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Systems Thinking in Investing

December 30, 2017 in Best Ideas 2018 Featured, Best Ideas Conference, Featured

This article is authored by MOI Global instructor Robert King, chief investment officer of Baskerville Capital Management. Robert is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

These days, anyone can pull up a Bloomberg terminal and screen for companies that are selling at a low price to free cash flow multiple or a significant discount to book value. Now, that’s a perfectly fine starting point for research, and there’s nothing wrong with investing this way. It’s how most of us find our way into the value investing world in the first place. (As someone with a science and mathematics background, I have to admit that it is also deeply compelling for its quantitative rigor.) It has also worked for generations of value investors, including Walter Schloss, who was able to achieve a 15% compound annual return over the course of more than four decades!

Notably, there are some drawbacks. It is hard to have a differentiated edge there aside from time horizon arbitrage and hoping for a return to the mean. Over time, as the cost of access to information has dropped due to the internet, the barrier to entry to this type of investing has also dropped. Moreover, this type of investing is likely more susceptible to disintermediation by computer algorithms. If patience and an iron stomach for volatility are critical to this type of investing, it is hard to compete against a computer which has no real concept of time or fear. That is to say, while the method still undoubtedly works, it is highly possible that some of the excess returns to this approach have been competed away. What’s an enterprising investor to do under such circumstances?

I think the answer is to look beyond the numbers by engaging in some systems thinking. Systems thinking is a method of trying to understand a system by examining the linkages and interactions between components that comprise the entirety of the defined system. Basically, you try to understand each unit of the system in relation to its environment so that you can understand whatever complex interactions might be happening within that system. As it relates to investing, systems thinking allows us to better understand how companies create value for their customers and suppliers, and that translates into a better understanding of a company’s competitive moat, the resilience of their free cash flow, and the risks inherent in their business.

A parallel to biology exists here. We can think of an industry as a giant ecosystem and attempt to figure out how each of the ecosystem’s constituent parts interrelate and interact over time. As we learn about the history of how an industry’s “ecosystem” has formed, and the possible path dependencies, we can better judge how various changes to that system might affect the overall profitability of the industry and the individual companies within that system. This provides us with a sustainable edge because viewing investments in this manner requires a certain amount of multidisciplinary thinking that is rarely found and difficult for most people to implement.

As a practical example, we can look at the development of the cable industry. The cable industry sprung into existence because over-the-air (“OTA”) broadcasts had gaps in their coverage. Rural consumers couldn’t access OTA broadcasts, so cable companies stepped in to fill the gap. They built antennas to catch the signal and lay cables to bring that signal directly to their rural consumers. Now, the cable industry, and a particularly fantastic manager named John Malone, was smart enough to realize that there was an untapped vertical hidden in their cable networks. As the cable companies charged consumers a fee to receive a return on their investment in antennas and cables, they figured out that they had a chance to monetize their captive audience by providing more entertainment than just the Big Three television networks.

The important epiphany at this point was that the relationship between content providers and cable companies was akin to eBay’s two-sided network effect. Malone’s genius was to go to nascent content companies and tell them that they could be let onto his cable network so long as he was able to invest in those content companies at attractive valuations. Once the content company was let onto the network, a flurry of network benefits kicked in on both sides. The cable companies immediately became more valuable because they could now differentiate themselves from OTA television by offering more choices of programming. This helped grow subscribers immensely beyond their initial rural customers and also helped them justify the growing cost of their service. Additionally, this created an incredible push towards acquisition because the larger companies, by virtue of extracting monopoly-type profits, could greatly increase their competitive advantage over smaller rivals by reinvesting those monopoly-sized profits to broaden their programming base.

Content companies also immediately became more valuable because they had an embedded two-sided network of their own where the greater their reach, the more valuable their advertising became. Moreover, once they signed up a few cable operators, they increased their bargaining leverage over other cable operators because cable operators had to compete against satellite providers on the breadth of their programming. In a foreshadowing of things to come, satellite companies had national coverage, which meant that they were a formidable and credible threat to cable companies, which only had regional coverage.

Eventually, content companies came to realize that they were in the position of the peddlers of technology to the old textile mills, as Berkshire Hathaway noted in its 1985 Annual Report:

“Over the years, we had the option of making large capital expenditures in the textile operation that would have allowed us to somewhat reduce variable costs. Each proposal to do so looked like an immediate winner. Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable expenditures in our highly-profitable candy and newspaper businesses. But the promised benefits from these textile investments were illusory. Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide. Viewed individually, each company’s capital investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes). After each round of investment, all the players had more money in the game and returns remained anemic.”

Once content companies became large enough, they were able to shift the competitive dynamic in their favor by pushing through large increases in affiliate fees. Of course, while textile mills were largely commoditized operations, cable companies were, at this point, local monopolies, so the economics of the companies have still been decent.

Fast forward to the present day, and the industry is undergoing another structural change. Befitting an ecosystem that resembles the predator-prey oscillations found in biology, the pendulum has begun to swing the other way. Content companies acquired or developed both “premium” and “non-premium” content companies along the way to our current situation. As the industry grapples with how to adapt to over-the-top (“OTT”) distribution, the landscape for content companies is going to shift in a pretty dramatic way. Content companies passed through too much price increase for not enough value provided. Think of ESPN with its $7 fee per subscriber where only 20% of the population watches. Four subscribers are subsidizing that fifth subscriber, and they are rightly pissed off about it. Moreover, who watches that fourth Disney channel that finds itself stuffed into your package tier lest the cable provider loses access to ESPN or ABC?

