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Why a Risk-Averse Value Investor Believes Today Is the Most Important Time in Our Investment Lives

January 7, 2018 in Best Ideas 2018 Featured, Best Ideas Conference, Letters

This article is authored by MOI Global instructor Bogumil Baranowski, partner and co-founder of Sicart Associates, a New York City-based boutique investment firm. Bogumil is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

My deep-rooted risk aversion

As early as my first job interview in the investment field, I was focused on avoiding risk. In that encounter I wasn’t very curious about my future boss’s all-time best investments; I wanted to know about the decisions he had made before the biggest market crashes. I figured if I could know how to avoid losing it all, I would do just fine.

I don’t know whether my risk aversion was hardwired into my DNA or developed while I grew up with raging hyperinflation in early 1990s Poland. Or maybe I soaked up my grandma’s almost instinctual financial acumen, formed by the harsh days of the Great Depression and wartime shortages. My natural predisposition was further strengthened by Benjamin Graham’s and Warren Buffett’s school of thought.

Above all, they taught me to never lose money!

This deep-rooted risk aversion comes in handy in the career I chose. And in this extraordinary period for investors — potentially the most important time of our investment lives – I believe it will be essential.

Challenges of wealth preservation

Eastern Europe, where I grew up, experienced many brief, exciting periods of wealth creation. It was also influenced by a very mixed record of wealth preservation. If countless wars, loss of independence, and partitions among major powers didn’t destroy individual wealth, then the communist regime made it disappear.

That may be why, as an avid student of history, I have always been fascinated by families that have managed to increase and preserve their wealth through multiple generations. Their choice of residence often made a big difference; family unity played a key role; but the investments they made during the most important time of their investment lives mattered the most.

Both the deep-rooted risk aversion, and the wisdom of worldly families that successfully preserved wealth through generations help me serve our clients better as an investment advisor.

We can ensure that our wealth is safe under a political and economic regime that is committed to protecting and honoring property rights. We can also maintain and nurture our family unity. However, today it is the choice of investments that will make the biggest difference over the next years, decades, and generations.

The bull market that never crashed

As of late 2017, we have had a bull market that’s lasted as long as 40 years (depending on how you define it). It has coincided with a few unprecedented and unrepeatable economic tailwinds. We have witnessed interest rates come down from double digits to 0%. Meanwhile central banks have used their balance sheets to create an illusion of almost unlimited free money. We’ve seen government deficits expand and public debt balloon, while the consumer borrows continually to maintain the same lifestyle. What’s more we’ve seen short-sighted investors encourage businesses to double down on their leverage for the instant one-time gratification of buybacks and dividends.

The result is an everything bubble. Today, with very few exceptions, assets globally are too expensive: equities, bonds, real estate. They have benefited from an ever-inflating debt bubble with ever cheaper money. Overeager central planners manipulating the cost of money (and distorting the incentive system in a naturally self-correcting capitalistic economy) have created a nightmarish, dead-end situation.

Everyone who is paying attention and has the audacity to think independently sees this clearly. Talking about the situation is difficult, though, and in the face of widespread inertia, complacency, and paralysis, acting on this situation seems almost impossible.

Yet if we were to pick the most important time in our investment lives – this is it.

It’s time to act

Investors have done very well over the last few decades by following the crowd, but today couldn’t be more different. We at Sicart Associates believe that how we invest today will affect our clients’ and our financial well-being more than at any time in financial history with a possible exception of the Great Crash of 1929, when the Dow Jones Industrial Average fell almost 90% between 1929 and 1932.
What are we doing, then?

1/ At Sicart we continuously and diligently review all holdings. Then we gradually sell off the overleveraged, weakest, or riskiest securities, even it means that we part with some of our biggest winners.

2/ We hold a higher-than-usual cash (or equivalent) position. True, the US dollar may not be a great store of value over the next hundred years, but in the near term, $100 is likely to remain $100.

3/ We look into diversifying away from overpriced, overvalued assets through both inverse ETFs (which go up when the specific asset class goes down), and/or precious metal exposure.

A prime example

Leaving aside for now the first two big questions (which stocks to keep, and how much cash to hold), let’s focus on an example of an investment that could help us diversify away from overpriced, overvalued markets.

Among that group, we’d consider inverse US high yield bond ETF products. High yield bonds (aka junk bonds) are among the best-performing assets since the Great Recession and over the last few decades. The yields and the spreads have never been this low, while corporate debt levels haven’t been this high or the quality of the bonds this bad.

We see an extreme, ready to spring back and normalize. Once the rates head up, yields recover, and the historic monetary experiment comes to an end, many junk bond issuers will default on their debt triggering a major sell-off in the high yield bonds.

We always want to know how we can be wrong, though

In this case, it’s easy. If the monetary experiment continues, and central banks expand their mandate, (effectively becoming buyers of last resort), high yield bonds will go up even higher. Steps taken by the Bank of Japan (which has become the largest owner of local ETFs), and the European Central Bank (which became a major holder of corporate bonds) show, though, that we might need to expand our imagination when it comes to how far and how long this global financial wizardry can go.

Remedy for imperfect timing

The only recipe for our imperfect timing is the very foundation of our process – doing everything gradually. We sell winners slowly, we raise cash levels slowly, we buy inverse ETFs at the same slow pace. That way our imperfect timing matters less. We’d rather be somewhat right than completely wrong (i.e. incurring a major permanent loss in all or most of our investments).

Excited about tomorrow

Patient, disciplined, investors trained in the value investing tradition have every reason to believe that before them lies an unprecedented bonanza when all assets will get repriced, and few investors will be around with dry powder ready to put to work. It could be the biggest revival of active investing ever witnessed by our profession. These are the days we patiently await, and they may come sooner than many expect.

We only need to ensure that we are making the right decisions in the most important period of our investment life.

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The opinions contained herein are those of Sicart Associates and are not intended to constitute investment advice and are based on information generally available to the public as of the date hereof from sources believed to be reliable. Sicart Associates does not represent or warrant as to the accuracy or adequacy of the foregoing information or any other work product or projections based upon such information, and in no event, shall Sicart Associates, its information providers or their respective directors, officers, managers, agents or employees be liable to you or anyone else for any decision made or action taken by you in reliance on such information. Market indices and other benchmarks are included in this presentation only as a context reflecting general market results during the depicted period. The comparison of any performance to a single market index or other benchmark may be inappropriate because it may contain materially different securities and other instruments, and may not be as diversified as the comparative index or other benchmark. The information contained in this presentation may not contain all of the information required in order to evaluate the value of the securities discussed in this presentation. There should be no assumption that any specific securities identified and described in the presentation were or will be profitable. Past performance does not guarantee future profits. This presentation is for general informational purposes only, is not complete and does not constitute advice or a recommendation to enter into or conclude any transaction or buy or sell any security (whether on the terms shown herein or otherwise). No investment should be made in any of the securities discussed herein without reviewing such security’s offering prospectus in order to understand all the risks pertaining to an investment in the security. All investments involve risk, including the risk of total loss. Risks: There are many risks associated with investing in ETFs, and inverse ETFs. We highly recommend reading the literature made available by ETF providers. The potential risks could be: risks associated with the use of derivatives; index performance risk; liquidity risk, market price variance risk; daily compounding risk, credit risk, debt instrument risk, interest rate risk, inverse correlation risk, non-diverse risk, portfolio turnover risk, correlation risk, fixed income and market risk, intraday price performance risk, short sale exposure risk, valuation risk.

