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Gregory Zuckerman on His Book, The Frackers

July 23, 2019 in Audio, Interviews, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured, Transcripts

Gregory Zuckerman discussed his book, The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters, at MOI Global’s Meet-the-Author Summer Forum 2019. Greg is a Special Writer at The Wall Street Journal.

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About the book:

Things looked grim for American energy in 2006, but a handful of wildcatters were determined to tap massive deposits of oil and gas that giants like Exxon and Chevron had ignored. They risked everything on a new process called fracking. Within a few years, they solved America’s dependence on imported energy, triggered a global environmental controversy, and made and lost astonishing fortunes.

No one understands the frackers — their ambitions, personalities, and foibles — better than Wall Street Journal reporter Gregory Zuckerman. His exclusive access drives this dramatic narrative, which stretches from North Dakota to Texas to Wall Street.

About the author:

Gregory Zuckerman is a Special Writer at The Wall Street Journal. He writes about big financial trades, hedge funds, private-equity firms and other investing and business topics. In the past, Greg wrote the Heard on the Street column and covered the credit markets for the paper.

Greg is the author of The Frackers: The Outrageous Inside Story of the New Billionaire Wildcatters, published in 2013 by Penguin Press. He’s also the author of The Greatest Trade Ever: The Behind-the-Scenes Story of How John Paulson Defied Wall Street and Made Financial History, published in 2010 by Random House. Greg and his two sons wrote Rising Above: How 11 Athletes Overcame Challenges in their Youth to Become Stars, and Rising Above: Inspiring Women in Sports, books for young readers and adults that describe the moving and remarkable stories of how various stars overcame imposing setbacks in their youth.

In November, PenguinRandomHouse will publish Greg’s latest book, The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution.

Greg joined the Journal in 1996 after writing about media companies for the New York Post. Previously, he was the managing editor of Mergers & Acquisitions Report, a newsletter published by Investment Dealers’ Digest.

Greg graduated from Brandeis University in 1988, Magna Cum Laude. He lives with his wife and two sons in West Orange, N.J., where they enjoy the Yankees in the summer, the Giants in the fall, and reminisce about Jeremy Lin in the winter.

Perspectives on Selected Holdings of the Ensemble Fund

July 23, 2019 in Equities, Ideas, Letters

This article is excerpted from a letter by MOI Global instructor Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital Management, based in Burlingame, California. Visit Intrinsic Investing for additional insights.

Like most investors, we’ve spent a lot of time this year thinking about the ways in which a recession, and/or a heating up of the US-China trade war, might impact the economy and the companies in the Fund. However, at the same time we’ve advocated the idea that when it comes to recessions, the best approach is to invest in strong companies that will thrive coming out the other side of recessions rather than trying to guess when a recession is on the horizon and attempt to get out of weaker companies just in time. On the trade war, as much as we think what happens is quite important, we also think that a US-China trade war will likely be a key feature of the investment landscape for the next decade or more. So rather than trying to guess what short term changes might occur, we’re more focused on making sure we own companies that can navigate a shifting set of trade rules over the medium to long term.

But for all the focus on the trade war, when you look at the stocks that most influenced our performance, the trade war was not a material driver.

Broadridge, a service provider to banks and brokers, rallied 24% in the quarter as the company reported their third fiscal quarter and continued delivering the message that the quarterly misses of expectations that had occurred earlier in the year were due to timing issues, while their full year results continue to be on track. The stock has performed about in line with the market over the last nine months. But after hitting an all-time high last September, the stock sharply underperformed in the fourth quarter, dropping as much as 30% as investors got caught up in the optically weak quarterly reports. But as 2019 has worn on, it has become clear that the difficulties in quarterly results last year was entirely transient and was not at all an indication of a slowdown in the core business. This realization has led to the stock rallying 40% this year. While market overreactions to transitory issues are not always this dramatic and don’t always reverse so quickly, the decline and rebound due to the short time horizon of most investors offered us a great opportunity to add more shares during the weakness and then trim back our position after the huge, quick gains. While we are long term investors, we are also willing to opportunistically add to, or trim, our positions when market pricing swings as dramatically as it did recently with Broadridge.

Ferrari tacked on another 22% in gains after posting a 35% return in the first quarter. With the stock now up 64% this year Ferrari has been a big driver of our performance. But like Broadridge, part of these gains are a recovery of what we thought was an undeserved selloff in the fourth quarter of last year. In our view, the four quarter sell off was due to market worries about a recession and auto tariffs. But both of these concerns are misplaced. Ferrari is actually the most recession resistant of all car companies. This is because of the 18-month wait list to buy a Ferrari and the fact that people who have enough money to buy a Ferrari almost always still have enough money during a recession. And while Ferrari could be subject to auto tariffs, their buyers are not very price sensitive. We saw this dynamic at play last year when the company announced their Monza supercar would be sold at a price of “somewhere between $2 million and $3 million” and then promptly sold out before they ever revealed the final price. This dynamic of companies with strong pricing power having a weapon to offset the impact of tariffs is an important part of how we think investors should seek to insulate their portfolio from the very real risk of a prolonged US-China trade war.

The strong returns from Starbucks, Mastercard, Trupanion and Verisk were all related to these companies continuing to generate solid results. For many of our Fund holdings, it isn’t so much that we think they will generate surprisingly strong results relative to short term expectations. Instead, it is far more common that we simply think that the Fund holdings have such strong competitive advantages that they will resiliently bounce back from short term challenges and can continue to churn out solid results for far longer than the market gives them credit for. That’s why we are often most pleased by under the radar performers in the Fund that may not always be sexy and exciting, but which grind out results to be proud of for decades at a time. Later in the letter we’ll discuss Fastenal, a company that fits this description very well.

On the weaker side, we saw both First Republic and Charles Schwab & Co decline due to interest rates falling. Both companies generate a significant part of their earnings from their “net interest margin” or the spread between the rates they pay their clients for depositing cash with them vs the higher rate they earn from lending that money back out. Over the last quarter, not only have interest rates declined, but the yield curve has flattened or even inverted, meaning that there is little or even a negative spread between very short-term interest rates and longer-term rates. We are of the view that over the medium to long-term, the interest rate yield curve will be steeper, as it has typically been in the past, and that interest rates across the board will be higher. But we recognize that we could be wrong about this. Interest rates are not easy to forecast. However, one reason to only buy stocks when they appear cheap is because that cheapness can help offset weaker than expected financial performance.

In the case of First Republic, the company has long managed their interest rate risk in such a way as to make their net interest margin very stable, even during period of large changes in interest rate levels. They give up the opportunity to generate outsize returns during periods of attractive interest rates regimes, but they also protect themselves against tough environments like we see today. Charles Schwab & Co sees more volatility in their net interest margin, but the company has also proven themselves adept at figuring out multiple, alternative ways to monetize their customer relationships over the years. With both First Republic and Schwab winning tons of new customers in recent years, we know they are delivering on their value proposition. We believe that in both cases, the companies will generate significantly higher earnings in the future than they do today. But even if we are too optimistic in our interest rate outlook, we think both stocks are cheap enough today to perform just fine.

