MOI Global | The Membership Community of Intelligent Investors

Introducing the ZIPSS: Zillow, IAC, PAR Technology, Stitch Fix, Square

January 5, 2021 in Best Ideas Conference, Commentary, Equities, Ideas, Letters

This article is excerpted from a recent Manager’s Commentary by MOI Global instructor David Barr, President, CEO and Portfolio Manager at PenderFund Capital Management, based in Vancouver.

David is a featured instructor at Best Ideas 2021.

We have been talking a lot internally about a group of holdings we call the “ZIPSS”. This is a group of technology companies that have some similarities to the business models of the popular high flying big five tech names like Amazon and Facebook, but which we believe have much longer runways of growth ahead which have not been fully appreciated by many investors. With the digital transformation that we are witnessing, further accelerated by the global pandemic, we believe these companies are poised to create of lot of value for patient shareholders in the years ahead.

The pack is represented in the Pender Value Fund by a group of five companies that are amongst the disruptive breakout leaders in their industry. Zillow Group Inc. (ZG) is disrupting how property is bought and sold in a world where consumers are increasingly demanding the same types of convenient online experiences and efficiencies they have become accustomed to in other industries. IAC/InterActiveCorp (IAC) is poised to transform a whole host of services “from search and entertainment to finding work and home repair”. PAR Technology Corporation (PAR) is gaining momentum and benefiting from the massive tailwinds caused by the sudden need to re-platform and digitize the restaurant industry. Stitch Fix Inc. (SFIX) is an online apparel company focused on hyper personalizing proper fit and style of clothing in order to delight consumers, and finally Square Inc. (SQ), a leading fintech that has become a significant disruptor in the payments and banking industry.

All together, we have coined these companies the “ZIPSS”. And there are others in our portfolio with similar models, but for simplicity’s sake, we wanted to keep the acronym describing this theme short and “zippy”. Collectively, these companies have vastly outpaced the returns of the FAAMGs (big five tech companies) during the pandemic and we anticipate continued momentum ahead.

What excites us about these companies is that they have promising economic models to drive profitable growth as they scale, they are amongst the breakout leaders in their respective categories that benefit from positive feedback loops which tend to make the strong even stronger, and they target industries with massive total addressable markets. The ZIPSS are already disrupting traditional incumbents and with the pandemic driving people online, demand for their service platforms has dramatically increased.

The trick for investors is to be patient and to hold as long as the companies continue to execute on their vision and valuations remain reasonable in the context of their potential future value creation. Each of these companies has seen the value of their shares drawdown in various periods, through a lack of confidence and other short term concerns, but if you sell during the dips because you are more worried about near term price action than the long-term value creation potential, you may miss out on longer term gains. Our goal is to hold onto core positions as long as our investment theses remain intact.

Ever wish you had bought into the FAAMGs when they were in the early stages of their value creation journey? We believe the ZIPSS of today have the potential to be the FAAMGs of tomorrow.

download printable version

Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the simplified prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in net asset value and assume reinvestment of all distributions and are net of all management and administrative fees, but do not take into account sales, redemption or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. This communication is intended for information purposes only and does not constitute an offer to buy or sell our products or services nor is it intended as investment and/or financial advice on any subject matter and is provided for your information only. Every effort has been made to ensure the accuracy of its contents. Certain of the statements made may contain forward-looking statements, which involve known and unknown risk, uncertainties and other factors which may cause the actual results, performance or achievements of the Company, or industry results, to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements.

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

The Unique Ingredient of Haidilao’s Success: Love

January 5, 2021 in Best Ideas Conference, Commentary, Equities, Letters

This article is authored by MOI Global instructor Ser Jing Chong, portfolio manager and co-founder of Compounder Fund, based in Singapore.

Ser Jing is a featured instructor at Best Ideas 2021.

I’m thrilled to have the opportunity to present at MOI Global’s upcoming Best Ideas 2021 online conference. The company I’ll be discussing is the Hong Kong-listed and China-based Haidilao (HK: 6862). This article you’re reading now is a short introduction to Zhang Yong, Hadilao’s co-founder and current chairman.

What I want to do is to present translations of some of my favourite passages from an excellent book on Zhang Yong and Haidilao that was published in 2011. The book is in Mandarin and is titled “海底捞,你学不会.” In English, it means “You Can’t Copy Haidilao”.

First, some background

Hotpot is a popular meal among the Chinese. It involves people – often friends and family – sitting around a big pot of flavourful boiling broth and cooking food items by dipping them into the broth. Haidilao’s business lies in running its namesake chain of hotpot restaurants. At the end of 2019, the company had 716 restaurants in China and another 52 in other countries and territories around the world, including Australia, Hong Kong, Japan, Singapore, the United Kingdom, the United States, and more.

I run Compounder Fund together with my co-founder Jeremy Chia and it has a position in Haidilao. Compounder Fund invests mainly in companies that we think can compound the value of their businesses at high rates over the long run (hence the name Compounder Fund!). To us, such companies tend to have the following traits:

1. Revenues that are small in relation to a large and/or growing market, or revenues that are large in a fast-growing market
2. Strong balance sheets with minimal or reasonable levels of debt
3. Management teams with integrity, capability, and the ability to innovate.
4. Revenue streams that are recurring in nature, either through contracts or customer-behaviour
5. A proven ability to grow
6. A high likelihood of generating a strong and growing stream of free cash flow in the future

We spend a lot of time looking at a company’s leadership. This is because of our belief that, in nearly all cases, a company’s leadership is the source of its competitive advantage (if any). A company’s current competitive advantage is the result of management’s past actions, while a company’s future competitive advantage is the result of management’s current actions. We study a company’s compensation structure, related-party transactions, and insider ownership to assess integrity. For capability and innovation, we think about how a company has grown its business over time and what really excites us are business leaders who have a unique way of looking at the world.

Zhang Yong is one such business leader, in our view. “You Can’t Copy Haidilao” is written by Huang Tie Ying, a professor at Beijing University. The book is written from Huang’s point of view and it discusses the highly unusual way that Zhang manages Haidilao. It helped us to understand that while Zhang is not perfect, he has an immense kindness and love toward his fellow man and an unwavering belief in the good of humankind. He had infused these qualities into Haidilao and it had helped him to develop employees who deliver extraordinary service to customers from the heart. And it is this genuine commitment to exemplary service from Haidilao’s frontline service staff that had propelled the company’s growth.

We invested in Haidilao before we came across Huang’s book. But we already saw strong signs that Zhang was unique. For instance, Haidilao’s 2018 IPO prospectus mentioned:

  • The company has industry-leading compensation for employees among all Chinese cuisine restaurants in China.
  • Restaurant managers are primarily evaluated based on customer satisfaction
  • Nearly all of Haidilao’s restaurant managers started working for the company in non-managerial positions (such as waiters, bussers or janitors) and steadily rose through the ranks
  • Restaurant managers share in the profits of the restaurants they manage, but that’s not at all – they enjoy an even larger share of the profits from restaurants that are managed by their first and second-generation mentees

We cannot confirm if the Haidilao described in “You Can’t Copy Haidilao” is still the same today. But there are also no strong reasons for us to believe that the current Haidilao has warped. The hotpot business is not complicated. You do not require a chef in the shop, so nearly anyone can run a hotpot restaurant. It also means that competition is tough. But Zhang Yong has grown Haidilao’s revenue to RMB 26.6 billion (around US$3.98 billion) in 2019, up 56.5% from 2018. Profit was up 42.3% in the same year to RMB 2.3 billion. The company is today a truly massive and global business – when Huang wrote his book, Haidilao was only in China.

We live in Singapore, so we’ve dined in Haidilao’s restaurants and those of its competitors on many occasions. As much as its competitors try to copy the form of Haidilao’s service, they can’t seem to get its substance. And we think there’s only a tiny sliver of a chance that Haidilao’s competitors can ever truly imitate the company. Haidilao’s substance comes directly from Zhang Yong’s worldview, and it is something that is unlikely to be replicable, since no two humans are ever identical. This means that Haidilao has a near unreplicable competitive advantage.

We hope you’ll enjoy the translations I’ve made from “You Can’t Copy Haidilao”. I wanted to do this because I think there’s plenty that we, as investors, can learn from Zhang Yong. I am fortunate to be able to read Mandarin and understand the book’s content (just please do not ask me to speak or write about business in Mandarin!) so I want to pay it forward by introducing the book to the English-speaking world.

And three more things: (1) I want to stress that the translations are my own self-directed attempt, so all mistakes in them are my sole responsibility; (2) I hope I’ve managed to capture Huang and Zhang’s ideas well; and (3) I look forward to sharing more about Haidilao during the Best Ideas 2021 conference. Now onto the translations!

Translation: On providing incredible service

“Even someone who has worked in Haidilao for only a day would know an aphorism of Zhang Yong’s: “Customers are won table by table.”