How “Quantamental” Combines the Best of Value And Quant Strategies

January 6, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Luis Sanchez, managing partner of Overlook Rock Asset Management. Luis is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

To most investment industry observers, quant investing and value investing stand at odds with each other.

Quant-oriented strategies are known to leverage technology to capture many small spreads before human analysts would have the time to parse through the data. Quant strategies generally employ complex black box models that focus on short term inefficiencies with less reliance on company fundamentals.

On the other hand, traditional value investors employ bottom-up security analysis to find opportunities in companies that may be under-valued over a longer time horizon but may have financials that look ugly or appear to be over-valued. Value investors take pride in their deep insight into companies and are often uncomfortable with the notion of trusting computer algorithms to invest without the need to understand a business model or whether a management team is trustworthy.

Despite some level of mutual skepticism, there are plenty of examples which indicate that both styles can sustainably beat the market. Quant investing works because it is empirically tested and employs a uniform process to exploit inefficiencies. Value investing works because after careful study, analysts can identify businesses that are under-valued and gain an information edge or a behavioral edge over a longer time horizon (“time arbitrage”).

Both styles of investing come with limitations and drawbacks.

Quant strategies are most often designed to go after shorter-term opportunities and are therefore not tax-efficient. Quant strategies often rely on better access to data; not only does data become an expensive arms race, but strategies often see their edge erode over time as other firms gain access to data or figure out how to exploit it.

Although bottom-up value managers roughly employ a similar process for each investment, the research process can vary quite a bit from idea to idea which provides managers wiggle room to make exceptions and potentially opens the door to make mistakes. Fundamental investors sometimes fall into the same behavioral traps that they are trying to exploit, for example, by selling when an investment feels too uncomfortable (even if the valuation justifies holding) or over-paying for a company that investors they respect are buying. It is not uncommon for fundamental investors become enamored of a company and feel a need to act on it (buy) as a result of the copious amount of research committed so far. It is very difficult for even the most disciplined investors to consistently avoid all behavioral biases.

At Overlook Rock, we believe there is a huge opportunity to combine the best of both worlds – both quantitative and traditional value techniques. We employ a “quantamental” approach which seeks to leverage quantitative techniques to invest in a fundamental, value-oriented strategy that emphasizes fundamentals reflective of attractive opportunities.

By employing a fundamentals-driven quantitative process with human oversight, investors can eliminate behavioral biases in an investment process. Furthermore, quantitative techniques can streamline the investment process by more effectively screening the universe for promising investments at a faster pace than possible by human analysts. Technology can empower talented analysts to focus on ways they can add value to an investment process and let computers handle repetitive tasks.

Value investing principles are tried and tested to work. Quants investing with straightforward value models over longer horizons do not have to worry as much about their signals losing effectiveness. And as long as investors are willing to have a longer time horizon, they can benefit from a more tax-efficient return stream.

Essentially, we are asking the question ‘can we combine the best of what humans and computers have to offer and avoid the worst of each?’ We respond with an emphatic yes. Although a system combining human and quantitative inputs must be carefully designed, it has proven to work in several fields (chess, fraud detection, semi-autonomous driving, to name a few).

While there will always be a place for pure quant and traditional bottom-up investing, a new category blurring the lines between the two will increasingly play a role in the public markets. Quantamental investors today can earn excess returns pioneering this emerging category

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Selected Investment Ideas in Eastern Europe

January 6, 2018 in Best Ideas Conference, Ideas, Letters

This article is authored by MOI Global instructor Steve Gorelik, fund manager of Firebird’s U.S. Value Fund and the firm’s Eastern Europe and Russia Funds. Steve is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

One of the first questions an astute prospective investor in Firebird usually asks is, “What differentiates your firm’s investment approach”? Since our firm has been around for over 23 years, the answer usually boils down to “experience,” but the bigger meaning of that answer has evolved over time.

Firebird started investing in Eastern Europe in 1994 with investments in Russian voucher privatizations. The goal was to take advantage of an extreme valuation gap between the real value of the Russian economy and the price put on it in voucher auctions – $9 billion for 1/6 of earth’s land surface was comparable with the amount paid by the Dutch to the natives for the Manhattan Island.

While our initial success can be attributed to that extraordinary opportunity, the fact that our initial investors have made over 49x their money has a lot to do with how Firebird’s thinking has evolved over the years. Our initial investments were primarily asset-based and satisfied Jim Tisch’s “$5 million test.” The firm focused on world-class resources available for pennies on the dollar because they were either unknown, misunderstood, or both. The exciting part was watching these businesses and management teams evolve, and ideas that are key to long-term success take hold. The companies in our region only started learning about capitalism twenty-five years ago. The fact that it took a while to internalize the benefits of reasonable capital allocations and proper minority rights protection is one of the most overlooked positive changes to the regional investment environment.

Macroeconomic analysis remains a crucial pillar of our investment process, but improvements to corporate decision making and reporting allowed us to apply what we call “incentive-based investing.” Most companies that are cheap are trading at low multiples for a reason. Market participants have pre-conceived notions about an aspect of the business that makes current profitability unsustainable or suspect. We dig deep into these situations to try to understand incentives of key stakeholders involved, and whether market concerns are justified.

One example of a company we like is Sberbank (SBER LI. Sberbank is by far the largest bank in Russia, with 46% market share of retail deposits. It is the inheritor of the Soviet banking monopoly, with over 300,000 employees and the largest branch network in the country. The perception against the company has always been that due to its size and importance to the overall economy it would be called upon to make bad loans to uneconomic projects, jeopardizing the bank’s balance sheet. However, the reverse seems to be true. While other Russian state-owned banks (VTB, VEB) are routinely saddled with inherently bad loans, SBER’s “obligations” are minimal.

