting.

In recent months, however, my skepticism about the usefulness of macroeconomics has been dulled by my contrarian streak. When every headline seems to be cause for a sell-off on Wall Street, I find myself reflexively searching for silver linings. And I’m pleased to say that despite recent headlines, there are more reasons for optimism out there than you might think.

But first, let’s review the main drivers of the stock market’s behavior over the last three months. Sovereign debt fears – in Europe of all places – seeped into the market’s consciousness around the same time some of the biggest banks on Wall Street started getting sued and subpoenaed by the U.S. government. Meanwhile, the biggest financial reform legislation of seventy years was being debated in D.C.

Then, the biggest environmental disaster in our nation’s history tragically unfolded live on YouTube. It was ridiculous, infuriating and entirely preventable. Strangely, Goldman Sachs appeared to have nothing to do with it.

All this was going on, mind you, as the country tried to emerge from a recession that began more brutally than the Great Depression. Let the resulting anxiety about jobs, real estate prices, and unsustainable deficits continue to build. Add a thousand click-happy hedge fund traders using leverage like it was table salt. Withdraw a huge amount of government support in the markets. Throw in a few datacenters full of buggy computers causing inexplicable 1,000-point drops in the major indices. Finally, give everyone with an opinion about any of the above a microphone, blog, camera or column.

What we have ended up with is utter information chaos. It is historic, it is unsettling, and is completely irrelevant when it comes to long-term investing.

Fortunately, there is some signal in all that noise. Alas, it can take a bit of wading through some macroeconomics to isolate it. I’ve found that to be a bit more tolerable, though, if you keep three things in mind:

First, to paraphrase one wise economist, the point of tracking economic data isn’t to be able to answer all kinds of questions – it’s to learn how to tell when you’re being buffaloed by an economist.

Second, until proven otherwise, assume all economic predictions reflect a strong, covert political ideology of one stripe or another.

Finally, keep in mind that, as one of my veteran friends recently reminded me, the entire field of economics is BOGSAT. As in: a Bunch Of Guys Sitting Around a Table. They contribute so little to GDP. Step it up, fellas!

In that letter I told everyone who wasn’t an investor in Tarpon but was nonetheless curious which bank it was that I’d reveal the name soon. I’ve had my head down on the portfolio lately, and I have yet to put out my report on that bank, but it’s Citizens Republic Bancorp, or CRBC. I’ll be done chroming up that report soon and will release it later this week.

To see my report on Citizens when it comes out, please sign up for my email list by clicking here.

And a special thanks to Plan Maestro for putting CRBC on my radar screen to begin with.

Back with much more after the holiday.

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