Why do we have to win customers table by table? Because every customer in a hotpot restaurant is there for a different reason. Some are couples on a date, some are there for a family gathering, while some are having business dinners. What every customer needs will be different, so how you move each customer’s heart will not be the same.

Zhang Yong has performed every single task that’s required in a hotpot restaurant… He knows that customers have a wide variety of requests. If you strictly follow standard operating procedures, the best result you can hope for is for your customers to not fault you. But you will never be able to exceed their expectations and delight them. For example, no restaurant’s operating procedure will include a free shoe-shining service.

In the early days after Zhang Yong opened his first hotpot restaurant, there was a familiar face who visited. Zhang Yong realised that the shoes of this old friend were very dirty, and so he arranged for an employee to clean his friend’s shoes. Zhang Yong’s little act moved his friend deeply. Ever since, Haidilao has provided free shoe-cleaning services at its restaurants.

A lady who stayed above a Haidilao restaurant once ate there and praised its chilli sauce. The next day, Zhang Yong brought a bottle of the sauce to her and told her that Haidilao would be happy to send her a bottle any time she wants to have it.

These are the roots of Haidilao’s extreme service standards.

But these differentiated services can only come from the creativity of every employee’s minds.

Having processes and systems are critical when running chain restaurants… Processes and systems can ensure quality control, but human creativity is suppressed at the same time. This is because processes and systems overlook a human’s most valuable asset – the brain…

… The goal of providing world-class service is to satisfy customers. Since each customer has different preferences in the process of consuming a hotpot meal, it’s not possible to fully rely on SOPs to achieve 100% satisfaction….

…If some customers do not enjoy a free bowl of soya milk and sour plum soup, can we give them a bowl of chicken egg porridge instead? Even if we normally charge for this porridge, an elderly person with weak teeth who receives it for free may remember this considerate act for life!

A customer craves ice cream – can the restaurant’s waiters leave their station to purchase the ice cream from a neighbouring shop? A customer realises he has overordered – can he return a plate of vegetables? A customer wants to enjoy more variety – can she order half-portions? A customer really likes the dining aprons that the restaurant provides guests – can the customer bring one home for her child?

When faced with these requests that are not included in SOP manuals, most restaurants will just say “No.” But at Haidilao, the waiters are required to exercise their creativity: “Why not?”

I grabbed a few stories from Haidilao’s internal employee magazine to highlight the company’s incredible service standards…

…Zhang Yao Lan from Haidilao’s third Shanghai restaurant says:

“Business was exceptional on a Saturday night. At 7:30pm, the Yu family visited the 3rd room… They ordered quail eggs and as I helped them cook the eggs in the hotpot, I noticed that Aunty Yu ate all the radish strips that came with the eggs.

I figured that Aunty Yu loves radish strips. So I called the kitchen to prepare a plate of radish strips and I added my own special concoction of sauces. The Yu family were really surprised when I served the radish and asked if they had ordered the dish. I said that it’s a gift from me because I guessed that Aunty Yu likes eating radish strips and that I hope they like it…

…They were really happy and praised me as they dug into the dish. They even asked how the dish was made… The following month, the Yu family came three times, and even brought their friends (with surnames of Cai and Yang) to Haidilao. See, how magical a plate of radish strips is – it has helped me to win so many customers!”

Translation: On winning over the hearts of employees (and more on providing incredible service)

Zhang Yong was once a waiter. So he understands that every employee is critical in ensuring the delivery of truly outstanding service. Haidilao’s employees are given the freedom to exercise their creativity and even make small mistakes – Haidiao can really touch the hearts of customers only if the company gets the short end of the stick at times.

But this is easier said than done. Haidilao’s employees have travelled far from home and they come from villages that are mired in poverty. They have little education, have not seen much of the world, and are often looked down upon, resulting in an inferiority complex. How can Haidilao motivate such employees to develop the initiative to provide excellent service for customers?

Zhang Yong said: “The hotpot business requires very little skill… Anyone can do it after some light training if they are willing. The key though, is the willingness. Waitressing is a physically demanding job with low social status and benefits. Most waiters don’t perform well because they have no other choice other than to take up the role. So to ensure that waiters can excel in their role, the focus should not be on the training methods. Instead, it should be on how to develop the willingness in people to take up waitressing jobs. If your employees are willing to work diligently, you win!”

I asked Zhang Yong: “Can you find me a boss who does not want hard working employees? This is the Mount Everest for every boss in the world. But it’s rare for any leader to achieve this.”

Zhang Yong replied: “I think that humans have emotions. If you treat somebody well, he or she will treat you well in return. As long as I can find ways to let my employees think of Haidilao as their home and family, my employees will naturally care for our customers.”…

…How can Haidilao get its employees to think of the company as family?

To Zhang Yong, the answer is simple – treat your employees as family. If your employees are your siblings and they have travelled afar to Beijing to work for you, would you house them in underground basements that most people in Beijing are not willing to live in? Of course not. If you have the resources, you wouldn’t bear to let your family members stay in a place that’s humid and lacks proper ventilation. But for many restaurant owners in Beijing, they house their employees in underground basements while they themselves live above ground.

Haidilao’s employees get to stay in proper housing, with similar living conditions to the locals in Beijing. There are heaters and air conditioning, and Haidilao ensures that there’s no overcrowding. In addition, each hostel has to be within a 20-minute walking distance to the restaurants that the employees work in.

Why? This is because Beijing’s traffic system is complex. Restaurant staff members work long hours, and as young adults, they require ample sleep. Because Haidilao is picky about where its employees stay, there are only a few suitable locations that also happen to be desirable among the locals in Beijing. This has caused some haughty locals in the city to be unhappy.

There’s more. Haidilao also has specialised employees who take care of the hostels’ housekeeping needs. There’s free internet, TV, and phones too. Haidilao’s employees state that their hostels are akin to hotels with “stars”!

Getting employees to treat your company as family is not as simple as just repeating some mantra or educating them. Humans are intelligent – your actions will show what you truly mean. Haidilao’s employees come from poor villages. During Beijing’s cold weather season, Haidilao issues hot-water packets to keep these employees’ blankets warm. For some Haidilao restaurants, there are even employees in the hostels who come in the night to fill up the packets with hot water. Isn’t this something that only mothers will do?

If your siblings travel from your village to work in the city, you’ll naturally be worried that they won’t be familiar with traffic, that they will be looked down upon by city folks. Because of this, Haidilao’s training program also includes soft skills such as map reading, how to use flush toilets, how to navigate the transport system, how to use bank cards etc…

…If your siblings have travelled somewhere far to work, what would happen to their children’s education? Haidilao set up a boarding school in Jianyang, Sichuan, for the children of the company’s employees.

Haidilao does not just take care of its employees’ children, it also cares for its employees’ parents. Haidilao provides a monthly stipend (a few hundred RMB) to the parents of employees who hold the rank of foreman and upwards. Every parent would want a capable child. Homecoming opportunities for Haidilao’s employees are rare. But Haidilao’s monthly stipend gives the parents of these employees a regular opportunity to feel pride for their children. Chinese people are stingy, the villagers even more so. Despite feeling pride, the villagers would only say: “My child is fortunate to have found a good company where the boss treats them as brothers!” No wonder Haidilao’s employees all affectionately call Zhang Yong, “Big Brother Zhang.”

Translation: On extreme trust

What does it mean to respect people? Does it mean you have to bow to your boss or cheer for your superiors? This is not respect for people – this is only respect for status and power. Respecting people means trusting them.

If I trust your ethics, I would never guard myself against you. If I trust your ability, I would entrust important tasks to you. This is what it means to respect someone! When a person is trusted, a sense of responsibility would arise within. When an employee is trusted, he can treat the company as family.

At Haidilao, employees are not only treated better than at other restaurant companies – they are also trusted by the company.

To treat employees as family is to trust them like you trust your family members. You have to show through actions that you trust someone – words are not enough. The only sign of trust is to confer authority…

…So at Haidilao, any expenditure above RMB 1 million will require Zhang Yong’s approval. Anything lower than RMB 1 million is the responsibility of the vice president, finance director, and regional manager. Sectional managers and the heads of the Purchasing and Engineering departments have the authority to sign off on expenditures of up to RMB 300,000, while restaurant leaders can do so up to RMB 30,000. It’s rare to find private sector enterprises that have the confidence to delegate authority to such an extent.

What Haidilao’s peers find the most unbelievable about Zhang Yong is the trust he places in his frontline service staff. Even Haidilao’s ordinary frontline service staff have the power to give customers partial to full discounts without having to seek approval from their superiors. As long as a staff member thinks it’s appropriate to discount a dish or provide a free dish (or even an entirely free meal), he or she can do so. This authority means that all of Haidilao’s employees – regardless of rank – are effectively managers, because such authority is usually reserved only for managers at restaurants.

