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Brandon Osborn on Concentrated Patience — an Entrepreneur’s Perspective

January 9, 2019 in Podcast, The Zurich Project, The Zurich Project Podcast, Transcripts

In an episode of The Zurich Project Podcast, presented by MOI Global, Brandon Osborn discusses “concentrated patience”, a concept he developed during his entrepreneurial journey. Brandon has honed the concept over the years, such that it has grown into somewhat of a philosophy of business and life.

Listen to his conversation with John Mihaljevic to find out what exactly Brandon means by “concentrated patience”.

Brandon founded HomeCEU.com and CEU360.com in 2005 and 2013. In 2017 he stepped away from day-to-day operations of the business to focus his attention on capital allocation using the family office structure as a mental model. The model is composed of three pillars: private business, real estate, and publicly traded securities.

The Zurich Project Podcast is on iTunes, Soundcloud, and Stitcher.

A transcript of the conversation is available to members of MOI Global.

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Fundamental Alternative Investments (Bond-like Equity Securities)

January 9, 2019 in Best Ideas 2019, Equities, Letters

This article is authored by MOI Global instructor Keith Smith, Fund Manager of Bonhoeffer Fund, based in New York.

One of the features of alternative assets is little or negative correlation with most investors’ growth engine — equities. One issue with many alternatives is little or no return.

One asset class that provides negative correlations to stocks are bonds. Bonds represent first-lien claims on corporate cash flows associated with corporate assets versus the more subordinated claims of equities. There are certain equity securities that have first-lien claims that provide similar cash flow characteristics as bonds but have upside from either increasing cash flows or distributions, modest levels of leverage, or higher yields than similarly positioned bonds.

Also, given the high valuation of many equity markets today, the appeal of securities that have bond-like cash flows and reasonable to low valuations (i.e., higher and growing yields) is appealing. Some of these firms provide the financing of assets to firms who can deploy their equity capital to better uses elsewhere in their operations.

Examples include triple-net (NNN) leasing of properties for distribution, restaurant, or retail firms and leasing of aircraft to airlines or ships to shipping firms.

Other firms provide specialty lending to highly cash-generative firms who have few bankable assets and are too small to access the syndicated loan or public bond markets. Finally, there are firms that lease equipment that is shared among many users.

Examples include car rental and equipment leasing firms. Although this type of leasing is not a predictable as long-term contracts, other forms of risk mitigation are available via geographic clumping, economies of scale, and the use of technology to efficiently share the assets. A common characteristic among winning firms across all three of the categories of firms is a robust underwriting approach.

In each of these categories there are inexpensive firms. The first example is in the NNN lease real estate space. STORE Capital (NYSE: STOR) provides NNN lease real estate to firms across a large geographic area across the United States and across many retail verticals. This diversity effectively provides the investor with a diversified group of secured bonds that have increasing coupons over time.

There is a privately funded but SEC-reporting competitor call Broadstone Net Lease that sells for less due to resale restrictions (5% discount for five years), has tax deferral of depreciation, and has a more diversified customer base across retail, medical office, and industrial properties.

In each of these cases, these firms provide first-lien financing to the business they finance by owning and leasing the mission-critical real estate that these firms use in operations. Since the value of the lease is typically greater than the underlying property value, the key to analyzing these investments is the credit analysis of the lessor.

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Best Ideas 2019 Preview: Enzo Biochem

January 9, 2019 in Best Ideas 2019, Equities, Ideas

This article is authored by MOI Global instructor Jim Roumell, President of Roumell Asset Management, based in Chevy Chase, Maryland.

Enzo Biochem was founded by Dr. Elazar Rabbani in 1976. Dr. Rabbani, a pioneer in labeling and detection of molecular diagnostics products, is the company’s CEO and Chairman. He is joined by co-founder and President, Barry Weiner. ENZ came to our attention one year ago when the stock was trading at about $12/share. We patiently kept updating our research on the company and when the stock hit the $4 level in the 3rd quarter, we ramped up our efforts.

