"If you see the world accurately, it's bound to be humorous, because it's ridiculous."
– Charlie Munger
— The Rational Walk (@rationalwalk) December 14, 2017
10 Questions: Todd Combs (B.S. '93) | FSU Alumni Association https://t.co/B7ejAKcKSl
— William Green (@williamgreen72) December 14, 2017
This is the best book I read this year. Ostensibly about tennis, it’s actually a guide to maintaining focus & a quiet mind “regardless of circumstances or surroundings”, and remaining calm “in the midst of rapid & unsettling change”. I highly recommend it. https://t.co/t0XxDs61h7
— Devin Haran (@DevinHaran) December 13, 2017
True Small-Cap Investing: An Institutional Blind Spot?
December 13, 2017 in Best Ideas Conference, Diary, Equities, Letters, Small CapThis article is authored by MOI Global instructor Howard Punch, president and chief investment officer at Punch and Associates. Howard is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.
Investors are attracted to small caps because of the outsized performance historically achieved. However, based on how they typically allocate money, many investors often overlook the smallest companies which historically had the largest impact on the group’s outperformance. As of June 2017, approximately 3,600 companies traded on major U.S. exchanges.¹ Roughly 1,750 of those companies have a market cap of $1 billion or less, representing some $567 billion of market cap. Large, institutional investors pass over these smaller companies in favor of larger ones in which they can take more meaningful positions. We believe that this relative lack of attention and ownership of companies with a market cap of less than $1 billion creates an institutional “Blind Spot.”
In our experience, we’ve found that many of these companies are often profitable, conservatively capitalized, and self-financing, so they are often ignored by sell-side analysts who have no incentive to offer research coverage. As a result, these companies are less well-known and their shares may trade less frequently. Most small cap investors fail to realize (as shown in the chart below) that as a group, the smallest companies have historically generated the highest returns. However, those sized companies are generally excluded from the average “name-brand” small cap portfolio.
“As to methods, there may be a million and then some, but principles are few. The man who grasps principles can successfully select his own methods. The man who tries methods, ignoring principles, is sure to have trouble.”
– Ralph Waldo Emerson
Focusing On the Blind Spot is Worth the Effort
For the thoughtful investor willing to “take the blinders off” and gain exposure to “true small caps,” we believe a compelling opportunity persists. The performance of this largely ignored group of companies is often quite compelling. Over the past 90 years, the smallest decile of U.S. stocks has outperformed all other deciles – on both an absolute and a risk‐adjusted basis – providing an average annual return of 26% since 1927.
Today, the average size company in the first, second, and third deciles are $121 million, $522 million, and $1.0 billion, respectively.² This compares to $2.3 billion weighted average market cap for the Russell 2000 and $3.2 billion for the top 50 (by assets) actively managed small cap mutual funds.
It’s Becoming Harder to Access the Blind Spot
The most recognized small cap benchmark is the Russell 2000 Index. Yet, the benchmark and the ETFs that track it fail to provide investors significant ownership of the companies with the smallest market caps. Over time, that problem has increased, and investors are getting even less exposure to the smallest companies in the small cap universe.
Over the last five years, the weighted average and median market cap of the Russell 2000 grew by over 65% and, as of June 2017, the median market cap was $802 million. Notably, the number of companies in the sub-$500 million market cap segment (roughly the cutoff for the bottom 20% of companies by market cap) shrank by 34%, and the number of companies in the $2 billion and greater segment grew by 363%. Because the index is market cap weighted, the overall exposure is skewed to the larger companies in the index. As of June 2017, the weighted average market cap of the index was approximately $2 billion, meaning 50% of money invested in the “small cap” benchmark is actually a blend between a small and midcap (SMID cap) offering.
A Passive Approach Arguably Fails in the Objective and Increases Risk
The rotation of funds to passive investing is well-documented. We are not surprised that, in the ninth year of a bull market where passive investing has dominated (delivered the best results), the drum beats are growing louder for active managers to hand over their Bloomberg terminals. We believe that in the least efficient areas of the market, an active approach has a higher probability of generating better risk-adjusted returns (with acknowledgements to our obvious bias). We believe better risk-adjusted returns come from companies that can compound value at an above market rate but also can provide good downside protection for when things do not work out as expected.
For investors seeking exposure to small caps through a Russell 2000 tracking ETF, the decreased downside protection over the last five years is a hidden risk. Excluding the technology bubble in the late 1990’s and the Great Recession of 2008-2009, the percentage of loss-making companies in the Russell 2000 Index is at a record high. In addition, the index has also seen a declining dividend yield and current ratio and a rising debt-to-equity ratio. Simply put, the average company in the Russell 2000 Index today is of lower quality than only a few years ago.
