They forgot Bias No. 21: believing there are only 20. https://t.co/EMgGSLasnr
— Jason Zweig (@jasonzweigwsj) October 31, 2017
This article is authored by MOI Global instructor Steven Kiel, chief investment officer of Arquitos Capital Management.
People who don’t understand value investing often say that in order to make a higher return, you must take on more risk. No risk; no reward. We know that those people are wrong, of course. The challenge is finding and investing in the opportunities where risk is low and the possibility of gains is high.
Let’s break this down into two parts: One, where are the opportunities where risk of permanent capital loss is low? And, two, what are some characteristics that may lead to exponential gains?
We can reduce the chance of permanent capital loss by looking for companies that have strong balance sheets, low debt, a large amount of cash relative to their market cap, predictable operations, and competitive advantages, to name a few characteristics. This part is actually not that difficult. The difficult part is finding companies with those characteristics trading at great prices. We want to look for companies whose other investors are involved in the company because of its balance sheet. We want the investor base to be conservative and the price to be reasonable. We want investors to view the company for its safety, not its potential.
What characteristics do we look for that may lead to exponential gains? These companies typically have significant reinvestment opportunities. Their managers have strong capital allocation skills. Returns on equity and returns on invested capital are high. They often are owner-operated, where the directors and managers own a significant number of shares. There are also often incentives in place that reward growth, whether it is a bonus structure, tax loss carryforwards, or engaged directors or large shareholders focused on performance.
The opportunity for us is to find a company from the first category that also has the characteristics from the second category. We are then able to buy in along with all of the other investors who are focused on the balance sheet, but at prices that do not reflect the growth opportunity and earnings potential. The good news is that there are not that many companies like this out there. That’s the bad news too. When we find these opportunities, we need to recognize them for what they are and be willing to allocate a significant amount to them.
The way to get exponential gains is for operational results to improve and for public market multiples to increase. Gains can be even greater if the company’s current investors are paying a multiple of book value, but future investors are willing to pay a multiple of earnings, or cash flow, or EBITDA. This is what I call balance sheet to income statement investing.
The company I [presented] at Best Ideas 2017 is a great example of balance sheet to income statement investing. It has several characteristics mentioned above, is one of my largest holdings and favorite ideas, and offers both safety and potential for significant gains.
On the safety side, this company trades for a significant discount to its book value. Even better, it has several off balance sheet items that cause its true book value to be even higher that its GAAP book value. The company is a cannibal. It has bought back a huge chunk of its outstanding shares over the past several years and will buy back another 9% of its shares next year. Shares trade for only 80% of the company’s stated book value, so all repurchase are accretive, even more so when taking into account its unstated assets.
This company also has significant earnings potential. They have entered several ventures where the chances of success are high. While these ventures are relatively new, returns on invested capital are high. Managers are actively buying shares and their incentives are aligned with shareholders. The company also has tax assets that are just beginning to be applied to its earnings.
Current investors are involved because of the safety of this company’s balance sheet. Future investors will buy into the company on multiples of its earnings. In this case, you don’t need to take on a high amount of risk to have the potential for significant gains.
download printable version
This article is authored by MOI Global instructor Amit Wadhwaney, portfolio manager of Moerus Capital Management.
At Moerus Capital Management, we employ a fundamental, bottom-up investment process, with the goal of investing in assets at prices which represent significant discounts to their estimated intrinsic value, all the while heavily emphasizing risk avoidance and mitigation. Importantly, the risk that we seek to mitigate is not short-term share price volatility (market risk), but rather the risk of a permanent loss of capital. In fact, we embrace market risk as a provider of periodic opportunities to invest in what we believe are high-quality assets or businesses at bargain prices. We believe that buying as cheaply as possible is critical both to risk mitigation as well as to the potential generation of attractive long-term returns.
In striving to buy as cheaply as possible, we estimate intrinsic value using very conservative estimates that weigh a company’s balance sheet and what is known today much more heavily than projections of future earnings and cash flow, which may or may not materialize. In other words, in general we try to buy shares of businesses at sizable discounts to what we think they would be worth if sold today, using conservative assumptions. The asset-based investment approach that we follow at Moerus stands in contrast to the approach of many in the investment community who tend to focus more heavily on earnings and cash flows.
We don’t heavily weigh forecasts of cash flows years into the future simply because we believe the future is notoriously and inherently difficult to predict. We are not willing to “pay up” for businesses at prices that would only be attractive under optimistic assumptions of continued prosperity. By contrast, we believe that a conservative, asset-based valuation methodology often yields a “bedrock” (lower-bound) valuation, and that buying at a steep discount to such a bedrock valuation provides a cushion that provides downside protection and offers meaningful upside potential when there are favorable future outcomes, which typically aren’t “priced in” to the stock at such beaten down levels.
