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The Two Reasons for Spinoffs

December 8, 2017 in Best Ideas Conference, Diary

This article is authored by MOI Global instructor Gautam Baid, CFA, portfolio manager at Summit Global Investments. Gautam is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Special situation investing involves participating in variety of corporate actions like buyback, rights issue, spin-offs, asset sales, etc. These are low-risk arbitrage opportunities which can act as a significant source of generating alpha in an investor’s portfolio. In my Best Ideas 2018 presentation, I am going to focus on spin-offs.

Spin-offs happens for two broad reasons:

1. Due to conglomerate nature or historical diversification steps, company could be operating in two completely different areas of businesses. Spin-offs can help to get better valuation (no more holding company or conglomerate discount) and unlock parent company’s value. It also gives focused management bandwidth to each business to grow and scale up.

2. Sometimes, parent company might be struggling with debt, which holds back the core operating performance of the company. Hence, the management sandbag one of its divisions with debt and spin them off. This will liberate the other operating company from the debt and help them to achieve better valuation in the market, especially if their underlying sector is currently in fancy.

This second category is the one I will be presenting at Best Ideas 2018. It is a typical case of how value migrates to the equity side from the debt side as deleveraging kicks in driven by sale of richly valued assets which are obscured from investors’ view due to the prominently visible high debt of the spun-off entity. It will also be a real-life application of the valuable vicarious learnings obtained over the years from the writings of Joel Greenblatt and Seth Klarman as elaborated below.

Joel Greenblatt in You Can Be a Stock Market Genius:

“Believe it or not, far from being a one-time insight, tremendous leverage is an attribute found in many spinoff situations. Remember, one of the primary reasons a corporation may choose to spin off a particular business is its desire to receive value for a business it deems undesirable and troublesome to sell. What better way to extract value from a spin-off than to palm off some of the parent company’s debt onto the spin-off’s balance sheet? Every dollar of debt transferred to the new spinoff company adds a dollar of value to the parent. The result of this process is the creation of a large number of inordinately leverage spinoffs. Though the market may value the equity in one of these spinoffs at $1 per every $5, $6 or even $10 of corporate debt in the newly created spin-off, $1 is also the amount of your maximum loss. Individual investors are not responsible for the debts of a corporation. Say what you will about the risks of investing in such companies, the rewards of sound reasoning and good research are vastly multiplied when applied in these leveraged circumstances. Tremendous leverage would magnify our returns if spinoff turned out, for some reason, to be more attractive than its initial appearances indicated.”

Seth Klarman in Margin of Safety:

“The behavior of institutional investors, dictated by constraints on their behavior, can sometimes cause stock prices to depart from underlying value. Institutional selling of a low-priced small-capitalization spinoff is one such example. Many parent-company shareholders receiving shares in a spinoff choose to sell quickly, often for the same reasons that the parent company divested itself of the subsidiary in the first place. Shareholders receiving the spin-off shares will find still other reasons to sell: they may know little or nothing about the business that was spun off and find it easier to sell than to learn; large institutional investors may deem the newly created entity too small to bother with; and index funds will sell regardless of price if the spinoff is not a member of their assigned index. There is typically a two to three month lag period during which the spin-off company’s financials have not been entered into financial databases and there will be very few analysts covering it. Thus, the stock could be the cheapest stock in the world during this time.”

I look forward to participating at Best Ideas 2018 alongside a group of like-minded individuals and actively engage in collaborative learning through the sharing of ideas, insights and personal experiences.

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Index Investing and the Assumption of Order

December 8, 2017 in Best Ideas Conference, Diary, Letters

This article is authored by MOI Global instructor Jonathan Isaac, portfolio manager of Quilt Investment Management, based in Tucson, Arizona. Jonathan is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

Index funds present a particular set of challenges, where money flow and mere inclusion in an index often creates individual buy/sell decisions. Those who invest in them may want to consider this final point: risk is investing without forming an idea of a company’s expected value, investing without adequate knowledge, and investing without an edge. Presumably, if market efficiency (the “edge” of many index investors) is created through a pricing mechanism enacted by the active decisions of others (those who invest using valuation as an input for their decisions), passive investors could profit from this pricing mechanism en masse by investing in broad indexes.

But how does the continued growth of index investing impact the “efficiency” of the market’s pricing mechanism? Like in so many instances, an analogy can prove our point. The first few people who stand on their tippy-toes in a crowded room (assume that everyone is the same height) can see the stage better, but as more and more do it, fewer and fewer people can see the stage. A belief in market efficiency is also a belief in the standardization of crowd behavior. What happens when someone pulls the fire alarm? As the hagiography of a parasitic way of investing continues to grow, we must wonder: what will become of the organism itself?

Warren Buffett, the last modernist

Comfort with the future in value investing history began to emerge with Warren Buffett, who can be viewed as an intermediary figure in ex-ante optionality becoming ex-post optionality. Investing in companies with durable competitive advantages presumes that certain demonstrable benefits, or protective “moats” surrounding a company’s competitive position, extend from the past into the future.

There is a presumption of normalcy in this process that can be observed in a range of business practices: the continuation of a predictable act (people like drinking a certain branded soda; seeing the image produces a sensation that often leads, in repetition, to consuming it, which is also consuming the memory of it), creating the conditions for future protected innovations (a company consistently has the best engineers and a great patent history), or, in its most base form, investing in a regulated utility that produces something the population will always need and for which extensive transportation will probably always be uneconomical (for instance, a water utility).

Here, the past extends through the future in a similar way, and we can all share in the common practice of telling fortunes (although, clearly, some people are more perceptive than others). However, with ex-post optionality, there is not a presumption of normalcy: future conditions are altogether different from what exists on the balance sheet or in current economic reality; we have to look elsewhere.