One would think that, based on diminished fundamentals and higher uncertainty around future profits, these companies would be assigned a lower valuation. In reality, the average market cap of a company in the benchmark has risen by more than 65% since June 2012 and a variety of traditional valuation metrics (P/E, P/CF, P/B) have increased. Today, a passive portfolio consists of companies that, on average, have a lower margin of safety and a higher valuation in addition to having fewer of the smallest companies that historically have generated the outsized returns.
“The inherent irony of the efficient market theory is that the more people believe in it and correspondingly shun active management, the more inefficient the market is likely to become.”
– Seth Klarman
Most Active Managers are Not Focused on the Blind Spot
There is an often‐overlooked aspect of small cap offerings by active managers that does not receive much attention: despite the fact that many professional investors closely track the Russell 2000 benchmark, many do so with a heavy bias toward owning the largest, most liquid stocks in the index.
Half the stocks in the Russell 2000 Index have market caps under $800 million, and many of these stocks share these distinguishing characteristics:
- under-owned by institutions
- under-researched by professional analysts
- unknown to most investors
- relatively illiquid
Investing in small, illiquid, under‐researched stocks takes more time and effort to do well. Moreover, the absolute size of these companies becomes prohibitive when investing large amounts of capital.
As of June 30, 2017, according to Bloomberg, 405 actively managed small cap mutual funds with more than $25 million in assets exist in the U.S. On average, these funds have a median market cap of $2.0 billion (2.5 times that of the benchmark) and a weighted average market cap of $2.8 billion (121% of the benchmark). Only 23% of these funds have median market caps below the benchmark, which represents less than 14% of total assets invested in all small cap mutual funds.
The average “asset gathering” small cap manager would rather piggyback on the long-term track record of the asset class, in our opinion, than do the hard work of owning the very vehicles that contributed most to this historical outperformance. Investing in small companies is simply not as scalable—or lucrative—as managing money in larger, more liquid companies.
It is no surprise that small cap mutual funds with more assets also have portfolios with higher median market caps. For small cap mutual funds with more than $1 billion in assets, their average median and weighted average market cap are $2.5 billion and $3.3 billion, respectively. This is to say that half of the companies owned in these portfolios have a market cap that is greater than $2.5 billion, and half of the assets invested in these funds are in companies with a market cap greater than $3.3 billion.
A relatively small number of portfolio managers pay any attention to the smallest stocks in the index despite the fact that they represent a significant number of its constituents.
With the Russell 2000 benchmark having 50% of its capital tied to companies with a market cap of $2 billion or greater and the majority of small cap mutual funds with a similar weighting, it becomes easier to understand why we ask the question, “Is true small cap investing an institutional blind spot?” As seen below, one could conclude that indeed it is a challenge for institutions to capture exposure to what has historically been the best performing segment of the market, the companies in the bottom deciles in size as measured by market cap.
Members, log in below to access the restricted content.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
Disclosures: Punch & Associates is registered as an investment adviser with the U.S. Securities and Exchange Commission. Registration as an investment adviser does not imply a certain level of skill or training. This material is for informational purposes only and is not and should not be construed as accounting, legal, or tax advice. Punch & Associates is not qualified to provide legal, accounting, or tax advice, and accordingly encourages clients and potential clients to consult their professional advisers with respect to such matters. The information is provided as of the date of delivery or such other date as stated herein, is condensed and is subject to change without notice. Information regarding market returns and market outlooks is based on the research, analysis and opinions of Punch & Associates, which are speculative in nature, may not come to pass, and are not intended to predict the future performance of any specific investment or any specific strategy. This document does not purport to discuss all of the risks associated with any specific investment or the use of any strategy employed by Punch & Associates. Certain information contained herein may constitute forward-looking statements. Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements. As a practical matter, it is not possible for any person or entity to accurately and consistently predict future market activities. While Punch & Associates makes reasonable efforts to ensure information contained herein is accurate, it cannot guarantee the accuracy of all such information. Further, some information contained in this report may have been provided by or compiled based on information provided by third party sources. Although Punch & Associates believes the sources are reliable, it has not independently verified any such information and makes no representations or warranties as to the accuracy, timeliness or completeness of such information. Past performance does not guarantee, and is not indicative of, future results. All investments in the market are subject to a risk of loss.
Bias from the Non-Mathematical Nature of the Human Brain
December 13, 2017 in Human Misjudgment RevisitedThis article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.
Bias from the non-mathematical nature of the human brain in its natural state as it deals with probabilities employing crude heuristics, and is often misled by mere contrast, a tendency to overweigh conveniently available information and other psychologically misrouted thinking tendencies on this list. When the brain should be using the simple probability mathematics of Fermat and Pascal applied to all reasonably obtainable and correctly weighted items of information that are of value in predicting outcomes.