The decline of Google’s share price in the quarter was due to news that the Department of Justice is investigating whether to launch an investigation of the company on anti-trust grounds. It isn’t just Google being targeted, the DOJ has said they are considering investigations of Google and Apple, while the Federal Trade Commission is considering investigations of Facebook and Amazon. It is important to note that no suits have been filed and no investigations have been launched. Instead the agencies are investigating whether to launch formal investigations.

On the surface, this certainly seems like bad news. However, we would note that the last similar antitrust investigation was of Microsoft and today they are the most valuable company in the world. That doesn’t mean an anti-trust investigation is irrelevant, but it is important to note that even if the DOJ were to launch a formal investigation, and file charges and win in court, that still doesn’t mean Google’s stock price will perform poorly or that their business will suffer.

From our perspective as investors, our primary focus is on whether Google’s profits are a function of illegal or anti-competitive behavior and if so, how any remedy to stop these behaviors would change future profits. I’ll say at the outset, that we believe unequivocally that the vast majority of Google’s profits are a function of the company offering one of the single most important services ever invented. A service that brings information to the 7 billion internet connected devices around the world to people of every walk of life. As an American working in an office job, I simply cannot imagine navigating personal and work tasks without Google. And democratizing access to information across national boundaries has hugely positive social benefits. In fact, a hundred years ago the primary focus of philanthropists was to build libraries for just this reason. Viewed in this light, Google’s opening up of the collective knowledge of humanity to anyone with an internet connected device at no cost to the user can easily be seen as one of the most important social benefits ever created by any nonprofit or for-profit organization.

That being said, might there be changes to some of Google’s practices if they are subject to an in-depth investigation? Sure. But we do not think that these changes, should they happen, will strike at the core value that Google provides to the world and it is this value, not any particular business practice of their advertising offering, that is the root cause of the company’s profit stream.

We will also say that at Ensemble Capital, we do agree that it is well past time for antitrust regulators globally to create a more modern approach to monopoly analysis. There is nothing inconsistent between being a supporter of free markets and a supporter of robust antitrust enforcement. Antitrust enforcement done right is designed to preserve free market competition and prevent companies from curtailing free market forces.

Two antitrust remedies that we think might be legitimate outcomes of these investigations, is a more robust understanding of when the government can and should block acquisitions. Today, that analysis is primarily a function of the market share, based on revenue, of the two companies in question. But when companies sell intangible assets with little to no incremental cost of production, it often makes sense for them to defer building revenue and instead focus on user acquisition. Viewed in this light, both Facebook’s acquisition of Instagram and Google’s acquisition of Waze (at the time, the only meaningful competitor to Google Maps) may well should have been blocked. It is plausible that these investigations will lead to the retroactive blocking of the acquisitions of Waze and Instagram. In the case of Google and Waze, we do not think this outcome would have a material impact on the value of Google. But in the case of Facebook, a company we do not own in the Fund, we think a retroactive blocking of the Instagram merger would trigger an existential crisis at the company.

Company Focus: Fastenal Co (FAST) and Starbucks Corp (SBUX)

Fastenal Co (2.7% weight in portfolio): Fastenal is a company that most people have never heard of, yet it touches nearly everything we see around us.

Fastenal specializes in the curation, management, and logistics of moving billions of low value parts like nuts, bolts, screws, rivets (collectively known as fasteners) and other products from their point of origin around the world to their destination at or near the factory floor in a timely and cost-effective manner.

Fastenal’s customers are manufacturers of end products we use every day, like cars, airplanes, furniture, appliances, electronics and so on.

While each of the parts Fastenal moves is low value, their role is essential in the manufacturing of high value products and the health of the manufacturers’ operations. Delays in their supplies or having the wrong type of fastener in inventory can mean millions of dollars in costs for the manufacturers in the form of slowdowns, shutdowns, or poor product quality, safety, and recalls.

Fastenal’s business is focused on making sure its customers have the right parts at the right time in the right place. If you’re missing one type of screw on a $10K or $100MM machine, you’re not shipping the product out today. At the same time having too many parts laying around can be costly and wasteful. Fastenal’s role is to provide the mission-critical but low value products efficiently and reliably to their customers’ factories.

Fastenal’s services therefore cater to customers who value its ability to deliver both reliably and cost effectively because it aggregates the demand of its customers to extract higher volume discounts from suppliers. As a result, customers see compounded savings across their procurement chain.

In many cases, Fastenal is so deeply tied into customers’ operations that it manages the real-time stock of inventory for their plants and takes on the burden of inventory costs on their behalf, helping them not only run their plants smoothly, but also in managing their working capital more efficiently.

Over time, Fastenal has also expanded on the types of materials it provides on the factory floor beyond fasteners to include things like safety goggles, tools, metal suppliers, janitorial supplies, and other consumables that have similar distribution benefits and leverage Fastenal’s expertise and infrastructure. And in fact, these other materials now account for most of its revenue with traditional fasteners accounting for less than 40%.

In return, customers have rewarded Fastenal with a healthy premium above the cost of supplied parts, which is what’s driving the 20% return on invested capital that has underpinned the stock’s return over time. Since it went public in 1987, Fastenal’s stock has returned a compounded 23% per year.

While most people have never heard of the company, Wall Street certainly has. In 2012, BusinessWeek ran a story highlighting the fact that in the prior 25 years since the crash of 1987, Fastenal had appreciated by 38,600% making it the best performing stock during that time period. But it wasn’t just great fundamental performance that had driven the returns, there was also the fact that in 2012, the stock was trading near its all-time high valuation, with a PE ratio of 37.

We took note of the company at that time but passed due to the valuation. Since then, the company has continued to execute very well, doubling earnings. However, from the time of the BusinessWeek article to our first purchases of the stock last summer, the stock only returned 40% (or 5% per year) while the S&P 500 returned 140% (or 15% per year). With rising earnings and a lagging stock price, we ended up being able to buy the stock last year at one of its lowest ever valuations, setting up what we hope will be a return to strong outperformance.

Fastenal’s growth is heavily tied to North American manufacturing growth, where its customers predominantly operate. It also grows by increasing its share of spend penetration by winning over more customer plants and selling adjacent consumables for the factory or its workers to keep the plants running smoothly. This also further entrenches Fastenal with its national accounts by getting even deeper into customers’ operations with tens of thousands of vending machines it directly manages in factories and hundreds of dedicated on-site stores within them. All of these bring Fastenal closer to its customers and deepens and expands its relationships, making Fastenal hard to displace.

Over the past decade, Fastenal has grown revenue by about 9% per year, with several points of that growth coming from market share gains. With only $5B in revenue in 2018, Fastenal still has a long growth runway available to continue increasing its share of a very fragmented market, estimated to be about $140B in the US alone.

Starbucks Corp (4.8% weight in portfolio): While manufactures depend on Fastenal for inputs that power everything they do, the same might be said for the role that coffee plays in many people’s lives. Speaking for ourselves at least, without our regular dose of daily caffeine, the rest of the day pretty much grinds to a halt. Luckily for us and the rest of humanity responsible for consuming 400 billion cups of coffee every year, while caffeine is addictive, studies have continuously found it has very limited negative health implications with more and more studies pointing to its role in making people happy, healthy and productive.

It is for this reason that when we added Starbucks to the fund last year, we joked that the company was like Philip Morris and McDonalds rolled together but with the negative health implications removed. In our view, Starbucks is the premier global supplier of a key aspect of the human diet. Like all addictive substances, consumers of caffeine wrap their habit in a set of rituals. It is these rituals that provide an opportunity for Starbucks to cater to their customers desires in a way that is highly profitable.

