Review of "Santa Monica Partners: Letters to Partners (1982-2021) - 40 Years of Pink Sheet Investing"

The following article I wrote in the past month and it recently appeared in a paid newsletter that focuses on over-the-counter stock investing. I believe that few of my subscribers would’ve read it there, so it should be new content to most readers.

Readers of this newsletter can obviously appreciate an undiscovered value stock. By the same token, obscure investment books can represent a treasure of information and insights as exciting as finding a community bank stock trading for half of book value with a double-digit ROE and 6% dividend yield. For me, finding this compilation of Laurence Goldstein’s investor letters was such a treasure. (For those who did not know, he is the founder of an investment fund called Santa Monica Partners.) The book is titled Santa Monica Partners – Letters to Partners (1982-2021).

For those interested in “investing” in a copy, as of the date of this writing, there is a thin market on Amazon with four book sellers that have “asks” ranging from $75-$100 per copy. I feel almost as guilty about pitching this book as I would an OTC Limited Tier stock with a wide bid/ask spread. But rest assured that I will be holding onto my one copy regardless of whether this article drives up the price on Amazon. For those “buy and hold” book investors, some other finance book comparables would be Seth Klarman’s Margin of Safety (at $3,642 per copy on Amazon) and Toby Crabel’s Day Trading with Short Term Price Patterns and Open Range Breakout (currently quoted for a more reasonable $620).

Perhaps the best description of Santa Monica Partners’ investment approach and philosophy comes from Mr. Goldstein’s own words in his July 6, 2016 letter:

Our view is that investors are generally intelligent. Many factors, including those previously mentioned, create certain areas of the market where those otherwise intelligent investors overlook attractive opportunities. A company may not show up well on a screen. It may only trade on the pink sheets. It may have hidden assets. It may have low trading volume. It may be closely held. There may not be any analyst coverage.

We feel we have a large advantage because those neglected areas of the market are where we hunt. This allows us to find and buy into companies when they have been overlooked by others. When those companies are discovered by others, significant multiple expansion can occur. The key to success when investing in this area is patience. It can sometimes take many years for these companies that are overlooked or ignored to be recognized. We may hold a stock for years where it does nothing only for it to fly over a short period of time when discovered by others.

Now that is a strategy that investors in oddball OTC value stocks can relate to!

Long Holding Periods and a Great Investment in Balchem

In his management of Santa Monica Partners, Mr. Goldstein exemplifies the attributes of long holding periods, avoiding realization of taxable gains, and comfort with concentrated portfolio positions. I was amazed to read that in Q1 2009 the fund made no sales of portfolio positions. I remember that period (with the global financial crisis equity sell off bottoming in March 2009) and it is hard to imagine an investor who was able to just sit on his hands during that period. Sitting was probably the right move, but so many businesses seemed to be facing existential threats and so many stocks were off 50+%! I certainly had some portfolio turnover in Q1 2009, although I am not sure any of my trading added any value to my portfolio that quarter.

One of Santa Monica Partners great successes was investing around $500K in the stock of a specialty chemical producer, Balchem, initially in the late 1980’s. At the time of the Fund’s initial investment in Balchem, the company generated around $7 million in revenues and had under $1 million in operating profits. Today the company is a $5 billion market cap leader in specialty chemicals and the stock price chart below makes it one of the top performing stocks of the past thirty years with a 980x-bagger on stock price from 16 cents (split adjusted) from the start of the year in 1990 to $157 per share presently.

Who among us honestly would have held for this ride the way Mr. Goldstein and his Santa Monica Partners did? And what better example of what investors can achieve looking for well run, value stocks representing investments in real businesses with management teams making smart decisions and providing value to real customers. Investors do not need to chase over-valued AI stocks or crypto-currencies to get rich, it just requires a little patience and discipline. (Note: readers may be surprised to learn that Mr. Goldstein is an ardent bitcoin enthusiast having gotten in early to the Greyscale Bitcoin Trust on behalf of his limited partners. You’ll have to read the book to learn about that one!)