“The right way to think is the way Zeckhauser plays bridge. And your brain doesn’t naturally know how to think the way Zeckhauser knows how to play bridge.” –Charlie Munger
Availability
“Now, you notice I put in that availability thing, and there I’m mimicking some very eminent psychologists Kahneman, Tversky, who raised the idea of availability to a whole heuristic of misjudgment. And they are very substantially right. Nonetheless, even though I recognize that and applaud Tversky and Kahneman, I don’t like it for my personal system except as part of a greater sub-system, which is you’ve got to think the way Zeckhauser plays bridge. And it isn’t just the lack of availability that distorts your judgment. All the things on this list distort judgment. And I want to train myself to kind of mentally run down the list instead of just jumping on availability. So that’s why I state it the way I do. In a sense these psychological tendencies make things unavailable, because if you quickly jump to one thing, and then because you jumped to it the consistency and commitment tendency makes you lock in, boom, that’s error number one. Or if something is very vivid, which I’m going to come to next, that will really pound in. And the reason that the thing that really matters is now unavailable and what’s extra-vivid wins is, I mean, the extra vividness creates the unavailability. So I think it’s much better to have a whole list of things … than it is just to jump on one factor.”
Examples include:
- Coke
- John Gutfreund and Salomon Brothers (also: reciprocation, base rate, vengeance)
- See’s Candy cashiers stealing from the till – consider the base rate (“what Tversky and Kahneman call baseline information”)
- Serpico – allowing corruption and terrible behavior to spread is evil
- Vengeance – don’t chase the last ounce of vengeance, or any vengeance (“I don’t think vengeance is much good.”)
Update
Munger added “Availability-Misweighing Tendency” as its own category in the update, along with his much expanded thoughts.
- “When I’m not near the girl I love, I love the girl I’m near.”
- “Man’s imperfect, limited-capacity brain easily drifts into working with what’s easily available to it. And the brain cant’ use what it can’t remember or what it is blocked from recognizing because it is heavily influenced by one or more psychological tendencies bearing strongly on it. ”
- Antidotes: Darwin’s search for disconfirming evidence; “emphasize factors that don’t produce reams of easily available numbers”; “find some skeptical, articulate people with far-reaching minds”
- Use vivid images and availability to your advantage in persuasion or improving your own memory.
“We tend to judge the probability of an event by the ease with which we can call it to mind.” — Danny Kahneman
There is now a treasure trove of behavioral economic work that is widely accessible, and Kahneman and Tversky were among the pioneers. Munger even cited their work in the mid-1990s before it had achieved such wide acclaim.
“Nothing in life is as important as you think it is when you are thinking about it.” — Danny Kahneman
Daejan Holdings: Conservative UK Property Owner at Steep Discount
December 12, 2017 in Audio, Equities, Europe, European Investing Summit, European Investing Summit 2017, Ideas, TranscriptsRichard Simmons presented his in-depth investment thesis on Daejan Holdings (UK: DJAN) at European Investing Summit 2017.
Daejan is a property-owning company (75% UK, 25% US; 54% residential, 46% commercial). Property is primary or secondary, often in central locations and almost all freehold or long leasehold. Daejan is a gradual grower, relying on rent increases, upgrades in the existing estate, small acquisitions, and limited development. Over a full cycle it returns 10-12% in NAV growth, dividends included. The balance sheet is extremely conservative. Daejan is priced at 58% of NAV, a discount of 42% to its fully realizable immediate value. Daejan has an inside value because one might sell it if it traded up to NAV, leaving only the ongoing 10-12% return on NAV.
Note: Richard Simmons discussed Daejan Holdings in a session that also included a discussion of used car finance company S & U (UK: SUS).
About the instructor:
Richard Simmons joined Credo as an Investment Manager in 2001. He discretionarily invests managed accounts and is the Investment Adviser of a Cayman fund, Derby Street Investments. Before becoming an investment manager he was a banker for eleven years. He was educated at Oxford and Cass Business School and is the author of “Buffett Step by Step”.
Members, log in below to access the full session.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
PNE Wind and Francotyp-Postalia: Misunderstood and Neglected
December 11, 2017 in Audio, Communication Services, Deep Value, Energy, Equities, Europe, European Investing Summit, European Investing Summit 2017, Ideas, Mid Cap, Small Cap, TranscriptsFlorian Schuhbauer presented his in-depth investment theses on PNE Wind (Germany: PNE3) and Francotyp-Postalia (Germany: FPH) at European Investing Summit 2017.
Florian’s firm, Active Ownership Capital, is the second-largest shareholder of PNE Wind and the largest shareholder of Francotyp-Postalia, including board membership at both companies. In accordance with the firm’s investment approach, Florian is actively working with management to drive value creation and results for shareholders.