ENZ owns one of the largest independent non-hospital-based clinical labs on the East Coast of the United States, in an industry dominated by non-hospital-based giants Lab Corp (LH) and Quest Diagnostics (DGX). ENZ’s footprint lies in the attractive tri-state New York area. The company recently expanded into the Mid-Atlantic and New England regions. ENZ operates a full-service clinical laboratory based in Farmingdale, NY, a network of over 30 patient service centers in NY, NJ and CT and a rapid response laboratory in New York City. ENZ has one of the largest clinical lab footprints (inclusive of LH and DGX) in the tri-state New York area.

Overall, Labcorp and Quest’s 7,500 labs represent about 20% of the clinical lab market. There are an estimated additional 7,500 other independent labs representing another 20% of the market. Hospital labs represent about 60% of total market volume.

In addition to its core lab business, ENZ is a diagnostic bioscience company that develops and sells its proprietary technology solutions and platforms to other clinical laboratories, researchers and physicians. These solutions are primarily in molecular diagnostics, which allow clients to analyze biological markers. Additionally, ENZ operates a therapeutics business that has had two drugs successfully complete Phase 2 studies. Lastly, given its 300-plus patent portfolio, ENZ is actively defending its intellectual property assets. In the past several years, the company has won over $100 million in settlements. ENZ has several active suits in progress with the prospect of capturing additional settlement or judgement wins.

ENZ is a classic RAM investment: a cash-rich unlevered company with five shots on goal, i.e., multiple ways to win. To wit, the company’s current market capitalization is roughly $130 million and its balance sheet boasts $53 million in cash. ENZ has been operating at cash-flow breakeven. We expect the company to burn roughly $20 million in 2019 as it takes its new low-cost Ampiprobe platform national.

Clinical Lab Business

As noted above, the clinical lab business is dominated by Lab Corp and Quest. It should be thought of as being, more or less, an outsourced servicing business. Differentiation lies in servicing capabilities, not in the quality of specimen analysis. The dominant players are active consolidators in the space and regularly pay 2x to 3x revenue to acquire smaller labs, e.g., Lab Corp bought Sequenom for 2.9x revenue in 2016 (the latest available transaction with a publicly-disclosed acquisition price). Moreover, ENZ’s geographic footprint lies in a highly dense and desirable area. Thus, it’s take-out value would likely be at a premium to comparables in less dense locations.

Here are links showing LH and DBX’s appetite for acquisitions: one | two

The company’s net cash plus 2.5x 2019 lab clinic revenue of $55 million equates to roughly $190 million versus today’s market cap of about $130 million based on a $2.75/share stock price. In other words, at the least, investors get everything else for free, and more likely are even getting ENZ’s clinical lab business at a meaningful discount to its private market value. The company’s current enterprise value of roughly $77 million equates to only 1.4x 2019 lab revenue. Here’s what’s free: Diagnostic Products, Therapeutics, IP Litigation and the optionality on investing in a Disruptive (vertically-integrated) Diagnostic/Clinical Solutions platform (Ampiprobe).

Diagnostic Products

ENZ generates roughly $30 million annually from the sale of its proprietary testing kits. As stated in the company’s most recent 10Q, “In the course of our research and development activities, we have built a substantial portfolio of intellectual property assets, comprised of 336 issued patents worldwide, and over 151 pending patent applications, along with extensive enabling technologies and platforms.” Recent product revenue declines (now stabilized and expected to grow) were primarily driven by the company’s decision to reduce the number of products it sells. Neither LH or DGX make any mention of possessing patents in their SEC filings.

However, we believe the real value of ENZ’s product diagnostics capabilities lies in its ability to monetize a vertically-integrated platform that can deliver significantly more cost-effective lab testing services in an environment where reimbursement payments are continually under pressure. AmpiProbe is the brand name of the company’s newer molecular diagnostics platform. It’s estimated that about 2% of healthcare spend goes toward diagnostics.

In July 2018 the company announced the validation of three high quality, low cost biomarkers for detecting cancers and their progression, especially in women’s health. In the announcement, ENZ stated, “The global cancer biomarkers market is projected to reach more than $20 billion by 2022, up from $11.5 billion in 2017.” The company went on to say, “These cost effective, high quality primary antibodies function with our full open system workflow and complement Enzo’s strategy of introducing lower cost testing solutions for the clinical laboratory market.”

In October 2017, New York state Department of Health approved ENZ’s new women’s health infectious disease panel, which can test for up to 13 different infections from one single swab sample.