The Russian leadership clearly understands that its credibility would be shaken if an institution holding the deposits of almost every “babushka” suddenly went under. With nearly half of the domestic deposits and a balance sheet equal to 30% of the Russian economy, Sberbank is too big to fail. The bank routinely generates ROE in the range of 20% to 25%, grows loans at about 5 to 15% per annum, and trades at 1.5x BV. A bank making similar returns in the west would be trading at double the price.

Another company that we like is GazpromNeft (GAZ LI), a 95% owned subsidiary of Gazprom. Gazpromneft was acquired by the mother company in 2005 with the idea of creating a subsidiary to develop its significant oil reserves. After the acquisition, a small free float remained, listed in Moscow and London. Owing to its small free float, Gazpromneft is not part of any Russian or EM indices, and is sparingly covered by the sell-side. While Gazprom itself is a byword for poor capital allocation, GAZ seems to be one of the best capital allocators in the oil & gas space. Since 2012, the company was able to grow its production by 44% while spending about 95% of its free cash flow on CapX. By comparison, Exxon spends 75% of its free cash flow on capex, yet its production barely grows. Currently GAZ’s production growth is capped by the OPEC production agreement, but the company has been cutting its least profitable barrels, which makes the restrictions cash flow positive.

We believe that the market is missing the fact that Gazprom depends on its oil subsidiary to generate the cash necessary for its own dividend, which it is pressured to pay to contribute to the Russian state budget. Since most of the money is upstreamed via dividends, we as minority shareholders get to participate alongside the parent. Moreover, GAZ’s independence depends on its superior execution – if the management ran the company as inefficiently as Gazprom’s does, their raison d’etre would disappear and the sub would likely be absorbed. As a result, we own a high-quality business with young upstream assets, and a profitable downstream business driven by highly complex refineries, that is valued at just 4x EV/EBITDA and a 7% dividend yield.

Outside of Russia, an example of a company that we think is misunderstood is Olympic Entertainment Group (OEG1T ET). Olympic is an Estonian listed operator of gambling halls with operations in six different countries, including Latvia, Estonia, and Italy. Olympic differentiates from most of the other offerings as a provider of a high-quality entertainment. With spacious halls, attractive bar areas, and modern slot machines, they offer the type of experience that gives people a reason to spend more time and money in their establishments. As a result, they generate higher gross gaming revenues per machine and higher margins.

Olympic was listed in 2007 and at the time was determined to grow at all costs. The company used IPO proceeds to buy operators in Ukraine, Romania, and Poland. With the 2008 crisis came a moment of reckoning and operations in these countries were shut down, generating significant losses for the company. In the process, the share price went down 90% and the founders, who still own the majority of the company, were forced to sell a portion of their shares at a rock-bottom price to satisfy margin calls. This experience proved profoundly painful for them, and they realized that they needed to bring in professional management and change their capital allocation priorities.

Since 2009, Olympic’s capital allocation framework has changed dramatically. Most of the new investments were made in existing markets where the company already had significant operating experience and enjoyed good government relationships. New markets that were entered, such as Italy, were developed with small incremental investments in a JV format. As a result of these investments, Olympic has been growing revenues and EBITDA at 11% and 17% per annum since 2010. Its ROIC typically ranges between 40% and 60%. Despite the firm’s success, most market participants still view it through the prism of poor decisions made almost ten years ago. This is one of the reasons why we are able to own this high-quality growth stock at 5.5x EV/EBITDA and a 5.5% dividend yield.

About five years ago, we decided to see whether our cash-flows and incentives focused investment approach could be applied outside of our core markets. Because of our experience in Eastern Europe emerging markets, we knew that success in places like India, Brazil, and China would depend on having similar in-depth knowledge of the market as we do in Russia and other countries in the region. Without the relevant experience, we risked being the proverbial “patsy at the table.” Counterintuitively, we thought that the most natural place for us to try our approach was the United States, where credible company imformation is widely available and so knowledge of the local players is less crucial, yet our experience in picking companies based on fundamental attributes should be just as relevant.

We wanted to see if we could build a portfolio of U.S. companies that generate high returns on invested capital and growth, and trade at a low multiple of free cash flow. After an initial screen yielded Apple, Microsoft, Harley Davidson, and other high-quality names, we decided to create a standalone portfolio and have been investing in the U.S. market ever since.

One of the companies we currently own is AMC Entertainment (AMC), the largest owner of movie theaters in North America and Western Europe. 2016 was a year of rapid growth for the company. As a result of three significant acquisitions, financed with debt, AMC’s movie theater base more than doubled. Unfortunately for the company, 2017 turned out to be a weak year at the box office, with a number of titles underperforming their initial projections. Also, the market became concerned with the possibility of studios changing the exclusivity window that currently allows theaters to show movies for up to 90 days before they become available through alternatives. After a couple of disappointing quarters, market sentiment turned firmly negative and AMC shares fell by two thirds.

Because of the proliferation of alternatives like Netflix, Amazon, and others, North American movie theaters are perceived to be in decline. The reality is slightly different. While viewership fluctuates based on the quality of the movie slate, annual visitor numbers have been surprisingly steady, with 2016 North American attendance approximately equal to 1996. At the same time, revenues for movie theater companies have been growing as a result of increases in ticket prices and concession sales. The average ticket price since 1996 has almost doubled, and concession sales have grown at a similar pace. Big chains, such as AMC, are investing in improving the quality of the offering through the installation of recliners, pre-assigned seating, broader concession offerings, and other changes. Despite the increase in prices, a night at the movies remains one of the more affordable family entertainment options.

Shortening of the exclusivity window is possible, yet an in-depth look at the incentives of the players suggests that significant adverse changes are unlikely. The U.S. movie theater industry has been consolidating around three major players (AMC, Regal, and Cinemark) which together represent approximately 50% of available screens nationwide. In addition to controlling half the market, these companies are also cooperating through a number of JVs designed to increase purchasing power. Since the movie theater industry is more concentrated than the studios, negotiating power seems to lie on the side of theaters, and any changes to the exclusivity window are more likely to result in improvements, rather than deterioration, of industry performance. The results of European movie theaters, where the exclusivity window is shorter but EBITDA margin is higher, support this hypothesis.

Thanks to a recent two-thirds drop in market value, AMC is trading at a 30%+ free cash flow yield. Most of the free cash is invested in theater upgrades, which lead to increased revenue per screen and typically generate ROIC’s of 25% or higher. AMC’s acquisitions of Carmike and Odeon, which had not been investing to upgrade their theaters, added a number of properties where improvements should yield returns even better than that.

