Tom Konrad CFA
It’s Good to be Small
investors have an advantage over big hedge funds and other
professional investors: They don’t have as much money.
Why is not having much money an advantage? It allows us
to invest in stocks that large investors simply cannot touch
because of lack of liquidity. If a stock only trades
$50,000 worth of shares a day, a even a relatively small $50
million dollar hedge fund would have to buy all of the shares
traded for two weeks just to allocate 1% to the stock, and would
have to do the same if it were to sell. As you can easily
imagine, that would send the stock price rocketing
(or plummeting when the fund sold), and remove much
potential for profit.
If the big funds can’t buy a stock, they’re not going to spend
any time researching it. Likewise, analysts, who make
their money selling their research to large investors, are not
going to research it either. With professionals
out of the picture, it’s relatively easy for a small investor to
gain an informational advantage: We just have to dig a little
deeper than others. The fewer investors who are paying
attention, the easier that is.
That’s not to say that all (or even most) illiquid stocks are a
good buy. You still have to do some digging. Yet
unlike with more widely followed companies, the stock price
can occasionally be much less than the value of the
company, especially if that value is not yet shown on the
A Very Illiquid Stock
Which brings me to Power REIT (NYSE:PW.)
The stock’s average daily volume is about 1300
shares, or only $10,000. With a market cap of $13 million, if a $100
million dollar hedge fund tried to allocate just 1% to PW, it
would send the price skyrocketing as it attempted to purchase as
much stock as normally trades in five months.
The fund would also end up owning over 5% of the company,
becoming subject to extra restrictions on trading and
With a stock this illiquid, even small orders of a few hundred
shares can move the price five to ten percent, so it’s best to
use limit orders to make sure you’re not paying a lot more than
you expected. Even limit orders will move the price over
time, however. That said, the current stock price of
$8.10 is more than justified by the current 4.9%
annual yield alone. Which means the large upside
potential I’ll discuss below is essentially free.
What Most Investors See
I mentioned Power REIT in my recent article on the possibility
REITs, as well as profiling the company earlier this year.
I think the comments I’ve received
are indicative of what most small investors see when
they look at PW:
Personally, I consider a 5% yield attractive in the current
interest rate environment, but it’s the litigation with Norfolk Southern Corp. (NYSE:NSC) that provides the
opportunity to dig deeper than most other investors have.
According to Power REIT’s recent
quarterly report and court documents, the substance
of the litigation is this:
- Power REIT believes that NSC, and its sub-lessee,
Wheeling & Lake Erie Railroad (WLE) are in default on their lease with
Power REIT’s wholly owned subsidiary, Pittsburgh & West Virginia Railroad (P&WV.)
That leased property is 112 miles of railroad track and
railroad property in Pennsylvania, West Virginia and
Ohio, and is Power REIT’s main asset. For the sake of
brevity, I will refer to NSC and WLE collectively as the
lessees from this point forward.
- The lessees are seeking a judgment that they are not in
default of the lease. If they are not declared
in default they have the right to unlimited
renewals of the 99-year lease on the current terms which are
very favorable to them.
- If the court declares the lessees in default, they
would have to re-negotiate terms for using P&WV’s
property. In addition, a substantial “indebtedness”
arising from tax payments made by P&WV on NSC’s behalf
and asset sales of unused portions of the leased
property would come due. The court may also declare
the lessees owe back interest on the indebtedness.
NSC has not provided access to the books which would
document the size of this indebtedness, but it was carried
(without interest) on P&WV’s 2009 tax return (prepared by
NSC) at $15,517,325. It has since increased to at least
$15,882,651, according to an exhibit filed by Power REIT.
The lessees refer to this indebtedness as the
“settlement account.” The lease limits the size of this
indebtedness to a tiny fraction of the size of the
current settlement account.
- P&WV believes that the lessees are in default for
at least three reasons, which they state in their answer legal
- Failure to pay specific P&WV’s legal fees which it
believes the lessees were required to pay under
the lease after 60 days notice.
- Failure reimburse P&WV in cash for Federal tax
payments made under the terms of the lease.
- Failure to allow P&WV to inspect books and records
regarding its property or inspect its track.
Payment of Legal Fees
The lessees argue that the lease does not require them to pay
P&WV’s legal fees. The relevant section of the lease,
4(b)(6), states that the lessee is
[R]equired to pay all obligations reasonably
incurred by [P&WV] … for … all acts and
things necessary or desirable for
the protection [of P&WV]’s rights
…. pursuant to this Lease, except such obligations
… solely for the benefit of its stockholders.
While I’m not an attorney, it seems clear to me that the legal
fees Power REIT has incurred to determine its rights under the
lease and to protect its interest in the current litigation are
both “necessary or desirable” to protect its rights under the
lease. While everything Power REIT does should eventually
be for the benefit of its stock holders, that clause is not
relevant here because, as P&WV points out in its legal
filings, NSC has not historically applied
that exemption to paying any of P&WV’s taxes.
