Investing Like the Pawn Stars

by JT McGee

The Pawn Stars are the best investorsThere aren’t many TV shows I watch. There are even fewer that I watch religiously.

Pawn Stars just happens to be a TV show I watch, and a TV show I watch religiously. I watch it because the Pawn Stars are some of the world’s best investors.

Investing Like the Pawn Stars

The Pawn Stars are pretty awesome investors. They understand that they should never buy something they don’t understand, and more importantly, never buy something that poses a significant risk to the business.

Now, whoever produces the show is really good at making really good investments look like terrible investments. Case in point: the Pawn Stars buy all kinds of major equipment, including a few hang-gliders and things that really aren’t in your typical pawn shop.

In almost every episode, Rick sweats some major purchase as if he’s actually concerned about making money on the deal. But what you’ll notice is that the Pawn Stars always look for a margin of safety. If Rick’s gonna throw down $2,000 for a hang glider, he’s going to make sure that, no matter what, he doesn’t lose the entirety of his investment.

Usually, though, he gets one of the best margins of safety one can find: he buys stuff for less than its liquidation value. If he’s paying $2,000 for a hang glider that might retail (after further investment) for $8,000, he almost always makes sure that the parts alone are worth $2,000.

There are really only two outcomes:

1) The Pawn Stars end up selling the item for its liquidation value, potentially making zero when you account for the time of employees and the time value of money.

2) The Pawn Stars end up seizing a better opportunity by further investing in the item to give it a higher valuation relative to the investment and risk. Their total margins on these kind of investments appear to be huge—they’re so large that they outsource almost all of the work required.

I invest like the Pawn Stars

I’ll give you a perfect example of a security I own that I purchased in much the same way as the Pawn Stars. The company is Wireless Telecom Group, Inc. (WTT). At the time of writing it’s worth less than $25 million and under $1 a share.

Now, these kind of securities are usually off people’s radar. For one, it’s a tiny company. I say that with a half-smile—99.9% of people who say that small cap stocks are too small would love to own a $25 million business. I’m always stunned when people reject the notion of buying a piece of a business, when they’d be happy to own the whole of it.

Secondly, it’s a penny stock, which doesn’t mean much to me, but it’s a negative qualifier for a lot of people in much the same way that a hang-glider is off the investment radar for individual investors, but not for the Pawn Stars.

This is a company that inspired my post on activist investing, which was timed perfectly to that nasty dip in the summer. I held my nose tight and bought more, while penning an article about how much I’d love to slap the CEO/CFO team silly. In truth, it’s a pretty lame business–and I’d still like to slap the executives. But that doesn’t make it a bad investment.

I bought this company because it has current assets worth roughly $25 million, and total liabilities of $2 million. My average price means I bought a piece of the business (a profitable company) for less than the value of the cash, inventory, etc. on hand. Basically, I had a very serious margin of safety. I stole the damn thing.

There are two possibilities for this stock:

1) It goes nowhere, just as it has for much of the recent past.

2) Investors realize its potential and pay for it, at which point I sell.

3) A competitor (probably Micronetics Inc. NOIZ) buys it out for their customer list/cash flow and pays a healthy premium for it. As is common with small caps, executives are paid too much. That’s a strain on the present market value, but not the buyout value. A business in the same industry could easily buy the company and give the current execs the finger, putting someone already in the firm (cheaper) in charge of both operations.

Get Companies for free!

I got the business itself for free. Seriously, I never paid a penny more than $.78 for any of the shares I hold in this company. At that price, I was buying a company with $.66 of cash, $.25 of inventories, and roughly $.12 of accounts receivables per share. That’s $1.13 in assets for a $.78 investment. AND I got the future earnings potential of all those assets to boot.

There aren’t many opportunities like this available in the equities markets. Most companies that sell for less than their net current assets aren’t worth owning. But, I enjoy nothing more than reading form 10-Ks and Qs and doing business analyses so it’s 1) fun as hell and 2) profitable as hell. And, if you enjoy that, you can find plenty of stocks like these that sell for less than their intrinsic value (in terms of net current assets, and future cash flows.)

“It is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately with people or it doesn’t take at all. It’s like an inoculation. If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference. They just don’t seem able to grasp the concept, simple as it is. There seems to be some perverse human condition that likes to make simple things difficult.” Warren Buffett

That’s neither here nor there, though. My point is that when you look for potential investments, always look for the inherent downside protection—I don’t care if you’re investing in hang-gliders, cars, or potato chips. Having a margin of safety is the surest way to beat the market day in and day out.

