Bandera – Microcap Activism Is A Hard Road To Travel by Jeff Gramm, MicroCapClub
Some people know me by my book, Dear Chairman, but what they don’t know is I’m an avid microcap investor. Along with teaching value investing at Columbia Business School, I co-manage a fund called Bandera Partners and we are active in the microcap space. I sent Ian one of my quarterly letters from a few years ago describing a long and arduous story with a microcap company, and he thought it was interesting enough to share with the world.
In 2003, I found a company called UCI Medical Affiliates with a market capitalization of about $3 million. I was in my twenties, working as an analyst at a distressed debt hedge fund in New York City. UCI, which ran urgent care clinics in South Carolina, had recently emerged from a rare bankruptcy that preserved the equity. Several large blocks of stock were available, but I failed to convince my superiors to buy them. I then bought some shares in my PA and embarked on an intense, eight-year, hard knocks education in microcap investing. I’ve been hooked on microcaps ever since, for better and for worse.
In early 2011, Bandera Partners (which I run with my partner Greg Bylinsky) negotiated UCI’s sale for $65 million. It felt like a minor miracle. A mere two years earlier, UCI’s valuation had fallen all the way back to the $3 million it garnered when I first found it. I ended up writing 6,000 words about the investment in our next quarterly letter. I also attached some of our correspondence with UCI’s majority owner, Blue Cross Blue Shield of South Carolina, as an exhibit. The letter was so well-received by our investors, that it gave me confidence to write “Dear Chairman.” The book takes its structure from this quarterly letter—a fun narrative followed by an original letter from shareholder to company.
I’m excited to share the UCI saga here, for investors that have learned the hard lessons that microcap investing offers. It is a lurid tale with all the hallmarks of value investing: drug addiction, suicide, prison, and, worst of all, accounting restatements. When I waltzed into this investment, I was incredibly naïve about public companies, boards of directors, and corporate governance. In fact, with UCI I committed the cardinal microcap investing sin: I bought into a company controlled by a majority shareholder. Don’t worry, as you’ll see, it got much worse.
You can read the full story in my Bandera Partners Q1 2011 Letter below.
Bandera 1st Quarter 2011 Review
Your investment in Bandera Value Fund LLC generated the following returns for the first quarter of 2011:
In the first quarter of 2010 Bandera Value Fund returned 4.9% net of management fees and performance allocations. The S&P 500 gained 5.9% for the quarter.
One of our biggest winners this quarter was UCI Medical Affiliates, which was Bandera’s very first purchase at the inception of the fund in 2006. The company operates Doctors Care, a large network of urgent care medical clinics in South Carolina. In March, after a year of negotiations with Bandera, health insurer Blue Cross Blue Shield of South Carolina (“Blue Cross”), UCI’s largest shareholder, announced a tender offer for all of the outstanding shares of UCI at $6.50 per share, a 141% premium to the share price before the announcement. We were UCI’s second-largest holder and sold all of our shares in the tender offer.
The following account of our involvement with UCI Medical Affiliates is very detailed, but for those of you with the time and stamina, we think you will enjoy the history of our first and most challenging investment. Buying small capitalization stocks can be a hazardous activity, but it can be very profitable if you maneuver carefully. UCI in particular was loaded with troubles as well as potential. An investor who bought shares of UCI ten years ago would have endured a bankruptcy filing, the resignation of a CEO with a history of drug abuse, an embezzling CFO who was sent to prison, several periods lasting over a year with no audited financial statements or stockholder meetings, various accounting restatements, the dismissal of its auditor, a controlling shareholder with clear conflicts of interest, and a board of directors that alternated between unresponsive and hostile to shareholders. The same investor who bought shares ten years ago would have witnessed remarkable growth in UCI’s business and a 2,000% return on his or her investment.
If you don’t have time to read 6,000 words about doctors’ clinics in South Carolina, let us refer you to our correspondence with Blue Cross about UCI’s value, attached as an exhibit to the end of this letter. It will help you understand why we liked UCI and how we approached valuing the business. While it is an informative and relatively concise document, it lacks the scandal, intrigue and drama of the complete history outlined below.
UCI Medical Affiliates – Our first investment
Our investment in UCI was a grueling endeavor that found your faithful portfolio managers racing across South Carolina in a quixotic attempt to free the company from the control of the multi-billion dollar South Carolina Blue Cross Blue Shield affiliate. We knew we faced a challenge – our first conversation with a UCI board member (and former Blue Cross President) ended with him telling us we were “crazy to buy the stock” and that UCI was “ a captive subsidiary” with “worthless” shares that we should stay away from. Undeterred, we proceeded to buy 13% of the company and fight for board representation. We outlasted two counterparties at Blue Cross as well as one CFO of UCI, who now resides in a federal penitentiary. At the darkest moment, UCI’s stock was so far down from our cost basis that we needed it to appreciate to ten times its market value for us to break even (it ultimately went up eighteen times).
Behind the hostile board member, the crooked CFO and the unresponsive majority shareholder was a twice-bankrupt company in a maligned industry that was itself riddled with bankruptcies. So why were we attracted to UCI Medical Affiliates? And why was UCI controlled by Blue Cross, its largest customer? Why buy stock in a company when the ultimate success of the investment depends upon fighting with its largest customer? Most importantly, why did we see potential in UCI’s business and why did the rest of the market disagree with us? This is a complicated story that begins, like the story of many good investment opportunities, with a Wall Street bubble.
The Physician Practice Management (PPM) Bubble
In 1997, the country’s two largest physician practice management companies, PhyCor and MedPartners, announced plans to merge. The deal to create an $8.5 billion company with a network of 35,000 doctors was never consummated, but for a brief moment the announcement validated the PPM industry and legitimized its meteoric growth. Healthsouth’s Richard Scrushy, who served on MedPartners’ board of directors, proclaimed at the time, “This is the model that works.”
PhyCor, founded in the 1980s by four hospital executives, was the pioneer of the physician practice management business model. The company rolled up small