In the spring of 2009, I invited Zhang Yong to give a lecture to MBA students in Beijing University. A student asked: “If all your staff can give full discounts for meals, will there be cases where rogue employees provide free meals to their own family and friends?”

Zhang Yong asked the student instead: “If I give you this authority, will you do it?”

The entire class of more than 200 students fell silent. Indeed, with your hand on your heart: Will you bear to betray such trust in you?

The truth is, the vast majority of people know deep in their hearts that kindness needs to be repaid and they would not betray the trust that others have placed with them.

Having been a frontline service staff, Zhang Yong understands this logic: If he wants to utilise the minds of his employees, he needs to give them authority. This is because the satisfaction of customers actually rests entirely in the hands of his frontline service staff. It is after all his frontline service staff who interact with customers from the moment they step into the restaurant till the moment they leave. If a restaurant’s manager has to be consulted before a frontline service staff can solve any unhappiness a customer experiences, the process itself will only vex the customer further.

Humans are often worried when they’re waiting for a problem to be resolved. So the only way to solve customer-unhappiness at scale is to give frontline service staff the power to deal with problems. More importantly, it is the frontline service staff who best know the whims and fancies of customers. They are the ones who can touch the hearts of customers table by table.

Translation: On treating employees the right way

Zhang Yong has an unwritten rule within Haidilao. And because he is the unquestioned leader of the company, the people within Haidilao believe his words.

He said: “Anyone who has been a restaurant leader at Haidilao for at least a year will receive a “dowry” of RMB 80,000 if they leave the company for any reason.”

I asked: “Even if they’re being poached by competitors?”

Zhang Yong responded: “Yes”

“Why?” His answer completely took me by surprise.

Zhang Yong explained: “The work in Haidilao is incredibly tough. Anyone who can rise to the rank of restaurant leader and above has already contributed significantly to the company.”

In fact, many of Haidilao’s leaders clock in overtime for extended periods and this takes a significant toll on their physical and mental health. Many of them are riddled with health issues even at a young age. Haidilao’s procurement head, Yang Bin, once set a record in 2004 by working for 365 days straight.

Zhang Yong said: “Every Haidilao leader deserves credit for building Haidilao to what it is today. So we should give people what they deserve when they leave for any reason. If a sectional manager leaves, we provide a reward of RMB 200,000. If a leader with the title of regional manager or higher leaves, the gift will be a ‘hotpot restaurant’ – that’s around RMB 8 million in value.”

I asked, somewhat in disbelief: “If Yuan Hua Qiang [a leader in Haidilao with significant importance] is poached, you will reward him with RMB 8 million?”

“Yes, if Yuan Hua Qiang wants to leave today, Haidilao will reward him with RMB 8 million,” Zhang Yong said gently and plainly, while lowering his head as though deep in thought.

Even though I know Zhang Yong wants to win over every talented individual he encounters, this policy of his is highly unusual – not many will dare to implement it. It seems like if you’re not trying to be different and do what others won’t, you can’t ever win – but even if you do, it does not guarantee success! Zhang Yong walks the extreme path….

…Haidilao’s entrance to Beijing did not go smoothly. The company fell for a scam in its first real estate deal there and lost RMB 3 million. At that time, it was all the cash that Haidilao had.

“Did you manage to find the culprit?” I asked Zhang Yong.

“So what if we had found him? There was even a retired judge in the group of scammers. We simply were not aware that we had fallen into a trap.”

I continued to ask: “Did you scold anyone after you heard the news?”

Zhang Yong said: “How would I dare to scold anyone?! The Beijing manager was already so anxious that he could not eat for two days. In fact, I did not dare to call him in those few days. I only decided to contact him after I heard that they wanted to kidnap the culprit. I said, are we worth only RMB 3 million? Let’s start doing the real work.”

I followed up: “Did you really not blame him, or feel any pain?”

Zhang Yong replied: “Of course I felt the pain. The sum we lost was all our cash at that point in time. But I really did not blame him. Because if I was the one in Beijing, I would have fallen into the same trap!”

Dear bosses, after reading this, please ask yourself if you would think this way if you were to run into the same situation?

No wonder Haidilao has only ever had to pay its “dowry” to three people in its 10-plus years of operating history, despite having more than a hundred people who qualified for the reward if they had left.

But as a company grows, there will be all kinds of people in it. Haidilao is no exception. Last year, there was a restaurant leader who quit Haidilao to join a competitor who set up shop just opposite her Haidilao outlet. She also brought along her Haidilao restaurant’s kitchen manager, area manager, and other service staff leaders. When she came back to Haidilao to ask for her “dowry,” Zhang Yong refused.

Translation: On priorities

In his 2006 New Year’s address to employees, Zhang Yong said: “If you’re talking to me and your phone rings because your staff is calling you, then you and I will stop our conversation. Your priority should be handling your staff’s issue. If you’re talking to your staff and a customer needs help, you and your staff should end the conversation and focus on the customer’s needs. This is what our list of priorities should look like when I talk about placing customer satisfaction at the centre of what we do. As I grow older, I’ve come to gradually understand the broader meaning of the term “customer” – it includes our employees.

Translation: On evaluating a restaurant business

Zhang Yong has an extremely strange way of evaluating the performance of every Haidilao restaurant. A restaurant’s profit is not part of the assessment criteria that Haidilao’s HQ uses. To add to the weirdness, Zhang Yong does not have any annual company-wide profit target for Haidilao.

I asked him: “Why do you not assess profits?”

He responded: “Assessing profits is useless because profit is the result of the work we do. If our work is bad, it’s not possible to produce high profits. But if we do good work, it’s impossible for our profits to be low. Moreover, the company’s profit is the end result of all the work performed by various departments. Each department has a different function, so it’s tough to clearly define their contributions. There’s also an element of chance in the profit a restaurant earns. For example, no matter how hard a restaurant leader and his team works, a poorly-located restaurant can’t hope to outperform a restaurant with average-leadership but a superb location. But a restaurant leader and his team have no say in choosing a restaurant’s location. It’s not fair, nor scientific, to insist on assessing a restaurant’s performance based on its level of profit.”

I followed up: “The level of profit depends, at least to some extent, on costs. Each individual restaurant should at least be able to control its costs, right?”

Zhang Yong said:

“Yes that’s right. But in what areas can those below the rank of restaurant leader have the biggest effect? It’s in improving service standards and winning more customers! Lowering costs is not as important as creating more revenue.

As Haidilao started to introduce more SOPs, we also began to assess results more. Consequently, some sectional leaders started to include profit in their evaluation of individual restaurants. When this happened, incidents like the following occurred: Brooms for toilets continued to be used even when there were no longer any whiskers on them for sweeping; the watermelons that we gave to customers for free stopped being sweet; and towels with holes were given to customers to dry themselves after using the washroom.

Why? Because each restaurant has very little control over its own costs. The important cost items in a restaurant – its location, renovation, dishes, prices, and manpower needs – are set in HQ. Rank and file employees can only focus on the little things if you insist on evaluating profit. We noticed this phenomenon before it was too late and promptly stopped using the level of profit as a criterion for performance-assessment. In actual fact, any employee with even a modicum of business sense does care about costs and profits. Even if you merely conduct a basic accounting of profit, everyone is already paying attention to it. So if you make the level of profit a key criterion for performance assessment, it will only magnify people’s focus on profit…

…I asked Zhang Yong: “You do not even look at a restaurant’s revenue when assessing its performance?”

Zhang Yong said: “Yes, our performance criteria does not include profit. But that’s not all. We also do not include revenue as well as other KPIs that are commonly used by restaurant companies, such as spending per customer. This is because these criteria are results. If a business manager insists on waiting for these results to know if the business is doing well or poorly, wouldn’t the food already be cold by the time? Imagine that there’s a polluted river and instead of trying to fix the source of the pollution, you’re only busy filtering, testing, and removing filth downstream. What’s the point?”…

…Zhang Yong said: “Now we only have three criteria for evaluating the performance of each hotpot restaurant. First is the level of customer satisfaction; second is the level of positiveness in the work attitudes of the restaurant’s workers, and the third is the restaurant’s ability to nurture leaders.

I replied: “These are all qualitative criteria. How do you measure them?”

Zhang Yong answered: “Yes, they are all qualitative, so you can only measure them qualitatively. Teacher Huang, I don’t understand why these scientific management tools insist on scoring qualitative things. Let’s talk about customer satisfaction for instance. Do they expect every customer to fill up a survey form? Think about this. How many customers are willing to fill up your form after their meal? Wouldn’t customers’ unhappiness increase if they’re being made to fill up forms? Besides, how believable can a form be if you’re forcing it onto someone?

I asked: “How then do you evaluate customer satisfaction?”

He said: “We get the direct superiors of restaurant leaders – sectional managers – to conduct frequent yet random visits to the restaurants. The sectional manager and his assistant will communicate at length with the restaurant leader. In what areas have the level of customer satisfaction increased or decreased? Have frequent diners appeared more regularly this month, or less? Our sectional managers were all once frontline service staff who rose to their current roles. They have intimate knowledge when it comes to customer satisfaction.