PNE WIND is a leading wind farm developer, realizing and operating wind parks in Germany and abroad, both onshore (pipeline with nominal capacity of ~4,700 MW) and offshore (pipeline with nominal capacity of ~5,000 MW). It also provides operational management services, including commercial and technical operations management for ~1,500 MW. In energy production, PNE derives income from minority shares in wind parks. The company is active in fourteen countries and has 380+ employees. PNE recently sold 80% of a 142 MW portfolio of own wind parks to Allianz for ~€330 million (cash consideration of €103 million).
PNE has been “uninvestable” for most institutional investors due to a messy governance situation, bad track record in creating value for shareholders, and perceived share overhang. However, this is changing as Florian and other shareholders succeeded in replacing management and aligning the board with the new strategy for the business. The new CEO, Markus Lesser, is an experienced industry veteran who is operationally focused and can roll up his sleeves. Investors may be overly focused on operational headwinds, including the introduction of a tender process in Germany in 2017, which has led to substantially lower kw/h prices for wind. There has also been unfair competition from Bürgerwindparks, and the future regulatory regime is unclear as Germany transitions to a new governing coalition.
On the positive side, (i) corporate governance has improved, as three of six supervisory board members, including the chairman, changed at the annual meeting in 2017; (ii) small players are likely to be put out of business due to a lack of scale, such that small service portfolios may be acquired at distressed prices; (iii) the levelized cost of energy may fall by another 30+% in the coming years, driven by turbine efficiencies and reduced production costs; (iv) substantial cost improvement potential may be unlocked by PNE in both capex and opex (purchasing and standardization); and (v) continued low interest rates and abundant financing support the business turnaround. Florian believes that investors substantially underestimate the earnings power of PNE due to the volatile nature of the business.
The shares recently traded at five-year average EV/EBIT of 5.4x and P/E ratio of 8.6, a substantial discount to peers. Florian expects PNE to generate similar average EBIT over the next five years (€30-35 million annually), but with a higher share of recurring earnings.
FRANCOTYP-POSTALIA (Germany: FPH) is a leading franking machine manufacturer, with global market share of 10% and 45% market share in its home market, Germany. Francotyp has an installed base of ~260,000 machines, of which ~100,000 are in Germany. Other key markets include the U.S., UK, France, Netherlands, Sweden, Austria, and Switzerland. Fourth-fifths of revenue is recurring, and barriers to entry are high due to postal regulation.
Florian views Francotyp as misunderstood, as investors mistakenly believe that (i) paper mail is dead; (ii) franking machines are no longer needed; and (iii) the company cannot keep growing the core business. The reality is that (i) 80+% of companies still use letter mail regularly, and paper production has grown from 130 million tons in 1970 to 440 million tons in 2015; (ii) franking machines in the large and medium mail volume segments are in decline, but the small mail volume segment (up to 200 letters per day) continues to grow at a low single digit rate; and (iii) Francotyp continues to grow revenue in the core business in the low single digits through consistent market share gains.
Florian expects the company to generate EBIT of €7.4 million in 2017, €10.5 million in 2018, and €12.8 million in 2019. The shares recently traded at 3.1x EV to 2017E EBITDA and 5.2x EV to operating FCF. Florian’s firm is the largest shareholder, and Florian’s partner Klaus Roehrig serves as chairman of the board.
About the instructor:
Florian Schuhbauer serves as managing partner of Active Ownership Capital. He has a strong track record of value creation in public companies. Before starting Active Ownership Capital in 2014, Florian was Partner at Triton Partners since 2010. Previously, Florian held top investment management and business operational positions at AVI/General Capital Group (Partner/Portfolio Manager), Deutsche Post World Net & DHL Global Mail (CFO & Executive VP), Newtron AG (Director Corporate Finance & Investor Relations) and Dresdner Bank / Dresdner Kleinwort Benson. At Active Ownership Fund, Florian is focused on making significant minority investments in a limited number of undervalued small and midcap companies in Northern Europe in order to increase their value through operational, strategic and governance improvements.
Members, log in below to access the full session.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
The Phillips Conversations: Frank Martin
December 11, 2017 in Audio, Featured, Full Video, The Phillips Conversations, TranscriptsThe 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.

Members, log in below to access the restricted content.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
About the interviewee:
Frank Martin has 45 years of investment industry experience. While a partner at McDonald & Company, he founded McDonald Capital Management in 1987, he acquired and changed its name to Martin Capital Management. He currently serves as Chief Investment Officer and managing member. Frank graduated from Northwestern University in 1964 with a concentration in Investment Management. He earned an MBA, with honors and as a member of Beta Gamma Sigma, from Indiana University at Sound Bend in 1978. Frank is currently a member of the boards of various charitable organizations. A prolific writer, he is the author of two books published in 2006 and 2011 and is completing the research on another to complete the trilogy.