Nonetheless, on a standalone basis, product businesses like ENZ’s (based on real internally built IP) would typically fetch somewhere over 2x revenue. For example, Fluidigm Inc. (FLDM), Harvard Bioscience (HBIO), and Nanostring Tech (NSTG) are all currently valued between 2x and 4x EV/Revenue. All three companies have high SG&A and R&D costs and, as a result, have poor operating margins and cash flow.

Therapeutics

ENZ Therapeutics focuses on the creation and development of commercial drugs. It currently has eight drugs in its pipeline that are in various stages of development from Discovery to Phase II. These products are intended to treat gastrointestinal, infectious, ophthalmic, and other diseases. This unit does not currently generate revenue. We believe ENZ will look to monetize this unit in the near-future. Management has indicated that it has no intention to pour money into financing Phase III studies. Our research indicates the value of this business unit is roughly $30 to $40 million.

IP Litigation

During fiscal years 2011 to 2016, ENZ netted (after legal costs) $67 million from legal settlements and licensing revenue. In May 2016, the company announced that it had settled with Thermo Fisher Scientific on two patent infringement lawsuits for $35 million. In January of 2016, the company announced a $9 million settlement with Agilent. A $21 million settlement with Illumnia, a $10 million settlement with Affymetrix and a $9.5 million settlement with Siemans were awarded in 2015. Consider the fact that ENZ has already collected its current EV in gross litigation settlements/royalty payments. The current round of litigation (unlike the first rounds), occur with some tailwinds, i.e. settlements underscoring the fact that the company’s IP has real value. Certainly, the IP litigation results, effectively a measurement of some fraction of the company’s IP, make clear that the company’s IP is worth more than the settlements.

ENZ continues to pursue an active campaign to defend its legitimate IP asset base with cases now pending against Hologic, Becton Dickenson, Abbott and Roche. Moreover, this potential value-creating option is more than a pie-in-the-sky pipe dream given its track record and the nature of the outstanding lawsuits. ENZ has six patent infringement cases outstanding on contingency basis in Delaware overseen by John Desmarais, the same attorney who won prior cases for the company.

Mr. Desmarais is a highly successful plaintiff attorney who can carefully pick and choose the cases he wants to pursue. He was formerly an Assistant U.S. Attorney for the Southern District of New York. He was ranked in Best Lawyers in America 2017 and as New York Patent Lawyer of the Year. Mr. Desmarais’s $1.5 billion win for Alcatel-Lucent against Microsoft resulted in one of the largest plaintiff’s jury verdicts in a patent infringement action. We believe his on-going involvement with ENZ, spread amongst six cases, creates favorable odds that meaningful settlements are on the horizon for the company.

However, ENZ’s “big” litigation cases involve Roche Diagnostics and Hologic. ENZ recently had a major victory when the judge denied Roche’s move to dismiss the case and set a trial date of April 1, 2019. Pre-trial motions are set for this month. What makes this case particularly noteworthy is that it involves both patent and contract breaches. Unlike its six Delaware cases, ENZ is financing the Roche litigation and consequently will be entitled to 100% of any settlement proceeds. The potential litigation settlement awards could well be in the hundreds of millions of dollars. However, such figures are highly speculative and thus we place a present value of a modest $50 million in total net IP litigation awards.

Disruptive, Vertically Integrated, Diagnostics/Clinical Services Platform

The real long-term optionality for ENZ’s lies in its vertically-integrated platform of cutting-edge diagnostic kits with an open-architecture for analyzing specimens that delivers a significantly more cost-effective solution to the marketplace. In fact, ENZ believes that its emerging platform provides 30% – 50% savings to the current molecular diagnostics industry. ENZ offers solutions across the entire diagnostic workflow: patient sample, sample collection, sample processing, analytical detection to clinical results. The company believes that it can leverage its own platform to provide outsourced diagnostic processing for those labs in the country that are less cost-efficient. ENZ is unique in combining diagnostic product development capabilities with a service platform. We agree with the company that this structure will enable them to be a low-cost provider.