Berkshire Hathaway’s purchase of BNSF can be viewed as Buffett situating himself between the ex-post optionality of incremental margins and the ex-ante optionality of historical truths and their continuation; Buffett, to extrapolate, saw conditions under which the durable competitive advantages of BNSF would impact the realization of incremental margins, and future conditions for this occurrence were mispriced in the present.

In short, Buffett saw reflexivity between ex-ante optionality and ex-post optionality through which historical forces would impact the future. This was, perhaps, the highest art of a crystal ball that integrates the past, through which tendencies and drive find their codifications. Buffett is a late modernist, maybe the last modernist, while Graham—who almost became a professor of classics instead of finance—is a classicist, buried in a tomb of financial statements which act as a horizon to Buffett’s infinity.

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Thoughts on Portfolio Management

December 7, 2017 in Best Ideas Conference, Letters

This article is authored by MOI Global instructor Amil Bera, founder and chief investment officer of Advaya Investment Management. Amil is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

“Stability leads to instability. The more stable things become and the longer things are stable, the more unstable they will be when the crisis hits.” –Hyman Minsky

We have grown more cautious regarding market exposure in our portfolios since the election. Most notable about the last three quarters of outperformance is that we have managed to do so while reducing risk – both in terms of leverage and market exposure. Our job is foremost to manage risk, which we define as the potential for a permanent loss of capital. We believe that tail risks to financial asset prices are greater today than they were prior to the election. Yet, on the surface, financial markets seem more stable than they have been over the past several years. This stability should not be taken as a sign that all things are good ad infinitum. As economist Hyman Minsky argued, long periods of stability in financial markets can lead to a false sense of security, which in turn increases instability when things correct – which they inevitably do. We are skeptical of – and not excited about – a rising market detached from fundamentals.

When it comes to portfolio management, one of the hardest things for an investor to do is not do anything. Not trading while markets constantly move around requires discipline. For long-term value investors, moments of doing nothing to the portfolio should be frequent; what is often called for is letting carefully selected positions purchased at a discount do their work. This work can take years. In the meantime, our job is to be ready with equally good companies when the time comes to sell out of an existing position. The hope is that one of these companies will sell at a significant discount to our estimate of its intrinsic value when we are ready to make a purchase.

One of our current priorities is to ensure that we can take advantage of a market dislocation when it occurs. It is important to note that while we remain fully invested, we are not betting on the market going up. Currently, we are invested in twenty companies, many of which have company-specific catalysts that investors have not priced in. Others are strong operators which are undervalued relative to the market. As a group, these companies are cheap in our view. This does not mean that if markets selloff, our stocks will remain unscathed. This does mean, however, if markets selloff and some of our stocks become materially cheaper, we would have confidence to add to our positions (all things being equal). In sharp market selloffs, correlations for all risk assets approach one. Investors tend to run for the exits at the same time, seeking the safety of cash.

This brings us to the “option value” of cash. Cash increases in value in times of market distress. For example, during a -20% market selloff in which a couple of our high conviction stocks fall -40%, cash would maintain its value. If we use that cash to double down on our two favorite stocks that fell -40%, we would suddenly be able to purchase 67% more shares after the decline – with the same amount of cash. In other words, cash becomes more valuable as asset prices decline. The irony is most people either do not have cash when markets are declining or are too afraid to put cash to work during periods of market turbulence. The aim is to increase cash in periods of stability to take advantage of dislocations in periods of instability. This is more art than science and requires discipline and patience as well as acceptance of periods of underperformance in return for potentially better long-term returns.

In periods of high market valuations, in addition to higher cash levels, our portfolios may grow more concentrated. As we sell overvalued positions, we may choose to reallocate cash into current high conviction positions that trade cheaply. In such instances, we would stay within our concentration limits. The more concentrated a portfolio is, the more volatile it is likely to be, and the more company-specific factors will affect portfolio volatility. We agree with Warren Buffett and Charlie Munger when it comes to concentrated investing: volatility of returns is not risk, and diversification for diversification’s sake is merely a way to protect against ignorance. Lack of volatility in portfolio returns does not mean a better portfolio. While we understand that many investors cannot stomach volatility, we believe that volatility is what creates the best long-term opportunities. We measure ourselves on long-term returns, irrespective of short-term volatility.

The topic of diversification leads us to passive investing. Many investors today choose to put their money to work in low-cost exchange traded funds (ETFs), most of which are tied to market indices, such as the S&P 500. Passive assets make up 30% of assets under management in the U.S. and are growing rapidly, while assets under active management are shrinking. Ironically, investor preference for passive investing – which is driving outflows from active strategies – creates more opportunities for skilled active investors focused on company fundamentals. Passive investing requires no stock selection skill; instead, the focus is on technology, trading, index replication and scale.

As more passive assets pour into ETFs that replicate market indices, movements of the index’s underlying stocks are increasingly driven by passive assets. These assets have complete disregard for underlying companies and their fundamentals. Subsequently, underlying stock prices can become disconnected from company fundamentals. In sharp selloffs, passive money exacerbates falls in indexes as investors pull money out of ETFs. Adding to declines is short selling of ETF shares by traders looking to make a quick profit. This selloff dynamic indiscriminately drives down share prices of all index components. Occasionally, there is an opportunity for the skilled active investor who has already done his research to grab shares of great companies with strong fundamentals at a sharp discount. This opportunity is more likely in stocks that make up a large share of an index or are components of multiple indexes replicated by popular ETFs. The popularity of low-cost passive investing that is putting pressure on the business model of active investors is also creating more opportunities to generate alpha over the long-term. Knowledge of market dynamics and passive index construction is instrumental to figuring out when to act. That – along with good stock selection – is one of the value-adds of an astute long-term investor.