The ritual of coffee consumption is important to Starbucks core customers. In the US, 40% of sales are made to active rewards members, those people who have the Starbucks app on their phone and use it to pay. Of these customers, half of them visit a Starbucks 16 times a month on average. In some ways, the Starbucks digital payment system can be considered the most successful digital currency of all time.

Katherine Fischer, an Advisor at Ensemble Capital, says that she orders a Starbucks drink from their app on most work days. The app saves her preferred drink – a venti Americano with a regular splash of steamed soy milk – so just two or three clicks on her phone will have her favorite drink waiting for her to pick up on her way to the office. When we asked Katherine to review this part of the letter, she pointed out that she doesn’t only go on most weekdays, but often orders from Starbucks on the weekends as well and, in fact, had ordered twice this past Sunday. And, in addition to her coffee-based drink, Katherine noted that she will occasionally add a spinach feta wrap if she needs an easy meal. Picking up a mobile order at Starbucks literally takes about 15 seconds. This is important to a parent of young children like Katherine who told us “When I’m with my kids the Starbucks mobile app is such a lifesaver. It means I don’t have to wait in line and tell the kids no to pastries when all I want is my morning coffee.”

So, what happens if a new coffee shop opens near Katherine and offers a modestly cheaper or even better product? Habits are powerful drivers of human behavior. Starbucks mobile infrastructure is designed to remove friction from the experience of buying from them. While a casual coffee drinker out for a walk and planning to wait in line anyway might give the new shop a try, a mobile first, habitual Starbucks customer, of the type that generates as much as 40% of their revenue, experiences much higher “switching costs” to try something new. Add in the rewards they offer to these customers, and competitors need to offer significantly superior value propositions to steal customers away.

There is one type of coffee retailer that is trying to do just this. Known collectively as Third Wave Coffee, these retailers lead by Blue Bottle and including many local and/or small chain stores, are attempting to offer a significantly higher end experience. Our bullish view on Starbucks is not based on a belief that these efforts will fail, but instead only that they will take limited market share and that Starbucks own Roastery and Reserve concepts will win a segment of customers wanting this higher end experience.

Mike Navone, another advisor at Ensemble Capital, is currently on vacation in Italy and sent us back a report of his visit to Starbucks Milan Roastery location. Here’s what he wrote:

“If there was one takeaway from Starbucks Milan I’d say two words: an experience. It was beautiful inside and the place was packed. Upon entry, you’re greeted and directed to where you should go (food, coffee, or the bar). We had espresso martinis. The server recommended some other drinks but at over 20 euros each we stuck with our martinis. Drinks surprisingly came with a full cheese board with olives, a nice touch! The couple next to us ordered one of the expensive drinks and the server said we should watch the preparation for ‘the experience.’ It was neat. Very carefully made with a beaker to steep, then shaken with ice. They wheeled out a special cart just to make this drink. Everyone was watching and taking pictures.

Then a huge copper cylinder in the center of the cafe had all the panels open up, like a flower blooming, and it revealed the coffee beans being sent to be washed, roasted, and packaged. There were no less than 30 people filming with their phones. The cafe was great, not a place to grab and go but instead stay for the experience and the show. It’s pricey but felt worth it for the unique experience.”

Now many retail products have gone through a premiumization process in recent years. Whether it is high-end chocolate, craft beer or organic, locally sourced produce, consumers have shown an appetite for replacing traditional mainstream products with higher end versions. Our contention is that this process has already happened with coffee and it was triggered by Starbucks successful efforts to premiumize coffee in the 1980s and 90s. While craft beer today still only makes up 25% of the beer market, Starbucks flipped closer to 80% of the coffee market to premium. What we see now with Third Wave Coffee is an ultra-premiumization trend. For a small slice of the coffee market, some customers are willing and able to spend even more on their coffee and they seek a truly authentic experience. Arif Karim, one of Ensemble Capital’s equity analysts, is a fan of Blue Bottle and other Third Wave coffee shops. While he rarely visits a Starbucks on his own, he will admit that when traveling with his wife and children, they will often choose Starbucks because it offers a range of products to fit their varied needs. In the end, we do not believe that the Third Wave trend is so broadly applicable that it threatens Starbucks in a meaningful way.

We’ve written in the past about the difference between search cost brands and identity brands. The former are those brands that offer a guarantee of a good product at a consistent quality level. The latter offers the purchaser a signal to them or their peers that reinforces the buyers’ self-identity. Our contention is that in branded consumer products, search cost brands are dying as consumers have come to depend on Amazon-star ratings and social media recommendations to influence purchase decisions. But Starbucks offers a service, not a product. When you are in a new town, or in an airport or even just in a different part of your home city, Starbucks offers a specific, known and consistent value proposition based on delivering you the dose of caffeine you seek and wrapping the purchase with a range of healthy foods or tasty treats as the occasion might call for. Speaking for ourselves, being served a bad cup of coffee is really annoying. And like most coffee drinkers, we have strong preferences that map not so much to objectively high or low quality, but instead are driven by what we’re used to. Sean Stannard-Stockton, the portfolio manager of the Fund, saw this preference on display recently when he was at JFK airport and found himself walking past five separate places offering coffee in order to buy from Starbucks, the brand he trusts to provide him the coffee he craves.

Now before we wrap up, we’d like to acknowledge that many of the questions we have been receiving have been about the risks of a recession and the US-China trade war. For those interested in learning more about our views on this subject, we would point you to the blog post we wrote in May titled Trade Wars & Recessions: Investing Under Conditions of Uncertainty.

Definitions

Price-to-Earnings (P/E) Ratio is the standardized valuation metric. The higher the number, the more expensive the stock is for each dollar of earnings per share.

Operating Profit is the profit of a company after it pays expenses attributed to its sales but before interest, taxes, restructuring and other onetime charges.

Operating Margin is Operating Profits divided by sales (or revenue). It allows you to compare profitability across companies and industries by standardizing across sales levels.

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Disclosures: Investors should consider the investment objectives, risks, and charges and expenses of the Fund carefully before investing. The prospectus contains this and other information about the Fund. You may obtain a prospectus at www.EnsembleFund.com or by calling the transfer agent at 1-800-785-8165. The prospectus should be read carefully before investing. An investment in the Fund is subject to investment risks, including the possible loss of the principal amount invested. There can be no assurance that the Fund will be successful in meeting its objectives. The Fund invests in common stocks which subjects investors to market risk. The Fund invests in small and mid-cap companies, which involve additional risks such as limited liquidity and greater volatility. The Fund invests in undervalued securities. Undervalued securities are, by definition, out of favor with investors, and there is no way to predict when, if ever, the securities may return to favor. The Fund may invest in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. Investments in debt securities typically decrease in value when interest rates rise. This risk is usually greater for longer-term debt securities. More information about these risks and other risks can be found in the Fund’s prospectus. The Fund is a non-diversified fund and therefore may be subject to greater volatility than a more diversified investment.

The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by an employee, principal and/or client of Ensemble Capital you will find a disclosure regarding the security held above. Should an employee, principal and/or client of Ensemble Capital subsequently purchase or sell any position in a security discussed in this blog entry, we will not update the above disclosure nor revise any archived blog entry after the date it is originally posted. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument.