There is nascent, but growing, evidence that ENZ is well-positioned to be a potential disrupter. It is signing up big insurers and recently announced being named an In-Network Provider to the fourth largest national insurer in the country. Further, the company is beginning to win clients from customers as far away as AZ and CA who are saving money even after shipping specimens overnight to ENZ’s primary lab in Farmingdale, NY. The company believes that even after further reimbursement erosion it will maintain healthy gross margins, estimated widely to be 35% – 55% versus the industry average of 30%. To wit, per the company, “Enzo’s integrated structure overcomes cost of goods layering thereby producing affordable products and services needed to combat increasing reimbursement pressures.” For instance, Mr. Weiner walked us through an example wherein their Hep-C diagnostic test/service can be done at a significantly lower cost than Roche.

We believe ENZ’s team is energized and excited about its future. We recently sat down with management and believe they possess a clear vision and are on the cusp of leveraging ENZ’s significant IP assets while also being committed to controlling costs along the way. SG&A expenses have dropped from 47% of sales in 2013 to 41% in 2017. Messrs. Rabbani and Weiner have been together for nearly 40 years and own roughly 7% of the company. To be clear, ENZ as a potential industry disrupter is a very interesting option, but by no means guaranteed. What we find so attractive in our investment is that we don’t believe we’re paying a dime for that option or the other ones described above. One way or another, we believe ENZ’s moment is about to arrive.

Sum of the Parts (SOTP)

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Disclosure: The specific security identified and described does not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that investments in the security identified and discussed was or will be profitable.

Why Listen to Someone’s “Best Idea” Pitch?

January 9, 2019 in Idea Generation, John's Blog

A member emailed me a few days ago, voicing a concern:

“MOI Global provides a great avenue to meet/discuss with like-minded investors and I thank you for that. My only caveat is with regards to the online conferences… I am still trying to figure out why would anyone pitch their best ideas (especially if they are small and micro caps) as it would bid up the price of an asset that they would/should want to purchase more of? The only way that would make sense is if they were looking to exit the investment. This is somewhat concerning and I was wondering if this is something that has crossed your mind. There may be an inherent conflict of interest.”

It’s a good question. I’m not sure there is an answer, but I’d like to share a few observations.

First, I believe people generally overestimate the likelihood that sharing an idea will have a material market impact. Every quarter, some of the world’s best investors reveal their holdings in a 13F-HR filing with the SEC. The fact that this is done with a 45-day delay does not negate the fact that prices do not seem materially impacted by the disclosures. Even a revelation of a new holding by Berkshire Hathaway does not typically cause a spike in the related stock price. Similarly, when well-known activists with long records of outperformance share their research, they typically do so with little, if any, immediate market impact. It does take considerably less to move a micro-cap stock. Still, many small companies have been known in value circles for years, yet their prices remain at wide perceived discounts to intrinsic value.

Second, quite a few investors, particularly in the MOI Global community, are genuinely motivated by a desire to learn and test their investment theses by soliciting opposing viewpoints. Presenting at an MOI Global online conference — or at many other conferences — provides an opportunity to engage with like-minded investors who may have new information, insights, or thought-provoking questions.

Third, it is hard to find an investment manager who does not appreciate greater interest in his or her investment firm. A well-researched presentation serves as somewhat of a “business card”, a way of introducing the manager to potential clients in a favorable light. The manager does not come across as asking for money but rather as a thought leader. While we discourage marketing pitches, a manager is absolutely welcome to highlight his or her background and investment philosophy to set the stage for the idea about to be presented.

Fourth, different instructors will have different motivations. While it’s impossible to gauge those motivations with confidence, the listener can set some (dis-)qualifying parameters. For example, I tend to be less interested in ideas that have tripled in price in the past year than in ideas that are down 50%. This is not only because, philosophically, I get more excited about beaten-down opportunities. Of greater significance for the issue at hand, it seems more likely that an instructor sitting on a triple may have a less-than-sincere motivation than an instructor whose idea has been cut in half — or do you know someone who likes to advertise a losing position in the hope of exiting it a few percentage points higher?

Fifth, MOI Global online conferences are in their seventh year at the time of this writing, with four distinct events per year — the Best Ideas conference (January), Asian Investing Summit (April), Wide-Moat Investing Summit (June), and European Investing Summit (October). Numerous instructors have presented more than once. As past sessions are archived and accessible to members, it is possible to review each instructor’s “track record”. Such a review is unscientific as the sample size for each instructor is small, but clues are available to those willing to dig deeper. Often, the most value-added instructors are long-term investors who are open-minded about their process and ideas. Once they have built a full position in a security, they are quite willing to share their research and engage with fellow members of the community.