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On Management Incentives

December 7, 2017 in Best Ideas Conference, Letters

This article excerpted from a letter by MOI Global instructor Peter Rabover, principal and portfolio manager of Artko Capital. Peter is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

“I will tell you a secret: Dealmaking beats working. Dealmaking is exciting and fun, and working is grubby. Running anything is primarily an enormous amount of grubby detail work . . . dealmaking is romantic, sexy. That’s why you have deals that make no sense.” –Peter Drucker

This quarter can be described as one of tepid disappointment in management teams of some of our holdings. One of the hardest things in active—but not activist—investing is making sure the management incentives of portfolio companies are aligned with those of minority shareholders. It is even harder in the small capitalization space, where corporate governance is often less sophisticated and occasionally mismanaged. There is no precise science to quantify the benefits, but ensuring that the incentives of shareholders and management are aligned through direct ownership or compensation structures is a significant way to limit the investor downside risk. We tend to favor companies where the CEOs and board members either own a substantial amount of stock or can create a substantial financial windfall for themselves through successfully increasing the value of the companies they manage.

Unfortunately, throughout our career we’ve found that after a certain financial threshold of ownership, the psychological motivations of wealth creation can move up the Maslow Pyramid into those of ego boosting, which may not align with those of other shareholders. In other words, after a certain amount of money is made, there may be less worry about the money and more worry about legacy, reputation, and control. On the other side, an argument can be made that having substantial wealth and reputation tied to a company creates an additional margin of safety where management is also motivated by capital preservation and is unlikely to take on value-destroying initiatives. There is no perfect solution, and finding a way to thread the needle of aligning management incentives with those of shareholders is often a challenging task. This quarter, we faced various transactions by management teams of our holdings that show the difficulty of aligning shareholder incentives with those of management:

National Research Corp. B Shares (NRCIB)

Our original thesis for investing in the B shares of what is now called NRC Health was the attraction to the oligopolistic high margin, recurring revenue business model engaged in rating the quality and patient satisfaction of hospitals and doctors in the United States. Additionally, the benefit of the B shares was that they received six times the voting and economic power of the A shares, including regular and special dividends, while trading at less than three times the value of the A shares. Founder and CEO Michael Hays controlled 54% of the A shares and 60% of the B shares, effectively controlling 56% of the company and receiving 56% of the dividend cash flows. We felt that being invested alongside the CEO and the board of directors in the B shares at a 50% discount to economic parity of the A shares provided a significant margin of safety in this special situation. Since our initial purchases two years ago at $33 per share, the B shares have paid out $6.34 cents per share in dividends (or close to 20%) and have appreciated in value to $54 for another 60% return. However, by September 2017, the discount between the economic parity to A shares has widened to over 70%, and the CEO saw the opportunity to recapitalize the company by buying back the B shares he did not already own at the current stock price. While a shrewd and opportunistic move to increase control of the company through a partial leveraged buyout, an exit scenario we always felt was the most probabilistic, we were extremely disappointed in the no premium, tender offer price significantly below the economic value of the B shares. We sold our 10% position at ~$54 per share and while pleased with the total returns we were dissatisfied in the transaction over which we had little control.

State National Companies (SNC)

During the quarter, our 11% investment in SNC received a buyout offer from Markel Corp. at $21 per share—a 15% premium to the price at the end of the previous quarter and 110% above our initial purchase price 10 months earlier. There are few things as prestigious as and validating of your personal success than having an insurance company that you founded be bought out by a venerable insurance institution like Markel. It is no surprise that the managing Ledbetter family, which owns 54% of the outstanding shares and has always had an interest in keeping SNC private, readily accepted the offer and committed to voting its ownership stake in favor of the deal where they would continue to grow the company within Markel. The $919 million offer would net the family close to half a billion dollars and allow the opportunity to continue to grow their legacy at Markel. However, we felt the $21 per share offer price was too low and allowing competing, but not necessarily as favorable to the family interests, bidder into the process would have netted offers of $25 per share or above, closer to our estimate of the company’s true value. This was another example of where we, as minority shareholders, had little recourse in addressing what we felt were decisions made not in the best interest of all shareholders. We have not yet sold our position given the high probability of the deal close in this current quarter, our partners are better served paying taxes on long-term gains rather than the higher taxes on short-term gains. We expect to convert this position to cash in the current quarter.

USA Technologies (USAT)

In our biggest disappointment this quarter, we sold our 11% position in USA Technologies at approximately $5.45 per share. USAT was one of our favorite stories of the last two years, with a significant runway to increase its leadership position in the six million vending machine payments market from its current base of over 500,000 connections. The market agreed with us, and the stock appreciated almost 100% from our initial purchase levels. However, the journey to this point has not been without its bumps. Four CFOs, internal control issues, continuous cost overruns, and an out-of-control CEO have contributed to the deterioration of our confidence of our original thesis. Unlike the prior two positions, where managers with substantial ownership created additional shareholder value, during the quarter the company announced an unexpected and highly dilutive equity raise, for no reason we could find other than to get favorable coverage from a sell side institution. The company refused to answer our communication with respect to the equity raise, despite knowing we’ve been long-term shareholders. CEO Stephen Herbert chased us in the hall at a recent conference in San Francisco to express his displeasure at us asking a question about the equity dilution at a Q&A event. While this isn’t the first time a CEO of a public company got upset with our line of questioning with respect to our investment in their company, we decided to exit our investment as a result due to the heavy concerns about Herbert. We realized Herbert’s attitude toward USAT shareholders changed from a willing seller of a company to one of a “trust me” empire builder. While owning less than 1% of the stock outstanding, or approximately $2.5 million in equity, Herbert’s salary climbed to over $1 million a year from $500,000 a few years ago, a high number for a small, $100 million/year revenue, company. A highly accretive sale of the company to a strategic acquirer would net Herbert an additional $1 million-$2 million, while he would surely lose his job or lucrative salary in any potential acquisition. Instead, it appears Herbert is focused on deal making, which as Peter Drucker said earlier in this letter, beats working. There is a good chance that this company will capitalize on its opportunities and the stock price may yet double from here. However, as a concentrated portfolio investment strategy, we believe our partners are better served being invested in management teams whose interests are aligned with our own.

