When looking for new stocks, it's always a good idea for retail investors to see where the smart money traded by large institutional investors is going. After all, many of these investors are paid huge salaries to invest, and they are quite good at what they do. One stock that performed well in recent years is the billboard and broadband operator Boston Omaha (BOC -0.26%), which many consider to be a mini Berkshire Hathaway.
Interestingly, Boston Omaha's co-CEO Adam Peterson founded another private fund called the Magnolia Group, which owns about a third of outstanding shares in a microcap stock with a $44 million market cap. Let's take a look at why a prominent investor like Peterson is investing so heavily in a stock that is clearly not receiving too much attention from the broader market.
A struggling subprime auto lender
Peterson and his fund Magnolia have beneficial ownership of 33% of Nicholas Financial's (NICK -3.62%) outstanding shares, and Peterson also sits on the company's board of directors.
Nicholas Financial is an auto lender that originates and services direct and indirect auto loans to subprime borrowers through many states in the U.S. The average loan size is around $4,300, and these loans are typically secured by a lien so Nicholas Financial can repossess the vehicle if a borrower defaults.
Image source: Getty Images.
In subprime lending, lenders are making loans with huge annual percentage rates (more than 30% for direct loans) because subprime lenders are a pocket of the population that is going to have high charge-off rates, which is debt unlikely to be collected and a good indicator of actual loan losses. Managing credit through a difficult economic period is usually challenging for this sector, which is why it often doesn't receive high multiples.
Now that credit has begun to normalize, particularly on the lower end of the credit spectrum, Nicholas Financial has begun to see charge-off rates soar. At the end of the company's second quarter of fiscal 2023 (ending in September 2022), Nicholas Financial reported a net charge-off rate of nearly 12.4%, which is up from a below-5% rate the previous year. The company also reported a loss of $3.2 million in the quarter.
In November the company announced a huge restructuring plan in which it will close all but two of its branches and lay off 82% of its workforce as it looks to outsource a lot of the activities associated with its business, including loan servicing.
What's the catch
If Nicholas Financial is struggling so much and the company could face more pain if the economy further deteriorates this year, why does Peterson have such a large position in this stock?
Well, one interesting aspect of Nicholas Financial is that it has a ton of excess capital. In its 2022 annual letter to shareholders, the company noted that most subprime auto lenders hold $2.50 to $3.50 of loan receivables for every $1 of equity.
Nicholas Financial ended its 2022 fiscal year holding $1.45 of receivables for every $1 of equity. The company also said it has previously done this to err on the side of caution, but that it sees the need to alter this structure to generate more competitive returns. Nicholas Financial said it would look to hold somewhere around $2 to $3 for every $1 of equity.
Even after the higher charge-offs in its most recent reported quarter, Nicholas Financial still had more than $109 million of shareholder equity. In its shareholder letter the company said it thought it would be more prudent to hold a little more than $67 million of capital.
A potential windfall for shareholders
Nicholas Financial is sitting on about $42 million of excess capital, which is almost equivalent to the company's total market cap. But the company can't just use it right away because it has certain agreements with its own credit lender that do not give it full autonomy over its excess capital.
However, Nicholas Financial recently restructured that agreement, which will now mature in May of this year, at which time it may have full autonomy over its excess capital.
Nicholas Financial does not seem like the greatest business in the world, and it may be looking to significantly change its strategic model with this restructuring. But the company has a tremendous amount of excess capital, and it's trading at just 40% of its tangible book value or net worth.
One thing I would caution investors about is that microcap stocks typically trade fewer shares and therefore aren't as liquid. This can make them much more volatile if an investor buys or sells a large amount of shares. But with Peterson on the board and having such a vested stake, I do see this as a better sign that shareholders are in good hands here. After all, Boston Omaha has grown nicely since it went public in 2017 and a large part of that is because of Peterson's ability to strategically deploy capital in a way that benefits shareholders.
Theoretically, management could eventually pay some kind of large special dividend down the line, or use $12 million of its excess capital and repurchase a quarter of its total market cap. If the company does this while trading below tangible book value, it's going to create a tremendous amount of value for shareholders.