It’s always good to maintain a healthy dose of skepticism, and it’s imperative to do your own work. Taking these assumptions as given, I believe one can learn quite a lot from many of the presentations at MOI Global online conferences. In the past, sessions have offered differentiated industry insights, dissected misunderstood business models, profiled exceptional owner-operators, identified great businesses deserving of “watchlist” status, and highlighted compelling and timely ideas.

Attend Best Ideas 2019

David Barr on Value Investing and the Business of Investing

January 8, 2019 in Podcast, The Zurich Project, The Zurich Project Podcast, Transcripts

In an episode of The Zurich Project Podcast, presented by MOI Global, David Barr talks about his value investing philosophy and the business of managing an investment firm.

The Zurich Project Podcast is on iTunes, Soundcloud, and Stitcher.

A transcript of the conversation is available to members of MOI Global.

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Best Ideas 2019 Preview: PDF Solutions

January 8, 2019 in Best Ideas 2019, Equities, Ideas

This article is authored by MOI Global instructor John Barr, Portfolio Manager at Needham Funds, based in New York.

PDF Solutions (PDFS) is a semiconductor data analytics company emerging from a period of investment in new products. It supplies software and other services to improve manufacturing yield for semiconductor manufacturing companies.

PDFS has a market cap of $275 million, about $100 million of cash and annual revenue of near $100 million. PDF’s SaaS offering for big data analytics, Exensio, has about $40 million of annual revenue and is growing 30% year over year.

Its solution for next generation chip inspection and control, Design-for-Inspection, is in use at a leading semiconductor manufacturing company.

At $200 million of revenue, PDF could earn $1.50 to $2.00 per share, which could result in a $20 to $30 stock price. Of course, there is risk in these new products and revenue, earnings and stock price appreciation may not happen.

Downside Protection

PDF has cash of $3 per share and $50-60 million of yield ramp royalties expected over the next few years, which could be worth another $1.50 to $1.80 per share.

Exensio could be valued at 3-5x revenues, or $3.50-$6.00 per share. These elements total $8-11 per share. Should PDF’s lead Design-for-Inspection customer not come to terms on a next order, this part of the business might not have much value in the short-term.

VIEX Capital Advisors recently disclosed a 6% stake in PDF. Should PDF fail to execute, VIEX might push for sale of the company or structural changes.

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Portfolio holdings subject to change. Needham Funds’ ownership as percentage of net assets in PDFS as of 9/30/18: NEEGX: 5.02%; NEAGX: 5.97%; NESGX: 5.02%. The information presented in this commentary is not intended as personalized investment advice and does not constitute a recommendation to buy or sell a particular security or other investments. This commentary is not an offer of the Needham Growth Fund, the Needham Aggressive Growth Fund and the Needham Small Cap Growth Fund. Shares are sold only through the currently effective prospectus, which must precede or accompany this report. Please read the prospectus or summary prospectus and consider the investment objectives, risks, and charges and expenses of the Funds carefully before you invest. The prospectus and summary prospectus contain this and other information about the Funds and can be obtained on our website, www.needhamfunds.com. Investment returns and principal value will fluctuate, and when redeemed, shares may be worth more or less than their original cost. Past performance does not guarantee future results and current performance may be higher or lower than these results. Performance current to the most recent month-end may be obtained by calling our transfer agent at 1-800-625-7071. Total return figures include reinvestment of all dividends and capital gains. Short sales present the risk that the price of the security sold short will increase in value between the time of the short sale and the time the Fund must purchase the security to return it to the lender. The Fund may not be able to close a short position at a favorable price or time and the loss of value on a short sale is potentially unlimited. All three of the Needham Funds have substantial exposure to small and micro capitalized companies. Funds holding smaller capitalized companies are subject to greater price fluctuation than those of larger companies. Needham & Company, LLC, member FINRA/SIPC, is the distributor of The Needham Funds, Inc.