If it seems like we are disappointed in our investments that doubled in value over one or two years, it is because we are. We do not like to leave money on the table, and we will continue to refine our focus on management incentives as part of our research process.

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DISCLAIMER: The Partnership’s performance is based on operations during a period of general market growth and extraordinary market volatility during part of the period, and is not necessarily indicative of results the Partnership may achieve in the future. In addition, the results are based on the periods as a whole, but results for individual months or quarters within each period have been more favorable or less favorable than the average, as the case may be. The foregoing data have been prepared by the General Partner and have not been compiled, reviewed or audited by an independent accountant and non-year end results are subject to adjustment. The results portrayed are for an investor since inception in the Partnership and the results reflect the reinvestment of dividends and other earnings and the deduction of costs, the management fees charged to the Partnership and a pro forma reduction of the General Partner’s special profit allocation, if applicable. The General Partner believes that the comparison of Partnership performance to any single market index is inappropriate. The Partnership’s portfolio may contain options and other derivative securities, fixed income investments, may include short sales of securities and margin trading and is not as diversified as the indices, shown. The Standard & Poor’s 500 Index contains 500 industrial, transportation, utility and financial companies and is generally representative of the large capitalization US stock market. The Russell 2000 Index is comprised of the smallest 2000 companies in the Russell 3000 Index and is generally representative of the small capitalization U.S. stock market. The Russell Microcap Index is comprised of the smallest 1,000 securities in the Russell 2000 Index plus the next 1,000 securities (traded on national exchanges). The Russell Microcap is generally representative of the microcap segment of the U.S. stock market. All of the indices are unmanaged, market weighted and reflect the reinvestment of dividends. Due to the differences among the Partnership’s portfolio and the performance of the equity market indices shown above, however, the General Partner cautions potential investors that no such index is directly comparable to the investment strategy of the Partnership. While the General Partner believes that to date the Partnership has been managed with an investment philosophy and methodology similar to that described in the Partnership’s Offering Circular and to that which will be used to manage the Partnership in the future, future investments will be made under different economic conditions and in different securities. Further, the performance discussed herein does not reflect the General Partner’s performance in all different economic cycles. It should not be assumed that investors will experience returns in the future, if any, comparable to those discussed above. The information given above is historic and should not be taken as any indication of future performance. It should not be assumed that recommendations made in the future will be profitable, or will equal, the performance of the securities discussed in this material. Upon request, the General Partner will provide to you a list of all the recommendations made by it within the past year. This document is not intended as and does not constitute an offer to sell any securities to any person or a solicitation of any person of any offer to purchase any securities. Such an offer or solicitation can only be made by the confidential Offering Circular of the Partnership. This information omits most of the information material to a decision whether to invest in the Partnership. No person should rely on any information in this document, but should rely exclusively on the Offering Circular in considering whether to invest in the Partnership.

Bias from Liking/Dis-Liking Distortion

December 6, 2017 in Human Misjudgment Revisited

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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Bias from liking/dis-liking distortion including the tendency to especially like oneself, one’s own kind and one’s own idea structures, and the tendency to be especially susceptible to being misled by someone liked. Disliking distortion, bias from that, the reciprocal of liking distortion and the tendency not to learn appropriately from someone disliked.

“Well here, again, we’ve got hugely powerful tendencies, and…you can see that very brilliant people get into this almost pathological behavior. And these are very, very powerful, basic, subconscious psychological tendencies, or at least party subconscious.” –Charlie Munger

Man with a hammer syndrome revisited and B.F. Skinner: “Why is man with-a-hammer syndrome always present? Well if you stop to think about it, it’s incentive-caused bias. His professional reputation is all tied up with what he knows. He likes himself and he likes his own ideas, and he’s expressed them to other people – consistency and commitment tendency. I mean you’ve got four or five of these elementary psychological tendencies combining to create this man-with-a-hammer syndrome.”

We also can’t outsource our thinking to advisors or other helpers. “Every profession is a conspiracy against the laity” is a popular phrase that captures most of the idea, but it’s not quite right. It’s more of a subconscious psychological tendency. “The guy tells you what is good for him. He doesn’t recognize that he’s doing anything wrong…So you’re getting your advice in this world from your paid advisor with this huge load of ghastly bias. And woe to you. There are only two ways to handle it: you can hire your advisor and then just apply a windage factor, like I used to do when I was a rifle shooter. I’d just adjust for so many miles an hour wind. Or you can learn the basic elements of your advisor’s trade. You don’t have to learn very much, by the way, because if you learn just a little then you can make him explain why he’s right. And those two tendencies will take part of the warp out of the thinking you’ve tried to hire done.”

“I have never seen a management consultant’s report in my long life that didn’t end with the following paragraph: ‘What this situation really needs is more management consulting.’ Never once. I always turn to the last page. Of course, Berkshire doesn’t hire them, so I only do this on sort of a voyeuristic basis. Sometimes I’m at a non-profit where some idiot hires one.”

Update

Also known as “Liking/Loving Tendency,” and separately, “Disliking/Hating Tendency,” with examples including:

  • a newly hatched baby goose that is programmed to follow the first creature that is nice to it, even if that creature is not its mother or even a goose;
  • the courtship habits of man, such that “many a courtship competition will be won by a person displaying exceptional devotion”;
  • this tendency’s role as a conditioning device to make the liker/lover ignore the faults of, and comply with the wishes of, the object of his affection, and to favor anything even associated with said object;
  • man’s long history of almost continuous war subverted by arrangements that direct the hatred and disliking of individuals and groups into elections – “Politics is the art of marshalling hatreds”;
  • sibling rivalry and Buffett’s quip that “a major difference between rich people and poor people is that the rich people can spend their lives suing their relatives”;
  • factual distortions about major events, such as the group to blame for the destruction of the World Trade Center on 9/11 – many Pakistanis blamed the Hindus, many Muslims blamed the Jews, etc.

