"Time and time again, in every market cycle I have witnessed, the extremes of emotion always appear, even among experienced investors."
— Science of Hitting (@TSOH_Investing) November 8, 2017
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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Prospect theory and loss aversion have a lot to say here. And beyond the idea of losing something owned or almost owned, there is a related deprival factor. Scarcity – real or perceived – is a huge driver of human behavior.
The QVC countdown clock is a great example of induced scarcity that drives behavior. We all know that if something is really going to sell, it’s just a matter of patience in waiting to get more supply. But when people see the QVC countdown clock, or when they see lines wrapped around the Apple store for a new iPhone release, the sense of scarcity takes over the decision-making process.
Another example of deprival super-reaction syndrome could come from the pension crisis. America’s pensions are underfunded by trillions and many are already running into extreme trouble. The police and fireman’s pension in Dallas, Texas is already facing severe issues, that’s in Dallas, not some low-growth or sclerotic economy. Millions and millions of people think they have pensions, but what will happen in the mathematically inevitable case that requires benefits to be cut and/or taxes to be raised? America’s social fabric could be in for a real test by this threatened removal of something almost possessed but never actually possessed.
The hangover from GFC has influenced an entire generation of investors. How many bad decisions were made in 2007-08-09-10 or since, all because of deprival super-reaction syndrome? How many people were scared into liquidating their last assets, right near the bottom? (See Bannon example below.) How many were scared out of coming back into the market when assets were cheap but the psychology was scary? How many people – or institutions – have had a new or outsized focus on short exposure to protect from that double-dip recession or crisis 2.0 that was always right around the corner?
How much of the interest in short-selling in general derives from deprival super-reaction syndrome? Shorting is a fascinating intellectual exercise that is occasionally very profitable. I saw it firsthand when I started my first job as a very green analyst in April 2007 and was assigned to cover financials. After an immaterial false start on the long side, I quickly got religion and shorted everything I could find in 2007 and 2008. And then that success landed us a short-only SMA for a few years…starting in 2009. Even before that I was never really convinced that this was a good activity for long-term investors who are only looking to protect principal. If done well – a big if – it can protect short-term downside volatility, sure, but I think that’s it – the main benefit is in subverting the deprival super-reaction syndrome effects in individuals and in institutional allocators. If you’re looking at any meaningful period of time – i.e., anything more than a year or two or anything not cherry-picked to look good for short sellers – the base rate for short selling is terrible. It is a tough, tough way to accomplish most goals in investing.
Other examples of deprival super-reaction syndrome include airline fares and “ancillary revenues,” also known as the fees the airlines charge for bags, food, etc. The fact is that airfares are down ~25-50% in real dollars over the past few decades, but they are down less or flat in nominal terms. And during that time fees on checked luggage and early boarding became the norm, and the food isn’t “free” in coach anymore, and in some cases the legroom is more pinched, all of which leaves some passengers to believe they’re getting a raw deal. But all the nostalgic talk of the “good old days” of airline travel is just that – nostalgic drivel fueled by deprival super-reaction syndrome and contrast phenomena. Customer behavior will tell you that the majority of customers fly on price and that all other factors rank a distant second in the decision-making process. The number of people who can afford to fly has skyrocketed, and all the economic activity and personal gain generated by more choice in travel is enormous but hard to measure. And even though some airlines have recently segmented their cabins or reduced legroom on some seats, that has always been the tug-of-war in the price-or-value experiment that all airlines experience.
And legroom isn’t even down much compared to 30 years ago! Even if it were, customers in coach now have a climate-controlled, quiet jet aircraft offering myriad travel choices and little perks like wifi connectivity, seatback entertainment systems, etc. Even first- and business-class seats are cheaper in real dollars than they were decades ago, and now they have luxury lie-flat accommodations with exceptional connectivity and entertainment options. And let’s not mention – vivid counterexamples notwithstanding – that modern air travel is the safest mode of transportation the world has ever seen. There are twice as many planes in the air today as there were 25 years ago, but the accident rate has made steady downward progress. The International Civil Aviation Organization reports that the fatal accident rate is one-sixth what is was in 1980.[46] The same applies to terrorism, by the way – we all remember the tragedy of 9/11, but the 1960s/70s/80s were beset by horrific bombings and hijackings that are exceptionally rare today.