It’s the same when it comes to employee’s work attitudes. Teacher Huang, if you’re the one doing the assessment, it won’t work. All you’ll see are people running about, with smiles on their faces. But if it’s me, I will be able to tell you: Look at that young chap there with hair that’s too long. This young girl has applied her makeup too sloppily. Some employees’ shoes are dirty. This service staff is standing there in a daze. These are all signs on the level of positivity that employees bring to work, aren’t they?! It’s the same when a restaurant leader assesses his team leaders and when his team leaders assess their teams.

I further probed: “So their rewards depend on these qualitative assessments?”

Zhang Yong replied: “It’s not just their rewards. Their promotions or demotions also depend on the three criteria. Think about this. How can most waiters have positive work attitudes if their restaurant leader is an unfair person? And how can customers be happy if they are served by waiters who are not positive at work? The revenue and profit numbers for such a restaurant will definitely be bad. There’s no need to wait for the numbers to be out to replace the restaurant leader or remind him that he needs to change his ways. And even if the numbers are good, it has nothing to do with the restaurant leader. We’ve had cases where we are unable to promote restaurant leaders who run very profitable restaurants. This is because they are unable to groom talent. The moment these restaurant leaders step away from their restaurants, problems occur. For these restaurant leaders, we may even demote them despite the high profits their restaurants are producing.”

Translation: What it means to truly care for employees

In 2006, Haidilao’s directors decided to establish a union. Unions are supposed to belong to employees, but Zhang Yong gave Haidiao’s union a unique mission. During the birth of the union, he said some important things:

“The 11 restaurants we have welcomed 3 million customers last year. The vast majority of these customers visited our restaurants because of the people working in Haidilao. This is proof of the excellent calibre of many of Haidilao’s employees. Since we have so many outstanding colleagues, shouldn’t we group them together, so that we can rely on them to influence even more people to remain at Haidilao and continue working hard (this is Zhang Yong’s purpose for setting up the union)? Because of this, I need the cream of the crop to join the union. The union should be an excellent organisation within Haidilao (Zhang Yong can really innovate!)…

…Every union member needs to understand this simple logic. We’re not caring for our employees simply to carry out the company’s orders. We’re doing so because we truly understand that we’re all human. And every human being needs to care and to be cared for. This care stems from a belief, and that is “all men are created equal.”

If our union members understand this point, then we’ll know that the union should not only be caring about the little things, such as taking care of employees when they have a small illness. What’s even more important is for the union to provide a platform for them to change their destiny. And to change their destiny is to win more diners for Haidilao with all their might. To open more restaurants so that there are more opportunities for career growth for the people of Haidilao to change their destiny. This is what it really means to care for employees.

download printable version
The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Best Ideas 2021 Preview: Commodity Company With Attractive Model

January 5, 2021 in Best Ideas Conference, Commentary, Equities, Ideas, Letters

This article is authored by MOI Global instructor Samir Mohamed, a collaborative value investor managing a private family fund.

Samir is a featured instructor at Best Ideas 2021.

With central banks printing unprecedented amounts of money, rapidly increasing global debts and fiscal deficits and strong pent-up consumer demand, many investors are looking for ways to hedge their portfolio against inflation. While gold is the widest known hedge against inflation (or more precise negative and decreasing real interest rates), some commodity companies appear suitable as well.

In addition, many commodity companies trade at historically low valuations and generate decent free cash flows at current commodity prices. After the last commodity price and cycle peak in 2011, many companies slashed exploration spending and CAPEX for the rest of the decade, with COVID-19 further delaying CAPEX decisions. As a consequence, it will take years for any significant supply increase even if commodity prices go up a lot due to infrastructure spending, fiscal and monetary policies.

Anglo Pacific Group is a commodity royalty company: They help finance e.g., a copper mine, and in return receive a royalty (e.g., 2.5%) on the revenue of the mine as long as the mine produces copper. Any increase in production or extension of mine life due to exploration success in the mine area is a free option. There are very few publicly listed royalty companies outside precious metals and oil & gas, and competition from banks for mine financing is decreasing due to ESG mandates excluding companies with a high CO2 footprint like miners.

Several banks in Switzerland – a major commodity trading and financing hub – have recently announced that they will reduce or close their commodity financing business. Raising equity is also difficult for miners as many large ETF providers have ESG mandates effectively excluding miners. This reduction in competition enables APF to achieve better financial terms in future royalty deals. Since 2014 the average annual yield on royalty deals was at least 10% while remaining mine life was typically 15-25 years.

The most important commodities for the company are iron ore, coking coal, copper, nickel, thermal coal, and uranium. Coking coal royalties contributed 62% to revenue in H1 2020. Within 4-6 years the operator of the coking coal mine will move outside the area APF has a royalty on, so the revenue from coking coal royalties will go to zero by then. (Revenues will return several years later when the operator is again moving into the royalty area.) However, in addition to eight producing royalties the company has a portfolio of seven royalties in the pipeline (e.g., mines currently in development) and management is optimistic that it can replace lost revenue from coking coal.

Most commodity prices reached a low point in spring-summer 2020. Copper, iron ore, nickel and uranium prices are currently significantly above the level of January 1, 2020 while the picture is less clear for Australian export prices for coal due to a Chinese ban on Australian coal imports since November 2020. This ban has led to reduced export volumes and lower prices as Australian miners scrambled to find customers in other countries.

By mid-December there were reports about surging thermal coal prices and some electricity rationing in China as non-Australian suppliers struggle to fill the gap short-term. Coking coal prices in China also increased significantly although there are no reports on shortages yet. If the ban stays in place during 2021 the most likely outcome is a re-arranging of the global seaborne coal supply chain where Australian miners ship to non-Chinese customers while others reroute their shipments to China. The adjustment might take several months but it is unlikely that Australian miners will suffer a long-term negative impact as total global demand for coal does not change due to the ban.

If commodity prices average levels of 2019 in 2021 the company trades at a free cash flow yield above 20% or an EV/EBIT below 6x. From a sum of the parts perspective, the company owns stakes in two listed companies which are worth almost 40% of enterprise value. Therefore, the company appears undervalued even without further significant commodity price increases.

The company is facing the following major risks:

  • A prolonged double dip recession could depress commodity prices for years if demand drops more than supply.
  • APF might not be able to completely replace the royalty revenue from coking coal until the mining activity moves out of its royalty area in 4-6 years.
  • The thermal coal royalty (8% of revenue in H1 2020) could be impaired long-term due to climate change policies and a remaining mine life of more than 20 years.
  • Institutional investors might sell the stock due to ESG mandates and depress the share price.

The main reasons to go long with APF are the following:

  • The company is a very good inflation hedge due to upside exposure to commodity prices while having almost no input cost inflation. (In 2019 the company had revenue of more than 50 Mio. GBP with just 11 employees and an EBIT margin of 80%.)
  • There is almost no bankruptcy risk as APF is free cash flow positive even at low commodity prices.
  • The business model is becoming more attractive as financing options for miners are increasingly constrained due to ESG. Less competition from banks and institutional investors leads to better royalty terms for APF.
  • The CEO has a good capital allocation track record since joining the company in 2013. Previously, he co-founded a UK-based value fund and advised on investments for 12 years.
  • The CEO owns 2.6% of the company – bought, not received via stock options. CEO and board members have acquired shares during 2020 in the open market.

We look forward to Samir presentation at Best Ideas 2021.

download printable version
The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

On Successful Investing: Start with the Simple Question, “Why?”

January 5, 2021 in Best Ideas Conference, Commentary, Equities, Letters

This article is authored by MOI Global instructor Jean Pierre Verster, CEO of Protea Capital Management, based in Johannesburg.

Jean Pierre is a featured instructor at Best Ideas 2021.

Simon Sinek did a great TED Talk in 2009 (the third-most watched TED Talk ever, with over 50 million views) regarding WHY. While he applied the concept to leadership, I believe that this mental model has wider application, including to successful investing.

Why are you involved in investment management? Is it to make as much money as possible? Or, putting it less crudely, to generate as high a long-term compounded annual return as possible? Is it due to a competitive spirit to beat other participants in the biggest game there is, i.e. in financial markets? Perhaps you don’t just focus on the scoreboard, and do it because of the intellectual challenge. Maybe it’s your natural curiosity regarding a wide range of subjects, which manifests in learning about companies operating in various industries. Or, you might have an innate fascination about what makes some businesses succeed and others fail. For me, it’s a combination of the above.

Whatever your raison d’être as investor, you must be able to articulate WHY. Your WHY will inform your HOW. If your primary motivation is to generate an above-average long-term return, you would necessarily study those who have done so in the past. While many of them have followed a similar approach, generally referred to as value investing, there have also been successful investors following approaches vastly different to what we understand value investing to be, traditionally speaking.