Both in Eastern Europe and in the U.S., we look for companies with superior cash flow generation and a strong track record of investing capital in high return projects. By concentrating on cash and analyzing a company’s positioning through Porter’s five forces framework, we are finding companies that can consistently generate mid-teens returns without any growth in market multiples. When the market does decide to change its opinion about these companies, the multiple goes up and the value of our companies increases exponentially.

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The Death of (Many) Brands

January 5, 2018 in Best Ideas 2018 Featured, Best Ideas Conference, Featured, Letters

This article is authored by MOI Global instructor Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital, based in Burlingame, California. Sean is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Brands are a key source of value for many companies. But while brands might seem a natural part of the economic order, they are a relatively new invention. 150 years ago, canned food companies learned that by building a trusted brand, consumers would pay a premium price in exchange for avoiding the spoiled food that was common in canned food at the time. Then, in the 1950’s the Mad Men era gave rise to today’s super brands as companies learned they could differentiated themselves via mass brand marketing campaigns as markets became crowded with competitors and consumers found themselves overwhelmed with trying to choose between so many seemingly similar products.

Here’s Marc De Swaan Arons writing in The Atlantic [emphasis mine]:

“There was a time, going back at least 70 years, when all it took to be successful in business was to make a product of good quality. If you offered good coffee, whiskey or beer, people would come to your shop and buy it. And as long as you made sure that your product quality was superior to the competition, you were pretty much set… The shift from simple products to brands has not been sudden or inevitable. You could argue that it grew out of the standardization of quality products for consumers in the middle of the 20th century, which required companies to find a new way to differentiate themselves from their competitors.

In the 1950s, consumer packaged goods companies like Procter and Gamble, General Foods and Unilever developed the discipline of brand management, or marketing as we know it today, when they noticed the quality levels of products being offered by competitors around them improve… As long as the brand was perceived to offer superior value to its competitors, the company offering the brand could charge a little more for its products. If this brand “bonus” was bigger than the cost of building a brand (the additional staff and often advertising costs), the company came out ahead.”

These brands created value by lowering “search costs” for consumers. Search costs are the costs incurred by a prospective buyer in trying to determine what to buy. In the case of a consumer packaged good like canned food, toothpaste, or laundry detergent, the search cost for consumers is the cost of trying to determine the quality of the product and weighing this against price differentials prior to purchase. By eliminating this cost for the consumer, companies with a successful brand were able to charge more for their products, even while providing an improved cost/benefit offering to the consumer. The consumer could pay more for their products, because doing so reduced the search costs they were otherwise incurring.

Companies with a trusted brand could earn excess economic returns so long as the cost of building the brand costs less than the premium consumers were willing to pay for a product due to the brand. Because brands have historically be very durable (notice the global brands that were built in the 1950 are still dominate today), they created an economic moat that caused these companies to generate outstanding returns for shareholders.

Many of the most well known brands in the world are based around reducing search costs. For example the Coke, Gillette, and Yellow Cab brands are assurances of quality and value that reduces the search costs of consumers looking to purchase beverages, razors and transportation.

But what if a new way of reducing search costs is developed? What happens to the value of these brands?

An alternate way to reduce search costs is for the distributor rather than the product manufacturer to play this role. The success of Costco is in large part built on the idea that any product sold in their stores is of high quality and is a good value. Costco leverages their scale to identify high quality, good value products and deliver them to consumers. This process reduces the value of brands and allows Costco customers to confidently buy non-brand products or products with limited brand recognition. In this way, Costco has managed to earn excess economic returns, even while selling the products in their stores at close to cost. Because consumers pay for the privilege to shop at Costco, the Costco membership can be thought of as the company charging directly for lowered search costs and inserting themselves between the consumer and the branded products.

But now the internet allows for the reduction of search costs on a global scale. Products like LaCroix sparkling water, Dollar Shave Club razors, and transportation service delivered via Uber have all exploded onto the scene, draining value from the Coke, Gillette and Yellow Cab brands because in each case, the online distribution of information radically reduced search costs for consumers. They didn’t need to buy these new products themselves to determine quality, instead they could plainly see their friends vouching for them on social media or via reviews on the distributors’ websites or apps. If these products were of low quality or value, this would have been quickly known to any consumer who spent a few minutes reading online reviews or searching their social media streams.

Over the last decade, unit sales of many branded consumer products has slowed considerably. Much commentary attributes this to changing consumer preferences (especially those of Millennials). But we believe something else is at work. Artisanal, local and other products without the backing of legacy brands are succeeding not solely because of new consumer preferences, but because with lower search costs consumers don’t need the Coke, Gillette or Yellow Cab brands to assure them that the products they are buying will be of sufficient quality and value. With search costs heading towards zero, products can succeed simply by providing quality and value, and so brands whose primary value is acting as a guarantee to consumers are quickly losing value.

For investors, this shift in economic value is incredibly dangerous. At Ensemble Capital, we focus on investing in companies with strong economic moats. Traditionally, strong brands have been viewed as classic examples of a moat. Coke, Gillette and Yellow Cab were businesses that you could have high confidence would be able to earn outsize returns on capital because their strong brands allowed them to capture economic value relative to companies selling similar products under less powerful brands.

It is important not to underestimate how powerful search cost brands have been in economic value creation in the past. Over the past 50 years, the top performing sector of the stock market has been consumer staples.

Now, however, the era of search cost brands is coming to an end. The moats are being breached. Over the long term, we do not believe that these types of brands will provide a significant competitive advantage to their owners and the companies will be forced to compete directly on quality and value instead of earning a return for selling reduced search costs.

But as the Yellow Cab brand suggests, search cost brands are not limited to consumer staple products. Why is it that while most people would never accept a ride from a complete stranger, they will happily climb into the back of a car painted yellow with the Yellow Cab brand? Because the Yellow Cab brand signaled to customers that the stranger driving the car would deliver them where they wanted to go at an agreed upon price and without risk of bodily harm.

But now we have Uber and we get this:

Uber cars are non-branded transportation. Uber provides distribution of transportation services, but not the transportation itself. The company has stepped in to provide a search cost brand that they are able to extend to all the non-branded providers of transportation that participate in their network. Uber’s value to customers is the elimination of search costs entirely so that at any given moment, in almost any urban setting, a customer can almost instantly be matched with an independent, non-branded provider of transportation and confidently climb into the back seat of the stranger’s car to be whisked to their destination.

Uber of course provides complex logistics and has developed powerful network effects, both of which are elements of its competitive advantage in addition to its search cost brand. Amazon similarly leverages this trio of advantages. While logistics and network effects are more obvious elements of Amazon’s moat, there is also the fact that many customers will happily buy whatever product has the #1 rank for a particular search so long as it has many customer reviews vouching for its quality and value. Amazon customers don’t need products to carry powerful search cost brands in order to confidently order something. They can just use the fact that the product being displayed has hundreds or thousands of positive reviews as a convincing substitute for a brand they recognize.