In my estimation, the content companies no longer have the same leverage that they once did because they’re being squeezed at two ends. Similar to satellite, the OTT companies have massive reach in that they’re not constrained by any of the regional considerations of cable companies, and they’re not even constrained by the national considerations of satellite providers. Netflix, Amazon, and Google are global players with the ability to have very attractive unit economics. For instance, Netflix can spend $8 billion on content because they can spread that cost amongst 110 million subscribers. These OTT providers are essentially super-competitors, and content companies have to contend with them because leisure time is finite. The OTT guys have a better cost structure. They’re more efficient organisms. Very few of the content companies can effectively compete against OTT. (Maybe Disney has a shot because you need content that is widely distributable and/or appreciate across borders. You have to find some way to compete against those fantastic unit economics.)

Content companies can no longer press their luck with the cable companies, because cord-cutting probably hurts the content companies more than the cable companies — cable companies aren’t making much on the video product anyway, and they’ve got a lock on broadband which is much higher margin. Importantly, for cable companies, the relationship between them and the OTT providers is not the same as the one between them and traditional content providers. There’s no Persian Messenger Syndrome where people get mad at the cable company for the bill rather than Disney or CBS in an OTT world. There’s not the “profit splitting” aspect that comes up when you think about cable and video. No one blames Comcast for the fact that Netflix just raised its prices.

So that’s the state of the ecosystem right now. Content companies are in a somewhat precarious position with a few notable exceptions. OTT companies that look like they’re spending irrationally may not be doing so because their content spend is simultaneously customer acquisition and spread out over a huge and growing subscriber base. Broadband companies are basically sitting pretty by providing a regulated monopoly on connectivity. Our job is to figure out who benefits from these changes. Some of the winners are easier to figure out than others, but a deep and thorough understanding of how the system works will provide us with the tools we need to evaluate this shifting landscape.

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What We Learned From Not Investing in Amazon

December 29, 2017 in Best Ideas 2018 Featured, Best Ideas Conference, Letters

This article is co-authored by Jason Gilbert and MOI Global instructor Elliot Turner, co-founder and managing director of RGA Investment Advisors. Elliot 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 our biggest mistakes was not investing in Amazon shortly after reading Josh Tarasoff’s 2012 VALUEx presentation, instantly recognizing the appeal and dismissing a potential purchase on account of the stock being “too expensive.”[1][2] We will forever hold ourselves accountable for this mistake, while simultaneously self-reflecting on what we can do to avoid this mistake in the future and figure out where and how value does accrue in commerce today.

In considering Amazon today, especially the stock, we all need to recognize that the perception pendulum has swung from perhaps “neutral” to exceedingly bullish. The fear of Amazon is so acute across various sectors that merely the whisper of Amazon’s encroachment in a given vertical moves market caps billions of dollars in a matter of seconds. As such, it is imperative that every investment manager and corporate manager recognize where and how their business does and might compete with Amazon in the future and consider what can be done to entrench any advantage that may exist as of today. Further, all stakeholders need to consider what their markets might look like over the course of five to ten years down the line since this is the playing field upon which Amazon’s shareholders afford it the right to compete.

In reflecting on our experience (or lack thereof) with Amazon, we think one of the company’s biggest successes is how they have changed consumer behavior and made buying online easy. With Prime, consumers know that whatever they may want can be bought and received within two days—Amazon has literally become the “Everything Store.” While Amazon was the first to drive this change in behavior, and has been the primary beneficiary thus far, they did something else at the same time: they opened the door to other different mediums for transactions and opened consumer minds to exploring more online consumption opportunities. Changing behavior from offline to online was the seminal achievement of Prime. Incumbents and upstarts alike cannot at this point displace Amazon; however, in the right situations, they can defend their own turf or forge new paths for themselves.

If it sounds like we are anti-Amazon, let us clarify: we are not. We are Prime members, habitually ordering a variety of products from Amazon, but we are also bargain hunters. As bargain hunters we both scour for the best combination of quality and price when in the market for a product purchase, and we look for situations in markets where there is a disconnect between sentiment and reality. There is no larger disconnect in our assessment of the market today than the implicit inevitability of Amazon’s dominance across a host of domains. When Amazon sneezes interest, the target sector immediately catches a bad cold. It has reached a point where even if Amazon does fulfill its rhetorical predestiny, there is ample room for others to succeed. In fact, we see several unique niches being carved out or already dominated by competitors whose servings meet a balancing of demands between quality, price and convenience.