Implications of the Asset-Based Approach
Our approach to investing has several noteworthy implications regarding the types of situations that tend to find their way into the portfolio, and why.
What’s the catch?
At Moerus, we search for high-quality, long-term investment opportunities which are available at attractive prices relative to what we believe their net assets are worth today, without attributing any value to optimistic forecasts of future earnings or cash flows. One implication of our approach is that such opportunities do not come easily or often – alas, there is usually “a catch,” or something “wrong” which drives pricing down to the unusually attractive levels which pique our interest. Common examples of what might be “wrong” include, among others, a challenging short-term outlook facing a company’s relevant industry or geography, or a company-specific misstep or hiccup that results in share price declines.
For traders and investors with very short time horizons, near-term uncertainty and turmoil might rule out any such investment. But our long-term focus allows us to look past temporary rough patches that render a company, industry or geographic market out of favor in the broader market as they often prove to be interesting sources of longer-term investment opportunities, provided that the turmoil is indeed temporary. Importantly, the underlying company must have the staying power and wherewithal to survive tumultuous times and thrive if, as and when the situation normalizes.
Unappreciated, Misunderstood, or Event-Driven
In addition to situations involving short-term (but temporary) turmoil, asset-based investing has also often led us in the direction of two other scenarios that sometimes lead to atypically attractive investment opportunities. First, companies that are underappreciated, underfollowed, complex and/or misunderstood occasionally provide interesting opportunities, in part because fewer eyes are examining and recognizing the value that may (or may not) be present within the business in question. Second, opportunity periodically can be found in situations in which hidden value could potentially be unlocked through event-driven scenarios; examples of these include liquidations, corporate reorganizations, mergers and acquisitions, and changes in industry or shareholder structure.
Deep Value and Emerging/Frontier Markets: Compatible… at Times
Another implication of our asset-based investment approach is that while opportunities to implement it in emerging and frontier markets are apt to be sporadic and infrequent, occasionally compelling balance sheet-based investments can and do become available at attractive prices. Traditionally these markets have not been considered a welcoming destination for deep value investors.
Notwithstanding the challenges currently facing many emerging and frontier markets, in general these markets have historically appealed to growth investors due to their attractive growth potential. Simply put, many investors have historically been willing to pay up for expected future growth in emerging and frontier markets, whereas at Moerus we look for bargains here and now, based on our estimates of net assets today. Partly as a result of this dichotomy, the predominance of investors who are willing to pay for projected future earnings growth in emerging markets has, in our view, generally translated into less frequent opportunities for the asset-based value investor such as Moerus. However, the very fact that these markets are heavily populated by growth investors provides us, from time to time, with intriguing investment opportunities that fit our approach – when events such as earnings disappointments, setbacks, or broader economic turmoil result in growth investors fleeing.
A final important point to make on this subject is that share price declines in emerging and frontier markets could be and often are exacerbated by the relative illiquidity of many of these markets. When investors flee illiquid markets, dramatic share price declines could result, potentially turning a stock that used to trade at a sky-high valuation a few years ago into a bargain today.
Patience
We think that it’s worth emphasizing that given the nature of these sources of opportunity, patience is a virtue when it comes to implementing this approach. Patience is needed to hold cash in the absence of attractive pricing and wait for quality investments to become available at truly modest prices. Once a promising long-term investment becomes available at a price that is cheap enough, patience is often required to hold (or add to) the investment, as the poor near-term conditions that contributed to the deep discount continue to run their course. Of course, patience must be backed by conviction – developed through research, analysis, and considerable reflection – that such a prospective investment has the staying power to navigate its way through temporary difficulties until the underlying value is ultimately realized.
Asset-Based Investing: An Example
Not for the Fashionable
The asset-based investment approach requires patience because investment opportunities available at the type of valuations we seek do not come available frequently, and when they do, it is usually at a point in time in which the assets in question are underappreciated or out of favor. Attractive value investments, particularly those at the deep discounts that we require, are not available whenever they are “in fashion.” In that sense, we often find ourselves looking for bargains in some of the most far-flung or “out-of-fashion” places, where many others in the investment community for various reasons are biased against venturing. Importantly, the “far-flung places” in which we often find ourselves are not always specific geographic locations, but also classes of companies that, for any of a host of possible reasons, fall under the radar of many analysts and investors who are more earnings-based.
One such class of companies is made up of those which, at some point, execute a sale of their principal operating business (and thus their principal source of earnings), thereby becoming cashed-up in the process, but often also falling off the radar of many earnings growth-oriented analysts and investors as a result of the sale. While infrequent and sporadic, in select cases “falling off the radar” could have such a dramatic effect on a company’s stock price that the business could become available at a meaningful discount to the current value of its primarily liquid net assets. This may (or may not) provide genuine opportunity, as we will discuss shortly. While the following investment is not (and was not) a Moerus investment, in hoping to better illustrate the risks and attractions that such an event-driven situation might periodically provide, we point to a historical example: Piramal Enterprises Ltd. (“Piramal”), an India-listed business development company, which sold its generics pharmaceutical business to Abbott Laboratories in 2010.