Similarly Dollar Shave Club used social media, especially shareable YouTube videos to build a multi-billion dollar company in just a couple of years. The fact they did it by piercing the previously ironclad Gillette brand makes clear that no legacy brand based on reducing search costs is safe. LaCroix sparkling water on the other hand seems more like Mark Zuckerberg’s proverbial “clown car that drove into a gold mine.” The brand has been in business for years, but was popular only in certain areas of the Mid West. But once a certain segment of trend setting customers found out about it, their constant social media posts extolling its virtues caused sales to explode and the product’s manufacturer to see its market cap rise by 5x in just the past two years. LaCroix didn’t succeed by slowly building up brand awareness and value until they were able to obtain shelf space and command a pricing premium that allowed them to profit from their brand. Instead, they made a quality product that delivered value and the search cost destroying power of social media rocketed the product to stardom.

The consumer staples sector and switching cost brands have offered a fertile hunting ground for investors for half a century. Many of the great investors of the past have built strong track records by riding the stocks in this high performing sector, which had the added benefit of offering low volatility resulting in even stronger risk adjust returns.

We believe that investors in these companies are in for a rude awakening. But there are brands that we believe are largely immune to these risk.

While many of the well known consumer brands derive their value by reducing search costs, there is another value proposition that some brands offer. An “identity brand” communicates something about the owner of the product to themselves or the rest of the world. The Ferrari brand for instance isn’t valuable because it reduces search costs. It is valuable because it tells the owner of the car as well as the rest of the world something important about who that person is. Tiffany’s little blue box is similar. While Ferrari and Tiffany brands both speak to quality, they are primarily brands whose role is to signal to the product’s owner and the rest of the world a key element about who that person is.

While high end, luxury brands are some of the most powerful, durable identity brands, there are also brands that speak to the buyers identity in ways that don’t relate to wealth. When my son was in third grade he came home from school one day and asked me if I was a “Nike guy or an Under Armour guy”. On the playground, a group of his friends had debated which one each of them were and he wanted to know what I thought. While neither brand signals to the world that the owner is wealthy,  they both speak to the owners identity. Many car brands are identity brands as well. Would you think differently about your accountant if she drove a Ford Mustang rather than a Volvo? Probably so.

Consumer staple products are items where the consumer wants the product to do a specific, simple job at fair price. Most people don’t have their personal sense of identity tied up in what soda they drink or brand of razor they use. Would you think differently about your accountant if she used Tide rather than All brand detergent? But many consumer products more generally do have issues of identity tied up with the functional role that they play. Many people care a lot about what car they drive, what jewelry or other accessories they wear and carry, what clothes and glasses they wear, what wine they drink, where they eat… the list could go on and on. These brands are about something more than a cost-benefit analysis. These brands provide non-functional, intangible value to the consumer that helps the purchaser more fully express who they are and what they stand for.

We don’t think the internet or social media or the logistical monster that is Amazon are doing anything to reduce the importance that people place on the role that brands play in developing and expressing self-identity. But we do think that these trends are bringing to an end the 70-year run of excess returns earned by companies who built their businesses on the back of search cost brands.

Clients of Ensemble Capital own shares of Costco (COST), Ferrari (RACE), Nike (NKE) and Tiffany & Co (TIF).

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Underwriting Value and Handicapping Returns

January 5, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Douglas Ott, founder and chief investment officer of Andvari Associates, based in Atlanta, Georgia. Doug is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

When someone asks an investment professional what type of investor they are, the quick response is typically “value” or “growth.” In my mind, the classical value investor is someone who looks for businesses trading at low multiples to book value or free cash flows while the classical growth investor is someone who looks for businesses with high current and future rates of growth, often with little regard to valuation multiples. At the beginning of my career, I would have described myself as a value investor because this was the term used by (and to describe) many great investors like Warren Buffett and Ben Graham (Buffett’s mentor). Who wouldn’t want to align themselves with these titans?

However, as the years have gone by, I’ve grown to dislike these simplistic labels. First, I’ve slowly learned that value and growth are one and the same. Second, investors who submit to this false choice of value or growth ultimately limit their opportunities to generate outstanding returns because they might exclude from consideration opportunities that conflict with their chosen identity as value or growth investor.

What is most important to remember is that successful value and growth investors are all attempting to buy shares of a company for less than their estimates of intrinsic value. Thus, until I think of a better way to describe my investing style in a nutshell, I’ll simply call myself an “underwriter of business value” or “handicapper of investment returns.” By adopting a more expansive description of what I do as an investor, I’ve opened myself to a wider variety of opportunities which in turn has led to a portfolio with a very interesting mix of companies and situations.

For example, in the “value” category, we are shareholders of companies with lower than average multiples like hospital operator HCA or cable company Charter Communications (via Liberty Broadband). Some Andvari holdings that might fall into the “growth” category are companies with high multiples like Visa, Constellation Software, and Roper Technologies.

One of Andvari’s latest investments is Keywords Studios plc, a company that provides outsourced services to the world-wide video game industry. It’s line of services includes art creation, audio production, translation and localization, quality assurance testing, engineering, and customer support. Keywords has grown revenues and profits at 55%+ for the past two fiscal years (the organic growth rate has been in the 20s and acquisitions have contributed the rest) and the share price has followed.

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The Phillips Conversations: Karen Linder

January 5, 2018 in Audio, Full Video, The Phillips Conversations, Transcripts

The following interview is part of The Phillips Conversations, hosted by Scott Phillips of Templeton and Phillips Capital Management.

MOI Global has partnered with Templeton Press to bring you this exclusive series of conversations on investing and the legacy of Sir John Templeton, one of the greatest investors of the 20th century.

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About the interviewee:

Karen A. Linder is an American author, artist and businesswoman. In May 2012, she wrote The Women of Berkshire Hathaway, published by John Wiley & Sons. The book examines broad trends of women in corporate America and looks at case studies within Berkshire Hathaway, a company once dominated by men. She notes that although women continue to lag far behind men as CEOs and board members, there has been a marked increase in recent years in the number of female business leaders in the United States. She frequently lectures on the subject of increasing the business leadership roles of women, including programs sponsored by the US Small Business Administration.