These tax payments are also required under the lease
subject to the same exemption.
Payment of Taxes
The lease allows the lessees to use the depreciation
of the property to reduce their tax bills, so long as they
compensate P&WV for the taxes then owed. Section 4(b)7
of the lease states such taxes (as well as the legal
fees discussed above) “shall be paid or discharged by
Lessee as and when they become due and payable.”
Rather than paying these taxes for P&WV, the lessees have
simply been increasing their “indebtedness” to P&WV, as
discussed above, forcing P&WV to pay the taxes out of its
own cash. This is another reason Power REIT argues that
the lessees are in default.
Pittsburgh and West Virginia Railway
Route Map, pre-1967 from Wikipedia
Refusal to Allow Inspections
NSC has also refused to allow Power REIT to inspect NSC’s
books, despite the fact that section 8(a)3 of the lease seems
crystal clear that it should be allowed to do so:
[NSC and WLE] shall permit at any and
all reasonable times such person or persons as
[P&WV] may designate to inspect the books and records
of [NSC or WLE] for any purpose whatsoever.
As far as I can tell, the track inspection Power REIT requested
is not required by the lease, but the refusal to allow an
inspection of NSC’s books seems sufficient to declare NSC to be
| A portion of Wheeling and Lake
Erie Railway's Route Map
Timing and Likely Outcomes
The case is pending in Federal Court in Pittsburgh, PA.
The litigation is currently in the active discovery phase.
While it’s extremely difficult to predict how long the
litigation might continue, and what the cost might be, both
parties are asking the court for a summary judgment, which
means that there could be a judgment soon after this phase is
The various issues that will need to be decided are:
- Can Power REIT terminate the lease?
- How should the “indebtedness” in the settlement account be
- Are the lessees responsible for any of Power REIT’s legal
From reading the filings, it seems to me that WLE and NSC’s
strongest argument is that they have been doing things this way
for 45 years, and P&WV has never objected before.
Hence, the argument goes, P&WV implicitly agreed
to their procedures with its lack of objection over four
decades. Power REIT’s counter is that P&WV was for all
intents and purposes a captive of NSC. NSC controlled PW’s
board (WLE’s President was chairman of the board.) NSC
even prepared P&WV’s taxes. Since P&WV did not
have the capacity to object, its previous silence did not
Termination of the Lease
It seems clear to me that WLE and NSC are
in default of the lease on several counts, and the
lease is quite clear that there is no remedy once a
default has occurred. That said, the court might still
decide that the possibility of economic disruption would
be too great if Power REIT were allowed to completely revoke the
lease, and so might simply change the terms of the lease, or
order that they negotiate a new lease that the court
Any of these outcomes would most likely be favorable to Power
REIT, since the current lease has no provision for inflation,
past or future, and the current rent is far below a market rate.
The worst-case scenario for Power REIT would be if the
court were to rule in WLE and NSC’s favor, and re-affirm the
If the court finds the lease in default, then WLE or some other
railway will need to renegotiate a lease with Power REIT.
Given the fact that the current lease is 50 years old and
has no inflation adjustment, it seems reasonable to expect that
any new lease would be considerably more lucrative for Power
REIT than the old one. It’s also worth considering that
the rail in question lies on top of the active Marcellus Shale
natural gas play. While the environmental impacts of shale
gas drilling are in question, the impact on
rail usage are not: shale gas drilling requires
incredible volumes of water, sand, and drilling chemicals to be
hauled, and rail is far more economical
for moving bulk goods than roads. Any new
market lease would probably be worth many times the $915,000 per
year ($0.55 per PW share) paid under the old lease.
The lease does not define the terms of the
“indebtedness” represented by the almost $16 million in the
“settlement account,” and is silent on when the indebtedness is
due. PW argues that because the lease is silent
on the matter, the money is payable on demand.
Even if Power REIT is not able to demand the money immediately,
the lease caps the settlement account at five percent of
P&WV’s assets, which, depending on how assets are valued, is
almost certainly less than $1 million.
Hence, there are a large number of avenues by which the court
might decide that at least $15 million of the settlement account
is due and payable immediately. Since Power REIT has only
1.62 million shares outstanding, that amount to a payment of
over $9 a share. As I write, Power REIT’s stock last
traded at $8.10.
In any case, the court may decide that the balance is subject
(as Power REIT argues) to interest at the Applicable
Federal Rate (AFR). I was only able to find AFR
data back to 1990, but the long term AFR appears to be about 1%
less than the 10 year Treasury rate for those years, so I used
this approximation for 1967 to 1989. If we assume that the
settlement balance has accrued in straight-line fashion over the
45 years since the beginning of the lease, we get a total (with
compounded interest) of around $70.7 million.