Best Ideas 2019 Preview: Despegar

January 8, 2019 in Best Ideas 2019, Equities, Ideas

This article is authored by MOI Global instructor Samir Mohamed, a collaborative value investor at a family office in Cyprus.

As the market capitalizations of Airbnb and Booking show, having a strong position in the online travel market pays off. By having a large inventory of accommodations and a large user base these companies benefit from strong network effects on a regional level: If you want to book an accommodation in a city you will likely want to check out the largest online travel agents for that city. This gives you most options at the lowest price.

The same is true for other travel services like flights or rental cars. If you are travelling in the US or Europe Airbnb and Booking often have the best options for accommodations. If you are travelling in Latin America though, the online travel agent with the largest and broadest inventory of service providers in many countries is a company called Despegar.

Despegar was founded in 1999 in Argentina as an online travel agent for flights. It expanded across Latin America and into accommodations and other travel services for consumers. Unlike with travel meta search engines like Trivago, Kayak or Google Flights, you can directly book flights and all other travel services with Despegar; i.e. you will not get forwarded to the website of the travel service provider for booking.

The company had sales of 524 Mio. USD in 2017 at a 13.6% EBIT margin with more than 70% of sales in Argentina and Brazil. Its share of the online travel market in Latin America in 2017 was 12.5% and increased further in 2018. It went public in September 2017 and lost more than 50% of its market capitalization since then due to its association with Latin America and its macroeconomic risks.

According to Euromonitor the Latin American travel market had a size of 99 billion USD in 2017 of which 36% was booked online compared to 56% in the US and 54% in Western Europe. Travel suppliers like airlines and hotels are more fragmented in Latin America than in the US favoring online travel agents as they help consumers to find the best offer among many suppliers. Based on search brand recognition the strongest brands in Latin America after Despegar are Booking, Trivago (a meta search engine for hotels), CVC (a strong regional player in Brazil) and Airbnb.

In addition, there are many smaller local online travel agents. This gives Despegar the opportunity to consolidate the market either through acquisitions using its strong balance sheet or by taking market share from weaker players. Current macroeconomic difficulties in Argentina and Brazil have led to a shrinking travel market in the second half of 2018 and might accelerate the consolidation of players.

The company has several strong competitive moats which can be described in a structure that Pat Dorsey introduced in his book “The little book that builds wealth…”:

1. Intangible assets: Brand – about half of user traffic is direct (comparable to Booking’s global direct traffic rate), so there are no acquisition costs via Google or Facebook for this traffic.

2. Increasing switching costs for users:

  •  A shift to the mobile app (35% of transactions in 3Q 2018) increases user engagement compared to web-site usage with PCs.
  • Despegar offers consumers to pay via installments through a broad network of banking partners in many countries. This option was used in 55% of transactions in 2017 and is a differentiator for the company.
  • A broad product offering including flights, accommodations, rental cars, bus tickets, experiences, cruises, package deals, etc. which can be booked directly with Despegar. Booking flights is not possible with Airbnb or Booking in Latin America.
  • A loyalty program is scheduled to launch in 2019.

3. Network effects: As a two-sided network with the largest user base on the one side and the largest inventory of travel suppliers on the other side Despegar benefits from increasing network effects as the company is gaining market share.

4. Economies of scale:

  • Volume discounts with travel suppliers, especially airlines.
  • Operating leverage – almost half of operating expenses were fixed costs in 2017.

Despegar has multiple growth drivers in two categories:

1. Increasing the number of customers:

  • A growing middle class in Latin America drives travel spending.
  • Increasing access to credit cards enables online transactions.
  • An increasing share of online travel bookings in the total travel market
  • Strong moats, especially network effects, lead to further market share gains.

2. Increasing the average revenue per customer:

  • The shift from PC to the mobile app increases user engagement and facilitates on-travel sales, e.g. for experiences or bus tickets.
  • More user data from the mobile app allows very targeted marketing and better conversion.
  • Broadening the product offering and package deals (e.g. flights and accommodations) increase the share of wallet.
  • The loyalty program (from 2019) encourages repeat purchases.

Valuing the company is challenging: It is a high growth compounder that has not reached scale yet in all its businesses and short-term forecasts can be obsoleted by macroeconomic factors like the devaluation of local currencies. Looking at a 6-10-year time frame, though, it is likely that the company will reach scale and macroeconomic volatility will have less influence on longer-term business results.