Charlie Munger describes value investing broadly enough to include all of these (supposedly) different approaches when he say it is “buying something for less than it is worth.” One should keep an open mind regarding investment considerations that are not associated with traditional value investing. It is imperative to continuously evolve one’s thinking and not to become dogmatic – the performance of large tech companies over the past decade has been instructive in this regard, as but one example of staying mentally flexible regarding the concept of value.

There is a second WHY imbedded in the study of other successful investors: why have their approaches been successful? Positive outcomes are generally due to a combination of skill and luck, which can be difficult to untangle, as explained in Michael Mauboussin’s book, The Success Equation. If you decide to follow a specific approach that has led to a successful outcome for another investor, how sure are you that luck did not play a decisive role? Warren Buffett’s famous article, The Superinvestors of Graham-and-Doddsville, addresses this in the context of value investing, but I would venture to say that there are other, more subtle attributes that these Superinvestors shared.

In a similar vein, there are countless investors who have (apparently) copied the same value investing approach as the Superinvestors and have not been successful. This is a dilemma still prevalent today: There are many investors who say all the ‘right’ things and expound on all the reasons why their approach is the ‘right’ one, but the outcome they seek (generating an above-average return over the long-term) remains elusive. In the absence of winning according to the scoreboard, it is difficult to enjoy the game. It is also difficult to stay in it.

Outside investors, who entrust their savings to an investment manager, generally do not care much for the investment manager’s enjoyment. The outside investor’s WHY is clear: backing the investment manager to generate an above-average return. This does not detract from the investment manager’s own secondary motivations, but it does mean that generating above-average performance is of primary concern.

I remind myself of this often, that my primary responsibility is to keep on chasing the investment rabbit, and that I will be motivated to continue doing it if I enjoy it. It is an enjoyable endeavor when an investment manager can deliver on the WHY of outside investors and on the WHY of the manager at the same time. The active investment management industry would do well to keep this front of mind, especially in the context of the deserved criticism that we endure for perennially underperforming comparable passive investments, on average.

As a subset of the active investment management community, may the MOI Global community continue to help each other learn, improve and generate above-average returns, delivering on the WHY of both outside investors and on the WHY of investment managers themselves – enjoying the game while winning on the scoreboard too.

download printable version

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Three Stages of My Evolution as an Investor

January 3, 2021 in Best Ideas Conference, Commentary, Equities, Letters

This article is authored by MOI Global instructor Christian Ryther, portfolio manager at Curreen Capital, based in New York.

Christian is a featured instructor at Best Ideas 2021.

After several difficult years, 2020 has been particularly difficult for many value investors. The frustration of this has made me more willing to review my process and to evolve as an investor. I hope that some nuggets from my story can help you improve your process.

You may have noticed that value investing has underperformed the market—and especially fast‐growing big tech stocks—over the past few years. I have seen plenty of serious analysis about how cheap value has become, and even more jokes about the death of value investing.

All of this has been less academic—and more painful—when I reflect on the underperformance of Curreen Capital, the fund I manage.

While we all implement our own particular form of value investing, lately many of them have told a similar story… of underperformance. From May 2018 through September 2020, whether you look at a large‐cap giant like Berkshire Hathaway, or a smaller‐cap index fund like Vanguard’s Small‐Cap Value – the result is under‐performing the S&P 500 by 20%+ points.

This has been frustrating, but I believe that challenging times are some of the best times to reflect and evolve, and ultimately become a better investor.

Things came to a head for me in March and April of this year. Curreen Capital was down 44.4% in the first quarter, a painful coda to several years of disappointing performance. Adding to the chaos in my life, my wife gave birth to our second child in mid‐April, in New York City, during a pandemic. This was a very stressful time, but all of this ultimately pushed me to reevaluate my investment process and find ways to improve it.

Stage 1: Circle the Wagons

My immediate first step was to pull back and restrict myself to only doing the things that I best understood and that had consistently worked for me in the past. This meant an almost‐exclusive focus on spinoffs, with some scope to invest in companies that I already knew well, and eliminating anything else. I essentially put myself on hold while I regrouped.

Stage 2: Where Did I Go Wrong?

Throughout May and June I reviewed my own actions, the resulting outcomes, and re‐read my investment bibles in search of insight to help me better understand where I could improve. The book that spoke to me most during this time was Peter Lynch’s One Up On Wall Street, and I began to evaluate my past actions through the lens of that book.

Most of the lessons I took from my review were nothing new or profound, but with fresh eyes and a willingness to undertake some harsh reflection, they were meaningful. The two biggest lessons were that I had been “watering the weeds”, and that I had been expressing a view on the stock market. On watering the weeds: my success in adding money to investments that got cheaper for no reason seemed to have blinded me to the losses that I took from adding money to businesses that got “cheaper” because of weak operating performance. There is a big difference between no information and negative information, but I had treated them the same, and averaged down into both opportunity and danger.

I also saw that I am terrible at timing or valuing the market. I am likely to buy stocks at market highs, and sell them at market lows. It would be fantastic if I could do the reverse, but I do not have that ability. However, I seem to be more than capable of taking advantage of opportunities to sell good stock A to buy better stock B. The lesson is that I must ignore what the market may do, and instead be fully invested in the best opportunities I can find at all times. The portfolio will drop when the market drops, but there is no realistic alternative where I somehow sell at the highs and deploy cash at the lows.

Stage 3: Improve and Advance

By July I was working to improve my investment process. Certain observations stood out to me, and I worked to run them to ground.

Over the years, I had repeatedly seen businesses that I recognized as great, with long runways for growth, but they had rarely been attractively priced according to my upside‐to‐downside framework. In several cases, I had analyzed these businesses when they spun out of larger companies at what hindsight would show to be extremely low prices. Though I felt that value would have its day again sooner rather than later, I still wanted to get a better handle on investing in fast‐growing businesses like these. I looked to Peter Lynch and re‐read other books that I trusted on the subject, and then went looking for businesses to research. I still cannot use my upside‐to‐downside framework with fast‐growers, and now believe that my framework is a marvelous hammer… but not every problem is a nail.

I had also seen director and executive share purchases at several of the businesses in the portfolio, while another had re‐worked its compensation system to replace the stock‐component with cash. The latter eventually filed for bankruptcy, while the former have performed surprisingly well. These observations drove me to spend more time learning about what tends to follow director and executives’ stock trades, which has proven to be an exciting new area of focus for me. I knew that buying was positive and selling was moderately negative, but research improved my intuition and sparked new ideas.

Personally, I also saw that—especially with two young kids—I no longer had time to waste on distractions. I have enough time to be a good husband and father, to invest intelligently, and to sleep… period. TV and movies, alcohol, staying up late, etc… those should mostly wait until the kids are older. To make this happen, I modified Ben Franklin’s checklist and gave myself a daily scoresheet: two points for each item that helps me, one for each positive, minus a point for each distraction, and minus two points for each item that is actively bad for me. Every night I review the day and mark my score on the calendar. It is a small nudge, but it has helped me consistently implement better daily habits for five months.

Conclusion

As painful as the past few years have been, with my own mistakes compounding value’s underperformance, I truly believe that this frustration is a blessing. A painful, character‐building experience that I would not wish on anyone… but a blessing nonetheless.

When the wind is at your back and everything is going well, it is easy to ignore small errors and keep following the same playbook. But markets are dynamic ecosystems, as is life, and we must learn and change to thrive in it. Headwinds like value’s recent underperformance can drive us to adapt intelligently. I feel that I have fixed some glaring issues, focused on what I do best, and learned new and useful things that will help me continue to evolve in the coming years.

The past few years, and 2020 in particular, have been tumultuous for investors. I hope that you can use this disruption to break stale habits you may have, and drive positive change in your investing process.

download printable version

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

A Snapshot of Our Investment Philosophy

January 2, 2021 in Best Ideas Conference, Commentary, Equities, Letters

This article is excerpted from a letter by MOI Global instructor Edward Chang, portfolio manager at Pledge Capital, based in New York.

Edward is a featured instructor at Best Ideas 2021.

We love finding two types of investments:

(1) A business which has a great product or service that is in the early days of market share gains. The company’s product/service is better than current industry norms and most customers have not discovered the company. There is usually a great management team, but the best businesses can do well with even average CEOs. In the ideal scenario, you do have a talented and highly incentivized executive team. The key is a great system, model, and advantage. Their product/service must address a major pain point and provide a superior customer experience.

(2) A company that is building or has recently built a new product. Good management teams maximize efficiencies, but great CEOs build new product cycles. They have a vision that will transform an industry and the ability to execute.