While Amazon has been conscious of vast potential future profit pools and willing to forego short-term profits for long-term potential, its scale and many simultaneous efforts will leave room for competitors to carve out enough of their own scale within niches to create their own offering premised on something other than mere convenience. We see the following opportunities for companies differentiate their offerings from the acknowledged leader:

  • Higher touch, service and education element
  • Smart curation in areas where selection matters
  • Trade away the convenience of fast shipping for even lower prices
  • Immediacy that next day is not enough for
  • Low volume, high price
  • Quality that inspires passion and a direct brand relationship
  • Unbiased openness

Acquiring customers isn’t necessarily easy, but cheap capital has afforded these nascent startups the opportunity to offer meaningful subsidization of everyday products. We initially mocked the idea of Jet when the company was featured in the Wall Street Journal for its negative gross margins–in other words, the more product Jet sold at the time, the more money they lost.[3] At the same time, we were cognizant that Marc Lore is a force to be reckoned with and he had a sensible idea for incentivizing optimized shipping structures while kicking back the savings to customers. Immediately upon the Walmart acquisition it struck us that perhaps Jet, Lore and the VCs involved knew of Walmart’s interest and merely needed to prove concept in order to bring about a swift acquisition and meaty IRR.

This Amazon prelude offers the opportunity to visit one of our best (PayPal) and one of our worst performers (Walgreen’s) so far this year.

1 – Amazon’s share of e-commerce = PayPal’s opportunity

One of our theses behind PayPal has been how significantly the company stands to benefit for online consumption outside of the Amazon ecosystem.[4] To that end, their growth in Total Payment Volume (TPV) is a great proxy for the growth in online sales-ex Amazon.

As the chart above and PayPal’s stock’s price clearly indicates: e-commerce outside of Amazon has been vitally strong this year.[5] Stated differently: there are beneficiaries other than Amazon of this sweeping change in consumer behavior, though this is not a story we often hear. Amazon created the “1-click” buy button, but PayPal has made the login-free “One Touch” buy button ubiquitous on every non-Amazon shopping experience and in virtually all important mobile apps. In fact, offering this as an “open-source” payment stack has been one of the key drivers of the explosion in innovative apps. For retail, it has been a key tool to foster improving shopping cart conversion rates. For consumers, PayPal has been a secure, easy payment platform that facilitates less sharing of sensitive financial information, ultimately creating fewer points of failure for credit card of identity theft.

PayPal itself is a key player behind behavioral change in commerce as well: PayPal was early to pointing out how the lines between a point-of-sale transaction and an online transaction are blurring. An oft-repeated example is how someone can buy goods online at Home Depot and pick up in-store. This is happening with increasing frequency. Similarly, in the past, when you ordered Chinese food from the local restaurant, this was registered as a “POS” payment, but now the same transaction made on Grubhub is recorded as “online.” As consumer behavior continues to evolve, the variety of offerings catering to this new demand is growing.

Amazon has not hid its ambitions of capturing more payment share, yet merchants need to think hard about whether they truly want to share key data with a company that could inevitably turn into a competitor.[6] While Amazon claims merchant data is anonymized, Amazon has not been shy about competing directly with companies who were customers of Amazon platforms. PayPal is the only truly open, unbiased end-to-end solution for e-commerce and we think it has a long runway for future success.

Walgreen’s: delivering on better outcomes at a lower cost

While PayPal is a new ecommerce company of similar vintage to Amazon, Walgreen’s is an old-world, century old stalwart. In further contrast to PayPal, Walgreen’s stock has been our weakest holding thus far this year. Given the weakness in Walgreen’s stock, one would assume from the look of things that Amazon is already competing with the company and inflicting considerable damage. That assumption would be wrong. Evidence of the zealotry behind the Amazon fear is all over Walgreen’s stock. Starting with Amazon’s acquisition of Whole Foods in mid-June, there have been three further instances of Amazon-related headlines leading to 5% or greater drops in Walgreen’s stock.

It has reached the point where outside of the financial crisis and the company’s dispute with Express Scripts (during which we commenced our position), Walgreen’s has never seen such lush free cash flow yields:

Meanwhile, in Walgreen’s own business they continue to take share from other pharmacies (CVS included) on prescriptions and have finally completed a complex and drawn out regulatory process for the acquisition of a large swatch of Rite-Aid stores. The delay in completing this acquisition was no-doubt a sore point for Stefano Pessina in pursuing his typically aggressive M&A strategy, though it has not hindered Pessina’s fostering of new partnerships to position the company for success in an evolving healthcare landscape (look no further than the creation of a strategic alliance with Prime Therapeutics for a new kind of PBM).[7]

Amazon’s ability to compete on a longer timeframe than competitors has been a crucial source of advantage and thus for Walgreen’s, Pessina himself is a key competitive advantage the company has that others have not. In many respects, Pessina should be the next chapter in William Thorndike’s acclaimed “The Outsiders” exploring CEOs with non-traditional backgrounds who built incredibly successful businesses and wealth for themselves and their shareholders. Pessina is a self-made billionaire who after having finished his academic career in nuclear engineering took over his family’s small pharmaceutical wholesaler. At the small family business, Pessina commenced a string of acquisitions—both vertical and horizontal in nature—ultimately building the most formidable global pharmaceutical organization. Pessina’s vision and large ownership stake insulate him from the short-term pressures that so many of Amazon’s competitors have succumbed to.