Scorpio Bulkers, Safe Bulkers, Navios, Songa Bulk: Improvement Underway
December 10, 2017 in Audio, Equities, Europe, European Investing Summit, European Investing Summit 2017, Ideas, TranscriptsDavid Marcus presented his in-depth investment thesis on dry bulk shippers at European Investing Summit 2017, focusing on four companies: Scorpio Bulkers (NYSE: SALT), Safe Bulkers (NYSE: SB), Navios Maritime Partners (NYSE: NMM), and Songa Bulk (Oslo: SBULK).
Dry Bulk Shippers: The low-hanging “easy money” has already been made. However, dry bulk names are coming off an extremely low base. David has higher conviction today than when his firm started investing in the space in light of the lower risk profile today: (i) secondhand asset values and charter rates (spot and one-year time charters) have both increased; (ii) the new vessel order book is historically low; and (iii) there is supply visibility. David also sees improvement in structural demand. Despite fears of China slowing down, dry bulk demand has been growing steadily. Demand growth is underpinned by domestic Chinese stimulus (One Road and One Belt) and regulatory policies that favor low-cost suppliers of high‐quality iron ore and coal. Australian and Brazilian iron ore exporters still have cost advantage over Chinese producers. Longer ton miles bode well for dry bulk. In general, management insiders have been recent buyers of dry bulk shippers’ shares.
Scorpio Bulkers: Founded in March 2013, Scorpio owns and operates modern mid‐ to large‐size dry bulk vessels (Kamsarmax and Ultramax). The company is incorporated in the Marshall Islands, headquartered in Monaco, and also based in New York. Management has attempted to replicate with dry bulk its past successes in tankers and LNG. The company was making vessel acquisitions into a worsening dry bulk market, leading to covenant breaches. Scorpio has one of youngest fleets of fuel efficient, mid‐size vessels. All vessels are eco‐design (20% higher efficiency, lower bunker consumption, and high cargo intake). The company has a strong, proven management team, led by chairman and CEO Emanuele Lauro and president Robert Bugbee. A March 2016 equity raise, in which David’s firm participated, provided a two‐year liquidity runway to weather the downturn. Bleak sentiment has led investors to overlook Scorpio’s balance sheet strength. Evermore also participated in a June 2016 equity raise at $3.05 per share alongside management. Proceeds were used to take advantage of compelling secondhand vessels coming to the market from distressed sellers, and extend liquidity to 2020 (more as a preemptive measure vs reaction to market direction).
In the session, David also commented extensively on three other companies owned by his firm, Safe Bulkers (NYSE: SB), Navios Maritime Partners (NYSE: NMM), and Songa Bulk (Oslo: SBULK). In response to a question, David also briefly discussed his positive view on John Fredriksen’s Frontline (NYSE: FRO).
The following transcript has been edited for space and clarity.
Evermore is value with a focus on catalysts. For us, it’s not just about cheap stocks, but making the distinction that cheap on its own isn’t good enough. We want to know there’s a path to getting less cheap, and know what is going to get the value out of the stock and into the investor’s hand. We focus on catalysts; we look at breakups, spinoffs, restructurings, turnarounds.
We love family-controlled businesses where we have dynamic value creators at the top making changes, good investments, creating value, and compounding, yet they’re trading at big discounts. The riskiest investment to us is when something is just a cheap earnings play, because you have to count on them selling more stuff next year at a higher price. That’s rife with potential for missed earnings, which we see all day long — companies missing earnings.
One of the great things I could do over my career was to take a few years when I was running a family office and go sit on boards. I was able to to go from being a stock picker to being an operator — I helped restructure businesses, helped them make decisions that changed the course of those businesses. In some cases, I helped fire managers; in some cases, hire managers.
That gives us a better perspective when we look at companies going through change, as to what can be done and in what kind of timeframe. We focus on areas where other people are not focusing. It’s not about being a contrarian as much as thinking of ourselves as independent thinkers. Let’s have our own perspective, whether people are there or not. Generally, we are going to where it is less crowded.
When I started investing in Europe many years ago, it was because people were not focusing on Europe. There were all kinds of problems twenty-five years ago. Europe has been a great place to invest, and it’s still at the early stages. In the next leg, given the specific individual cases we see, there are more breakups, more spinoffs, more restructurings, and all kinds of M&A activity. This is because we’re in a low-growth environment, so companies are buying growth. We have not even seen the private equity guys come in yet with their cash. Rather, we’re seeing strategic buyers doing bolt-on acquisitions of businesses, product lines, and services.