Update on Our Investments in Building Products Companies

July 23, 2019 in Commentary, Ideas, Letters

This article is excerpted from a letter by MOI Global instructor Phil Ordway, Managing Principal at Anabatic Investment Partners, based in Chicago, Illinois.

Armstrong

AWI remains our largest investment. AWI’s returns were the star of the show in the first half of 2019 but the company has been performing well for a few years now. The flooring segment spin-off is in the rear-view mirror; the international segment sale proceeds have been received; the manufacturing operation has been streamlined; the balance sheet is in good shape and the free cash flow is piling up.

AWI has been the biggest investment in our partnership’s history and it’s been a very successful one. The core elements of the business – its dominant competitive position, high margins, and free-cash-flow generation – were in place and apparent in 2015 when we initiated our investment, yet investor patience was still required. There was fairly little risk in owning the business over a period of years but there was the usual uncertainty about the near-term specifics that drove market volatility. The biggest change has been in the market’s perception of the company, as the share price has almost tripled.

A look back at our activity provides some insights. We acquired shares steadily through the second half of 2015 and first quarter of 2016 as the share price declined almost in a straight line. We then added to our investment by approximately 10% in the first half of 2017 at prices near those we paid in 2015 and 2016.

It’s also worth noting that the path to good returns is almost never a straight line. The total return, compounded annually, from owning AWI has been 55% over the past year, 46% over the past two years, 36% over the past three years, and 21% over the past four years (essentially the entire life of our investment).[1] And yet the first two years of our investment provided…nothing. From the third quarter of 2015 through the third quarter of 2017 the stock declined and bounced around and provided no return despite plenty of business progress. By contrast, the first half of 2019 saw little news and only some slow, steady progress in the underlying business, but the stock returned 67.7%.

So now what? There is a school of thought that would have us sell some or all our shares because they’ve “had a good run” and are “fairly valued.” There is no denying either sentiment, but the sarcastic quotation marks probably gave away the punchline. If we owned the entire business – which is the scenario I always envision when making investments – would I be tempted by an offer at this price? Only if we were short on cash and had opportunities that offered clearly superior returns. Neither condition holds at the moment.

Builders FirstSource

BLDR remains a significant part of our portfolio. As discussed in prior letters, the market price has bounced up, then down, then partially back up again, but the business prospects remain favorable.

Temporary constraints hampered business in 2018, and housing-related fears lead the share price to decline 50% for the year. The company never stumbled in any meaningful way, and as industry worries subsided to a degree the shares returned 54.5% in the first half of 2019. The more important facts lie with the business itself. Efficiency gains, an ever-increasing value proposition in the market, share gains over local competitors, a successful management transition, a more robust balance sheet, and growing amounts of free cash flow all point to a bright future.

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[1] This is for illustrative purposes only; it does not exactly correspond to the timing of purchases made in the Fund and LP returns will vary. All market prices and total shareholder returns in this paragraph are through June 30, 2019. Source: FactSet.

Disclaimer: Gross Long and Gross Short performance attribution for the month and year-to-date periods is based on internal calculations of gross trading profits and losses (net of trading costs), excluding management fees/incentive allocation, borrowing costs or other fund expenses. Net Return for the month is based on the determination of the fund’s third-party administrator of month-end net asset value for the referenced time period, and is net of all such management fees/incentive allocation, borrowing costs and other fund expenses. Net Return presented above for periods longer than one month represents the geometric average of the monthly net returns during the applicable period, including the Net Return for the month referenced herein. An investor’s individual Net Return for the referenced time period(s) may differ based upon, among other things, date of investment. In the event of any discrepancy between the Net Return contained herein and the information on an investor’s monthly account statement, the information contained in such monthly account statement shall govern. All such calculations are unaudited and subject to further review and change. For purposes of the foregoing, the calculation of Exposure Value includes: (i) for equities, market value, and (ii) for equity options, delta-adjusted notional value.

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ALL FUND OR PRODUCT PERFORMANCE, ATTRIBUTION AND EXPOSURE DATA, STATISTICS, METRICS OR RELATED INFORMATION REFERENCED HEREIN IS ESTIMATED AND APPROXIMATED. SUCH INFORMATION IS LIMITED AND UNAUDITED AND, ACCORDINGLY, DOES NOT PURPORT, NOR IS IT INTENDED, TO BE INDICATIVE OR A PREDICTOR OF ANY SUCH MEASURES IN ANY FUTURE PERIOD AND/OR UNDER DIFFERENT MARKET CONDITIONS. AS A RESULT, THE COMPOSITION, SIZE OF, AND RISKS INHERENT IN AN INVESTMENT IN A FUND OR PRODUCT REFERRED TO HEREIN MAY DIFFER SUBSTANTIALLY FROM THE INFORMATION SET FORTH, OR IMPLIED, HEREIN.

PERFORMANCE DATA IS PRESENTED NET OF APPLICABLE MANAGEMENT FEES AND INCENTIVE FEES/ALLOCATION AND EXPENSES, EXCEPT FOR ATTRIBUTION DATA, TO THE EXTENT REFERENCED HEREIN, OR AS MAY BE OTHERWISE NOTED HEREIN. NET RETURNS, WHERE PRESENTED HEREIN, ASSUME AN INVESTMENT IN THE APPLICABLE FUND OR PRODUCT FOR THE ENTIRE PERIOD REFERENCED. AN INVESTOR’S INDIVIDUAL PERFORMANCE WILL DIFFER BASED UPON, AMONG OTHER THINGS, THE FUND OR PRODUCT IN WHICH SUCH INVESTMENT IS MADE, THE INVESTOR’S “NEW ISSUE” ELIGIBILITY (IF APPLICABLE), AND DATE OF INVESTMENT. IN THE EVENT OF ANY DISCREPANCY BETWEEN THE INFORMATION CONTAINED HEREIN AND THE INFORMATION IN AN INVESTOR’S MONTHLY ACCOUNT STATEMENT IN RESPECT OF THE INVESTOR’S INVESTMENT IN A FUND OR PRODUCT REFERRED TO HEREIN, THE INFORMATION CONTAINED IN THE INVESTOR’S MONTHLY ACCOUNT STATEMENT SHALL GOVERN.

NOTE ON INDEX PERFORMANCE

INDEX PERFORMANCE DATA AND RELATED METRICS, TO THE EXTENT REFERENCED HEREIN, ARE PROVIDED FOR COMPARISON PURPOSES ONLY AND ARE BASED ON (OR DERIVED FROM) DATA PUBLISHED OR PROVIDED BY EXTERNAL SOURCES. THE INDICES, THEIR COMPOSITION AND RELATED DATA GENERALLY ARE OWNED BY AND ARE PROPRIETARY TO THE COMPILER OR PUBLISHER THEREOF. THE SOURCE OF AND AVAILABLE ADDITIONAL INFORMATION REGARDING ANY SUCH INDEX DATA IS AVAILABLE UPON REQUEST.

Jeroen Bos on His Book, Deep Value Investing

July 22, 2019 in Audio, Interviews, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured

Jeroen Bos discussed his book, Deep Value Investing: Finding Bargain Shares With Big Potential, at MOI Global’s Meet-the-Author Summer Forum 2019. Jeroen is a Fund Manager at Church House Investment Management.