Elsewhere Munger notes that “hating and disliking also cause miscalculation triggered by mere association. In business, I commonly see people under-appraise both the competency and morals of competitors the dislike. This is a dangerous practice, usually disguised because it occurs on a subconscious basis.” An extreme example of that many be Warren Buffett himself. Despite a record that is difficult to criticize, I often see people who dislike his politics attack his competency, his morals, or some other unrelated characteristic, and they often do so with totally irrational arguments.

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Transcript of Peterson Capital Management Annual Meeting

December 6, 2017 in Best Ideas Conference, Letters, Transcripts

The following transcript of the Peterson Capital Management annual meeting, held in August 2017, has been provided by MOI Global instructor Matthew Peterson, managing partner of Peterson Capital Management. Matthew is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.

I’d like to welcome you to the first Peterson Capital Management Annual Meeting. We had to compete with the solar eclipse, and some significant traffic and parking, so I’m really happy you are all here. I’m going to start with a few housekeeping items before we kick into things.

The meeting here is going to go until about 4:30pm. We’re then going to head outside. I’m going to walk out to the dinner venue, we’re hosting a dinner a Pancho’s. If you’re able to make it, we’d love for you to be there. You’re welcome to walk, drive, ride share. It’s a little more than a mile, it’s a beautiful walk. For those of you who still haven’t had enough, tomorrow we’ve committed to going out on a deep sea fishing trip. I’m going to bring my children, my wife is coming, and if you’re interested we’d love to have you there. That’s a cash trip. I think for the license, equipment, and the event it’s about 75 dollars; they take cash on the boat.

So with that, again, I’d like to welcome you all here to the meeting. The plan here is, I’m going to go through a few slides, about a dozen slides. I want to get everybody on the same page. Some of you have been with us, following us, and been investors in the fund for many years. Some of you are newer to the fund. So we’ll get everybody on the same page for a minute, then we’re going to take a quick moment and I’m going to play a video; it’s a 14 minute video, it’s a wonderful video. During that time if you need some refreshments, or to use the facilities, I encourage you to do so. When the film is over, we’re going to go right into a Q & A. I want to get to the questions session, hopefully question and answer session, as quickly as possible, so we can talk about what’s on your minds.

I’m going to run through these [slides] pretty quickly here. [First, I will] give you a quick background on fund overview. It’s mostly fund performance. I’m going to talk high-level about how we think about building wealth, how I think that we should all consider building wealth, and then, talk to the practical application of creating alpha. Alpha is the managers added value to the fund.

We have a mission statement. Our mission is to provide a world-class capital allocation vehicle that builds enormous wealth for our long-term partners. We’re not thinking about three years, were not thinking about five years, were thinking about 10, 20, 30 years, and the wealth that we can create for our partners.

I moved here six years ago— for those of you not from Manhattan Beach, I know a few of you flew in from Salt Lake, San Francisco, New York, and it’s great to have everybody here. I moved here from New York six years ago, launched the fund, and we have done very well. Our annualized performance since conception is 14.16 percent, I don’t have to tell you how remarkable that is. It’s certainly world-class. We live in a world where we have zero percent interest rates, your cash at the bank [pays] next-to-nothing, ten-year bonds are paying two percent. So we are very pleased. Over the last 12 months we returned 29 percent. This is not linear, we don’t expect it to be linear. We will have years where we are down, and we will have years when we are up. Five years from now, I expect we’ll have another set of years, some where we are down, and some where we are up. But, for our long-term partners, we expect to be up significantly over the long term.

Let’s talk about the concept of wealth creation and building wealth. This is a slide that Warren Buffett used to show his early LP’s in the early 50’s and 60’s. I don’t think he called it a slide. This was the [content] on a piece of paper that he used to show them. This is meant to illustrate the power of compounding over the long term. There are two variables you can look at. It’s your rate of return and it’s the time you have. And we all have different amounts of time, but I was at a CFA conference in Seattle a couple years ago and I listened to a 75-year-old explain that his time horizon is 50 years. He has a certain amount that is allocated to his children and his grandchildren. He’s expecting to live for a while longer, and he’s expecting to give away money and help out future generations. So, at 75 he has 50 years remaining. I have young children, so I think I have a lot longer than that.

This is what Buffett used to show. If you’re able to obtain these types of interest rates, a $100,000 investment becomes very significant over time. If you’re at a 16 percent rate here, over 10 years, significantly, you’ll have $450,000. That would be a huge return on your investment. However, the incredible bit is that between years 10 and 30 it goes from $450,000 to $8.5 million. What most people don’t recognize is that the human mind doesn’t understand compounding intuitively. Everyone gets praised for being rational, logical, and thinking linearly. Nobody says, ‘oh, that’s a really scalable thought you just had.’ The fact of the matter is, people project in a linear manner what they anticipate the future rate of growth to be. It’s very hard to think exponentially.

I was going to surprise my assistant Parise here with a question and ask her if she could tell me what 7 x 4 is. And she’s good at math, I’m sure she could tell us that it’s 28. But, if you think about it as an example, what is 7 to the 4th [power], and you’d have to really think about it to come up with 2,401. So, the mind is not thinking exponentially, or scaleably. You have to focus, and really concentrate on understanding the potential. The potential is shown right here. It’s 10-years to 30-years [growing from] $450,000 to $8.5 million. I like to think about it in terms of 12 percent returns on 175,000, it’s just easy math in my mind. $175,000 at 12 percent over 30 years turns to $5 million. If you happen to have 50 years it grows to $50 million. So that is building significant wealth, enormous wealth.