In a conservative forecast assuming average historic growth in number of customers of 11.3% and no growth in revenue per customer Despegar would have an EV/EBIT ratio in 2025 of about 3 at the current share price.

Customers often pay Despegar a few months before a holiday trip while the company pays its travel service providers like hotels after the trip. This attractive cash flow cycle leads to negative capital employed; i.e. the company is effectively financed by its customers and travel suppliers. Therefore, the company does not need additional capital for future growth.

By far the biggest risk is the spread of the currency and debt crisis from Argentina to other Latin American countries, especially Brazil. In addition to the decline of local currencies the company’s business would be affected by a significant decline of consumer spending on travel. A second risk is a global recession that could increase risk aversion towards emerging markets, weaken local currencies and create problems with debt issuing for governments and companies.

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Finding Value Through Portfolio Rationalization

January 8, 2019 in Best Ideas 2019, Diary, Equities, Portfolio Management

This article is authored by MOI Global instructor Kevin Cope, Chief Investment Officer of Hutchinson Capital Management, based in San Francisco.

Success in finding suitable investments has always required a blend of analytical skill, intuition, and good data sourcing. Under the heading ‘data sourcing,’ I have had to add data filtering. Hardly a day goes by that I don’t receive a solicitation from a data vendor claiming to have the golden ticket to my future investment edge. Much of these new data are so fascinating that they form deceptive traps of distraction. However, ‘new and unique’ does not assure investment merit.

The nuisance of noise heightens my appreciation of John Mihaljevic’s keenly insightful The Manual of Ideas. As a subscriber, I benefit from the unique insights of the many contributors; as a contributor at the upcoming MOI Best Ideas Conference 2019, I face the exciting challenge of sharing insights that I hope others will find helpful in their own pursuits.

Value investors have not had an easy go of it recently. The distorted economic and market cycles have persisted so long that even some of the most seasoned value investors are whispering those four most dangerous words. These despondent views resemble those of Benjamin Graham in 1927, a time when Graham lamented the loss of discipline and analytical rigor. The Roaring ‘20s period was filled with investor zeal over a “New Era” of investing, one for which value investors were said to be ill-equipped. Mr. Graham disparaged the fact that investors had to apply methods of pseudo-analysis to support the delusions necessary to justify the persistence of imaginary values.

Many of us saw this firsthand during the (last) tech bubble. Twenty years ago, value investing was declared dead. The media trumpeted that Warren Buffett just didn’t get it. His style of investing was ill-equipped to understand the “New Economy.” Value investors today are grappling with significant distortions and disruption. It has gone on for so long now that it’s understandable for some to believe that ‘it’s different this time.’

As hard as it has been to remain patient and disciplined during this cycle, I continue to apply a consistent process that has worked for me during other difficult periods. Many of the statistically-cheap companies we have analyzed have become cheap because they face a disruptive challenge to their business models. I have learned the hard way not to be dismissive of such threats. Even mature industries with stable cash flows can be at risk from technological change; threats that are not always straightforward.

While I remain consistent in the way I estimate intrinsic value, I have tried to adapt to changes in the economy’s competitive landscape. Simply stated, I have become less patient with companies unable or unwilling to proactively deal with disruptive threats. For our existing holdings, where management is being proactive, I have grown more patient—giving them a slightly longer runway.

I approach the valuation function more as a business analyst than an accountant. Value is created by either increasing the after-tax earnings of all assets deployed or maintaining margins and earnings power while shrinking the asset base. The cornerstone of my valuation process is deriving and evaluating cash economic profit. Equally important is the durability or sustainability of the company’s economic profit margins. Much of this is determined by the company’s competitive position within its industry.