(Sidebar: This particular security is one of four I included in TheFinancialBlogger’s 2011 stock picking competition. In all, WTT, ADGF, CNU, and MDF were included. CNU was bought out by MDF for a 37% premium to Jan 1 price. MDF is up 63% this year. ADGF is up 13% and WTT is up 26%. All of these were my super margin of safety picks–tiny companies with big potential selling for way less than what they’re worth.)

Photo by: berenicegg

{ 14 comments… read them below or add one }

cashflowmantra November 16, 2011 at 10:55

Sounds like you have made some good calls.

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JT McGee November 16, 2011 at 12:30

Things have gotten a lot better thanks to ETFs and general indecision in the markets. The question now seems to be “in or out of the market?” instead of “in or out of what firms.” The risk-on, risk-off ups and downs present a lot of opportunities to the individual investor.

The American Association of Individual Investors hasn’t had a good YTD performance, but even after losing to the market this year, they’re still trumping the S&P500. Greenblatt’s magic formula screen does even better.

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PKamp3 November 16, 2011 at 11:35

While I agree with your sentiments – trading securities with smaller market capitalization keeps them off the radar of institutional investors (you might do okay, but you won’t become rich with larger stocks with few exceptions) – I would still caution that it is easier to manipulate smaller stocks. Not saying it’s automatic, but it’s easier to pull off a scheme like a “pump & dump” with a stock that has lower volume and a lower market cap than, say, Citigroup.

With a company like Citigroup only huge entities like the Fed are able to do it. (I kid!)

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JT McGee November 16, 2011 at 12:19

Yeah. Most of the pump and dump securities I find in my email inbox are usually:

1) Reverse merger shams
2) Chinese companies with BS’d numbers
3) Junior miner advertisements right after a massive dilution.

I don’t invest in miners, reverse mergers, or Chinese firms. Just a matter of principle. Miners have no long run competitive advantage–just a play on higher commodities. Reverse mergers can’t be believed. Chinese firms lie through their teeth about their numbers.

Two of the firms listed at the end were/are >$300MM in market cap. They have a margin of safety from FCF generation, not necessarily from current assets. Though, at the time of purchase, current assets made up a significant portion of market cap. The remaining are sub-$50MM securities. Those were net-net plays I liked for the NCAV play.

There are still tons of companies that have sell for less than 10 times FCF in profitable industries with market caps in the billions. Those are kinds of firms you have to catch on the “risk-off” days, or after a missed earnings call. They take more work, but they’re not in short supply.

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Funancials November 16, 2011 at 22:14

I love Pawn Stars, but I can’t stand Chumly

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JT McGee November 17, 2011 at 11:31

I think it’s all an act.

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101 Centavos November 17, 2011 at 08:04

I quite like mining exploration companies, but it’s a personal preference. Retail investors shun penny or nano-cap stocks precisely for the pump-and-dump promoters who give the sector a horrible image. Good analysis on WTT.

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JT McGee November 17, 2011 at 11:30

Exactly. It’s a self-imposed rule that I won’t go looking for mining and exploration companies, but I’m sure that if you know the industry well you can beat the benchmark/broad-based indexes. Same thing goes for bio-tech and (some) chemical companies. It’s just not something I understand, and no matter how attractive the numbers look, I simply cannot know enough to place a position. Plus, there’s a ton of bad information/pump and dumpers in the biotech industry. Their sales letters are good, their investment thesis is (usually) logical, but I have no idea what the competitive landscape looks like. And then there’s the FDA…

I’ll remain willfully ignorant in those sectors. There’s always opportunities available in the markets with securities/industries I actually understand.

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Evan November 17, 2011 at 11:26

I freaking Love that show:

http://www.myjourneytomillions.com/articles/reality-show-pawn-shop-teach-life-making-money/

You inadvertently highlighted my issue with small caps and value investing (vs dividend investing) in general. You are holding onto WTT for the sole hope that someone down the line is willing to pay more for it rather than sharing in its profits.

Lets say this nice $25mil business goes on with its life taking the same profits, keeping the execs very wealthy, but they don’t share the profits, no one notices them for buyout and everyone continues not to care about them…you are stuck with a non-moving highly illiquid asset.