Seth Klarman, an excellent, world-class investor, says the greatest single edge that an investor has is long-term orientation. I believe that to be very true.

So what does it require, what do you need to achieve those types of returns? You can evaluate your own period of time. What do you need to do to have great returns? I think there are three things that are essential to building wealth.

Number one, it’s imperative, its fundamental that you have a grasp of financial statements. You have to have your basic financial analysis internalized. That’s everything you learned in B-school, it’s everything you learned in [the] CFA program. It’s understanding that when you buy 10 percent of the stock from a business, you own 10 percent of that business. You’re buying the assets, you’re buying the liabilities, you’re buying that future return on equity. And, you need to think of stock ownership as ownership of the business and you need to understand the financial statements and everything associated with ownership of that business.

The second aspect here is financial theory. So the next level is, who’s winning the Nobel prize? What are they winning it for? Is the CAPM a good theory? Or, is it just a good theory in theory? At some points these theories break down. They’re really fun to teach, they’re really nice mathematically, but there are exceptions to these theories. The unique aspects where these theories break down is often where you can find ways to build wealth.

Then there’s the human side. I think the human side is the most underappreciated aspect of portfolio management. It is the psychology underlying the market participants, and it’s absolutely imperative to understand the psychology of the herd, and ideally to be working as a contrarian against that mentality.

So, just a few examples of this theory verses practice I just want to show you. This is basically the efficient market hypothesis. Markets are supposed to be efficient, objective and the asset prices are supposed to be right. That is the theory. Prices are correct. Everyone’s rational, everyone’s betting they’re own money. There’s enough market participants, the prices are supposed to be accurate. If its overpriced somebody would sell and the price would dip down. But, that’s not what happens in practice. In practice we see all the time that markets are made of emotional beings, and they swing like a pendulum too far, or too euphoric, and then too low, and too pessimistic.

Theoretically, you also see that people are risk adverse in theory, riskier assets should lead to a higher performing asset. But, in practice, the higher performing asset just has to have the perception of more risk, it doesn’t actually have more risk. Uncertainty, for example, would appear in some cases to be risky. However, if two [potential] outcomes are both positive, it might not necessarily be an riskier asset, just an uncertain asset and people often confuse uncertainty and risk.

Finally, this point at the bottom, I think that if you can really internalize this, it will help you immensely. Everybody knows the demand curve slopes [down] and to the right: you’re supposed to want more of a product at a lower price, and less of it at a higher price. But, in practice, in the markets, people warm to stocks as they go up, and they become more euphoric. And, the higher they go the more they want to buy. And when [stocks] go down, and they’re cheap, people panic and sell.

Everybody knows, buy low, sell high. Why do people so consistently do the opposite? It is such a mistake to be fearful when everyone’s fearful. When everybody’s fearful and the markets are low, try to be a buyer in that space. People treat stocks and a lot of financial products like Giffen goods, the exact opposite of the typical demand [curve]. So, as the price goes up, people buy more. And it’s simply economically wrong, but in practice that’s very much what happens.

Q: Can you explain what a Giffen good is?

A: A Giffen good [describes] a product where as the price increases, people demand more of it. There’s an old example about a potato famine in Ireland, where as the price of potatoes were increasing, people were buying more and more because they could no longer afford the substitute, beef. So as prices go up, you buy more. It’s rare to find those types of products, but financial products tend to operate like Giffen goods. And, it’s not how they should operate, it’s how the market participants think about the product, and they buy more as the price increases.

Q: What about Tulips?

A: Yes, well, there has been a lot of market mania, I can think of a few cryptocurrencies that have done that too.

I think the best way to conceptualize the market is as a pendulum. And I think one of the most important things that you can do as you’re making investments, is to gage where we are in the market cycle. There’s a business cycle, that is factual. We go into recessions, that is factual. We have euphoric periods, we have pessimistic periods. If you think about where the herd is in this swing of the pendulum, it will help you when you’re figuring out how to [invest] your capital. People swing from risk tolerant to risk averse all the time. I mean, in 2009, you couldn’t get people to put their money in the market while it was selling for a quarter of its intrinsic value. Today, people are different, people are more comfortable— it’s been eight years— people are much more comfortable with risk today than they were in 2009. That is a simple swing of this pendulum. I encourage people to think about the markets this way. It’s the easiest way to conceptualize the markets. So with that, what I’d like to do is talk a little bit about how we put this in to practice in our portfolio. I’ve been working on structuring a lot of this for decades, and what we have now is a concrete process.

We focus on process because process drives the outcome. If you constantly improve your process with a probabilistic [average] outcome of out-performance, you will, over the long term, be achieving out-performance. Each step in this process is an alpha created component, and I’m going to walk through them.

The first is the F13 analysis. That is, understanding what the super investors in the world are buying, and using that as your baseline of what you might start analyzing and looking [through].

Number two is fundamental analysis. Value investing itself is an alpha producing activity. The value investors of the world make up about 20 percent of active fund managers, and I would argue that many of them stray from their value mandate, so it’s actually quite rare to be value investing today. Fundamentally, as a value fund you are buying things for below their intrinsic value.

Then [third], we’re looking at leaps and structured products, and something I perfected while I was in New York. The fact is, you can combine products to allow you to have a better entry point. I buy the securities we build in the portfolio for below the prices in the New York Stock Exchange. I do not pay retail prices, I find ways to move into the securities for less than they would cost the typical investor in the market. Certainly an alpha adding step.

Then, finally, how do we objectively build out portfolio allocation in a concentrated manner such that it will give us the greatest returns over the long term? That’s the portfolio construction.