In the April 2012 investor letter, Mr. Goldstein discusses the Balchem investment, writing in a quarter where the fund lost 5.2% while the DJIA earned 8.1% and the S&P 500 advanced 12.0%, and at a point where Balchem had grown to close to a 40% portfolio position for the fund:

As they say too much of a good thing sometimes can be a bad thing. On a relative basis we just experienced one such “sometimes”. Despite our having distributed over 211,000 shares, some 21% of our original Balchem Corporation investment, in in-kind distributions in the last four years, we still own 776,151 shares. Importantly, it should be noted as well that as a result of too numerous to mention stock splits over the years, all the shares distributed had an adjusted cost basis of pennies per share but a market value that averaged $34 a share. The result of this was that for all remaining partners it was the same as if we sold the stock, but with one huge difference. Unlike a sale we avoided having to report, and you did not have to pay taxes on, the more than six million dollars in capital gains we have realized so far. We had our cake and ate it too, enjoying the full profit from the appreciation which amounted to a 16,900% increase.

In recent years, Balchem stock, reflecting its growth and its potential, has made a new high in every single year of the past decade. Moreover, it has ended most of those years, including the G-d awful year of 2007, very close to the new high it made that year. Last year was no exception. What has been the rule rather than the exception is that Balchem’s stock made a new high during each year and closed not very far from that high at year-end.

You should be aware that we purchased the shares we hold today over a nine-year period, from 1989 through 1998 at a total cost of a little over half a million dollars. 80% of the shares we still hold have a split adjusted per-share cost of between $0.24 and $0.49 and, by the way, the shares we distributed cost as little as one cent a share. At the end of last year, the stock was $40.54 and worth a total of $31.5 million. It seemed the more shares we distributed the more we had as a result of splits and the more what was left was worth. Many an investment manager would have cut his or her position long ago when it reached above some fixed percentage such as 5% or maybe 10% or possibly even 20%. Balchem has been a stock that has kept giving and giving.

While the Balchem investment represents the investment of a lifetime, the characteristics it represented for Santa Monica Partners – (1) long holding period (the Balchem holding spans the entirety of the book), (2) comfort with concentration derived from appreciation (in the October 1989 letter, Mr. Goldstein notes that Adrian Steel comprises 31% of the investment portfolio), and (3) avoidance of taxes for limited partners, are repeated throughout the book with other examples of portfolio investments profiled in investor letters over the years. Mr. Goldstein is remarkably candid and transparent in his letters around the reasons for portfolio purchases and holding or selling decisions. This clarity around his process is part of what makes this book such a compelling read for investors in thinly-traded value stocks.

On Catalysts

In the course of my investment career, I have interviewed hundreds of investment managers. As I am inevitably trying to understand the elements of their strategy and how these attributes lead to results, frequently the conversation moves to the topic of catalysts. Catalysts can be defined as likely future events or triggering actions that result in an undervalued security moving towards fair market value. Everyone has an opinion on catalysts and I have heard investment greats express strongly-held opinions on catalysts ranging from (1) “just something people talk about after the fact”, to (2) “catalysts are critical elements to any investment.” Over-the-counter value stock investors generally need to be comfortable with the lack of a clear near-term catalyst, but realization of value in an acquisition to an acquiror is a welcome scenario for any investor I have ever met.

Larry Goldstein loved the ability of his portfolio investments to compound value over long periods of time so much that acquisitions at a large premium were not always welcome. While I have heard investors dismiss the importance of a catalyst, reading this book presented me with the first instance I have encountered of an investor who was upset at the emergence of a catalyst that would take him out of a desired long-term hold at a substantial profit. In July 2007, Mr. Goldstein wrote about take-overs in general and the announced acquisition of a large portfolio holding, Penn Gaming, in particular:

During the past 25 years, seldom have we ever sold stocks of our own volition. I think 99% of our selling has resulted from cash takeovers in which were given no choice other than to take the money and run. The fact is acquisitions of our holdings all too often amounts to a process of selection of our fittest. Nevertheless, notwithstanding what I or anyone else may think about takeovers, during the second quarter we were blessed (or victimized-take your choice) by announcements of five takeovers that were or will be forced on us. One actually came before the pre-market opening on the very first day of the third quarter.