Just some random thoughts…

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JT McGee November 17, 2011 at 11:57

Yeah, there’s a risk that no one ever notices the company, that it never gets bought out, and that I never have the opportunity to sell it to someone else. I should be more clear–I didn’t buy into this company just because it was inexpensive, but because it had features that make it attractive in a buyout (NOLs, customers, competitors). There are plenty of companies that sell for less than their Net Current Assets that I would never buy because they just aren’t as attractive as their peers. Still, the risk exists, I’ll give you that.

But then again, how many times have you found $100 bills lying on the sidewalk for people to walk past, but never pick up? Sure, maybe there aren’t that many people walking down the street, but that doesn’t mean the bill will lie in wait forever. Ben Graham managed 20% annualized returns and his picks were far less choosier than mine.

Graham’s fund was all quantitative. The analysts who worked for him and learned his methodologies went on to become the world’s best investors. That list includes Buffett, Walter Schloss (who beat the S&P500 by 13% annually), Tom Knapp and Ed Anderson (who beat the S&P500 by 10-13% annually), and others. You can call it random, but I don’t think it is. There’s a natural benefit to a value approach. Dividend stocks only occasionally fall into the value category because they pay consistent dividends. Otherwise, investors usually pay too much for them.

I don’t intend to change anyone’s mind. The methods Buffett/Graham/Knapp etc. used have been published for 60-70 years now, and you can find “Security Analysis” on Amazon for $40. You’d think that the market would have adopted this valuation approach, but it hasn’t. That’s okay. I don’t think it will any time soon, either.

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Evan November 17, 2011 at 12:04

I don’t completely disagree with the methodology I just can’t full subscribe to it and while you have some great names to back up the theory there is always that lingering thought in the back of my mind. Besides, in reality you don’t want to change everyone’s mind lol

Personally, I do look for value but just within the dividend aristocrats and soon the dividend champions list. So I’ll look for low P/E compared to industry peers, then their OpMargin has to be higher than peers in that industry, then their yield as to be over 2%, then their b/v should be reasonable…but I only do this analysis on stocks that are within those indexes/lists.

So I guess I try to mix it up? My best pick but I only put a couple hundred (DCA) on it was AFLAC…all indicators said it was really undervalued so I purchased it 32

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JT McGee November 17, 2011 at 14:05

I wouldn’t even know where to begin in explaining my criteria. Varies by industry.

Op margin, for example, is way more important to me in an industry like health care, where revenues can plunge on a whim due to a change in Medicare. If Medicare says, “hey, we’re paying 2% less this year for your services,” then a company with an operating margin of 4% loses half it’s margin, whereas a company with a 10% operating margin loses only 20%. In other industries where the environment is different as a matter of structure, I might not care all that much at all.

Book value only matters to me if I have limited confidence about the business, or if I’m buying it as a play on net current assets. P/E ratios vary in importance, too. I’m much more interested in my projections for FCF, since I target buyout candidates.

A company “earns” $100 million this year, but generate only $20 million in FCF this year, that’s a problem to me. If a company earns only $50 million/year but will generate..say, $200 million in FCF, that’s a big upside for me. The duration of free cash flows is especially important for buyout plays because if I’m hoping for a buyout at full value, with a reasonable discount rate, then the free cash flows generated in the first few years have a LOT more value than those way far out in the future. They’re also far more predictable, so I’m willing to pay more for them, as is any potential buyer.

We have entirely different investment strategies, so it’s almost impossible to compare/contrast the two. Big name dividend companies aren’t ever going to get bought out by a private owner, or by a competitor. At least, its far less likely, so those are mostly off my radar. More likely, they’re doing to be on the buying end of a M&A activity.

We’re almost on two different ends of the investment universe. Good to hear different viewpoints, though. And nice call on AFLAC–I guess you called Greece’s summertime bluff? 😉

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Evan November 17, 2011 at 14:41

No Just really really lucky! I figured if Greece went under maybe I could by the island my family is from for a couple hundred grand lol

Darwin's Money November 20, 2011 at 15:37

I’ve enjoyed the show from time to time; it’s amazing what some stuff is worth that seems like total crap. Sometimes I wonder how much of the show is contrived or rehearsed (certain transactions seem that way), but it probably has motivated several people to go clear out their attics and make a few bucks off of stuff they wouldn’t have otherwise.

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