While many companies in the second group come from the start-up universe, they also come from incumbents with an established competitive position that management then builds on top of. In the mid-2010s, while covering restaurants at UBS, I witnessed Panera and McDonald’s roll out digital initiatives to their franchised systems. They were early adopters of mobile ordering and tablet/kiosks that transformed their customer experience. These initiatives took significant investments in technology and restaurant re-designs, but ultimately helped reduce wait times and increase convenience. The changes were popular with customers and drove improved financial performance. As a result, investors in these two stocks reaped a considerable financial return.

With the second group of opportunities, the key is finding a management team that thinks like a founder. They are making strategic changes and building a new product cycle that solves a significant pain point in their industry. As this new product is developed and improved, the company hits an inflection point when customers embrace the new product/service.

download printable version

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Ep. 23: Wholesale Transfer Pricing | Investor Expectations for 2021

January 2, 2021 in Audio, Diary, Equities, Interviews, Podcast, This Week in Intelligent Investing

It’s a pleasure to share with you Season 1 Episode 23 of This Week in Intelligent Investing, featuring Phil Ordway of Anabatic Investment Partners, based in Chicago, Illinois; Elliot Turner of RGA Investment Advisors, based in Stamford, Connecticut; and your host, John Mihaljevic, chairman of MOI Global.

Enjoy the conversation!

download audio recording

In this episode, John Mihaljevic hosts a discussion of:

Wholesale transfer pricing: Elliot Turner talks about business models that involve some degree of wholesale transfer pricing. We discuss what works and what doesn’t when it comes to creating sustainable business value.

2021 expectations: Phil Ordway talks about the expectations and forecasting games being played by many market participants and so-called experts. We reflect on 2020 and assess market-implied expectations for 2021.

Follow Up

Would you like to get in touch?

Follow This Week in Intelligent Investing on Twitter.

Engage on Twitter with Elliot, Phil, or John.

Connect on LinkedIn with Elliot, Phil, or John.

This Week in Intelligent Investing is available on Amazon Podcasts, Apple Podcasts, Google Podcasts, Pandora, Podbean, Spotify, Stitcher, TuneIn, and YouTube.

If you missed any past episodes, you can listen to them here.

About the Podcast Co-Hosts

Philip Ordway is Managing Principal and Portfolio Manager of Anabatic Fund, L.P. Previously, Philip was a partner at Chicago Fundamental Investment Partners (CFIP). At CFIP, which he joined in 2007, Philip was responsible for investments across the capital structure in various industries. Prior to joining CFIP, Philip was an analyst in structured corporate finance with Citigroup Global Markets, Inc. from 2002 to 2005. Philip earned his B.S. in Education & Social Policy and Economics from Northwestern University in 2002 and his M.B.A. from the Kellogg School of Management at Northwestern University in 2007, where he now serves as an Adjunct Professor in the Finance Department.

Elliot Turner is a co-founder and Managing Partner, CIO at RGA Investment Advisors, LLC. RGA Investment Advisors runs a long-term, low turnover, growth at a reasonable price investment strategy seeking out global opportunities. Elliot focuses on discovering and analyzing long-term, high quality investment opportunities and strategic portfolio management. Prior to joining RGA, Elliot managed portfolios at at AustinWeston Asset Management LLC, Chimera Securities and T3 Capital. Elliot holds the Chartered Financial Analyst (CFA) designation as well as a Juris Doctor from Brooklyn Law School.. He also holds a Bachelor of Arts degree from Emory University where he double majored in Political Science and Philosophy.

John Mihaljevic leads MOI Global and serves as managing editor of The Manual of Ideas. He managed a private partnership, Mihaljevic Partners LP, from 2005-2016. John is a winner of the Value Investors Club’s prize for best investment idea. He is a trained capital allocator, having studied under Yale University Chief Investment Officer David Swensen and served as Research Assistant to Nobel Laureate James Tobin. John holds a BA in Economics, summa cum laude, from Yale and is a CFA charterholder.

The content of this podcast is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this podcast. The podcast participants and their affiliates may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated on this podcast. [dkpdf-remove]

[/dkpdf-remove]

Reiterating Robotti & Company’s Value-Based Approach to Investing

January 2, 2021 in Best Ideas Conference, Commentary, Equities, Letters

This article includes modified excerpts from the 2020 Annual General Meeting of Robotti & Company, based in New York.

Bob Robotti, Founder and CIO, is a featured instructor at Best Ideas 2021.

BOB ROBOTTI: The format is different this year, but our message is exactly the same. There has been a consistent foundation to our investment approach over the 35 years we have been around, and that is we are unabashed value investors. Covid has provided a generational entry point which includes the acceleration of trends we have been noting for years along with consolidation activity among core themes in which we are active investors.

What is value investing? Security Analysis, the seminal work by Ben Graham, introduced that investment approach. And the title is a key indicator of what it is: it is individual stock research and bottom-up investing is a critical element of this investment approach. Now the way it is practiced today is different than when Graham first wrote his text. Back then, he wrote it in the middle of The Great Depression. So, he bought stocks that had low price to book, low PE rations, high dividend yields, and that was the approach. But the intention all along was looking at individual securities, analyzing those companies, making determinations as to what a conservative fair value of that business is, and buying those businesses for less than what that value indicated.

Why is that a potential opportunity? Ben also spent a lot of time talking about investors, the rationality of investors, the emotion of investors, and how that affects security prices. So, another fundamental part of value investing is the disbelief in the idea that there is an efficient market, that every security properly evaluates the future cashflows of that company discounted down to today. An important behavioral bias that Graham often alluded to was the idea of recency bias. What is today and what was yesterday is projected to be what will be tomorrow. Frequently yesterday and today are not the right indicators for the future opportunity. So, it is looking at businesses, understanding the businesses, and making conservative estimates of future values: that is a key determinant. It is individual security analysis and the belief that securities can frequently be mispriced.

The longer a security is mispriced, potentially, the more it is underpriced. That gives you the opportunity for both returns, and, of course, it mitigates risk, the margin of safety that Graham also spoke about. So, those concepts and precepts continue throughout our investment approach today.

THEO VAN DER MEER, SR INVESTMENT ASSOCIATE: I’ll start off with a question that is on a lot of people’s minds today, which is when do you think that we’ll get back to some semblance of normalcy?

BOB ROBOTTI: I guess the important thing, in my mind, is to emphasize the last part of your question: “back to some semblance of normalcy.” The key, in my mind, is that the current situation with the pandemic is not the “new norm.” Frequently what we’re talking about are behavioral biases. People know the current situation and project it into the future. We think this is a transitory issue. We do think– we don’t know if it’s six months or a year or two, whether it is one of these vaccines or some other solution. But this is not the new norm. So, the importance in thinking about the pandemic or political unrest and social unrest, all of those things, we’re looking to invest in businesses and make estimates as to the future cash flows of that business, the present value of those cash flows, and how much will accrue to equity owners. The important question is, okay, so what’s the impact on the business? How does it change those future cash flows? How does it potentially reduce some of those cash flows in the short term? How long does that last? How big is that impact? What things are unleashed? What trends that were potentially underway are actually accelerated in the process?

So the important question is not when do we get back to normal. What is important is estimating the impact of the current situation. How much of it is permanent? How much of it is not? And how that affects the valuation of the businesses we’re invested in. I’d also highlight that, when the market gets that estimate wrong it creates a really opportune situation for stock pickers like ourselves.

THEO: Bob, do you want to talk about some other ways in which a long-term time horizon has manifested itself in the portfolio?

BOB ROBOTTI: Once again, it’s the market looking from the wrong time horizon thinking that today is tomorrow. Our investments in home building are an excellent case study. In 2008, 2009, we were looking at the home building business and thinking, this is an interesting industry. The industry has imploded, worst ever post-World War II, with the lowest amount of new homes being constructed. There was a significant amount of oversupply, too many homes were built, and with the financing on that, foreclosures were rising. With an oversupply that was significant, new home building fell to very low levels, and there was no appreciation, no understanding and no timeline for when that would be corrected.

We started to look for businesses that were well-positioned, differentiated in terms of their business, had financial situations that ensured their ability to withstand the situation, to survive the downturn, and importantly, to thrive in the recovery because clearly those kinds of situations create great dislocations, and for certain well-managed businesses that are well financed, the opportunity is substantial. We believed that the 1 to 1.1 million annual single-family home start number, which had been a 50-year average, would continue to hold, and that’s during a period of time when the beginning population was half of what it is today and the beginning number of households was half of what is it today. So, to get back to that modest trendline we thought was almost a surety. The timing of it, however, was uncertain. So, we identified the companies to invest in.

Now, frequently, when we do invest in cyclical businesses like this the recovery often does not happen as quickly as we anticipated. But in the meantime, things are still happening in the industry to those well-managed differentiated companies that are improving their competitive position and improving their earnings power even before the recovery comes. And the extension of a downturn provides even a greater runway of opportunity for a recovery. So, that’s, we think, a classic example of something that you’ve already seen the manifestation of in homebuilding.

