Trouncing the S&P, but When Do I Take Profits?

by JT McGee

I’ve managed to beat broad market indexes for a few years in a row now, and I’m pretty darn happy about it. Thing is, though, I take on a lot of risk at any given time, and I invest in companies that are generally off the radar for most investors.

In general, I like:

• Stocks with low floats
• Share prices of less than $5
• Market caps as small as possible
• Volume of less than 250k shares per day

I also tend to think that diversification is, in a broad sense, a bunch of nonsense. Yes, you can decrease your risk-profile by increasing your diversification. Diversification sounds fine and dandy, but it also means that you diversify into companies that aren’t so spectacular.

At any one time, I own no more than 10 securities in my portfolio. Usually, I keep it to less than five. Right now, it also means that I have more than 50% of my portfolio in one industry. Stupid? Maybe. But I like a good gamble.

If you’re a passive investor, I probably just made you cry. If you’re an active investor, I might have just redefined “gunslinger” for you. 😉

I have 8 companies in my portfolio right now, four of which make up roughly 90% of my portfolio. These are:

Adam’s Golf – Wrote about this one at InvestitWisely

EMC Insurance – a P&C company I’ve written about before here. (This one is getting slaughtered right now thanks to storm losses. Good thing I don’t care! More cheap fixed-income securities for me!)

Continucare Corp – A medical company.

Metropolitan Health Networks – A medical company.

Freakout

This week, I flipped out—and relearned why I only check my portfolio when the market is closed. Company #3 on my list is being bought out by Company #4 on my list.

I own both securities because they fit within my general “weakness and rebound” portfolio thesis. Adam’s Golf is a play on improving consumer spending among wealthy golfers. EMCI is just a long-term cash machine, and unlikely to go anywhere but a generally good storage for excess cash. CNU and MDF are offensive defense plays.

Why I Bought Each

CNU has:

• A very capable CEO who previously led a Florida education company from 0 to a $200MM+ buyout. He rebuilt the same team at CNU. How are education and health care related? Big government in both. If you can sculpt a company around one portion of government (education) you can do the same with another (health care).

• Awesome board, boosted by Philip Frost, who successfully exited his own Ivax for $7.6 Billion

• Economic exposure, in that it is in the managed care business. Managed care is really profitable in economic downturns since the cash keeps coming in from the HMO (Humana, in this case) but patients don’t show because they don’t want to spend the time/cash.

• Interest rate exposure in working with Medicare patients. Mostly an older bunch, their core patient is broke because interest rates are, and will be for the foreseeable future, insanely low. This works out well for me, and not so good for patients. Sorry, I’m just a greedy capitalist.

• Lots of cash, no debt.

MDF has:

• A not as sexy board of directors or managers, but excellent cash flow.

• A board interested in buying back stock, which has been good for accumulators like me. 😀

• Amazing ROE, internal returns.

• Lots of cash, no debt.

MDF announced it will buy CNU for $6.25 plus (practically) 1/20th of a share of MDF for every share of CNU. And of course, the lawyers were in the deal hot and heavy. I was particularly worried that if this turned into a long slug fest, I’d end up losing money (from the companies losing cash) on the punks that are legal teams.

This deal will likely go through. Major holders at CNU own a near-majority of the float, and they approved the merger. Under the deal, CNU becomes a wholly-owned subsidiary of MDF.

Now that I’m not flipping out

The leverage, then, based on a trailing-twelve months model works to roughly 3.5-3.8 (including cash from both companies) which I think should add anywhere from $.10-$.17 per share in earnings to MDF, assuming $300-375MM in debt and a reasonable interest rate from GE Capital, which is helping make the deal happen.

This would mean I get a company (MDF) that makes $.75-$.80 cents per share each year and sells on the market for…oh, only $4.80. CHA-CHING!

But when do I exit? Realistically, I’m up pretty big, which my dad reminded me of when I shared my joy with him. I could afford to take profits here, with my exit price being well above my current cost-basis.

But I’m tempted to hold on. My thinking is as follows:

1. The combined company would sell for a reasonable price to earnings of 6-7. Cheap
2. The combined company is now better positioned for anti-cyclicality.

In terms of getting a better exit:

1. The combined company will add tons of (probably costly) debt
2. The financing will make it a better target for a boutique private equity firm, which could make serious cash in buying it out and getting better financing
3. The company is now on the radar, as it will be a pretty major player in the space.

So I’m thinking about holding on for another buyout round, this time of MDF. Greed has the better of me right now. I’m up big time in ADGF, and probably 100% in both CNU and MDF based on my average cost-basis. However, I’m thinking MDF could double once more, which would put me solidly in the black in another buyout.

So what do I do? Hold on for a larger leveraged buyout? Sell it and take my profits, walking away from the deal in its entirety? What to do…what to do. Pigs get slaughtered, but early sellers are the world’s worst losers. Tough call.

{ 3 comments… read them below or add one }

Jeff Reed June 30, 2011 at 12:43

I believe successful investors have a process they follow regardless of emotion. If you can isolate emotion and put it on the top shelf in the behavioral closet you will usually make better decisions (you can always take “emotion” out a play with it later if you want).

My friend David Moon, a local money manager and columnist for the local newspaper, had an interesting commentary a few weeks ago titled “Prediction of Future Price Should Not Be Measure of Value”. David asserts, correctly in my opinion, that value is a function of one thing: how much cash will the asset generate for its owner. Over time I believe the market fairly values a security giving the investor the opportunity to take profits when full/fair value is reached.

Football can teach us something about a sound investing practice. Focus on first downs and touchdowns will come. If we get greedy we might throw the interception or fumble the ball.

Link to David Moon’s article: http://bit.ly/mPC05I

Reply

Financial Uproar June 30, 2011 at 21:14

You poor guy… What a horrible problem to have 🙂

I’d wait and let CNU get bought out, for a couple reasons:

1. While it sounds unlikely, there’s always the chance of another offer.

2. I’m cheap, so I’d want to save the exit commission that I’d have to pay selling CNU.

As for continuing to own the combined company, I probably wouldn’t. Like you, I don’t typically like companies with levered balance sheets. Plus, there’s always uncertainty around takeovers. Will they get the synergies they want? Will they be a good fit for each other?

Reply

JT McGee July 3, 2011 at 07:41

Thanks to both of you for your comments. Seeing as the consensus has been mostly “sell,” I think I’ll hang in.

@Jeff

Completely right on emotional investing–it usually doesn’t work out too well. I can get pretty excited about things, but most things don’t become actionable, so all is well (for now. ;))

@Nelson,
CNU probably won’t get another offer since they’d have to pay up big to MDF for accepting it, and the current price gives a forward multiple at close to long-term borrowing costs. Growth aside, looks tough for most would-be buyers.

Good point on the decision to hold for the buyout. I’ll also get a few extra free shares that are only half-dilutive to my ownership, which is cool.

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