The Crowd

January 4, 2018 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Scott Phillips, a principal and portfolio manager at Templeton and Phillips Capital Management. Scott is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

After years of watching value managers lose ground to more popular investment strategies, including passive ETFs, as well as the growth and momentum styles, we believe it seems likely that the overall number of value investors populating the market has ebbed over this time-period. In an industry where the majority of practitioners show a preference to blend-in based on existential considerations this phenomenon should not only be expected, but seen as an ideal source of opportunity for the steadfast bargain hunter. Ironically, the industry-wide pursuit of convention, and the misplaced satisfaction found in rising near-term performance measures eventually coalesces into higher levels of risk.

From our perspective, the circumstances described above, and the opportunities they create exist today. The popularity of ETFs and strategies embracing growth and momentum has in our opinion created a situation where the tail is wagging the dog. Our first observation is that the shares most commonly held among ETFs carry materially higher valuation multiples relative to the market index. To understand the effect of ETFs herding into a rather narrow basket of equities, we looked at the average valuation for the 150 most commonly held stocks among ETFs to learn if these stocks traded at a premium to the rest of the market. Indeed, we found that the top 150 stocks held among ETFs trade at an average P/E of 31.1x compared with 16.7x in the MSCI ACWI Total Return Index for global stocks. Moreover, even when we remove the so-called FAANG stocks, the average only declines to 30.2x.


Source: etfdb.com, Templeton and Phillips Capital Management, LLC.

Our second observation on this phenomenon is joined at the hip with our first observation. We see the second risk component that investors are overlooking as a thinly veiled correlation among the majority of ETFs. Given the rapidly growing number of ETFs in the market, these funds tend to increasingly hold the same set of stocks in common.

Let us take Apple as an example. As you know, Apple is one of the largest tech companies, and to clarify, one that we generally view favorably for a long-term investor. However, by our count, Apple is now held by 155 ETFs. Notably, among these ETFs we find some odd-couple strategies cohabitating Apple that contradict each other. For instance, Apple is held by six value ETFs, five momentum ETFs, and ten growth ETFs. While we can argue that a growth company like Apple can fall out of favor and become a value, the contrast between value and momentum is too stark. We suspect if investors in the Deep Value ETF (DVP) knew they were commingling in a stock with the Powershares Momentum Portfolio (PDP), they might take issue.

This raises the important question, why are these disparate buyers trafficking in the same stocks? The answer we believe is liquidity. ETFs must find highly liquid stocks that make the purchase and redemption of shares-in-kind a fluid process for the ETF manager. This helps explain to us why the Catholic Values ETF (CATH) also owns Apple, even though Apple has historically been linked to child labor in the cobalt mines within its supply chain. We believe CATH, like all other ETFs requires liquid stocks in its portfolio, forcing it to make concessions on its investment mandate and hold stocks that are much like, if not the same as the remainder of its ETF brethren.

We believe when enough ETFs crowd into the same stocks, the ETF investor innocently picks up correlation across their portfolio (which undercuts the benefit of diversification). This erosion can occur irrespective of the ETF’s name, or its purported strategy. Interestingly, these risk-correlation circumstances surrounding ETFs seem mindful of investor complacency leading up to 2008, as it related to CDOs and other debt instruments.

Back then, we believe investors became complacent to underlying risk following years of rising asset prices. At that time, the individual debt positions these instruments held was often mislabeled and increasingly correlated due to the extreme loosening of credit standards across the board. This risk dynamic flourished and spread as investors were either not paying attention to, or did not understand the underlying risk. To be sure, we are not “against” ETFs in principal but rather, we see their popularity creating an unrecognized risk in the market.

Putting it all together, we see potential danger for these investors as we suspect they are unknowingly herding into a rather narrow band of commonly held stocks that appear inflated in price. Most importantly, and above all else, when the market eventually corrects, we also believe that these same stocks most commonly held among ETFs will represent a fertile hunting ground for the most attractive bargains. These factors seem likely to become exaggerated in ETF strategies that necessitate holdings where liquidity in the underlying is insufficient, and pro-rata selling across a basket of securities could create very attractive opportunities on a bottom-up basis. In these special cases it seems possible for bargain hunters to purchase the ETFs themselves at a discount to NAV.

Not surprisingly, for the independent-minded bargain hunter the current opportunity set lies well outside of the ETF thoroughfares. Likewise, when the market eventually declines we believe investors inhabiting names primarily outside of the major ETF holdings possess a better chance to preserve investor capital. In sum, it has most often been the case that market downturns create the proving grounds for value managers as they are tasked with offering the dual service of capital preservation and opportunistic bargain hunting to create future returns. We believe that the only way this is possible to invest differently from the crowd, and this time will be no different.

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This information is for one-on-one client presentation only. Past performance is not indicative of future results. The actual characteristics with respect to any particular client account will vary based on a number of factors including but not limited to: (i) the size of the account; (ii) investment restrictions applicable to the account, if any; and (iii) market exigencies at the time of investment. Templeton & Phillips Capital Management, LLC (“TPCM”) reserves the right to modify its current investment strategies and techniques based on changing market dynamics or client needs. The information provided in this report should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in an account’s portfolio at the time you receive this report or that securities sold have not been repurchased. The securities discussed may not represent an account’s entire portfolio and in the aggregate may represent only a small percentage of an account’s portfolio holdings. It should not be assumed that any of the securities transactions, holdings or sectors discussed were or will prove to be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. Recommendations from the past 12 months are available upon request. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. The comparative benchmark represents past performance and is utilized on the statement solely for comparative purposes and may not be indicative of future results. The MSCI AC (All Country Total Return Index) Index is a free float-adjusted market capitalization weighted index that is designed to measure the equity market performance of developed and emerging markets. The volatility of this index could be materially different from that of the portfolio. The index does not reflect fees and expenses and is not available for direct investment. 1Returns are presented net of investment advisory fees and include the reinvestment of all income. TPCM is a registered investment adviser. Registration does not imply a certain level of skill or training. More information about TPCM including its advisory services and fee schedule can be found in Form ADV Part 2 which is available upon request. LTF-17-11

Overoptimism Tendency

January 3, 2018 in Human Misjudgment Revisited

Demosthenes said, “What a man wishes, that also will he believe.” He was referring to denial and excessive optimism. There are other factors at play too, and they lead to happy people buying lottery tickets. –Charlie Munger

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

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Update

Kahneman is also keenly aware of this issue. He cites overconfidence as “the most damaging” thing, leading “governments to believe that wars are quickly winnable and capital projects will come in on budget despite statistics predicting exactly the opposite. It is the bias he says he would most like to eliminate if he had a magic wand. But it ‘is built so deeply into the structure of the mind that you couldn’t change it without changing many other things.’”[63]

Tetlock’s principles for Superforecasting apply here. One giant exercise in learning to apply confidence when you should have it, and avoid overconfidence the rest of the time. “Aggressive open-mindedness.”[64]

  • Learn to avoid the gambler’s fallacy of detecting nonexistent patterns.
  • Learn to avoid overcompensation for previous mistakes. The false negative of 9/11 à the fall negative of WMD?
  • Learn to analyze from the outside in – what is the base rate?
  • Learn to apply new information (Bayesian updating) appropriately, avoiding under-adjustment (“This is just a blip”) and over-adjustment (“This changes everything!”)
  • Learn to collaborate. Diversity on teams is helpful.
  • “You only win a forecasting tournament,” Tetlock said, “by being decisive—justifiably decisive.”