Moreover, we think we’re still extremely well-positioned today in the homebuilding space interestingly because we still think there was a 10, 11-year period of significant underbuilding. That means you have underbuilt 3 to 5 million homes over that extended period of time. And we’ve gone from 67% homeownership, an all-time record high, down to 62%, which is a long-time low. And we think there’s a lot of underlying trends that already had started to change, that already increased the demand for single-family homes, the interest for people to move out of urban areas, into suburban areas. We think COVID clearly has been an accelerant to that change and, therefore, the expansion of the earnings power and the timeline and the realization for these investments.

THEO: Do you want to give a specific example?

BOB ROBOTTI: The best example of what we’re talking about are our investments in the distributers to the homebuilders: first, Builders FirstSource in 2009, then BMC in 2010 post its bankruptcy we accumulated equity from a number of the banks who were the lenders. These businesses are better businesses with product and service offerings that are differentiated. The scale and scope of the businesses give them competitive advantages, the geographic spread of the businesses is another positive to the companies. So, the recapitalization of BMC gave it a great financial position for the ability to participate in the recovery.

August of this year was kind of a culminating event when Builders FirstSource and BMC announced they were merging together to form by far the largest building products distribution company. And it’s not just this consolidation. In 2015, both companies also participated in a consolidation event. You had a radical change in the structure of the business, the competitive offering of the company, its continued growth and value-added services. So, therefore, it’s continued differentiation from its competitors. So, it’s, we think, an excellent example of how a patient investor in a cyclical business has an opportunity for an entry point and a long-term runway for opportunity that even today we think is still in middle innings of a very positive trend.

And we also thought that there was a number of suppliers that also were favorably affected by the consolidation trend. So, one of those is Norbord. And, David, you’ve done a lot of work on it and maybe you’d share with us our investment thesis.

DAVID: Thanks, Bob. Norbord actually is a great case study for how we invest. Norbord is the largest producer of oriented strand board, or OSB, which is a replacement for plywood used in building homes. Now, interestingly, we spend a lot of time speaking about investing in cyclical companies, which is a dominant theme across our portfolio, and I think it’s actually one that differentiates us from the majority of investors who list cyclicality at the top of their list of what to avoid.

Of course, or maybe ironically, the reason we often find bargains in cyclical industries is because there’s less competition in such a large segment of the market. But that’s just one of the tools or frameworks we utilize at Robotti to identify potential value. So, we eventually found Norbord through a company it acquired because that company was raising capital through a rights offering which was backstopped by its largest shareholder. That’s another tool we use to identify potential value.

Once identified, we were able to really quickly increase our conviction on the business because, as Bob said, his experience on the BMC board had given him this lens into the industry to help us understand it holistically. Now, Norbord has experienced most of the same dynamics as Builders and BMC that Bob just spoke about. And specifically, it’s continued to see the benefit of a more consolidated industry over the past decade.

Now, with what is a somewhat fixed amount of supply currently available in North America, the survivors have become more dedicated than they’ve ever been in the past to producing only what they can sell. And this rational discipline production will eventually result in a more rational and less volatile pricing, which will favor the OSB producers.

Interestingly right now, we’re in the midst of what Charlie Munger a lollapalooza effect. Initially when the pandemic hit and we had to lockdown, Norbord’s stock was hit especially hard because of its economic sensitivity. And management quickly responded imprudently by enhancing their balance sheet liquidity, but also by curtailing production capacity.

The curtailments that they took were on top of what had already been taken offline in the second half of 2019 as the business focused on matching production with demand. Now, of course, what I don’t think anyone predicted is that instead of a pullback in housing demand, the pandemic would actually be the catalyst to unleash this previously dormant demand for new homes, the one we initially identified that Bob just spoke about and that was one of our key investment factors underlying our investments in the home building industry.

When this surge in demand for single-family homes met an even more limited supply of OSB, Economics 101 took over and the price of OSB skyrocketed to all-time highs. And we do expect that prices will moderate from the unusually high level threat. But we also believe that the dynamics are now in place to sustain a disciplined pricing environment for a considerable period of time allowing Norbord to have an extended runway to produce significant amounts of free cash flow.

Now, the stock’s up an astonishing 330% from its March low. It was currently up just over 45% year to date. But just 12 days ago, West Fraser, which is a Canadian-based producer of lumber and wood panels, made an all-stock offering to acquire Norbord in a transaction that, once it goes through, will value the company at $37.78 a share. And we’re still in the process of doing our diligence on West Fraser so we can understand the impact of our unchanged thesis on OSB and Norbord, how that will impact the new business combination. And in fact, we look forward to speaking with West Fraser’s CEO later in this week, which is an important part of the diligence we do. As we make sure we’re invested in the securities of the business’ or businesses’ best position to take advantage of what we really believe is a tremendous multi-year opportunity.

BOB ROBOTTI: We are value investors, we are unabashed value investors in a time where that label has been tarnished.

It’s the confluence of events: macro environment, point in cycle and differentiated individual company (or companies) and our active engagement to maximize the outcome – the right place, the right time, the right company and a compelling, strong opportunity.

Moreover, we are not just doing research; we are active owners of our investee companies, seeking to increase value whether by the size of our holding, by writing letters to the board or joining the board and having a ‘seat at the table’ and more direct say.

Importantly, while we discussed homebuilding specifically, much of our remaining portfolio consists of businesses in other sectors as well also in various stages of recovery similarly seeing COVID accelerate industry trends which will accelerate recoveries and strengthening economics. The present value of the future cash flow of these businesses are misunderstood due to the view from the rearview mirror market analysis. These investments reflect a decade of very modest economic growth. Valuation is the ultimate determinant of an investment’s merit. In the end, the market is a weighing machine. Cash is what equalizes all businesses, not popularity.

Our goal is always the same, as unabashed value investors, to maximize the valuation and, in doing so, the opportunity. It’s fact-based research on individual companies, doing analysis, and that highlights the attractiveness of the investments that we’re invested in today. Our investment approach should be labeled ‘valuation investment.’ Valuation matters and is a key differentiator between our investment approach and much of the market.

download printable version

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Small Cap Value Investing: Why Bother?

January 2, 2021 in Best Ideas Conference, Commentary, Equities, Letters, Small Cap

This article is authored by MOI Global instructor Chris Colvin, founder and portfolio manager at Breach Inlet Capital, based in Dallas, Texas.

Chris is a featured instructor at Best Ideas 2021.

Are we in a stock market bubble? I think you first need to define the “market”. During the five years ended in October 2020, the price of the Large Cap Growth (“LCG”) index[1] more than doubled leading to a 16% annualized return. The same cannot be said for Small Cap Value (“SCV”). Its index[2] gained only 20% over this timeframe equating to a paltry 4% annualized return. Said differently, LCG outperformed SCV by 86% for the five years ended in October 2020.

While a LCG bull may point to the dominant market share and significant cash flow generated by the FAAMG, there are many examples where this is not the case. As I write this, DoorDash (NYSE: DASH) closed its first day of trading at ~$190 per share or more than double its initial IPO price range. The market is ascribing a value to DASH that exceeds Chipotle and Domino’s combined. DASH burned over $0.5b in cash last year, but…it has enormous growth potential. Investors’ obsession with growth has come at the expense (pardon the pun) of disregarding profitability. Given today’s investing environment, it is not surprising many market pundits believe value investing, especially SCV investing, is “dead”. Yet, I want to share a different perspective.

Despite the consensus chorus again echoing that “this time is different” and LCG’s outperformance is sustainable, I choose to side with Howard Marks. He reminds us: “Investment markets follow a pendulum-like swing: between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overpriced and underpriced.” The sentiment pendulum also swings across subsets of the equity markets, such as from LCG to SCV. Was November evidence of the pendulum swinging toward SCV?

Last month, SCV gained 19% while LCG rose only 10%. This trend continues in December. Though not specific to small caps, inflows into value ETFs also recently outpaced inflows into growth ETFs by the widest margin ever[3]. As more evidence, fund managers have been rotating from growth to value stocks according to the BofA Global Fund Manager Survey in December[4]. Two months cannot be called a sustainable trend, but history provides a useful guide.

During the last five years of the tech bubble (Mar-95 to Mar-00), SCV underperformed LCG by 219%. Similar to today, prognosticators claimed SCV investing was “dead”. During the five years following the tech bubble bursting (Mar-00 to Mar-05), SCV beat LCG by 139%. More importantly, SCV outperformed LCG by 116% over that full decade (Mar-95 to Mar-05) highlighting that valuations matter and patience can be rewarded.