Perspective on Dry Bulk Shipping
I’d like to focus on an industry that up until a year-and-a-half ago, we never would have looked at — we would have said, “please stop talking to us, you’re wasting our time” — the dry bulk sector.
Historically, we have never invested in this industry, let alone anything connected to it, like containers, tankers, LNG. We typically avoid commodity-type businesses and very cyclical investments. Although energy is a magnet for a variety of value investors, we are not interested. We focus in other areas. When companies have a dependence on the price of oil or other commodity prices — “I need China to do this, or GDP to do that to get real value out” — it is less compelling to us. We want to know there are things the companies themselves can do. That said, there are times when we make exceptions to the rule.
As global special situation investors, we became interested in this industry when it was facing death and carnage. Only 18 or 20 months ago, there wasn’t just blood in the street; there was blood in the water. We were attracted just like sharks would be. There was so much opportunity.
Prior to our getting involved, this industry had sucked in all kinds of investors — through “interesting” situations, capital raises, ships being built, pie-in-the-sky forecasts that China was only going to grow. It didn’t happen that way. Companies had to do massively dilutive financial restructuring to shore up their balance sheets. All the names in the industry were crushed. Stocks were down 80%, 90%, 95%. They generally didn’t quite die, because the banks would extend loans rather than write them off completely. But the stocks were decimated.
We look at these kinds of businesses when panic sets in. Sporadically, you get to a point at which investors are throwing out their gold coins along with their gum wrappers. They want out, and they can’t get out fast enough. They’re not focused on value. They want to move on, go home, and forget they ever invested here.
When we saw that, we were interested. It all began when a banker called us because a dry bulk company was recapping its balance sheet at very weird terms. It had one set of terms for American investors and a different set of terms for Norwegian investors, where the company was headquartered. It was Golden Ocean Group. U.S. investors were to have a six-month lockup while Norwegian investors could sell the next day. We were not interested.
We realized that if the bankers were calling us about a company going through this kind of transition and was desperate for capital, first they had called the traditional investors; then they had called everybody else they knew; then there was a list of “who knows who”. After they made all those calls, they called us, because normally we wouldn’t care about anything like that. It didn’t make us interested in that specific company. But as we started to get other calls, we decided we needed to understand better what was going on. We knew why they were desperate for cash, but what was detracting all the other investors from making the investment?
This industry has more conferences than any other industry we’ve seen. There’s always a shipping conference. There was one this week in New York, and they’re already talking about the next one and the one after that. We constantly ask the CEOs, “How do you have time to run your business?” They’re always at the conferences. In any case, it was a situation in which the more work we did, the more compelling it became to us.
The Baltic Dry Index shows a blended rate of all ship sizes — an amalgamation of day rates into an index. Until 2008 it was pie-in-the-sky, going straight up as though it would never end. It ended in the financial crisis. It ended for many industries, but this one especially was down over 90% from peak to trough. Over the next nine years there were fits and starts along the way, but this was a boom-bust scenario. While the scale of the index chart, due to the large decline, makes the moves in 2013-15 seem small, they were also dramatic. Those were the years when China was perceived as growing forever and shipping owners were ordering new ships faster than before.
Another implosion occurred in 2014-15, as China started to slow down and day rates came down. More than that, the perception of the future of this industry changed rapidly. Why? The owners were ordering so many ships and they had not even been delivered yet, but China was slowing down. So just as the slowdown started to manifest itself, it was still only the front end of deliveries. There was an explosion of supply and a decline in demand.
In the last year or two there has been a bounce in the stocks in the dry bulk index. But while the underlying stocks have moved substantially, they have not moved enough to be appropriately valued. When spot rates drop below asset values, it impacts day rates and cash flows. Companies started to break covenants, the bankers were nervous. Various German banks were lenders to the industry. When the first domino fell, things rapidly spiraled. This predates our getting involved.
During the crisis, we saw asset values at historically trough levels, with five year-old capsize vessels trading at ~50% discounts to their twenty-year average. Spot rates, or second-hand vessels, traded at 35-40% discounts and 55-60% of newbuild prices. At a point in January 2016 day rates hit $1,500 per day. This is so far below the daily operating cost of ships that ship owners start saying, “Wait a minute.” They can handle chartering out ships below cost to keep things going. It costs a lot of money to put your ship in the middle of nowhere and decommission it for a few months. You can’t just decommission it and recommission it; you have to commit to quite a number of months due to the nature of the process and the cost. Even if they are running below operating cost, owners will keep going for as long as possible because they’re hoping for a turn. In this case, the turn didn’t come.