So, let’s look at these in detail. Every fund manager that manages over 125 million is required to publish publicly their holdings to the SEC every quarter. It’s remarkable. So you get Buffett, and you get Lou Simpson, and you get every great famous manager you know, who’s managing millions and billions, and who has analysts, support teams, and everybody else looking at the stock. Those that are concentrating their portfolios are taking huge amounts of money and placing huge bets on companies they know extremely well. There are 10,000 securities in the American public markets. We have a 15 position portfolio. If we are analyzing and looking for the .01 percent of companies that might be cheap enough to allocate the portfolio, we could look for years before we identify that via a needle in a haystack approach.

Using the 13Fs as a filter allows you to look at a few dozen managers, I look at 50-70 different managers. I look at what they are buying, what are they selling. When I can see that there’s a reason why they’re buying. An obvious discount to intrinsic value, it’s possible it might warrant a position in our portfolio.

This is a beautiful shortcut and you can do the same thing. You go to the Edgar SEC website, you look through your managers, and every quarter they’re going to put up their new buys and sells. There was actually a study done by a couple of professors a few years ago which really made me confident in this. All they analyzed was Berkshire Hathaway. They were looking for a way to outperform the S&P systematically because 80% of fund managers fail to outperform the S&P each year. And over the long term, that number comes way down. They were looking for a systematic approach to out performance and they decided to look at Berkshire.

Well, we know that Berkshire has out performed historically. We don’t quite know what happened in the future. [The professors] then said, why don’t we look at the 13Fs, and we buy what [Buffett] bought and sell what he sold and we do so not the day after its publicized, but three weeks later, at the end of the month, so there’s no time advantage. And what they found was that simply by copying the new positions and building a portfolio in that manner, they were outperforming the legacy holdings, and you could beat Berkshire Hathaway by 2 or 3 percent per year. So, through that simple approach I just extended our analysis over a larger range of incredible fund mangers and that allows us to narrow things down to a few hundred securities for analysis each quarter.

[Next is] financial statement analysis, I think we were pretty clear on that. Understanding the income statement, cash flow statement and balance sheet, and understanding if the company is under-valued. We are looking to buy a percentage of an undervalued business when we’re making asset allocation. We need to know why is the company mis-priced, we need to know the catalyst that’s going to bring it to full valuation, and we have a checklist to run through. Pilots have checklists, doctors have checklists. It’s surprising that more fund managers don’t have a checklist to make sure that they’re not overlooking common errors, or get tripped-up. The video that I’m going to show in a little bit is about human misjudgment. I think it is extremely applicable to investment fund managers and the management industry, and that’s what we’re trying to avoid with things like checklists.

Ok, step three. We only have four steps. Step three is our structured value [approach]. I will tell you, when I first launched the fund, I was nervous to share this with people. I thought we had such a proprietary model and it was so valuable. I used to have a home office, now I have a real office, and my wife would joke that we were printing money in the back room, because it was just so easy at certain times, more difficult at other times.

Structured value is basically using structured products, sometimes warrants, sometimes calls, sometimes puts, as a tool to move in to the security you want to own far below market prices. I’m going to give you a quick example about how advantageous this is, and also how irrational and mispriced this stuff can be.

This is a real example. This was in the portfolio in 2011, 2012, and 2013. In 2011, Warren Buffett announced that the company was so undervalued that they were going to take their cash, and instead of buying other businesses they were going to buy back their own stock. They were going to make it a company policy, they were going to buy back their shares at 1.2 times book value. The A share is famous because the A share is 250,000 dollars per share. The B share is 1/1,500 of an A share. At the time, 1.2 times book value was 80 dollars per share. So Buffett comes out and he announces across every financial journal we’re putting a company policy in place so anytime shares are below 1.2 we’re going to buy it back because it’s so undervalued. So obviously, efficient market hypothesis, the theory works. Prices automatically move to 80 dollars a share, no one is willing to sell for less. It is what you would expect, there is no arbitrage, in theory.

I went and looked at the Chicago Board Options Exchange. And, it was a few days later, it wasn’t the next day or the next minute, it was days later. I went to the CBOE and wrote a cash secured put. I was looking for a buyer who wanted to sell me their shares for $80 a share. We committed our cash to buy the stock for 80 dollars any time over the next 15 months. And they paid us 20 dollars for that commitment.

So think about what’s happening. Most people use these products in different ways. They use these products for short-term trading, they use these products in combination with another trade. We are literally using, these like a pork belly future where we actually want the pork belly.

We are taking these [puts] and insuring somebody else’s stock portfolio, and hoping that the price declines and they put their share to us. They have paid us 20 dollars per share to buy their stock for 80, and so we then hold 60 dollars in cash. We hold the 20 that they paid to us, and we wait for 15 months. We sit there, it’s like watching paint dry. The price goes up, the price goes down, we report returns to you guys. You’re like ‘what’s happening.’ I mean, not much. And at the end of the contract, 15 months later, there’s a binomial outcome. Either the price of the stock is above 80, in which the contracts finish and we keep the 20. We made 20 dollars on 60 over 15 months. We made 33 percent— we didn’t even own the stock. Or, in my view, the better situation is the prices declined. The price moves below 80, maybe it goes to 75, 70, the shares are put to us. Our counterpart thinks they’re lucky, they get to sell us the stock for 80. But, they paid us $20. So we now move in, we pay them the $80, and our net cash outflow is $60. Now Warren Buffett is telling the world that the stock is not fairly valued at $80, undervalued at $80. They’re willing to buy it up to $80 as a policy, we he’s gone, because its so undervalued. We have people paying us to buy their stock for the same price. So when we can take products like these, and use them to build our portfolio, we absolutely do our best to get the cheapest [entry] price possible.

Finally, step four is the Kelly Criterion. This Kelly Criterion is very unique and very important as you try to build out portfolios. I’m a member of a 10k club, and there are a few members here in the room. The 10k club is basically some very sophisticated fund managers and individuals in the Los Angeles area. We get together, maybe 10 times a year, and discuss important theories, sometimes company ideas, and opportunities, and it’s just a great group of minds sharing information.