On balance, customers are getting a better deal and a better experience than ever before, but high-profile customer problems and the recent diatribes in the media – accusing the airlines of answering only to their financial masters on Wall Street or being uncaring monsters in general – would have you believe that things have never been worse.[47]
Another potential example in this regard with a different twist is the pervasive effect of inflation over time. Do investors notice the erosion of their purchasing power? Everyone loves to complain about how “things are more expensive these days,” but how many decisions actually get made with the explicit thought that a dollar today is likely to have 10%, 25%, or even 50% less purchasing power within the next few years/decades? Have central banks adopted this framework as a lesser of two evils?
[46] https://www.nytimes.com/2017/05/27/opinion/sunday/there-was-no-golden-age-of-air-travel.html
[47] https://www.nytimes.com/2017/05/28/business/corporate-profit-margins-airlines.html
Persi Diaconis writing about chance? Hard to beat that. http://pic.twitter.com/rgc2reHmlw
— Michael Mauboussin (@mjmauboussin) November 7, 2017
Chris Crawford on Contrarian Investment Principles
November 7, 2017 in Full Video, Interviews, Video ExcerptWatch an excerpt of our exclusive interview with Chris Crawford:
Chris Crawford is the Managing Partner and Chief Investment Officer of Crawford Fund Management, LLC, a Boston-based Registered Investment Advisor. The firm manages a long/short fund that invests in equities and options with an emphasis on underfollowed public companies. Prior to co-founding Crawford Fund Management in 2009, Chris was Managing Director, Portfolio Manager and head of the Boston office with Stark Investments, a $10B multi-strategy global hedge fund. At Stark, Chris built the firm’s equity long/short team and managed $1.5B in equity long/short assets as well as a $200M short-biased portfolio. From 2003-2006, Chris was Senior Vice President and Portfolio Manager with Putnam Investments, and co-Portfolio Manager of the $3B Putnam International Capital Opportunities Fund and related client accounts. From 2000 to 2003, Chris was a Partner and Senior Analyst with ABRY Partners on a team managing a $400M TMT-focused hedge fund. From 1996 to 2000, Chris was with Wellington Management Company, where he served as a Global Industry Analyst covering the media industry and as a Portfolio Manager for $600M in client sector-fund and institutional assets. Chris holds an MBA from The Wharton School of Business and graduated magna cum laude from University of Pennsylvania with a BA in Physics, BS in Economics, BAS in Systems Engineering and an MA in International Relations.
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This article by Matthew Sweeney is excerpted from a letter of Laughing Water Capital.
“Gamblers bet on possibilities. Pros bet on probabilities.”
–Bob Dancer, Professional Gambler
Our investment process entails identifying companies that pass a four-part framework before we ever consider the fifth piece, which is price. The four questions I seek to answer are:
1) Is it a good business? (what will it look like in 5-10 years)
2) Who are we partnering with? (is management capable and properly incentivized)
3) Why does the opportunity exist? (are sellers irrational or shortsighted)
4) What happens when something goes wrong? (because it will eventually)
Each of these questions is deliberately open-ended, and meant to encourage careful analysis and deep thought, not quick answers. When followed properly, this process should lead us to better than average companies, with better than average management teams, that we buy at better than average prices, that will do better than average when the economy hits a rough patch. While nothing is guaranteed, if we can simply stick to this process, the result should be a portfolio that has a high probability of performing better than the averages (ie the SP500 or R2000) over time.
However, while it sounds simple, when spending a week off the grid I had little else to do other than run our businesses through this framework, and I came to realize that one of them fell short.
Points International (PCOM)
In the 1H ’17 letter PCOM was introduced as a mid-sized addition to our portfolio. This was a mistake, and we sold our shares well below my multi-year price target. Thankfully, the combination of a large margin of safety from our initial purchase price, our short holding period, and an aggressive move in the stock led to us realizing an IRR of almost 90%. This is not cause for celebration. Rather, this should be viewed as a pyrrhic victory, and not only because it comes with painful short-term capital gains.
In the case of PCOM, I came to realize that our investment was based on a short-sighted answer to question 1 (putting too much weight on the possibility that the company would be sold), and an insufficient answer to question 2 (management does not own much stock, and after repeated questions on this topic, the CFO and President both responded by buying a measly 1,000 shares). Our portfolio is concentrated; we only need a few good ideas a year to perform well. There is no reason to own stock in a business that fails to impress at 2 points during our process.