When evaluating value creation, I focus on three primary drivers:

1. Operating Efficiency: Increase NOPAT without increasing invested capital

2. Profitable Growth: Invest only in projects expected to generate returns exceeding the cost of capital

3. Asset Rationalization: Whenever practical, liquidate assets generating returns below the cost of capital

I set out to purchase companies that are committing increasing amounts of capital to high-return businesses while avoiding those that are pouring capital into low-return ventures. In this way, I don’t think about growth and value in discreet terms. I attempt to buy enterprises generating profitable growth in economic profits at prices sufficiently discounting the market’s uncertainty. The difficulty is always in pricing growth. Trying to consistently forecast future growth is fraught with hazards. As a sanity check, I find it useful to reverse-engineer the process. Looking at the current market price and evaluating the embedded expectations is a sensible process to me. It is made easier by focusing on the capital intensity of the business. In this way, I gather meaningful information content from management’s capital allocation decisions. How a company deploys its free cash flow tends to be a long duration decision, framed by competitive factors, and therefore more relevant to my process.

By focusing on capital intensity, I find value in growth but also in rationalization (e.g., shedding low-return assets). In the current market environment, I have to be more patient with the companies that are growing value by shrinking their footprint. Paying the right price for growth depends upon several factors:

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The Chinese Consumer Is a Bargain

January 8, 2019 in Best Ideas 2019, Equities, Ideas

This article is authored by MOI Global instructor Scott Phillips, Portfolio Manager at Templeton & Phillips Capital Management, based in Chattanooga, Tennessee.

In the midst of the market’s anxiety surrounding Fed policy and trade disputes, we have become impressed by the relative bargains available surrounding the Chinese consumer. In our view, the Chinese consumer remains one of the more compelling investment opportunities over at least the next ten years (if not longer).

Regardless of the correction in global share prices, consumer behavior in both the U.S. and China shows little evidence of the pessimism that is dominating investor psyche. On this matter some simple data helps illustrate that the dispute has not advanced to the point that it is materially damaging China’s exports to the U.S., and for that matter, draws into question the extent to which that outcome is probable. To begin, China’s net exports only account for 2% of its GDP.

Additionally, only 19% of China’s exports are destined for the U.S. In other words, a more dispassionate view of these numbers suggests to us that the Chinese economy may eventually be affected by the threatened 25% tariffs, but perhaps not to the extent that some investors fear.

In the meantime, the Chinese consumer has demonstrated some slowing effect from earlier 2018 related to the government’s self-imposed deleveraging efforts (including shadow banking). However, the Chinese consumer is still producing retail sales growth in the 8% range, or approximately twice its U.S. counterpart. For evidence, October U.S. retail sales increased 4.6% year-over-year followed by 4.2% in November, and Chinese retail sales rose 8.6% and 8.1% in the same months, respectively. Despite any policy effects, secular growth trends related to the consumer appear to remain intact.

For instance, Alibaba’s “Singles Day” (i.e., similar to Cyber Monday) set a new record for Gross Merchandise Volume at $31 billion, representing 27% growth from last year. Despite the relatively solid results, shares among leading consumer enterprises tapping into secular growth have come under pressure alongside the broader markets. Importantly, this has led to valuation discounts that are attractive by historical measures, as well as versus global peers, whom we believe often carry considerably less growth potential and more financial leverage.

In the table below, we illustrate the data among a selection of leading Chinese consumer firms spanning a number of industries including technology, e-commerce, restaurant franchises, express delivery, online travel booking, and packaged food.

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Is Joint Chiropractic a “Punch Card” Investment?

January 7, 2019 in Best Ideas 2019, Equities, Ideas

This article is authored by MOI Global instructor Edward Chang, Portfolio Manager at Pledge Capital, based in New York.

JYNT, a franchisor of chiropractic clinics in the United States, is a particularly compelling investment opportunity. I fell in love with the franchisor business model, when covering them on the sell-side. As Warren Buffet put it – “the best business is a royalty on the growth of others, requiring little capital itself.” JYNT is a stand-out among the franchisors, because it is on pace to clock three years of 20%+ system-wide same store sales growth. This is an incredibly rare feat, and, in my opinion, a reflection of the chain’s strong customer value proposition.

I personally experienced the benefit of visiting a chiropractor. For about a year in high school, I suffered from chronic lower back pain as a year-round runner. Since my family is strongly opposed to pain medications, I went to see a chiropractor. She explained that my lower back pain was caused by the pressure long distance running had put on my body. Since one of my legs was slightly longer than the other, one side was under consistent physical stress. One side of my lower back was stepping into help, and this was causing my lower back pain. But the issue was addressable. Every week, her manipulations helped alleviate my pain and her strength training recommendations ultimately eliminated my pain.

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