How Larry Goldstein made $250,000 in 2 hours

Case Study: A fast growing net-net selling for 3x earnings

Almost nobody knew who Larry was in 1982.

Outside of niche investing circles he’s still unknown today.

I first heard of him a few years ago when he wrote the SEC opposing a rule change for thinly traded OTC securities. Some of his quotes in that letter were unbelievable:

• “I actually have a less than $200,000 investment which has become worth about $50 million and all I had when I was accumulating the shares was an annual financial report.”

• “…by counting trailers leaving a warehouse, speaking to employees, customers, competitors and suppliers as well as management so one can piece together what is going on in a company.”

His name is Larry Goldstein. And he’s been running Santa Monica Partners since 1982.

Over a 40 year period Larry compounded at 16.1% annually (before fees).

This undoubtedly makes Larry one of the best fund managers to ever play the game. His track record was built by owning illiquid, unknown securities trading at cheap valuations.

The best book I read last year was “Letters to Partners”.

It’s a collection of the letters Larry wrote to his investors over 40 years.

It’s like reading Warren Buffett’s shareholder letters if he were managing a small sum of money.

Do yourself a favor and read this book:

BUY THE BOOK HERE

Just in case you’re wondering, I don’t make any money if you buy it. I just think it’s well worth your time.

Today’s case study comes from the book.

It’s a story about a rapidly growing business trading for 3x earnings in the depths of the Great Recession. When the capital structure changes the market breaks, and Larry makes a $250,000 profit in a matter of minutes.

It’s Larry in the wild, wild west that is the OTC.

I hope you enjoy…

It’s January 2009.

Santa Monica Partners (Larry’s fund) just had its worst year in fund history.

A 46% loss. Ouch.

The financial world was brought to its knees as the housing bubble burst. The S&P had its worst year since the Great Depression. Banks evaporated overnight. Entire developments were abandoned. The city of Detroit started a program to sell foreclosed houses for $1. Warren Buffett went on Charlie Rose and described the situation as an “economic Pearl Harbor”.

It was mayhem.

Larry was down, but not out. He’d seen his share of market meltdowns and he knew this was the time to harvest.

Larry finds a tiny little business called Compass Knowledge Holdings (Ticker: CKNO).

CKNO partnered with universities to offer graduate degrees for online learning. Remember, this is 2009. The online learning thing is brand new. CKNO sits in a unique position because it was the only publicly traded online learning platform that was partnered with reputable colleges.

Strayer, Grand Canyon University and others all had their own programs. These were hot stocks in the late 2000’s, but Compass was arguably more sustainable given its partnership with bona fide schools.

So, let’s look at the numbers:

CKNO was a non-SEC reporting company with a $10mm market cap.

Shares sold for $0.60.

The business was sitting on a mountain of net cash. Current assets were 4x larger than total liabilities.

Despite its overcapitalization, Compass earned a 36% ROE.

Put simply, the stock was cheap.

Larry said it best:

“One could ask what can be lost at $0.60 and an adjusted P/E of 0.95x? The risk is what? Less than a T-bill yielding 0% would one say? The opportunity would appear to beat anything I could imagine or anyone else might know of.”

So Larry bought plenty of cheap stock. But then he had another idea.

The stock would be worth a lot more if it filed with the SEC and a broader set of investors could see how cheap the business was.

But how can you make a company register with the SEC?

There is an obscure rule in public markets. If a business has less than 300 registered shareholders, it can remain “public” without filing financials with the SEC. It’s an odd rule that exists to let smaller companies avoid the cost of filing.

Anyway, Larry decided to register a single share in each of his investors’ names. This was done to increase the number of record holders. Shares held by a single broker come through as one record holder for legal purposes. So, by registering each investor individually, Larry increased the number of record holders.

In response, the company initiated a 1 for 25,000 reverse split in April 2009. The reverse split would reduce the number of shareholders to a level that guaranteed the company would prevent any kind of record holder shenanigans in the future.

Anyone owning less than 25,000 shares would be cashed out at $1.45/share.

Not a bad return from $0.60/share in a 3-month period.

By the way, even after receiving the reverse split notice, Larry was able to buy several thousand shares at $1.20. A high return arb could’ve been obtained from buying 24,999 shares at $1.20 in the weeks leading up to the reverse split. Shareholders could’ve made a 21% return in a matter of weeks. Do the CAGR on that. Efficient markets though, right?

But we’re just getting started…

On May 19th, 2009, the split went into effect.

The share count was reduced, and the post-split valuation was $36,250 ($1.45 * 25,000 shares).

To Larry’s amazement, when he checks the quote the morning after the split, he sees shares being offered for $2,000!

This is a 94% discount to where shares traded the day before! And even that price was a steal!

Larry called a market maker, and after double and triple checking, was ensured that the $2,000 offer was in fact for the post-split shares.

Larry was able to buy 100 shares at $2,000 apiece. This purchase effectively valued the business at 0.5x earnings and 20% of net cash.

As it turns out, the seller was UBS. The offer to sell was a mistake. They must’ve left a stale offer out, or somehow otherwise goofed up the math. FINRA recommended that the trade be broken. It was an accident after all, though Larry played the game as honestly as any man could.

After a morning of discussions with FINRA, UBS and market makers, UBS offered to buy back the shares at $4,500 apiece.

Larry decided to take a quick profit and avoid arbitration with an army of UBS lawyers.

So, he sold his 100 shares (after owning them for half a morning) for $4,500 a piece - netting a $2,500 profit on each share.

And that’s how Larry Goldstein made $250,000 in a matter of hours.

He held the remainder of his shares - having owned enough to avoid being cashed out in the reverse split. In October 2010, CKNO sold to Embanet for $209,000/share.

When it was all said and done Larry quadrupled his money in less than 2 years.

Legend.

DISCLAIMER: THIS IS NOT INVESTMENT ADVICE. I MAY OWN SECURITIES MENTIONED IN THIS ARTICLE. THIS IS NOT A RECOMENDATION TO BUY THIS STOCK OR ANY OTHER STOCK. I MAY BUY OR SELL ANY SECURITY AT ANY TIME. I MAY NOT TELL YOU IF AND WHEN I BUY OR SELL. THESE STOCKS ARE ILLIQUID AND YOU SHOULD UNDERSTAND THE IMPLICATIONS OF THAT IF YOU BUY THEM. THIS IS NOT TAX, LEGAL OR FINANCIAL ADVICE. I AM NOT YOUR FIDUCIARY. THIS IS THE INTERNET AND YOU’RE LISTENING TO A GUY NAMED DIRT.