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About the book:

Deep Value Investing by Jeroen Bos is an incredibly candid and revealing guide to the secrets of deep value investment. Written by an investor with a long and remarkable track record, it shares for the first time the ins and outs of finding high-potential undervalued stocks before anyone else.

Deep value investing means finding companies that are genuine bargains that can pay back phenomenally over the long term. They are firms so cheap that even if they were to close tomorrow their assets would pay you out at a profit. But if they can turn things around, the rewards will be many times greater… These were the favorite shares of Benjamin Graham, author of The Intelligent Investor.

Inspired by Graham’s classic and with a long history of discovering these great value stocks — sometimes known as ‘bargain issues’ or ‘net nets’ — author and investor Jeroen Bos reveals: – how to use only publicly available information to discover these shares and filter the gold from the dross – everything he did when analyzing, purchasing, monitoring and selling more than ten recent successful deep value investments — the complete philosophy behind deep value investing, and the ins and outs of this strategy in practice — what can go wrong and how to minimize the chances of it happening to you.

Deep value investing has a better track record than almost any other approach to the market. Even better, it doesn’t require minute and technical knowledge of a company, nor is it fixated on earnings or often-unreliable future projections. It’s all about the balance sheet and patience. This makes it the perfect investing approach for those who want to see phenomenal stock market returns without wasting time or commission costs.

About the author:

Jeroen Bos has worked in the City of London for more than 25 years and most recently for Seilern Investment Management Ltd. He was a director of Panmure Gordon & Co. Ltd from 1989 to 1999. He holds a diploma in Economics from Sussex University and is a Member of the Chartered Institute for Securities & Investment. He has managed our Deep Value Investment Fund since 2012 and before that its predecessor from 2003.

Value Investors – Avoiding Mining at All Costs, But Why?

July 22, 2019 in Commentary, Equities, Industry Primers, Letters, Materials

This article is authored by MOI Global instructors Will Thomson and Chip Russell, managing partners of Massif Capital, a value-oriented partnership focused on the small- and mid-cap space, with special attention on industrial and commodity-related businesses.

We recently had the pleasure of giving a presentation on our approach to investing in mining firms at a conference hosted by the Manual of Ideas in Zurich, Switzerland. For those not familiar with the Manual of Ideas, it is a community of value investors that is run by the author of a book by the same name, a book we highly recommend to anyone who has not read it.[1] As far as investor communities go, Manual of Ideas is as good as it gets. John Mihaljevic, the author of the book, has managed to create a diverse community of value investors that we are privileged to be a part of.

Events are a rich mix of successful entrepreneurs turned private investors, fund managers, chief investment officers of foundations and endowments, venture capitalists, etc. We learn a great deal from the conferences and are often convinced that what the group gains from our attendance pale in comparison to what we gain. While there is a great diversity of thought and investment acumen at these events, investing in mining firms is a rarity.

At the start of our presentation, entitled “Beyond Commodity Prices: Finding Value in Mining Firms,” we asked the audience “who invests in mining firms?” In a group of roughly 25 people, about three people raised their hand. This ratio seemed to hold for the broader conference audience as well, about 100 or so individuals. We take no issue with investors choosing to avoid sectors based on a lack of opportunities or not being interested in spending the time to bring a company into their circle of competence (there is after all only so much time in the day), but we found the ratio sufficiently skewed to ask most attendees we spoke with why they choose to avoid mining. Based on our conversations, there are three areas of concern:

1) Mining was too volatile;
2) Mining was too technical, and;
3) Many felt uncomfortable forecasting commodity prices.

Regarding the first issue, volatility, we never really figured out how to respond to this concern. We like volatility; it creates opportunity even if it creates heartburn. Confusing the absence of volatility for the absence of risk is also not appropriate. Furthermore, much of the volatility in the mining sector is driven by commodity price movement. Often the impact of commodity price moves on the value creation of mining firms is illusory, or transitory, with minimal impact (we will show how this can be the case later). As for the technicality of the investment, we find little evidence to suggest mining is any more or less technical then numerous different areas in which people find high-quality investments.

The final issue, forecasting commodity prices, is an interesting concern. Regardless of the asset, an investment is always worth the present value of future discounted cash flows. This means that present value assumptions are always about events in the future and always about forecasts of some kind, which is to say an investment is always made in the presence of uncertainty about how future cash flows will unfold. The key then to the investing process is not the pursuit of a precise forecast, whether that be of commodity prices, demand for some consumer good, the stability of pricing for services, etc. but coming up with a method of gaining conviction about the potential value of a company across a range of potential futures. We do not claim to have the ability to forecast commodity prices, nor are we familiar with anyone who does, but we also don’t see it as a key to successful mining investing, just as predicting the future price of advertising on Facebook or the future price of Tide detergent is the key to investments in the social network or in Proctor and Gamble.

We approach our due diligence of mining investment as follows:

First, we evaluate the management team, project risk, the balance sheet and finally, we assess the present value of the company using probabilistic scenario analysis within the context of the capital cycle of all the firms that mine for the target company’s commodity. The front end of this process (management teams, project risk, balance sheet) is no different than the process one might take for any other company. The back end differs only insofar as we must seek to establish conviction around there being tailwinds for a company’s industry in the form of both industrywide capital allocation and medium to long-term commodity price movements (i.e., higher probability of commodity prices moving up then down, that statement is the extent of our commodity price forecast).

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[1] If you are an investor in Massif Capital and have not yet read this book, please contact us and we will send you a copy.
[2] Our understanding of momentum is shaped by white papers produced by AQR and by the book Quantitative Momentum by Wesley Gray, as such it is limited in diversity of perspectives. We hope that any readers who have seen a discussion of the link between the capital cycle and momentum will reach out so we can investigate this link further.
[3] Those well versed in the thinking of Karl Popper and George Soros will see a direct link to the General Theory of Reflexivity in this understanding of the capital cycle.
[4] By compounding errors, we mean erroneous assumptions or conclusions made on the basis of erroneous assumptions or conclusions, the end resulting being an exponential growth in the overall error of the forecast.
[5] The viciousness of turns in commodity cycles has much to do with the fact that what depresses the returns of producers (new supply) also depresses the price of commodities, creating a double impact on a firm’s financials. In this way the capital cycle takes on additional importance for commodity firms in that where an industry is in the capital cycle is telling of the likely medium to long term direction of the commodity price due the link between price and supply.
[6] High levels of M&A do not always indicate this, as with all things market related the rules are not hard and fast.
[7] Can Gold Industry Return to Golden Age, McKinsey
[8] Ibid.
[9] Ibid.
[10] We utilize Palisades @Risk software for our Monte Carlo Simulations. We integrate it into standard DCF analysis by substituting variables that might traditionally by forecasted on the basis of historical averages with variables that are actively changed across thousands of scenarios that mimic a sequence of random historical pricing events for a given variable. The result is a more multifaceted valuation output.
[11] A three-point valuation is a sampling approach, in the language of stochastic processes, it creates alternative sample paths, meaning we see only one possible outcome among a collection of many possible outcomes. Furthermore, in the case of valuation it is a deterministic outcome because primary variables are decided ahead of time by the analyst. Monte-Carlo creates a random sample path, meaning the output is a succession of virtual events subject to varying levels of uncertainty.
[12] Stochastics is a branch of probability mathematics that concerns itself with the study of the evolution of successive random events, Nassim Talab refers to Stochastics as the mathematics of history.