Another favorite example comes from golf. A study found that on shots that were on line but misjudged for distance, eight times as many shots were short as were long.[65] Players routinely overestimate their own abilities, ignore the overall base rate of the shot and/or assume idea conditions and a perfect swing with a given club when calculating yardages.

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[63] https://www.theguardian.com/books/2015/jul/18/daniel-kahneman-books-interview
[64] http://longnow.org/seminars/02015/nov/23/superforecasting/
[65] https://www.wsj.com/articles/why-golfers-overestimate-their-ability-1494591233

Robotti & Company Annual Meeting Highlights

January 3, 2018 in Best Ideas 2018 Featured, Best Ideas Conference, Curated, Featured, Letters

This article is shared by MOI Global instructor Robert Robotti, the founder, president and chief investment officer of Robotti & Company Advisors, based in New York City. Bob is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

On November 13, 2017 Robotti & Company Advisors, LLC hosted its annual investor meeting at The Yale Club in New York City. The highlights below, delivered by Bob Robotti, have been edited for clarity.

“Thirty four years ago, a handful of us here in the room started a business with the concept that by doing fundamental bottom-up stock research, we could identify companies that would outperform the market. That is what we have done and it has always been the mandate of the business. Now this is a concept that is simple to say, but is not necessarily so easy to achieve. We believe now, as then, opportunities still exist in the marketplace.

By focusing on the longer-term prospects of a business and not just looking at the short-term, immediate outlook, we think we can identify companies that are substantially mispriced and mis-valued by the market. This takes us to places that are not typical, so there is very little-to-no overlap between what we own and what is found in the popular indices.

Of course, we know that over the long-term there will be periods when we will underperform the market. We think an important component of long-term success is the appreciation and realization that during these periods of underperformance you must remain consistent, and stay true to what you understand and the variant view you have developed versus the market.”

Investing in building distribution companies

“One of the things that we do is invest in cyclical businesses. We think that cyclical businesses often provide us with an opportunity to buy when the price per share is significantly less than the normalized earnings power value of the business. Back in 2003-2004, which is where we have to go to understand our housing related investments, we invested in manufactured housing. This was a mistake and didn’t work out in the short-term. Our visits to manufactured housing plants informed us that this is an efficient way to build a home. If you use the same materials that you do on a site built home, the quality ends up better because you have a controlled environment, which includes supervisors making sure the laborers didn’t go out for 3 beers at lunch and forget to install the insulation. Since the quality was better and the cost per square foot was lower we figured manufactured housing was an out of favor industry that would have a revival.

The problem was that in 2005-2006 the federal government stopped buying mortgages for manufactured homes. So a homebuyer could buy a $200k site built home for less money down, with a reverse amortization mortgage leaving them with a lower monthly payment for that site built home than for an $80k manufactured home. This meant a recovery would be significantly forestalled. In 2009, Alan Weber, a long-time colleague of ours said, ‘Go visit Builders FirstSource – a distributor to the homebuilders.’ We first invested in Builders FirstSource back in 2009 estimating that we were paying 2x normalized EBITDA for a business that was not a buggy-whip business – so it wasn’t going away. Yes, it did have significant financial headwinds, so from 2009 to 2011 we looked wrong. The stock traded from $3.40 down to $1.70, so we bought more.

As value investors we often purchase too soon but we continued to have conviction in our investment thesis. The industry had gotten closer to a recovery while the valuation had gotten dramatically cheaper. In the meantime, there was a competitor that was coming out of bankruptcy. By 2010 we had accumulated a 15% position in the equity of that post-bankruptcy because its valuation was a fraction of Builders FirstSource’s and it also had better cash flow characteristics. In 2012 I joined the board of that company and was a director of BMC over the time that sales grew from $650 million to $1.3 billion. The company reverse-merged into a competitor, Stock Building Supply (which interestingly generated roughly the same revenue as BMC but only ½ the EBITDA). That window is an important part of our process – we get involved with our investments, we are shareholders for a long period of time and we become active with the company as friendly, cooperative shareholders which sometimes leads to becoming a director of the company.

The base premise of our investment in this sector is that single family homebuilding is dictated by irrefutable demographic trends. While there are plenty of headwinds that still persist for the business, we think those long-term demographic trends will win out over time. So you have an industry that today will build about 800k single family homes while the 50 year average is between 1.1 – 1.2 million single family homes or 40% – 50% above the current level of activity. For 10 years single family homes built have been significantly below that long-term average. There were definitely too many single family homes built in 2006 and 2007 but those have all been absorbed into the marketplace while inventory continues to come down. So we ask: What is the normalized level of activity in this business? And that is really what we are looking to do – invest in cyclical businesses at low points in the cycle when you can buy the business at a significant discount to its normalized earning power value and then hold the business for a long-period of time.

Of course, what you really have with cyclical businesses is that they often go through a catharsis. The competitive landscape winnows down through industry consolidation. At the same time internal processes improve lowering cost structures. This results in growth of the normalized earning power of the survivors. We believe the long-term mid-cycle earning power of Builders FirstSource, for example, is between $4 and $5 while the stock price is currently in the high teens. So it trades at a single digit P/E multiple of our estimate of the normalized earning power of the business. Demographic numbers continue to grow meaning that a reversion to the historical mean is really a modest expectation.”

Energy

“You shouldn’t believe everything that is written in the newspaper! Articles in the newspaper are written by someone who may have above-average writing skills, but probably doesn’t understand the core tenets of a business. So if you are a journalist and you are writing about the energy business, you end up reporting what people tell you and they usually tell you about what is in the news or what might make a good headline. We think there are huge misunderstandings about what the real dynamics are in the energy industry. I’m referring to conventional energy, though we closely follow renewable energy as well.

An important fact is that natural gas accounts for half of the hydrocarbons produced in the world today. And while natural gas doesn’t grab headlines, the fact is that natural gas is a growing source of energy, it is a bridge fuel and it is less carbon unfriendly. This means that oil is not necessarily the only driver of energy anymore as natural gas consumption grows.