Analytical mistakes are a simple fact of life in the investment business. Even the world’s very best investors have batting averages in the mid .600s, and we are guaranteed to have investments that simply don’t work out the way we thought they would (such as DNOW). However, PCOM was less an analytical mistake, and more a mistake in process. Mistakes in process are much more worrisome and much less forgivable than analytical mistakes because over an investment lifetime, a repeatable process well-followed is much more important than any individual investment. Thus, our successful outcome in PCOM should be viewed no more favorably than a drunken bachelorette who screams “Black Jack!!!” upon being dealt a 3 after hitting on 18. Winning one gamble doesn’t make you successful. Diligently following the process in order to put the probability of success on our side is our only chance for long term success.
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Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.
The Phillips Conversations: Robert Hagstrom
November 6, 2017 in Audio, 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.
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About the interviewee:
Robert Hagstrom currently serves as Chief Investment Strategist of Legg Mason Investment Counsel. Previously, Robert was Senior Vice President and Portfolio Manager of the Growth Equity Strategy at Legg Mason Capital Management. Prior to that, he served as President and Chief Investment Officer of Legg Mason Focus Capital, General Partner of Focus Capital Advisory, and Principal at Lloyd, Leith and Sawin. Robert acted as Portfolio Manager with First Fidelity Bank from 1989 to 1991. From 1984 to 1989, he was a Financial Advisor for Legg Mason Wood Walker, Inc. Robert earned a B.A. and M.A. from Villanova University. Robert received the CFA designation in 1992 and is a member of The CFA Institute and the CFA Society of Philadelphia. Robert is also known for his best-selling book, The Warren Buffett Way: Investment Strategies of the World’s Greatest Investor. He has also written a number of investment books including; The Warren Buffett Portfolio: Mastering the Power of the Focus Investment Strategy; The Essential Buffett: Timeless Principles For a New Economy; Investing: The Last Liberal Art; and The Detective and The Investor: Uncovering Investment Techniques from the Legendary Sleuths.
This article by Matthew Sweeney is excerpted from a letter of Laughing Water Capital.
“All man’s miseries stem from his inability to sit in a room alone and do nothing.” [sic] — Blaise Pascal, c/o Mohnish Pabrai
The above quote has been popularized in investing circles by super-investor Mohnish Pabrai. It is especially relevant to our portfolio at the moment due to the previously referenced increased level of activity. Our strategy is largely based on buying good businesses during moments of weakness, and giving our skilled management partners the time they need to work through their problems. Focusing on price is extremely important during the buy process, but once we have purchased shares, the stock price can do whatever it wants to do in the near term as irrational sellers weigh on shares. Our ultimate success will be based on our ability to weather the short term volatile stock action, and patiently wait for the true economics of our businesses to shine. Patience is key to the strategy: frequently trading in and out of businesses will not help our long- term results.
While our “busy” quarter would represent a slow hour on most hedge fund trading desks, relative to 2016 when we made one meaningful investment all year, the 3rd quarter was a flurry of activity. This activity level meant that entirely too much time was spent staring at screens thinking about price, and not enough time was spent simply thinking about our businesses, their management teams, their problems, and their opportunities. In order to help tip the scales of my focus away from short term market action, and back toward the fundamentals of our investments, I spent a week in September “off the grid” on a backcountry archery elk hunt.
From my perspective, spending a week in the middle of no-where is perhaps the best way to conduct a portfolio review. With no access to the internet or cell phones, and no possibility of getting distracted by new ideas, one is forced to focus entirely on the present opportunity set.
Additionally, there are a lot of parallels that can be drawn between hunting in the backcountry and concentrated value investing.
For starters, it is not for everyone; in fact, it is basically anti-social. There is a certain confused/skeptical look that most people give when they learn that our strategy is based on the belief that one person with limited resources willing to dig through the hidden corners of the investment universe searching for anomalies has massive advantages over Wall Street and its infinite resources. This look is basically the same look I get when I explain to people who are panicked by the idea of a dead cell phone battery that my idea of a “mental-reset” is not a trip to some exotic beach location. Rather, I much prefer spending a week by myself sleeping in a tent in bear country while hiking through the mountains 10,000 feet above sea level, hours from the nearest paved road and wi-fi signal.