Disclaimer: Opinions expressed herein by Massif Capital, LLC (Massif Capital) are not an investment recommendation and are not meant to be relied upon in investment decisions. Massif Capital’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is limited in scope, based on an incomplete set of information, and has limitations to its accuracy. Massif Capital recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ regulatory filings, public statements, and competitors. Consulting a qualified investment adviser may be prudent. The information upon which this material is based and was obtained from sources believed to be reliable but has not been independently verified. Therefore, Massif Capital cannot guarantee its accuracy. Any opinions or estimates constitute Massif Capital’s best judgment as of the date of publication and are subject to change without notice. Massif Capital explicitly disclaims any liability that may arise from the use of this material; reliance upon information in this publication is at the sole discretion of the reader. Furthermore, under no circumstances is this publication an offer to sell or a solicitation to buy securities or services discussed herein.

Series on Position Sizing (Part One): Research Stages

July 22, 2019 in Equities, Letters, Portfolio Management, Risk Management, Skills

This article is authored by MOI Global instructor Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital Management, based in Burlingame, California. Visit Ensemble’s Intrinsic Investing website for additional insights.

“There are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns—the ones we don’t know we don’t know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones.” –Donald Rumsfeld, Secretary of Defense (2002)

Earlier this year, we wrote about our thinking on how many stocks an investor should own in their portfolio. While the average mutual fund portfolio holds in the range of 100-200 stocks, we argued that the ideal number of stocks in a portfolio is closer to 25 and that anything over 50 was likely a significant negative indicator of the portfolio’s potential to outperform. While there are strong theoretical reasons for why the optimal number of stocks in a portfolio is around 25, we also cited evidence that while most actively managed portfolios underperform, the top 25 stocks in the average actively managed portfolio actually tend to outperform. In other words, for all the talk of active managers underperforming, the real issue is that they hold too many stocks in their portfolios, not that they are no good at stock picking.

But even once you’ve decided how many stocks to own in a portfolio, you need to decide exactly what percentage of your portfolio to invest in each stock you’ve selected. So with this post, we’re starting a series on how we think about position sizing at Ensemble Capital.

We consider three inputs when we size our positions.

  • Return potential: Higher return potential stocks get higher weights, all else equal.
  • Conviction: Companies in which we have more conviction about their future get higher weights, all else equal.
  • Research stage: The longer we’ve actively researched a company the higher weight it gets, all else equal.

Return potential is pretty straight forward. We value companies based on the amount of cash we think they can return to shareholders over the long term. Conviction we’ll explore in a follow up post. So today we’ll focus on Research Stage.

Earlier in my career, I thought that it made the most sense to do all the research on a company up front and then invest the full amount you intended to invest at once. My thinking was that you shouldn’t invest at all if you haven’t finished your research and if you have finished your research, then you should make your full investment.

This makes good theoretical sense, but it ignores the way that humans actually collect information. The assumption I was making earlier in my career was that I could control what I learned or didn’t learn during the initial research phase on a company and thus I could collect all the needed information to assess a company prior to making an initial investment. But this isn’t how the human mind actually operates.

The short video below is a rather amazing demonstration of what we’re going to discuss in this post. Give it a view before reading the rest.

Did you pass the test? If so, well done. But studies show that less than a third of viewers notice what’s most important in the video. So even if you passed, if you were to take a lot of tests like this one, you’d likely fail over two thirds of them. Of course, now that you know what to look for, if you rewatch the video it will be impossible to miss.

This concept shows up in a number of different contexts. The “cocktail party effect” for instance, describes the way that when you are at a crowded cocktail party you are able to filter out all the many sounds and visual stimuli, and focus your attention on the person you are speaking to. Of course, while this is an important skill for humans, this filtering also means that when you are focused on a particular person at the cocktail party, you won’t notice much about what is going on around you.

The psychological concept of “priming” plays a role here too. Priming is when your brain is prepared ahead of time to notice certain things (and thus, as we saw in the cocktail party effect, ignore other things). In the video, you were primed to notice the number of passes being made. But had the narrator not primed you, you would have been much more likely to notice what was really important in the video, as your focus would have been more diffuse. That being said, without being primed to count passes, you almost certainly would not have known how many passes had been made.

Importantly, these effects operate at an unconscious level. You might think that your conscious mind can overcome these effects and you can choose what to pay attention to. But all I have to do is say “don’t think about an elephant” to demonstrate that the conscious mind has little ability to override unconscious thought processes.

OK, so what does all this have to do with position sizing? Basically, the amount of relevant information you have about an investment opportunity plays an important role in the likelihood that your assessment of that opportunity is accurate. Unfortunately, your ability to gather a portion of that information is limited due to the effects above.

Prior to researching a company you can not know what is most important to pay attention to. Until you figure out what to pay attention to, some critical aspects of a company will be literally invisible to you no matter how hard you look.

An example: Years ago, we invested in ScottsMiracle-Gro (SMG). I owned a house with a lawn at the time, but I had never paid that much attention to it. After researching the company and making an investment I suddenly found myself noticing a lot about my lawn (in particular, how poorly I had been maintaining it). I also started noticing other people’s lawns. I began noticing ads on the radio for lawn and garden supplies and most importantly noticed that most of the ads for Scotts products were actually ads being paid for by Home Depot and Lowe’s. Why in the world were the retailers paying to advertise a manufacturer’s product? The answer to that question held the key to understanding Scotts.

All of this information had already been present in my life prior to investing in Scotts but had been effectively invisible to me. But actually making an investment in a company focuses the mind. While this type of information may not have been critical to the research process in isolation, it all worked together to help build the mosaic of understanding I constructed over time about Scotts. It broadened my context and helped me place critical information into a more robust understanding of the value proposition of the company.

The priming of our brains to pay attention to relevant information about an investment takes time. But it is critical to minimizing the scope of what Donald Rumsfeld called “unknown unknowns” in the quote at the top of this post. When you first start researching a company, most of the information is unknown unknowns and it is impossible to prime your mind to pay attention to things that you don’t even know about yet.

This process is not just about general information of the type I described in the Scotts example. It is also critical to absorbing the most important information from research reports and company data.

An example: When we first invested in Netflix in the summer of 2016 our thesis was similar to the same thesis we have today, with one key difference. We understood from our initial research that Netflix was building a moat around their business. And we understood that the more content they offered, the higher they could push up the subscription price while the higher they pushed the subscription price, the more content they could afford to offer. We knew that the company was underpricing their subscription offering and that it would move higher over time. But initially we didn’t have a robust view on where exactly pricing might go over time as we didn’t yet fully appreciate how massively important the assumption around long term pricing was to the value of the business. But as we spent more time as shareholders, we came to focus more and more on the long term subscription price and begin understanding data that we already had in hand in a new light.

As the video showed, the research stage position sizing process isn’t just about giving ourselves time to find new information, it is also about giving ourselves time to see the information that is right in front of our nose.