Importantly, there are no signs in any financial performance to-date that Walgreen’s is in fact vulnerable; however, from the outside, the company’s US-heavy retail footprint appears primed to lose business to Amazon. Pharmacies in the US are a complex, highly regulated business with multifaceted relationships. In most cases, the person purchasing a drug at the pharmacy counter is not the person paying for it—that would be the PBM. Deals with PBMs can be complex (as was evidenced by the past Walgreen’s/Express Scripts problems) and competitive. Even were Amazon to make inroads in pharmaceuticals, the shape of the competitive market needs to be contextualized: Walgreen’s retail foot-print has already withstood competition from “convenience” and “price sensitive” mail order business driven by PBMs. Global scale at Walgreen’s is a crucial driver of a cost advantage that has led to the capture of share from peers. This has been aided by the company’s growing stake in AmerisourceBergen.  Moreover, Walgreen’s has key profit-pools that are largely immune to Amazon’s foray into pharmaceuticals including, but not limited to same-day needs, vaccinations, a European wholesale and distribution business, and a thriving portfolio of proprietary cosmetics mainly sold in Europe.

With all this said, it’s worth concluding by pointing out it remains uncertain if, or even how Amazon will try to compete in this industry. If they do, there will be losers, but Walgreen’s will be fighting from a strong, defensible position. Alternatively, should Amazon opt not to compete, it would be but one more indication that Walgreen’s is a truly special business.

What do we own:

The Leaders:
Envestnet, Inc (NYSE: ENV) +30.40%
GrubHub Inc. (NASDAQ: GRUB) +20.78%
PayPal Holdings, Inc. (NASDAQ: PYPL) +19.86%

The Laggards:
AmerisourceBergen Corp (NYSE: ABC) -12.06%
Twitter, Inc. (NYSE: TWTR) -5.60%
The Howard Hughes Corp (NYSE: HHC) -4.00%

[1] https://twitter.com/ElliotTurn/status/297072766518177792
[2] https://www.scribd.com/document/98208572/ValueXVail-2012-Josh-Tarasoff
[3] https://www.wsj.com/articles/jet-com-runs-into-turbulence-with-retailers-1438899476
[4] For our fuller PYPL thesis, check out the presentation from 2015 http://www.rgaia.com/ebay-paypal-split-analysis-buy-two-moats-for-the-price-of-one/
[5] http://files.shareholder.com/downloads/AMDA-4BS3R8/5421520140x0x960247/15B1F272-F94C-4743-84BB-A36C509F557C/Investor_Update_Third_Quarter_2017.pdf
[6] https://www.cnbc.com/video/2017/10/23/amazon-pay-vp-on-amazons-push-into-payments.html
[7] http://news.walgreens.com/press-releases/general-news/walgreens-and-prime-therapeutics-agree-to-form-strategic-alliance-includes-retail-pharmacy-network-agreement-and-combines-companies-central-specialty-pharmacy-and-mail-service-businesses.htm

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Past performance is not necessarily indicative of future results. The views expressed above are those of RGA Investment Advisors LLC (RGA). These views are subject to change at any time based on market and other conditions, and RGA disclaims any responsibility to update such views. Past performance is no guarantee of future results. No forecasts can be guaranteed. These views may not be relied upon as investment advice. The investment process may change over time. The characteristics set forth above are intended as a general illustration of some of the criteria the team considers in selecting securities for the portfolio. Not all investments meet such criteria. In the event that a recommendation for the purchase or sale of any security is presented herein, RGA shall furnish to any person upon request a tabular presentation of:
(i) The total number of shares or other units of the security held by RGA or its investment adviser representatives for its own account or for the account of officers, directors, trustees, partners or affiliates of RGA or for discretionary accounts of RGA or its investment adviser representatives, as maintained for clients. (ii) The price or price range at which the securities listed.

Preview of Madalena Energy: A Small Black Gem in White-Hot Argentina

December 28, 2017 in Best Ideas Conference, Ideas

This article is authored by MOI Global instructor David Tawil, co-founder and president of Maglan Capital, an event-driven, corporate turnaround-focused fund. David is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Ever since Argentina elected its new President, Mauricio Macri, in 2015, the country has been on a fast-track to economic stability and fiscal prudence, making Argentina the best economic trajectory in Latin America. The Argentine stock market has reacted in-kind, and there is a lot more room to run.

Argentina currently produces only half of its oil and natural gas needs (consumption). To the contrary, Argentina has one of the world’s largest gas (2nd) and oil (4th) shale deposits (“Vaca Muerta”), which has already been the subject of years of comprehensive data-collection and testing and has started producing.

Madalena Energy (MVN CN; MDLNF) is the only independent, publicly-traded, Argentina-exclusive oil and gas exploration and production company. In May 2017, we hand-picked new management for the Company led by Jose Penafiel (CEO) and Alejandro Penafiel (board member).

The Company is primed for massive growth. We spent the past few years on heavy restructuring of the Company’s asset portfolio, balance sheet, operations and management. We are the Company’s largest shareholder.