Natural gas also represents a tremendous opportunity for America. North America has a 10 to 20 year oversupply of natural gas which has caused a disconnection between the price of energy in North America and energy prices worldwide. The price of natural gas is roughly $3 per MMBtu in the U.S. and $2 per MMBtu in Canada. This translates to an energy equivalent price of $12 – $18 per barrel of oil. So even at today’s oil prices in North America there is a huge arbitrage opportunity. This is a very important driver and is also extremely positive for the U.S. economy given that energy intensive businesses in North America are competitively advantaged against other energy intensive businesses anywhere in the world. We think these dynamics will continue to play out for at least the next decade.

We also think energy markets will continue to come into balance as oil consumption continues to grow – even though we don’t know what the longer-term future holds. My nephew recently tried to get me to buy an electric car. In fact, I don’t own a car anymore and I primarily use shared vehicles – I am a part of the new millennial economy! These are examples of what is coming and will clearly be an important factor that eventually enter the equation. In the meantime, older wells which represent 1/3 of North American production have been declining at double-digit rates for the past two years. So U.S. onshore shale oil producers are depleting reserves while telling everyone that they are economic at $50. We believe that this is not only false but is also exacerbating the problem. Instead, our contrarian view is that over the next year or two the risk is that we are actually short oil which would lead to a spike in its price.

In our portfolio we own companies’ related to offshore production because the other general perception is that onshore is economic at $50 and therefore offshore is dead – both of which are false. Offshore is not dead. Just like onshore, offshore economics have dramatically and significantly improved as a result of technological advances and cost reductions. We have already seen signs of increased activity although investors don’t seem to be buying into it yet. Over the next year we will see offshore activity continue to pick-up. For now, investors continue paying high prices for uneconomic onshore stocks while shorting the stocks of offshore companies because “offshore is dead.” We believe these investors will be wrong on the long and wrong on the short.”

Are there any risks that keep us up at night?

“There are two risks that everybody seems to be thinking about. The first is that the markets keep hitting new highs every day. Of course, the other is that we all know that the two of us (Bob referring to himself and Isaac Schwartz) are dinosaurs because we pick stocks in a market where passive investing reigns and active management is dead. Of course we don’t believe this and we think this actually creates an opportunity for us. It is true a tremendous amount of capital has flowed out of active strategies and into passive ones where there is no regulator since valuation is irrelevant to this process. As a result, fewer and fewer companies have higher and higher valuations driving higher market levels that are no longer constrained by valuation.

What we do as investors is very different because our philosophy is all based on valuation. Valuation is our real litmus test for whether or not an investment makes sense. Is this a good business? Does it have a good balance sheet? Is there an owner operator? These are all very important questions but only so far as they help determine valuation. We look for companies where the valuation can be understood and appreciated and we can therefore determine whether there is a margin of safety and an opportunity to profit. We believe that the fundamentals of a company is what really drives performance over time which is why it is so important to stick to what you know.

I don’t think there is much risk of a 2008 event, which was a worldwide financial crises where there was really no safe haven and everything was at risk of being worth a lot less. I think what we have now is a valuation issue which causes a lot less concern for us. Yes, there could be an event that is perhaps analogous to 1987 where you had portfolio insurance that was touted as a guaranteed way to make sure you don’t lose money while you get a great rate of return, similar to the way many perceive passive investing today. We believe the markets are laying the groundwork for future opportunity. As more money goes into things without regard to valuation, active managers will have an easier time identifying stocks that really are disconnected from their underlying economic opportunities. That is exactly what we look for as an active manager.”

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The above text is an excerpt of certain comments made by Robert Robotti at the 2017 Annual Meeting of Robotti & Company Advisors, LLC (“Robotti Advisors”) with respect to its separately managed account and business and private fund business. The above excerpt should be read in conjunction with the following disclosure information: This information is for illustration and discussion purposes only and is not intended to be a recommendation, or an offer to sell, or a solicitation of any offer to open a separate account managed by Robotti & Company Advisors, LLC, nor should it be construed or used as investment, tax, ERISA or legal advice. Any such offer or solicitation will be made only by means of delivery of a presentation, prospectus, account agreement, or other information relating to such investment and only to suitable investors in those jurisdictions where permitted by law. Further, the contents of this letter should not be relied upon in substitution of the exercise of independent judgment. The information is furnished as of the date shown, and is subject to change and to updating without notice; no representation is made with respect to its accuracy, completeness or timeliness and may not be relied upon for the purposes of entering into any transaction. The information herein is not intended to be a complete performance presentation or analysis and is subject to change. None of Robotti & Company Advisors, LLC, as investment advisor to the accounts or products referred to herein, or any affiliate, manager, member, officer, employee or agent or representative thereof makes any representation or warranty with respect to the information provided herein. In addition, certain information has been obtained from third party sources and, although believed to be reliable, the information has not been independently verified and its accuracy or completeness cannot be guaranteed. Any investment is subject to risks that include, among others, the risk of adverse or unanticipated market developments, issuer default, and risk of illiquidity. Past performance is not indicative of future results. If interested, please contact us for additional information about our performance related data. The attached material was provided to investors in a specific Robotti Advisors vehicle at a specific past point of time, advice that may no longer be current or timely. References to past specific holdings of that specific vehicle and matters of related historic fact must be seen in context (as would have been apparent to investors in that vehicle) and are not intended to refer directly or indirectly to specific past recommendations of Robotti Advisors (other than as an indication of language sometimes found in the newsletters). Any reference to a past specific holding or outcome is not intended as representative. None the less, for individuals actively interested in investing in such vehicle, a list of recommendations made by Robotti Advisors with regard to the vehicle in question will be made available on request. Note: certain statements on the attached material, including but not limited to (a) statements of things that “are well known” to be the case (other examples include: “In hindsight people often say, “I should have known better,” and more often than not, they did.”), (b) statements with the phrase “always”, and (c) certain similar statements, are not intended to represent absolute literal fact, but rather represent certain colloquialisms/mannerisms expressed by select market participants (but not necessarily individuals associated with Robotti Advisors). Opinions contained in this letter reflect the judgment as of the day and time of the publication and are subject to change without notice and may no longer represent its current opinion or advice due to market change or for any other reason. Robotti Advisors provides investment advisory services to clients other than the separately managed accounts, and results between clients may differ materially. Robotti Advisors believes that such differences are attributable to different investment objectives and strategies between clients. The information provided herein is confidential and proprietary and is, and will remain at all times, the property of Robotti Advisors, as investment manager, and/or its affiliates. The information is being provided for informational purposes only. A copy of Robotti & Company Advisors, LLC’s Form ADV, Part 2 is available upon request. Additional information about the Advisor is also available on the SEC’s website at www.adviserinfo.sec.gov

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