It seems like this should be so easy! But as George Orwell wrote in 1946, “To see what is in front of one’s nose needs a constant struggle.” This is particularly true because humans use “conventional wisdom” or “whatever the tribe believes” as an initial filter to process information. But investing is about building a differentiated point of view. Thus when we are first researching a company, you will not see what is in front of your nose, you will only see what everyone else says is in front of your nose.

Early in a research process, it is easy to recognize “known knowns.” We can also establish the “known unknowns.” But by definition, it is impossible for us know what the “unknown unknowns” are.

Eliminating unknown unknowns takes time. Not time of detached contemplation and consideration, but time filled with the emotion rich focus that comes with making an investment and caring deeply about its outcome.

After coming to understand this dynamic, Ensemble moved to a three stage research process.

  • Starter positions: After performing initial research and coming to a conclusion that a stock is a buy, we will only take a very small position.
  • Research positions: After a stock is qualified as a starter position we continue researching, but now we’re better primed to process what’s most important and can better focus on the critical information and filter out the noise. After a period of time following the company in this phase, we will increase our position size to about half of a full size position.
  • Core positions: After following a company for a bit longer as a research position, we begin to build confidence that there are no significant unknown unknowns that will impact the outcome. We’ve established the known unknowns and determined that they are not critical to the investment thesis or that they constitute a level of known risk that is acceptable within the context of the overall investment thesis. At this point we take a full size position.

Unknown unknowns can of course be positive attributes or opportunities, but in limiting our initial position sizes we are focused on limiting our risk of exposure to negative unknown unknowns. Importantly, this process is not about “averaging into a position.” We do not increase our position over time in an attempt to pay a lower average price. Instead, the scaling into an investment is about increasing our position size as we become more confident that we have minimized the risk of unknown unknowns with potentially negative implications.

Next up in this series on position sizing, we’ll explain how we transform qualitative assessments about a company into a quantitative conviction score and then use these scores to size positions in our portfolio.

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The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment, financial, tax, legal, or other advice. No advisor/client relationship is created by your access of this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire investment. If a security discussed in this blog entry is owned by clients invested in Ensemble Capital’s core equity strategy you will find a disclosure regarding the security held above. If reviewing this blog entry after its original post date, please refer to our current 13F filing or contact us for a current or past copy of such filing. Each quarter we file a 13F report of holdings, which discloses all of our reportable client holdings. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Nothing contained within this post (including any content we link to or other 3rd party content) constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instrument. Ensemble Capital employees and related persons may hold positions or other interests in the securities mentioned herein. Employees and related persons trade for their own accounts on the basis of their personal investment goals and financial circumstances.

William Duggan on His Book, The Seventh Sense

July 21, 2019 in Audio, Meet-the-Author Forum, Meet-the-Author Forum 2019

William Duggan discussed his book, The Seventh Sense: How Flashes of Insight Change Your Life, at MOI Global’s Meet-the-Author Summer Forum 2019. Bill is a Senior Lecturer at Columbia Business School.

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About the book:

Flashes of insight—the “Eureka!” moments that produce new and useful ideas in a single thought—are behind some of the world’s most creative and practical innovations. This book shows how to cultivate more and better flashes of insight by harnessing the science and practice of the “seventh sense.”

Drawing from psychology, neuroscience, Asian philosophy, and military strategy, William Duggan illustrates the power of the seventh sense to help readers aspire to and achieve more in their personal and professional lives. His examples include Gandhi, Joan of Arc, Starbucks founder Howard Shultz, and executives and students he has taught in his classes. His book presents specific steps in the form of three practical tools to help prepare the mind, see and seize opportunity, and follow through on one’s resolution. Based on Duggan’s perennially popular Columbia Business School course, this book teaches the mental skills and discipline that power the seventh sense.

About the author:

William Duggan is a leading expert on creativity and innovation.

He has published three recent books on this subject: Strategic Intuition: The Creative Spark in Human Achievement (2007); Creative Strategy: A Guide for Innovation (2012); and The Seventh Sense: How Flashes of Insight Change Your Life (2017). In 2007 the journal Strategy+Business named Strategic Intuition “Best Strategy Book of the Year.” William is the author of three previous books as well, and has twenty years of experience as a strategy advisor and consultant.

He has BA, MA and PhD degrees from Columbia University. William teaches creativity and innovation in three venues at Columbia Business School: MBA and Executive MBA courses, and Executive Education sessions. He has given talks and workshops on creativity and innovation to thousands of executives from companies in countries around the world.

Aaron Brown on His Book, Red-Blooded Risk

July 20, 2019 in Audio, Meet-the-Author Forum, Meet-the-Author Forum 2019, Meet-the-Author Forum 2019 Featured

Aaron Brown discussed his book, Red-Blooded Risk: The Secret History of Wall Street, at MOI Global’s Meet-the-Author Summer Forum 2019.

Aaron is an Instructor at NYU’s Courant Institute for the Mathematical Sciences. Previously, he was a Managing Director and head of Financial Markets Research at AQR Capital Management.

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About the book:

From 1987 to 1992, a small group of Wall Street quants invented an entirely new way of managing risk to maximize success: risk management for risk-takers. This is the secret that lets tiny quantitative edges create hedge fund billionaires, and defines the powerful modern global derivatives economy. The same practical techniques are still used today by risk-takers in finance as well as many other fields. Red-Blooded Risk examines this approach and offers valuable advice for the calculated risk-takers who need precise quantitative guidance that will help separate them from the rest of the pack.

While most commentators say that the last financial crisis proved it’s time to follow risk-minimizing techniques, they’re wrong. The only way to succeed at anything is to manage true risk, which includes the chance of loss. Red-Blooded Risk presents specific, actionable strategies that will allow you to be a practical risk-taker in even the most dynamic markets.

  • Contains a secret history of Wall Street, the parts all the other books leave out
  • Includes an intellectually rigorous narrative addressing what it takes to really make it in any risky activity, on or off Wall Street
  • Addresses essential issues ranging from the way you think about chance to economics, politics, finance, and life
  • Written by Aaron Brown, one of the most calculated and successful risk takers in the world of finance, who was an active participant in the creation of modern risk management and had a front-row seat to the last meltdown
  • Written in an engaging but rigorous style, with no equations
  • Contains illustrations and graphic narrative by renowned manga artist Eric Kim

There are people who disapprove of every risk before the fact, but never stop anyone from doing anything dangerous because they want to take credit for any success. The recent financial crisis has swelled their ranks, but in learning how to break free of these people, you’ll discover how taking on the right risk can open the door to the most profitable opportunities.

About the author:

Aaron Brown is the author of Red-Blooded Risk, The Poker Face of Wall Street, and Financial Risk Management for Dummies, and a co-author of A World of Chance. He has retired to teach and write after a 36-year Wall Street career, as a trader, portfolio manager, head of mortgage securities, and risk manager; ending as Managing Director and head of Financial Markets Research for AQR Capital Management. Aaron is a columnist for Bloomberg as well as Wilmott Magazine. For more information, visit www.eraider.com.

David Rolfe on Investing in Growing, Wide-Moat Companies

July 19, 2019 in Equities, Interviews, Video Excerpt, Wide Moat, YouTube

Companies with a durable competitive advantage and a long growth runway have always been a favorite of many investors. If these growing, wide-moat businesses come with honest and capable management, they quickly get embraced as “great” companies with “great” management.