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Hunting for Value in Singapore

December 28, 2017 in Best Ideas 2018 Featured, Best Ideas Conference, Letters

This article is authored by MOI Global instructor William Thomson, managing partner of Massif Capital, a value-oriented investor partnership focused on global opportunities in the small- and mid-cap space, with special attention given to industrial and commodity-related businesses. Will is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Singapore has a long history of serving the world as a vital financial center, a role the city has played regionally since before Sir Stamford Raffles established it as a critical trading post of the British Empire in 1819. Given the cities strategic geographical location, at the mouth of the southern end of Straits of Malacca, Singapore’s rise in the global ranks of significant trading and financial centers is unsurprising. The emergence of a financial services sector is often predicated upon the existence of thriving trade flows, with financial services associated with trade and shipping activities, such as currency exchange, shipping insurance, and maritime finance giving rise to other related financial services. This has most certainly been the case for Singapore.

In more recent history, geographic location played another role in Singapore’s financial development, as the city’s time zone allowed it to fill in a gap in global trading hours. This led to the establishment of an Asian Dollar Market in 1968, filling a hole in global trading hours between the close of American markets and the opening of European markets. At the same time as the centrality of Singapore’s location to the broader Asian markets has played an essential role in developing the city and its financial services industry, it also seems to have created a situation where it’s equity markets are easily overlooked in favor of the small-city states larger neighbors.

Value investors would be well served not to overlook this underserved market as opportunities abound.

The Quantitative Backdrop

In a world of expensive equity markets, Singapore’s stands out as cheap. Based on data provided by Datastream the Singapore equity markets have traded at an average P/E of 16.6 since 1988i. By comparison, the SPDR Straits Time Index ETF (ES3) has a current P/E of 11.3. Star Capital analyst Norbert Keimling publishes up to date international CAPE data that corroborates this conclusionii. As of September 30th, 2017, Singapore had a CAPE of 12.9, this compares favorably to not only Developed Markets, which have a CAPE of 24.3, but also Emerging Markets, 16.5, and the Emerging Asia-Pacific, 17.9.

According to the MSCI Singapore Index, which covers 85% of the free float-adjusted market capitalization of the Singapore equity universe, Singapore ROE has declined from a peak of 17% in 2008 to a current level of around 8.5%. Furthermore, the MSCI Singapore is currently trading at a P/B of 1.13x, which is close to 2008-09 lows of 1.06x. From here it would seem that the downside is limited as the market is already trading at a discount to P/B of 1.23x in 2001 (global recession). Only during the Asian Financial Crisis of 1997/98 did the MSCI Singapore P/B move to lower levels (0.77x).

The Qualitative Backdrop

Two qualitative factors make Singapore an even more interesting equity market. The first is the significant role that family businesses play and the second is the ongoing restructuring of corporate Singapore.

Among SGX listed firms, roughly 60% can be described as family firms. These businesses have historically outperformed those of non-family owned companies on the SGX with a return on assets of 3.7% vs. 0.9%. Roughly a third of these firms are still run by the first generation of the family, and 54% are run by the second generation, making them relatively young in comparison to publicly listed family-run firms in the rest of the world. The businesses are also tightly controlled with the founding family typically owning 38.3% of sharesiii.

Family businesses tend to take a longer-term view than non-family firms when it comes to business strategy, prioritizing stability over quarterly returns, they tend to be patient capitaliv. In Singapore, that tendency is even more pronounced, with 80% of respondents to a recent PwC survey focused on either consolidating their businesses or steady growth over the next five years, and just 15% saying they plan to grow aggressivelyv. Throughout the rest of Asia 74% of Family Business respondents where focused on steady growth or consolidation while 24% were focused on aggressive growth. The key take away: Singapore family-run businesses strive to be, and think of themselves as, patient capitalvi.

Although value in and of itself is often worth buying, a catalyst for realization makes it more appealing. According to a recent study by Credit Suisse, 79% of the MSCI Singapore is currently involved in some form of corporate action whether it be a strategic review, asset divestment, consolidation of holdings or an improvement of capital structure. Slow economic growth, the rise of competitive threats in Singapore’s near abroad and two consecutive years of EPS declines have prompted many businesses to reexamine priorities.

Forecasted growth in corporate activity is also driven by the more aggressive approach to portfolio management that Temasek, the Singaporean state investment arm, is taking. As state expenditures have grown over the past decade so too has the role of investment returns in plugging public spending gaps. As one of the largest investors in many blue-chip Singapore companies, the demand for better returns is driving strategic reviews at government-linked firms.vii Regardless of the cause, whether it be prodding by Temasek at blue chips or disappointing performance in recent years at family controlled firms, the reviews underway stand a good chance of improving near-term ROE for many Singapore investments.

The Big Risk

A cheap market is rarely cheap without cause though, and the Singapore market is no different. Singapore is not only one of the world’s most trade-dependent economies, with exports of value-added goods to the world representing 56% of GDP, but it is also dependent on global trade to meet many of the city’s basic needs (food, fuel and even water). Should the current backlash against globalization continue the retreat of global trade represents a very real existentially threat to Singapore. Despite the cheapness of the country’s equity it is an economy comprised of businesses dependent on the network effect of globalized supply chains.

Regardless of the near terms threats from a potentially weakened global trading system, Singapore equity markets remain a fertile ground for opportunistic value investors. Massif Capital looks forward to building on some of the themes discussed above during our presentation at MOI Global’s Best Ideas 2018 conference.