While the legal argument that a debt should accrue interest
seems sound to me, I have trouble believing that the court would
award $70 million to a company with a $13 million market cap.
On the other hand, much stranger things have been known to
Payment of Legal Costs
The lease seems quite clear that the lessee should pay all
P&WV’s tax payments and legal costs that are not strictly
for the benefit of shareholders.
The legal costs are disclosed in Power REIT’s 10Q, and amount
to $366,000, or $0.23 a share. Although these legal
costs are recoverable under the lease, GAAP accounting rules
require them to be booked as an expense, and this has been
depressing earnings over the last few quarters. There was
also a smaller amount spent in 2011.
Power REIT management believes that the lessees will
have to reimburse these legal fees. This confidence makes
this tiny company willing to take on a behemoth like NSC in a
legal battle. The expense might be hurting the stock now,
but the cost is much easier to bear when it’s likely your
opponent will be paying your expenses. This also means the
lessees have an incentive to wrap the case up quickly.
When the case is over, the worst case scenario is that the
court decides NSC will not have to reimburse any of these
expenditures or taxes. In that case, the bleeding will
stop, and PW’s earnings per share will return to their former
level of about $0.44 a year based on the rent from the lease.
Otherwise, we will see a one-time earnings boost of $0.23
a share or more, some of which might have to be returned to
shareholders as a special dividend in order for Power REIT to
retain its REIT status.
Implications for Power REIT
This litigation has so far prevented Power REIT from
progressing with its plans
to diversify its business into Renewable Energy
Real Estate. I have also spoken to multiple
investors who are unwilling to invest in the company until the
dispute is resolved. I think such investors are being
Potential moneys that the lessees might be ordered to pay are
- $0.23 per share or more in legal fees. I think this is
- $15,882,651 or $9.80 a share for the value of the
settlement account. I think there is a decent chance
that the court will order NSC to pay this one way or another,
although it might not come as a lump sum.
- Interest on the above amount. If the court does award
interest, it would come to about $55 million ($34 per PW
share) of compound interest on top of the $15.5 million
principal if they use the long term AFR.
- Increased rent under a renegotiated lease, which could be
many times the current lease payment. The current lease
pays $915,000, or $0.56 per PW share per year.
The downside for Power REIT would simply be that the court
orders that the status quo be maintained (in which
case they could still order the lessees
to reimburse Power REIT’s legal fees.) In this
case, the legal spending will stop, investors will have greater
certainty and still own a REIT yielding over 5% which
has plans to expand its asset base into renewable energy real
estate. As I have previously written, that expansion is
likely to allow PW to increase its per share dividend.
In addition, Power REIT could write off the noncollectable
settlement account against future income. This has been
carried on Power REIT’s tax returns as a receivable.
While no cash would change hands, writing off
the $15,882,651 against future income would allow Power
REIT to return $9.58 per share to shareholders as a tax-exempt
return of capital, rather than as unqualified dividends.
At the current quarterly dividend rate of $0.10 per share,
that would mean that all Power REIT’s dividends would
be exempt from tax for the next almost 24.5 years.
With the stock price at $8.10, PW’s annual yield is
4.9%. While the write-off would make no difference to a
tax-exempt investor, a taxable investor in the 30% tax bracket
would get an after-tax income stream comparable to another
REIT yielding 7%, a substantial difference which
I do not believe is yet priced into the stock.
Normally, I would suggest that any investor with the option
should purchase a REIT in a tax-advantaged account, such as an
IRA. In this case, if you think the chances of Power REIT
being able to collect on the indebtedness are low, a taxable
account would be most appropriate.
Heads: Win Big, Tails: Win Small
PW is a $8.1 stock carrying no debt whose price can be
justified on the basis of current assets and dividend
alone. On top of that, it has a decent (in my opinion)
chance of a legal victory in 2013 that could result in
payments significantly in excess of the company’s
entire market capitalization. If they lose, they can still
write off the noncollectable $15,517,325 settlement account,
allowing the company to characterize distributions to
shareholders as non-taxable capital gains for many years to
That’s an investment even a large investor would love… if only
they did not have too much money to buy it.
Disclosure: Long PW.
This article is derived from two
published on the author's Forbes.com blog, Green Stocks on
November 27th and 29th.
DISCLAIMER: Past performance is
not a guarantee or a reliable indicator of future results.
This article contains the current opinions of the author and
such opinions are subject to change without notice. This
article has been distributed for informational purposes only.
Forecasts, estimates, and certain information contained herein
should not be considered as investment advice or a
recommendation of any particular security, strategy or
investment product. Information contained herein has been
obtained from sources believed to be reliable, but not