Even if SCV’s recent outperformance proves temporary, I believe SCV will continue to provide fertile grounds for a Long/Short strategy. Many investors associate SCV with broken business models and stretched balance sheets. This is partially true and leads to compelling candidates for Short positions. On the flip side, the SCV market also includes industry leaders that dominate niche markets and have long runways to grow. These are the types of companies we target for Long positions. For instance, Rent-A-Center (NASDAQ: RCII) is a member of the SCV index (RUJ). It is a market leader, quadrupled EBITDA in the past three years, and expects to sustain rapid growth through e-commerce & its FinTech platform (Preferred Lease). From February 2017 to October 2020, RCII gained over 250% despite the SCV index (RUJ) falling 2% over that timeframe. Hence, RCII highlights that you can identify rewarding SCV investments even when SCV is broadly “out of favor”.

A small cap strategy benefits from the ability to repeatedly exploit a persistent dynamic. Relative to large caps, I believe small caps is a less efficient market because there are far more companies covered by far fewer sellside and buyside analysts. Also, I think small caps can be more efficiently researched because they are often simpler businesses and provide greater access to senior management. This access is also more critical and meaningful at smaller companies where executives’ decisions are often more impactful to value-creation than decisions by executives at large, multi-national conglomerates. In sum, a less efficient market coupled with more efficient research results in small caps being a compelling opportunity set.

Going a step further within small caps, I think focusing on “value” is more attractive than “growth”. The primary reason is that many “growth” small caps have limited visibility to generating earnings, which ultimately drives value. Meanwhile, a SCV investor can aim to own companies that are growing earnings and thus, increasing intrinsic value. That is our focus for Long positions. Revenue growth without a tangible pathway to profitability is a recipe for disaster. Furthermore, “growth” companies are typically priced at high revenue multiples. A “growth” company’s share price may have far to fall if growth expectations are not met and there is not an earnings yield to provide support.

To conclude, I believe “you can have your cake and eat it too” by investing in companies that are sustainably growing profits yet are trading at “value” multiples (i.e., low price-to-earnings). Given the information inefficiencies in small caps, a SCV investor can repeatedly identify such opportunities. I think the prospects for SCV have never been more attractive. If history is any indication, SCV is positioned to materially outperform in the coming years. While we are confident in our ability to compound capital in any market, we would certainly welcome better sentiment towards SCV.

download printable version

[1] Large Cap Growth (“LCG”) Index = S&P 500 Growth Total Return
[2] Small Cap Value (“SCV”) Index = Russell 2000 Value Total Return
[3]
[4]

Disclosure: Any investments discussed in this letter are for illustrative purposes only and there is no assurance that Breach Inlet Capital will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any client account. Further, you should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses. THE INFORMATION IN THIS LETTER IS NOT AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY AN INTEREST IN ANY INVESTMENT FUND OR FOR THE PROVISION OF ANY INVESTMENT MANAGEMENT OR ADVISORY SERVICES. ANY SUCH OFFER OR SOLICITATION WILL BE MADE ONLY BY MEANS OF A CONFIDENTIAL PRIVATE OFFERING MEMORANDUM RELATING TO A PARTICULAR FUND OR INVESTMENT MANAGEMENT CONTRACT AND ONLY IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW.

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

The Manual of Ideas – Winter 2021 Edition

December 28, 2020 in The Manual of Ideas

One of the most unnerving years in recent memory is finally behind us. Congratulations, we made it!

In considering the many lessons of 2020, one conclusion is so inescapable as to feel like a truism: The world is unpredictable, and markets are unpredictable. Who would have guessed in late 2019 that a virus would come to dominate our consciousness only a few months later? Or in early 2020, that oil prices would turn negative? Or in mid-March, that markets would race to all-time highs?

As we look ahead with a temptation to predict the future — or to listen to those who wish to convince us they can predict it — it might be instructive to keep the foregoing in mind: The world is unpredictable, and markets are unpredictable. True, but not a truism.

If we cannot predict, then what? As Buffett suggests, “Predicting rain doesn’t count. Building arks does.” Here are a few arks to consider building in 2021:

The Inflation “Ark”

Despite unprecedented balance sheet expansion by the Federal Reserve and the European Central Bank, a low-inflation consensus persists among investors. While gold and bitcoin prices have risen, those gains may be considered little more than “noise” when compared to the trillions still invested in negative-yielding bonds. Inflation protection remains cheap.

For perspectives on this topic, you may like to revisit our conversations with Chris Bloomstran, James Davolos, and Daniel Gladiš. For specific “inflation ark” ideas, you may like to replay our conference sessions with Santiago Domingo Cebrian on Atalaya Mining, Marta Escribano on Polyus, Juan Huerta de Soto Huarte on Maire Tecnimont, Bob Robotti on energy sector ideas, Amit Wadhwaney on asset-based ideas, and Samuel S. Weber on Swatch. Recent sessions on great businesses with pricing power also offer plenty of ideas to consider.

The Bubble “Ark”

Another Buffett quote applies: “What the wise man does in the beginning, the fool does in the end.” Some investors embraced “compounders” years ago — Nick Sleep with Amazon, Sean Stannard-Stockton with Netflix, Elliot Turner with Roku, Peter Mantas with Zscaler; the list goes on.

These days, “compounders” are seemingly everywhere, as undisciplined investors justify nosebleed prices for largely unproven businesses — no need to “name names,” as I’m sure you have your own mental list of such highflyers. Simply avoiding the worst excesses of today will put us in a better position to preserve capital when the froth inevitably dissipates. (Did I just make a prediction?)

A classic piece you may wish to revisit in this regard is Chris Bloomstran’s letter on Microsoft in 2000. Chris argued that the company’s soaring stock price would lead to investor disappointment while the business grew into its valuation in subsequent years. After the bursting of the Internet bubble, it took more than fifteen years for Microsoft shares to best their bubble peak.

The Obsolescence “Ark”

“Traditional” value investors – those seeking out companies selling for less than readily ascertainable net asset value – are going through a soul-searching time. While it would be foolish to give up on value, it is similarly foolish to ignore the massive and enduring changes underway in almost every segment of life and the economy. We must demand higher premiums for businesses that may become obsolete, and we should think creatively about value in businesses that will remain relevant for decades to come. Bruce Greenwald shared this view in a recent conversation with MOI Global.

For instance, investors tend to place ocean shipping companies into one large bucket entitled, “Do not touch with a ten-foot pole.” Meanwhile, most would agree that oil tankers are unlikely to be around in fifty years while containers should remain a widely used standard in the shipment of various products. If you can buy tankers and containerships at similar valuations, why would you opt for the asset more likely to become obsolete?

Wide-Moat Investing Summit 2020 offers a place to start your search for businesses that are likely to endure and prosper. Selected ideas are highlighted in this issue. A standout presentation of a great business at a reasonable price was Stitch Fix, presented by Felix Narhi at $28 per share in early July. As Felix’s thesis started playing out in recent months, the stock has advanced toward $70 per share. While ideas like Stitch Fix may not have the hard asset backing of many “traditional” value ideas, their prospective earning power makes them worthy research candidates, even for those of us insisting on a bargain purchase.

The FOMO “Ark”

We have all probably felt it at one point or another — the “fear of missing out.” Even those of us who don’t generally have FOMO when it comes to highflyers outside our circle of competence or valuation comfort zone tend to have some version of FOMO. For me, it usually kicks in after I sell a stock. Irrationally, I want the stock price to go down in order to feel good about my sell decision. I feel massive FOMO if the stock keeps rising, with “newbies” getting rich off my idea.

The Newtonian version of FOMO is more destructive because it leads to permanent loss of capital. Sir Isaac Newton once famously said, “I can calculate the motions of the planets, but I cannot calculate the madness of men.” Even with this realization, the FOMO Newton experienced during the South Sea Bubble was so strong that he ultimately succumbed to it.

My appeal to all of us: Let’s not let FOMO drive any of our investment decisions going forward, whether on the buy side or the sell side. Let’s stay focused on our long-term goals, without getting envious of those who might be getting richer more quickly. Let’s be comfortable with being the proverbial tortoise every once in a while.

The Fixed Mindset “Ark”

Going beyond the narrow definition of investing, it might be worthwhile to devote more time and energy in the new year to “investing in ourselves.”

MOI Global members tend to be lifelong learners already, so this might be a superfluous point, but I have found the distinction between a fixed and a growth mindset incredibly helpful for my own development. A growth mindset seems more congruous with where the world should go and with where it is going, at least for now. As value investors, let’s commit to developing a growth mindset. It will help us in life and in investing.

The go-to book on this topic is Carol Dweck’s Mindset: Changing The Way You Think To Fulfil Your Potential.

It has been a great pleasure to launch a new podcast in 2020, This Week in Intelligent Investing, featuring two of my favorite up-and-coming fund managers — Phil Ordway of Anabatic Investment Partners, based in Chicago, and Elliot Turner of RGA Investment Advisors, based in Stamford, Connecticut. Tune in weekly to hear the three of us discuss timely and timeless investment topics. We welcome your questions and topic ideas.

Members, log in below to access the restricted content.

Not a member?

Thank you for your interest.  Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:

MOI Global