Second, well known hunting personality and author Steve Rinella often comments that successful backcountry hunting is dependent on, “being comfortable with being uncomfortable.” This quote bears a striking resemblance to two of my favorite investing quotes. The first, “you can have comfort, or you can have value. You cannot have both,”1 and the second, “the capacity to suffer is essential for successful investing.”2 The point is the same whether you’re talking about hunting or investing; if you want to seek out the best opportunities, it is not going to be easy.
Third, whether you are talking about backcountry hunting or investing, the proper approach is to spend 99% of your time planning, preparing, and waiting, and 1% of your time taking decisive action.
Fourth, in both hunting and investing, it pays to be very selective. If you take your shots at middling opportunities, you will never have the opportunity for tremendous success.
Lastly, and perhaps most importantly, in order to be successful in either hunting or investing, you have to enjoy the process, not just focus on the endgame. Just like most hunts end without a shot, almost all research ends without a buy decision. The only way to eventually succeed is to continue to iterate the process.
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Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.
This article by Matthew Sweeney is excerpted from a letter of Laughing Water Capital.
EZCorp (EZPW) – EZCorp has moved past the stock price weakness caused by the convertible bond offering which I detailed in our 1H’17 letter. More importantly, the company recently announced a major acquisition in the form of 112 Latin American stores. While operationally this appears to be a good use of cash, there are larger implications which I believe will play out in the months and years to come as the market digests the news. First, for the last few years the narrative surrounding EZPW has been somewhere between “it is a disaster” and “they have a lot of changes to make.” As the company enters the final year of their 3 year plan with a cleaned up balance sheet and incredible operational improvements, the narrative should shift to, “they are back on a growth track,” which should lead to increased interest from the investment community. Secondly, for the last few years while EZPW struggled, their largest competitor, FirstCash (FCFS) has been hoovering up large pawn operations throughout the western hemisphere without any competition. Now that EZPW has signaled they are back in the game, I believe it is likely that FCFS will realize that their best move would be to buy EZPW, even if it required a large premium. First, FCFS would be able to realize massive synergies by eliminating virtually all of EZPW’s infrastructure. Second, if they do not buy EZPW, FCFS will be living in a world where all of their substantial growth ambitions will lead them to competitive bidding processes, driving up prices. Simply stated, paying up for EZPW means they will be able to pay down for every other pawn group. EZPW remains a top 5 position.
Iteris (ITI) – In our last letter, I noted that curiously management created a new, separate legal entity to house the agriculture/weather business, which suggests that an eventual sale of this business may be somewhere on their radar. Adding to the intrigue, Iteris recently hired Jim Chambers to run the agriculture/weather business. A review of Mr. Chambers’ CV reveals that of the previous companies where he was employed, four (4!) of them were acquired. It seems clear that management has positioned the agriculture business for eventual sale, and hired an executive that knows a thing or two about selling businesses. However, the company has also registered a shelf which would allow them to raise capital in a secondary offering. If the agriculture business was sold in the near term it would be unlikely that the company would need to raise additional cash, so the tea leaves are muddled. This is just fine because the company continues to execute at a very high level, and the traffic management business remains an undiscovered gem at the forefront of the future of intelligent transportation and autonomous vehicles. ITI remains a top 5 position.
Now Inc (DNOW) – I have sold our shares in DNOW. The original thesis was that an investment in DNOW was an investment in the beaten-up oil space that would benefit independent of oil prices as management used their massively over-capitalized balance sheet and long track record of successful M&A to gain market share by buying struggling Mom and Pop players in the oil field distribution business. Shares rallied quite a bit from our purchase price as the price of oil recovered, but quickly gave back the gains. The price of oil was never germane to our thesis so we should have exited on this brief move, but we did not. Management has since signaled that the rally in oil prices has made M&A increasingly unlikely because bid-ask spreads between buyers and sellers are too wide. Absent the opportunity to take market share through M&A, in my view DNOW is a bet on oil prices, and I have no reason to think I am any good at predicting oil prices so we exited the position.