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i The Singapore DS Market Price Index is a synthetic stock index devised by data provider Datastream that is similar to the STI, but which has historical data that goes back further than what is available for the STI.
ii Star Capital Research: http://www.starcapital.de/research-en
iii 65% of Singapore listed companies are controlled by the top five shareholders.
ivPatient Capital is focused on achieving future economic advantage through continues and sustainable progress as opposed to most capital which has an impatient focus on near term or immediate results.
v Patient Capital prioritizes the accumulation of means over ends and the deployment of capital at strategically advantageous times. Steady growth, although slower then aggressive growth, allows for the accumulation of means to act opportunistically in the future which allows creation of great value over time.
vi Survey data available at: https://www.pwc.com/gx/en/services/family-business.htm

Excessive Self-Regard Tendency

December 27, 2017 in Human Misjudgment Revisited

Man commonly misappraises his own abilities and his own possessions. –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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The overappraisal-of-your-own-possessions is also known as the “endowment effect.” If I ask one group of people how much they’d pay for a coffee mug, the answer might be $5. But if I give a coffee mug to a similar group of people and ask them how much it’s worth, the answer is usually $8 or $10. The mere act of owning the coffee mug makes it more valuable to its owner.

The same effect is extremely powerful with regard to investments. “The stock doesn’t know – or care – that you own it,” as Buffett would say.

On a related note, lost wallets are most often returned when the contents of the wallet lead the finder to believe its owner bears a close resemblance to the finder.

The tendency to like oneself and similar people makes for self-reinforcing culture. Thus, when an institution or organization goes wrong “some of the most useful members of our civilization are those who are willing to ‘clean house’ when they find a mess.”

Other examples from Munger:

  • Foolish gambling decisions. Excessive self-regard leads to more addictive sports betting than race track betting, or to cases of stupid bets against superior players in poker or golf.
  • Bad hiring decisions. The antidote here is to “underweigh face-to-face impressions and overweigh the applicant’s past record. Just such a case happened on an academic search committee. Munger convinced his fellow committee members to cease all interviews and appoint the person with the superior record despite protests of his lack of “academic due process.”
    • “In my opinion, Hewlett-Packard faced just such a danger [of being overinfluenced by face-to-face impressions and by skillful ‘presenters’] when it interviewed the articulate, dynamic Carly Fiorina…and I believe (1) that Hewlett-Packard made a bad decision when it chose Ms. Fiorina and (2) that this bad decision would not have been made if Hewlett-Packard had taken the methodological precautions it would have taken if it knew more psychology.”
  • Criminal justice. “According to Tolstoy, the worst criminals don’t apprise themselves as all that bad. They come to believe either (1) that they didn’t commit their crimes or (2) that, considering the pressures and disadvantages of their lives, it is understandable and forgivable that they behaved as they did and became what they became.” The antidotes are fair meritocracies and severance for the worst offenders.

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Preview: A Value Investor’s Approach to Natural Resources

December 27, 2017 in Best Ideas 2018 Featured, Best Ideas Conference, Diary, Letters, Materials

This article is authored by MOI Global instructor Dustin Johnson, senior manager with Pala Investments, based in Switzerland. Dustin is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Investing in the natural resources sector is often excluded from the investment mandate of value investors due to the inherent volatility and need to forecast macroeconomic factors. I am a value investor at heart, however my professional investment mandate at Pala Investments focuses largely on managing investments within the metals and mining sector. As such, I continually assess the framework under which one can be an investor in the natural resources sector while still adhering to sound value investing principals.

Warren Buffett has openly commented on commodities as an asset class, which is often interpreted as regarding the sector as uninvestable:

“The problem with commodities is that you are betting on what someone else would pay for them in six months. The commodity itself isn’t going to do anything for you.” –Warren Buffett

In the first component of my presentation at MOI Global’s Best Ideas conference I would like to discuss how we can justify investing in natural resources sector from a value investment perspective.

From there I would like to propose a framework for evaluating the long-term prospects of individual companies and commodities in order to ensure that selected investments align with unchanging economic realities that will endure shorter-term changes in macroeconomic variables.

With a long-term framework in place, I will then discuss the medium and short-term factors that frame the timing and sizing of prospective investments, as well as key risks to be assessed throughout the process.

Finally, I will outline my investment thesis for Ivanhoe Mines, applying the process and frameworks as discussed above. Ivanhoe Mines is a Canadian-listed mining company founded by Robert Friedland. The company’s primary assets are based in the Democratic Republic of Congo and South Africa. Ivanhoe is in the process of unlocking one of the world’s greatest copper discoveries in addition to having world-class zinc and PGM (precious group metals) assets.

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Evolution of Value Investing: More About Value, Less About Price

December 26, 2017 in Best Ideas Conference, Diary

This article is authored by MOI Global instructor Brian Brosnan of Crystal Amber Advisers, based in London. Brian is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

“Nowadays people know the price of everything and the value of nothing.” –Oscar Wilde

Everybody loves a bargain. On Black Friday shoppers are carried along on a wave of momentum that overwhelms sober considerations of whether the item is really needed. Our brains are seduced by the artificial time scarcity and the ‘saving’ on an arbitrary reference point. As the behavioural economist Dan Ariely says, “Discounts are a potion for stupidity”. Likewise as investors the salience of relative prices can dominate our decisions. Price multiples are often the first port of call in the search for value. However the siren song of low prices can lead investors astray. In this article I highlight pitfalls of the ‘multiple mindset’ and offer some illustrative ideas for bridging the gap to value.