One month, a few years ago, the subject was portfolio allocation, asset allocation. What do you do to determine what your asset allocation is to a particular new opportunity? And I was really interested in the subject because I didn’t think that I had the optimal answer. I thought there was too much subjectivity. Everyone went around the room, and shared their approach. And I was surprised because I heard everyone’s answer and everyone was having the same issue. There was subjectivity in all of the approaches. They’d find an idea, and they’d rank their confidence level on a scale of 1-10, and if they were extremely confident, maybe they’d put on 15 percent position. If they were not very confident, they would put on a two percent position. But they are determining their own confidence. And so, I continued to search for a more objective way, and what I came across was John Kelly.

John Kelly was originally working with Bell Labs, and he was tasked with the job of pushing a frequency through a telephone line. And, he found that optimal way to do it was essentially through this formula. That actually transferred very well in the betting markets, and they went to Las Vegas, and they won a lot of hands of blackjack. What the formula basically says is: if you know your probability of winning, and you know the outcome if you win, and you know the probability of losing, and you what you’re going to lose when you’re wrong, then you have exact objective answer on how much of your bankroll should be allocated to that particular single opportunity. That’s it. It has nothing to do with volatility, it has to do with maximizing your long-term growth rate.

The problem is, you think it would translate into the financial market as well, but all of those variables I just listed are subjective. I actually don’t know the probability of success. I think that it’s 100 percent, but I don’t know what the probability of a given opportunity is in terms of success. I also don’t know what the long-term gain is going to be as a result of that success, and I don’t know the probability of it being wrong, and I don’t know what the downside is if we are. And so, I tried to incorporate one of Charlie Munger’s theories/suggestions, which is: invert always invert.

I thought, if John Kelly was figuring this out in the 50’s and 60’s, he probably didn’t have a lot of computing power. And we do. And within about an hour, I went and looked at every probability. I said, let’s just calculate it for everything and see what happens. So I looked at possibilities from negative infinity to infinity and filled an excel sheet, and then I backed it in to some parameters and said let’s look at what’s realistic. And shockingly, what I found is that when you applied the Kelly criteria to a realistic set of parameters, and you calculate all the cells and probabilities, it basically says you should be allocating somewhere between 10 and 50 percent of your portfolio to every one of these ideas.

That means your portfolio should be made up of between 2 and 10 positions. Now, that is extremely concentrated. Currently we have 3 positions making up 70 percent of our portfolio. We have a 15 position portfolio, but [Kelly] is optimal. It won’t decrease volatility, but it will make the maximum performance available.

Statistically, if you start incorporating a 25th or 26th position into your portfolio, as, by the way, most mutual funds and many managers do, you are actually not decreasing the risk, or volatility. There is no longer an impact, you’ve all ready maximized your diversification. I like to say, now you’re “diworseifing” your portfolio.

And, what happens is, when you incorporate a 25th or 26th position in your portfolio, that position should not be expected to outperform one of the first, second, or third positions in your portfolio. So you’re incorporating a position that will have a lower return with a portfolio that’s all ready diversified completely. So, your basically incorporating a position that’s going to decrease your returns and not help you with your risk management.

It is much more effective to have a very concentrated portfolio. Something along the lines of the Kelly Criterion. I spoke on this in Switzerland. Guy Spier [holds] a conference called VALUEx. I spoke on this at VALUEx to the group of global managers there. I did not know this was happening, but there was an author in the audience, Christopher Mayer, and he wrote a book, and that’s the book that you all have here. And chapter 10— I didn’t know until it was published and somebody else told me, but chapter 10 is about this approach, my speech and my firm.

Finally, in conclusion I want to leave you with this image here, I think it’s incredibly powerful. Jeremy Siegel is a Wharton professor, and he has, I believe, the most comprehensive data set dating back 200 years. He goes from 1802 to 2006. And what he’s determined, he’s looked at all of these major asset classes, from dollar and gold to bills, bonds, and then stocks or equity. What he’s found is that over the long-term due to a number of economic factors, the return on equity is very consistent at 6.8 percent after inflation. Now you have 2.5 percent inflation and you get to the 9 percent that everybody talks about in the markets.

But here’s what’s really significant. This is all after inflation data. This is real purchasing power. In 200 years a dollars has gone from one, to 6 cents. And that makes sense, we all know we have inflation. That means that inflation took out 94 percent of the dollar.

What I think is surprising is that a dollar, the real purchasing power of a dollar, is now a $1.95 in gold. What a terrible long-term investment gold is. There have been periods—I mean this is a 10-year period, from maybe 1971 to 1981 where it looks like it maybe went from 80 cents to 8 dollars, and that will really jade a generation. But, the fact of the matter is, if you look over the long-term, it hasn’t done much for investors.

Bonds have gone from a dollar to let say, $1,000, that’s decent. But what’s most remarkable, and again, he made this a logarithmic scale because we can’t think about exponents very well. One dollars has not become $1,000 in bonds, but $755,000 in equities. There’s no question which asset class you want to invest in if you’re investing for the long term. I don’t hold any bonds, I mean, I barely have any dollars, I just hold my equity portfolio. And I think that’s really important.

I’d like to share this [shortcut] with you because I find it valuable, I use the Rule of 72 quite a bit when I’m thinking about exponents and exponential growth. The Rule of 72 basically says whatever return you are getting on your investments, divide that number into 72 and that’s how many years it will take for your portfolio to double. So, if you’re getting 9 percent, the S&P plus inflation, your portfolio’s going to double over 8 years. If you have 24 years to go, a million becomes two, then four, then eight. It also works with debt. So if you have a lot of credit cards, you can also use that formula to figure out how quickly that’s going to be doubling. Ok, so with that, that’s the end of my slides, thank you very much.

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