What started to happen was that older ships began to be scrapped. Drydock and maintenance costs were adding up for ships that were not utilized at all; they were alive but not charted out. After the owners had cut the price — and cut, and cut again — scrapping started to grow. Older, less economically efficient ships were being sent to the scrap heap, and that was changing the supply of capacity. It got to a point where there was negative implied capacity growth. It actually shrunk.
There was an inflection point between demand and supply for a brief period because people were scrapping so aggressively. 8% of the total fleet was sent to the scrapper; the number of ships was much reduced. Companies we had gotten to know were cancelling orders, leaving $5-10 million cash deposits with shipyards just to walk away from ships. They took the view that it was better to lose $8 million than to pay the balance of the ship and then have to manage it. It was absolute carnage, devastation, panic. Early 2016 was a nightmare.
Looking at asset values historically, they had gapped up in 2008. Since then asset value in the market are not just below the levels of 2000, but we are actually replicating the levels of 1980. Assets are trading at levels not seen in a long time.
The first conference I went to in this industry was in early 2016. It was amazing. I was there with one of our senior analysts, who has worked in this industry with me from the beginning. Tommy and I were there, and we were the only people smiling. People were practically in tears — the bankers, the ship owners, the CEOs, and especially the CFOs. You could feel it in the room. It was unbelievable.
We walked around and started to meet the owners, the shareholders, the operators. It was quite simple: Whether you had a young fleet of ships, good cost controls, and solid management, or whether you had an old fleet, bad controls, and weak management, your stock was trading at about the same percentage of net asset value. The market was not discriminating between good and bad — the whole industry was simply “dead”.
A quick anecdote related to the mention of “Nevermore” vs. “Evermore” in my slides: We were going to see the CEO of Star Bulk Carriers at the conference. Before we even said hello, he saw my name tag and said, “Evermore!” I said, “Yes?” He said, “I bet you’ve never invested in this sector, and you probably didn’t even look at it until recently.” I said, “You’re correct! What are you, a mind reader?” He replied, “If you had invested any time before today, your name would actually be Nevermore.” His point was this industry had crushed everybody.
That’s when we knew we were on to something. It couldn’t be that the whole industry would go away. The key was to figure out who were the players that would survive, who was trading at the cheapest levels, who was going to recap their balance sheet, and how could we weasel our way into not only buying the stocks in the market but also finding an opportunity to participate in the recaps.
Ultimately, we went from being newbies and knowing nothing about the industry to the other end. We got to a point at which we were helping companies recap their balance sheets. We helped them restructure so they could push out their liquidity windows, giving them a chance to cut costs, refocus their businesses, scrap the ships that needed to be scrapped, and maybe even make a sale. More than anything, it was a chance to buy assets. We were excited about the opportunity to buy second-hand ships and to invest in the companies that would survive — and to take away the lowest-hanging opportunities from distressed sellers. Some companies were doing recap after recap after recap, so we had to figure out what the insiders were doing.
Selected Ideas in Dry Bulk Shipping
Members, log in below to access the full session.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
About the instructor:
David Marcus has more than 20 years of experience in the investment management business. He began his career at Mutual Series Funds, mentored by renowned value investor Michael Price, and rose to manage the Mutual European Fund and co-manage the Mutual Shares and Mutual Discovery Funds. He also served as director of European Investments for Franklin Mutual Advisors, LLC. After leaving Franklin Mutual, David founded Marcstone Capital Management, LP, a long-short Europe-focused equity manager, largely funded by Swedish financier Jan Stenbeck. When Mr. Stenbeck passed away in 2002, David closed Marcstone and then co-founded a family office for the Stenbeck family; as an advisor to the family, he advised on the restructuring of a number of the public and private companies the family controlled. He later founded and served as managing partner of MarCap Investors LP, the investment manager of a European small cap special situations fund, which he managed from 2004 to 2009.
When Is It Appropriate to Re-Underwrite an Investment Thesis
December 9, 2017 in Best Ideas Conference, LettersThis article is authored by MOI Global instructor Gary Mishuris, managing partner and chief investment officer of Silver Ring Value Partners. Gary is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.
A value range is an estimate at a point in time about the likely range of business values. As we get additional information, sometimes changing our value range is warranted, while other times we actually gain additional confidence in our initial conclusion. The two extremes, neither of which are optimal, are:
1. Materially changing our value range very frequently based on each incremental data point
2. Anchoring on our initial value range and never changing it regardless of the new evidence
It is also important to differentiate between two types of changes:
1. Changing the base case but leaving the range itself unchanged. Given that the base case is just the point along the confidence interval that represents the most likely scenario, it is more likely that we would be wrong about where the base case lies along the likely range of values than that we are wrong about the range itself.