… “Under the terms of the agreement, Penn National shareholders will receive $67 in cash per share. The purchase consideration represents a premium of approximately 31%.” … “We purchased our shares at $10 a share. However, as a result of numerous stock splits our cost basis is $0.83 a share.” … “Yes, being human, seeing the announcement was thrilling to me. But then I became realistic and true to my views as stated above. Penn National gaming is, as its name implies, in the business of operating gaming facilities, racetracks featuring slot machines, off-track betting, casinos on land and riverboat. As I mentioned in one of my recent letters, the company has yet to enter either Las Vegas or Atlantic City or for that matter the World’s biggest gaming location, Macau (China). Unfortunately, the CEO who we admire greatly and who happens to own 11% of the company, was taken (take this to mean what you will) by Fortress Investment Group and its 31% above the market cash offer. This offer may be discounting some years into the future, but it comes at a cost. I think the company’s past achievements are only prologue so I am not the happiest of campers.”

Having read these thoughts, I will forever think about catalysts and large premium above market acquisitions differently. These thoughts also sum up nicely what a long-term perspective Santa Monica Partners has taken with its portfolio investments.

Santa Monica Partners Track Record

The final page of this article includes a summary of Santa Monica’s track record from January 31, 1982 through December 31, 2021 (latest data included in book). On a gross-of-fee basis, Mr. Goldstein delivered a 16.1% annualized return to his investors. This compares very favorably to the S&P 500’s total annualized return of 12.36% over this same time period and the Russell 2000 Value Index’s 11.96% annualized return. (Note: I believe that these two indices are the best readily available indices for comparison to OTC or “Oddball” value strategies. I view the S&P Index return as being the opportunity cost of equity capital for most investors and the Russell 2000 Value Index is the most common passive investment approach for investors to access small value companies.)

This premium return of close to 400 bps compounded over forty years is truly powerful. $1,000 invested at inception would have grown close to 400-fold to $390,733 at this 16.1% compound annual growth. By contrast, the S&P 500 would have turned the $1,000 into $105,663 and the Russell 2000 Value index would have resulted in $91,849 of ending value. Mr. Goldstein never claims in his letters to be any smarter than any other investors and never claims to be able to time the market. Rather, by fishing in a pond that is less busy and consistently applying a winning investment approach with discipline he delivered truly remarkable investment performance. This type of investment performance should garner the attention of anyone looking to find an investment game that they can play in and can win.

Santa Monica Partners investment performance certainly has my attention, but his record also argues for the Do-It-Yourself approach that so many readers of this newsletter also embrace. If one assumes a 1.5% management fee, the 16% becomes 14.5%. Further, if one assumes that 20% of profits after management fee are paid as an incentive, the 14.5% becomes 11.6%. Net of this assumed 1.5% and 20% fee structure, the limited partner in Santa Monica Partners slightly underperforms passive exposure to the S&P 500 and the Russell 2000 Value Index over this forty-year time period in spite of the masterful gross of fee performance. The book never gets into the specific fee structure of clients of the fund, however, on one instance I noted where gross and net fees are disclosed. In the January 2017 letter, the following is noted:

“Since we began on February 1, 1982, a period of nearly thirty-five years, Santa Monica Partners has managed a compound annual growth rate of return of 16% before fees and expenses. Limited Partners earned a compound annual growth rate (CAGR) of 11.7% net of fees and expenses.”

So whatever the fee structure of the fund, net results do end up around what I calculated on a 1.5% and 20% basis. My take-away from the book: study great investors like Larry Goldstein. If one has time to manage one’s own portfolio, emulate great investors like Larry Goldstein. If one chooses to outsource management of the portfolio, either strictly invest with great investors like Larry Goldstein or engage in low cost index strategies, as a mediocre active manager or mere mortal is quite unlikely to outearn their fees. My guess is most readers here will choose to manage their own money. If you fall into this category, I recommend Santa Monica Partners – Letters to Partners (1982-2021) highly, it is the best $75 you will ever spend on a book.