Revlon (REV) – Revlon’s wild ride continues, with shares having traded hands below $16 in mid September and above $27 in late September. Business value just doesn’t change that quickly absent catastrophic events, but as a stock Revlon is its own animal as controlling shareholder Ron Perelman and the largest independent shareholder, Mittleman Brothers, do battle through SEC filings that seek to influence the supposedly fiduciary minded board of directors. Notably, Mittleman asked for Perelman to agree to not squeeze out minority shareholders for a period of five years. Perelman agreed to not exceed 90% ownership for a (woefully short) one year period. From our perspective, it is of course frustrating that shares have traded down from ~$35 earlier this year, but they remain drastically under-valued if you are a long term, patient shareholder. Lower prices make Revlon an attractive candidate for tax loss selling, but Perelman’s 1 year standstill agreement had the curious side effect of emboldening short sellers (who are likely hedging debt investments) who no longer have any reason to fear a buyout deal at a premium. As a result, we are presently earning a ~15%+ yield lending our shares to those who are concerned with short term volatility while patiently waiting for long term value to develop. Getting paid 15%+ to wait for something that I believe may ultimately be worth multiples of its present price helps sooth the pain of our mark to market losses incurred this year.
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Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.
This article is excerpted from a letter to partners of Boyles Asset Management.
Having already discussed our Mastermyne exit in relation to the capital cycle, we also wanted to discuss our experience with the company as it relates to one of our investment category mental models. Earlier in the year we presented our “Temporary Trudgers” model. Here we discuss a model we’ve come to refer to as “The Considerably Challenged.”
The “considerably challenged” investment category mental model can typify some of the most challenging business and investment operations. Companies meeting this model are navigating a battlefield dotted with landmines.
There are unique challenges with owning companies that fall into this category. As we’ve alluded to, these positions can ultimately become quite taxing before the ultimate prize is realized. As our quote highlights, investors have to be aware that they and the business are traversing a battlefield dotted with landmines. You have to realize that the landmines are there; you just don’t know where they are or when the company will hit one. These ideas require a type-specific investment approach and mental awareness.
When we refer to “The Considerably Challenged,” in the context of our operations at Boyles, this does not refer to balance sheet stress. We specifically avoid that particular challenge. We seek other challenges, including: severe cyclical downturns, poor operational decisions, significant customer issues, etc.—anything that is likely to severely depress, or even eliminate, current earnings.
Investment and Portfolio Management Considerations
Given our focus on little or no downside in these situations, the balance sheet must be quite strong, not just acceptable. Given the challenges being endured and the landmines likely to be triggered, the company must be in a position to absorb them, a fact that will likely weaken the balance sheet during one’s holding period. In addition to allowing for survival, a strong balance sheet, both absolutely and relatively, can be key to capitalizing on the upside envisioned.
You can be patient in share accumulation. After the company hits a landmine, you are likely to be presented with wonderful buying opportunities.
Purchasing well below book value is a good place to start. Given what may transpire, starting to get excited at book value or above is likely to prove less productive than it may seem at the time.
An ability to generate cash, if not earnings, is particularly important. This may come in the form of working capital release, ongoing operating cash flows, asset sales, tax recoveries, etc.
If such an idea presents itself in a small-cap name with limited liquidity, the changes in sentiment and stock prices can be quick and significant.
Mental Considerations
Owning such ideas can be mentally taxing. It may require you to show a large unrealized loss at some point during your holding period. Not only may you look silly for owning it, but also you must be prepared to avoid the behavioral challenges associated with such a situation, and make the appropriate decisions when something you own seems to go down in a straight line.
When it really hurts to buy more shares, it may very well be a good sign.
One must recognize that after owning such a company for a substantial period of challenging times, you may be in a better position than others in the marketplace to make significant sums on the idea.
When we exited Mastermyne, we earned a total return, including dividends, of 122% in U.S. Dollars during our approximate three-year holding period. The IRR on the capital deployed was 40%. In AUS Dollars, the total return was 127% and the IRR was 42%. While we made money on all share purchases based on our exit prices, developing the mental model outlined here allowed us to make significant returns on capital deployed after our initial purchase—when that initial purchase looked poorly made. While our initial small purchases would have produced a mid-to-upper-single-digit IRR during our holding period, our lower subsequent average cost produced a much more attractive outcome.
During the period we owned shares, the company hit plenty of landmines. Large long-term customers were lost, specific business expansion opportunities that looked promising failed to materialize, environmental challenges pressured the industry, commodity prices suffered even further, an acquisition didn’t perform to expectations in its first two years, cash flows deteriorated beyond our expectations, customer asset sales disrupted relationships, maintenance work was deferred beyond anyone’s expectations, and the list goes on. Despite all the landmines, with the right purchase price(s), and the right mental model, we achieved an acceptable return.
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A thing I learned advising startups that generalizes: people get the most upset when you tell them true things they wish were false.
— Sam Altman (@sama) November 4, 2017