2. Changing the range itself. I underwrite the range of values to represent ~ 90% of possible outcomes, meaning that if I do a good job the business should be worth less than my worst case no more than 5% of the time. These numbers are meant to be representative of the approximate degree of severity of the worst case that I underwrite to, rather than to reflect any false precision about the probabilities themselves as the exact numbers are impossible to precisely quantify. Therefore, it should take substantially more evidence to change the range than it should to change the point that is the most likely one along that range (base case).
The process through which I update my value estimate for each business is based on Bayesian updating. My initial estimate, which is the result of a rigorous process that attempts to properly weigh the relevant information that is available at the time of the underwriting acts as the Bayesian prior. As new information comes along, some of it causes me to update that prior estimate conditional on the new information. Most of the time the changes are small, and merit immaterial changes. Some of the changes in value are due to the passage of time (e.g. if a company was worth $10 a year ago that means that at that time my future value estimate for it today was $11 using a 10% discount rate). Other changes can occur due to capital allocation actions (e.g. share buybacks or change in the debt levels of a company). These kind of changes tend to be individually immaterial and while it’s good practice to do this sort of housekeeping on a regular basis to keep the value estimates up to date, they are unlikely to move the needle on the value range.
There are three key points when I re-assess the value estimate for a company:
1. Quarterly results. The main question I ask is: What evidence, if any, has become available that either confirms the thesis or informs me that results are tracking either better or worse relative to my long-term expectations? (See the thesis tracker that I discussed earlier in this letter that I use to formalize tracking the output of this process.) Usually little or no thesis-changing information is present in a quarter’s results – some who believe otherwise are likely forgetting that a quarter is shorthand for one fourth of a year and that it is unlikely to have a forecast of many years materially affected by developments over such a short period of time.
2. Material events. These include substantial acquisitions, management changes, material changes in the capital structure and material competitive developments that affect the long-term competitive position of the business. These require a careful reassessment of the thesis and the value range.
3. Three consecutive quarters of results tracking either better or worse than my base case would suggest they should. I have improved my process as a result of instituting my thesis tracker that I described earlier and carefully considering this question. Previously, I would re-underwrite the investment by considering the incremental information in the context of my original thesis for one of the two prior reasons. However, I believe that we are all impacted by behavioral biases, and one of the most prevalent is anchoring on our prior conclusions. It’s easy to let this bias lull us into complacency by disregarding small quarterly deviations from original expectations. On the other hand, we wouldn’t want to overreact by doing a time-intensive re-underwriting of an investment because of a small deviation in a single quarter. I believe that using the rule of doing a mandatory, in-depth re-underwriting following three consecutive quarters of deviation from the base case assumptions is a good way to balance those considerations and guard against behavioral biases.
Some of the steps involved in a full re-underwriting process are:
• Seeking out or, if unavailable, creating the strongest possible opposing thesis
• Building a model from scratch using the full set of currently available data rather than simply incrementally updating an existing model
• Re-assessing each of the three quality ratings (Business, Management and Balance Sheet) to make sure the situation has not changed materially
• Creating a list of all the forces/facts that are making this a structurally better business and a list of those that are making this a lower quality business than it had been historically
• Seeking out additional sources of primary research to confirm/reject concerns about the business
DISCLAIMER: The information contained herein is confidential and is intended solely for the person to whom it has been delivered. It is not to be reproduced, used, distributed or disclosed, in whole or in part, to third parties without the prior written consent of Silver Ring Value Partners Limited Partnership (“SRVP”). The information contained herein is provided solely for informational and discussion purposes only and is not, and may not be relied on in any manner as legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or vehicle managed or advised by SRVP or its affiliates. The information contained herein is not investment advice or a recommendation to buy or sell any specific security. The views expressed herein are the opinions and projections of SRVP as of September 30th, 2017, and are subject to change based on market and other conditions. SRVP does not represent that any opinion or projection will be realized. The information presented herein, including, but not limited to, SRVP’s investment views, returns or performance, investment strategies, market opportunity, portfolio construction, expectations and positions may involve SRVP’s views, estimates, assumptions, facts and information from other sources that are believed to be accurate and reliable as of the date this information is presented—any of which may change without notice. SRVP has no obligation (express or implied) to update any or all of the information contained herein or to advise you of any changes; nor does SRVP make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. The information presented is for illustrative purposes only and does not constitute an exhaustive explanation of the investment process, investment strategies or risk management. The analyses and conclusions of SRVP contained in this information include certain statements, assumptions, estimates and projections that reflect various assumptions by SRVP and anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes. As with any investment strategy, there is potential for profit as well as the possibility of loss. SRVP does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable. Past performance is no guarantee of future results. Investment returns and principal values of an investment will fluctuate so that an investor’s investment may be worth more or less than its original value.