Successful investors, however, know that great companies with great management do not necessarily make for great investments. The price at which these companies are purchased is, of course, another key determinant of future investment return. So, how can investors increase their chances of identifying and investing in attractively-priced great companies?

In search for an answer to this question, we had an opportunity in 2013 to sit down with David Rolfe, Chief Investment Officer at Wedgewood Partners. David joined the firm in 1992 in his current role and has been instrumental in shaping Wedgewood’s investment philosophy and approach since then.

Our conversation with David Rolfe touched on many aspects important to investors in growing, wide-moat companies, including how to identify a wide-moat business, why do wide-moat businesses become mispriced, what are the best methodologies for valuing wide-moat businesses and, of course, how can investors increase their chances of investing in attractively-priced wide-moat businesses. David also generously shared the investment case for several of his major holdings and relayed an insightful story about GEICO and the lessons it holds for investors. We are pleased to share the below excerpts from the conversation.

Wide-Moat Investing Success Factor #1: Focus

When it comes to investing in growing, wide-moat companies, focus is a key success factor, according to David Rolfe. David limits his portfolio to 18-22 investments. This focused approach leads to fewer, but more impactful decisions where only his best ideas make it into the portfolio. To populate a larger portfolio, one would have to suspend a lot of the valuation criteria just to get them in the portfolio. And, of course, there are not that many attractively-priced wide-moat businesses to invest in, especially for investors running multi-billion dollar portfolios.

Says David Rolfe:

“By being focused at the company level, we’re going to be very picky. In other words, we’re putting our twenty best ideas in the portfolio and that’s where we stop. Given that we have very little turnover at Wedgewood, we hope to own these terrific growth companies for many years. Right out of the box, our focus to coin a phrase, no pun intended, is on those businesses that we think are best in class, that are uniquely competitively advantaged, that we believe at a minimum can double over the next three to five years. It’s not growth for growth’s sake, hyper growth, imprudent growth, risky balance sheet leverage growth. We’re looking for these terrific businesses, market share dominating leaders that don’t have to use financial leverage.”

Wide-Moat Investing Success Factor #2: Patience

Another key success factor of investing in growing, wide-moat companies is patience. According to David Rolfe, far too many growth-minded investors pay too high a price for these companies, so the biggest challenge is having the patience to wait for the company to get valued attractively. On the other hand, investors who have the patience are able to benefit, as even the best wide-moat businesses stumble at some point and offer investors an opportunity to buy them at an attractive price.

Says David Rolfe:

“You’ve got to be patient. No company clicks along without any bumps in the road forever. You look back at the great investments over time – Wal-Mart [WMT], Coca-Cola [KO], maybe even GEICO as an example here talking about Buffett. There’ve been plenty of times when those companies were out of favor, there’s something that’s going on at the company level where the valuation comes in.

The trick is to discern if it’s just a short term phenomenon that’s fixable or not. Our biggest mistakes over the years have been getting the company wrong, not the valuation wrong. We’re not chasing high momentum stocks of the day, paying 35, forty times earnings for a 20% grower…we have to be patient on the valuation to come to our levels where we believe the risk reward is attractive enough that we swing the bat.”

Growth vs. Value: A Lesson from GEICO

“In 1948, we made our GEICO investment and from then on, we seemed to be very brilliant people.” –Benjamin Graham, 1976

What can GEICO teach us about “value” versus “growth” investing? Plenty. As David Rolfe explains, both Benjamin Graham and Warren Buffett owe a substantial part of their wealth and public reputations — and deserved accolades — to a singular great “growth company”, the Government Employees Insurance Company (GEICO).

We share below David’s very instructive insights into GEICO.

Says David Rolfe:

“It’s a story that we’ve liked to tell when we’ve met with clients and prospective clients over the years because the long history of GEICO is ripe with examples for growth investors and value investors. The company was started in 1937 with about $100,000 in seed capital. Interestingly enough, in 1948 Benjamin Graham, again to coin a phrase, coin of the realm of late, he broke bad and he broke his rules, and he put 25% of his investment partnership in a privately held company.

Fate would have it that the SEC ultimately ruled to allow that purchase because he was an advisor buying an insurance company and there’s some regulations, and rules, and limitations. It allowed for the first publicly traded shares of GEICO, and GEICO soared, and it soared.

Graham was very quick to admit over the course of his career and at the end of his career, two things. Graham purchased half of GEICO in 1948 for about $712,000. Ultimately, it would rise in value to over $400 million at its peak in 1972. And Graham was very upfront admitting that the gain in GEICO was more than all of his other successes combined. And if it wasn’t for GEICO, his reputation for a great investor wouldn’t have been such.

But what’s interesting is that a lot of the study of Benjamin Graham, rightfully so, is that classic deep value, honed out of the scars, if you will, of the great depression. But he broke the rules and he bought this company, and held it for all those years where his discipline would have said to sell it.

Then, as fate would have it, Buffett became involved when he was going to school at Columbia, studying under Graham. He found out about GEICO. It was a company he hawked when he was a stockbroker after he left Columbia University. And as fate would have it, when GEICO stumbled in the early 1970s, it was Buffett who swooped in and started buying the shares when they had fallen. They reached a high of $61 in 1972, were about $40 in 1974, and they fell to a couple of dollars [by 1976].

And here was the opportunity, classic value opportunity. Buffett knew the underlying advantage of GEICO, their low cost advantage versus their competitors, was still intact and that would be the foundation for growth going forward.

For those who have followed Buffett’s career, they know that GEICO was a huge win for him, huge success. And ultimately, he bought about a third of the company in those dark days. His last investment was in 1980. He owned about a third of the company. Through share buybacks at GEICO, he ultimately got to about 50% of the ownership of GEICO. He bought the other half in late 1995 for $2.3 billion.

When you read the annual reports even when he first invested in GEICO, and then particularly in the annual reports starting in 1995, 1996, when the details were singing the praises of GEICO in terms of growth, and the opportunity, and the growth, and the growth.

Again, he liked to joke that he wanted Tony Nicely to step on the accelerator to spend all this advertising, and then Buffett kept his foot on Nicely’s foot. But when Buffett arrived on the scene, GEICO was spending about $33 million in advertising per year. They’re up to a billion now per year, like $1.1 billion. It’s three times the advertising, roughly, of their three largest competitors combined.

Even maybe more so than the mentor, teacher, pupil relationship that Buffett and Graham had over all those years, and then he would go work at the Graham-Newman Partnership, and a lifelong friend, and mentor, and hero, as Buffett describes Benjamin Graham.

But this GEICO connection, I’ve never heard Buffett talk about it in these terms, but it had to give him satisfaction, that he played a significant role in saving GEICO, if you will. And Benjamin Graham still owned it. His wife, when he passed away in 1976 I believe, members of the Graham family still had their GEICO investment and that was a significant part of that rebirth, if you will, was the impact of Buffett.

Again, the Graham-Buffett relationship, it’s been like sixty years now and Buffett still sings the praises of this great growth company, GEICO. At the risk of getting long-winded, it’s the story I like to tell that explains what we’re trying to do at Wedgewood.

There are plenty of times when a great growth company stumbles. Now, that was a significant stumble back then, but all along the way, there are times that GEICO was imminently investable in terms of a good valuation, and all the while, the growth was clicking along.”

Read David Rolfe’s in-depth case study of GEICO.

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