1. Unstable baseline

The comparability of a stock’s historic multiples is skewed by a plethora of changes (macro, business model, cyclical, tax and accounting etc). While investors may be aware of these issues they are easily overlooked. For example, value investors are usually reluctant to consider a stock whose multiple is above its historic average. In recent years changes have raised the level and dispersion of stock multiples. Investors looking through the prism of multiples have been slow to recalibrate what is considered ‘fair’. They use the emotive label ‘overpriced’ which suggests a sudden collapse is imminent rather that the open-ended description of a ‘low-return environment’.

2. Peer anchoring

Peer multiples are especially pernicious. Investment banks often try to highlight relative value by averaging a diverse range of unadjusted multiples. The variation in peer multiples alone should be disqualifying evidence of the utility of the exercise. Even identical peer comparisons often do more harm than good. How many points of P/E is it worth paying for better management? Multiples will not tell you the answer.

3. Bias of mean reversion

The ‘multiple mindset’ subtly conditions us to expect mean reversion. That’s helpful when things don’t change. Human nature drives the eternal ebb and flow of sentiment. We are cautioned that ‘this time it’s different’ are the most expensive words in investment. In reality the economy and markets evolve continuously. To outperform as fundamental investors we need to assess and interpret the significance of change. History ‘rhymes rather than repeats’. Precedents are a stimulus for questions rather than a playbook for answers. Why shouldn’t access to low cost diversification from passive investing raise average multiples permanently?

4. Quest for safety

Low multiples proffer investors undue reassurance that a stock is likely to have a margin of safety. The most hazardous case is the infamous ‘value trap’. The default view is that stocks on single digit multiples are ‘cheap’ until proven otherwise.

5. Pull of short-termism

We are attuned to multiples because the price numerator in valuation multiples changes continuously unlike the denominator. We typically pay more attention to how a ‘long-term position’ performs over the first week than we do subsequently. The proximity of initial price feedback to our decision makes us sensitive to ‘loss aversion’.

6. Tyranny of averages

Even if cheap multiple stocks as a category outperform long-term, it does not follow that an investor should start the search for value with multiple screens. We are not buying baskets. It may be easier to eliminate ‘losers’ among high multiple stocks through fundamental analysis. In any case finding a stock that will benefit from multiple appreciation is less relevant as the holding period expands. Fascinating research from Professor Hendrik Bessembinder finds that the entire gain in the U.S. stock market since 1926 is attributable to the best-performing four percent of listed stocks. The fear of multiple compression deterred many potential Walmart investors over decades and the same pattern is repeating itself with Amazon. Furthermore good businesses may also pay a better return on time invested because they permit multiple points of entry over time.

7. Commoditization

If ‘value investors’ as a group are to outperform they must do so at the expense of another constituency. Yesterday’s patsies at the table were unsophisticated retail investors and herd-following institutions. Both groups tended to chase glamour stocks and indiscriminately offload losers. Low multiples were good indicators of value. Unfortunately the mean reversion play on multiples is being commoditized as demonstrated by the poor performance of many long-short hedge funds. Quantitative funds offering variants of ‘smart beta’ are emerging as a new competitor. Quant models don’t suffer emotional turbulence from holding pariah stocks. They can load up on traditional ‘value’ factors which compresses returns. Increasingly stocks on low multiples will be more likely to be genuinely higher risk. While value opportunities will periodically re-emerge in periods of turbulence the overall utility of standalone value metrics is declining.

8. Lower information content

Traditional multiples are becoming less meaningful. According to a study by Ocean Tomo intangibles assets represent 87% of S&P500 value in 2015 versus only 32% in 1985. The value of a security is revealed only retrospectively through cash flows. We are looking to be approximately right rather than precisely wrong. No matter how expensive the market seems to be, in retrospect there are always many great businesses which turn out to have been undervalued. Perhaps the entry point was not ideal, but deferring purchase is really a matter of speculating on tomorrow’s price.

Buffett was a pioneer in appreciating the value of brands. The challenge for us as contemporary ‘value investors’ is to enhance our tools and processes to:

• insulate our assessment of value from the contamination of price signals
• better incorporate unstructured and non-financial information
• assess the scalability and risk of intangible assets
• avoid the behavioral biases inherent in methods such as DCFs & multiples
• assess management and organisations in a more objective manner
• focus more on identifying the few long-term winners
• appreciate the impact of new financial market participants

Rather than lament high multiples we should be on the lookout for new opportunity sets. For example we cannot compete directly with quantitative funds on speed and consistency but we can selectively exploit their weaknesses. Most quantitative funds have a pricing kernal that relies on relative multiples and price action. While new money is growing the overlap in their input variables bolsters outperformance. However their methods are underpinned by methods of averaging and extrapolation from the past. As value investors we can cherry-pick where their reference class is flawed to benefit from a more nuanced understanding of mean reversion and mean divergence.

In my Best Ideas 2018 presentation, “Ocado – Overpriced, Undervalued”, I will discuss our investment in Ocado a stock that is heavily shorted.

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The views expressed here are those of the author in a private capacity.

Focus on Good Businesses with Low Expectations

December 26, 2017 in Best Ideas 2018 Featured, Best Ideas Conference, Letters

This article is excerpted from a letter of Lowell Capital, based in El Segundo, California, and authored by MOI Global instructor Jim Zimmerman, founder of the firm. Jim is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

We believe the U.S. economy continues to expand steadily but there are certainly risks. We remain optimistic for modest earnings improvement in 2018 with a reasonable economic environment. Our earnings confidence faces potential challenges such as a more aggressive Fed, European debt problems, political struggles in the U.S, and continued global deflationary concerns, etc. Another risk is the over-stimulation of the U.S. economy which drives unexpected inflation and interest rate increases. As we have noted before, the U.S. equity markets have had several positive years of performance after the steep decline in 2008. It has been a slow but steady climb back for the U.S. economy. It is possible the slow pace of the economic expansion could mean that it may last longer than is typical.

On the positive side, global interest rates remain low. It is hard to be certain exactly why interest rates are so low. It could be several factors combined. It could be technology putting downward pressure on labor markets globally and it could be demographics and it could be several other factors. It is possible low interest rates could remain with us for an extended length of time. Nobody really knows for sure. However, we continue to believe that carefully selected equities provide one of the best options for investors to protect their purchasing power. The global economy remains fragile and the result is low interest rates as governments seek to support growth and employment. This could maintain a favorable environment for stocks versus fixed income securities. We believe fixed income securities offer very little value at today’s prices, with ten-year treasuries offering a risk-free yield of about 2.4%.

We believe most of the Partnership’s investments have 10% or greater unleveraged free cash flow yields. While we have little confidence in our ability to forecast the stock market, we are confident of the free cash flow yields that support our investments. We do a lot of work to try to maximize our confidence that these free cash flows are sustainable and reliable. This is what keeps us invested in carefully selected equities despite several consecutive years of positive stock market returns. We believe our large free cash flow yields provide a significant margin of safety for our investments, especially when compared to a 2.4% risk-free yield on ten-year treasury rates.

Our objective, at the end of the day, is to protect the purchasing power of the Partnership’s capital over many years. Holding cash may seem like a low- risk strategy in the short run, but over many years inflation is highly likely to significantly reduce the purchasing power of cash. As Warren Buffett noted in Berkshire Hathaway’s 2011 Annual Report, the purchasing power of the U.S. dollar declined a staggering 86% from 1965 when he started his investment partnership to 2011. It took $7 in 2011 to purchase the same items as $1 purchased in 1965. Our objective is to keep a large portion of the Partnership’s capital invested in businesses that provide important goods and/or services that customers will continue to want and need over time. We believe the value of the Partnership’s capital so invested should grow over time with inflation, and hopefully even more so, as customer demand is sustained or grows.

Good Businesses with Low Expectations

We are focused on investing in good businesses with low expectations (i.e., low valuations). For us, a “good” business is one that earns high returns on invested capital or where you don’t have to spend a lot of money to make a lot of money. We look at businesses where the total investment in tangible assets to run the business (i.e., net working capital plus the book value of property, plant, and equipment) are modest relative to the sustainable operating earnings or free cash flows. The business is not capital intensive. Businesses with high returns on invested capital tend to be strong generators of free cash flow. These are businesses that we like very much.

In terms of low expectations, our investments generally have valuations which are low and this helps reduce risk. The market does not expect much from the business in the future or is worried about current earnings or free cash flow sharply declining. These may also be situations where a business is simply misunderstood or undiscovered. Our experience is that if the business is able to exceed these low expectations or generate results that are less bad than expected, the stock price is likely to increase. Also, if expectations are low, when results are disappointing, the stock is likely to decline less than otherwise. We spend a lot of time studying these types of companies to try to get comfortable that their prospects are better than the market believes. Often specific businesses or industries get painted with a very broad brush – Wall Street gets lazy sometimes – and their valuations are driven down to what we find to be attractive levels. We think our focus on these out-of-favor companies and industries gives us an opportunity to earn better risk-adjusted returns than the general market.

Focus on Smaller Companies

We focus on smaller companies, searching for “low- risk, high-return” opportunities. We believe a few good ideas can drive the Partnership’s results. We believe the Partnership can generally achieve better risk- adjusted returns by uncovering a few small “gems” than by focusing on larger companies or macro issues which are much more widely covered.

Our focus on smaller, less-followed companies represents a potential sustainable competitive advantage for the Partnership relative to larger investment funds that must focus on much larger companies. Our empirical investment experience validates this belief, as our most successful investment positions have pretty consistently been smaller companies.

We are specifically looking for small companies that may appear risky on the surface but are actually much less risky due to characteristics such as: (a) cash-rich, “Ft. Knox” type balance sheets, (b) consistent free cash flows; (c) unique niches or business models; (d) very low valuations with minimal expectations imbedded in the stock price; and (e) honest and intelligent management teams that are highly focused on driving shareholder value. Most small companies do not possess any of these characteristics. We focus most of our attention on a handful of companies that we believe possess almost all of these characteristics.

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