Noteworthy Features
In the case of Piramal, there were a number of noteworthy features that we have also seen in other asset-based investment opportunities over the years:
- Piramal sold its principal business on very favorable terms, realizing significant cash proceeds in the process.
- This sale left the company with little to no forward earnings visibility, as well as no obvious earnings growth for analysts to point to, forecast, and model.
- Sell-side analysts who had been covering the company subsequently dropped research coverage after the transaction.
- Further, the paucity of recurring earnings that remained resulted in a stratospheric P/E ratio (since there was no “E”) and in virtually no ROE (with no earnings to make up the numerator) – two basic statistics that are closely followed by many earnings-focused investors.
- As a result, subsequent to the sale of its principal businesses, Piramal presumably “screened badly,” or did not rank highly on the quantitative screens of investors searching for, among other statistics, low P/Es and high ROEs.
- Piramal was controlled by committed, competent ownership/management, with a long-term track record of growing shareholder value (through both operations and thoughtfully timed deal-making), and with significant skin in the game via equity ownership.
- Piramal’s well-timed sale of its generics business – which was priced at a whopping 30 times EBITDA – left behind a very strong, liquid balance sheet.
- Yet subsequent to the asset sale, an opportunity became available to invest in Piramal at a material discount to its reported book value, much of which, importantly, was attributable to cash and other liquid financial assets.
“Killing” the Messenger… Who Brought Great News
In sum, in our view Piramal’s asset sale was clearly a positive event for the company, given that it was completed on attractive terms, leaving the company with a massively liquid balance sheet in the hands of ownership with a proven record of creating value. However, somewhat paradoxically, this impressively value-realizing transaction seemed to be greeted by many analysts and investors with indifference and skepticism, if not outright negativity. Why?
- Many sell-side research analysts dropped coverage; we suspect because Piramal no longer neatly fit into a specific industry and because the company no longer produced recurring earnings from which to forecast and model in a straight-forward manner.
- Many earnings and growth-based investors – which we suspect make up the majority of players in most markets – also likely lost interest, given the absence of recurring and growing earnings.
- The transaction essentially eliminated recurring earnings while raising cash. Our experience has shown that the value of the optionality that cash provides is often underappreciated by the market as compared to traditional earnings metrics.
Situations like this one – in which there is a clear discrepancy between an unambiguously positive event from the standpoint of economic reality on one hand, and the recognition and appreciation (or lack thereof) that the transaction receives in the public securities markets on the other hand – are often sources of great long-term opportunity. Unusual bargains can sometimes be found in corners where many market participants are biased against looking.
Subsequent Events
The results? After the sale of its generic pharmaceutical business, Piramal, in our view, reasonably and thoughtfully redeployed the sales proceeds into new investments in numerous areas, including pharmaceutical services, financial services, and real estate. In the process, the company built a stable of new businesses that today generate almost US$1 billion in sales annually.
Investors who took advantage of the opportunity to invest in Piramal common stock (PIEL IN) at the unusually modest prices that had prevailed in the market after the sale of its generics business have, in our opinion, been well rewarded as, over time, its share price has, in our view, come to reflect the substantial value creation at the corporate level that we believe has been generated by the reinvestment of the proceeds raised from the asset sale.
Caveats and Concerns
Again, Piramal is not, nor has it ever been a Moerus investment; we only bring up this case to show a specific type of special situation that can offer opportunity. An obvious point is that not all cases of companies that sell a significant chunk of their assets end well for shareholders. As in all industries, geographic markets, indices, and investment portfolios that bear risk, this “class” of companies – those which have sold their primary business(es) – has had its share of both glowing successes as well as catastrophic failures over the years.
A company that builds cash on its balance sheet by selling its main assets might offer an intriguing investment opportunity, but on the other hand such a transaction often raises a host of red flags that must be identified in order to avoid impending investment disappointment, if not disaster. And this specific class of companies, in general, brings with it a lot of baggage in the form of issues that must be thoroughly considered and vetted before investing. In our view there are a couple of very significant issues surrounding this specific group.
First, when a company sells its principal operating business, we cannot overstate the degree of uncertainty that such a transaction adds to a company which had previously compiled a history of operating results, a history which many investors use to anchor their future expectations. Uncertainty abounds regarding a number of issues, including the loss of recurring income, the use of sales proceeds, and the timing and nature of the potential payoff from the investment.
Additionally, investors in companies where much of the value is attributable to cash and liquid assets, are inherently heavily reliant upon the management team (or controlling shareholders) in order to generate a successful investment outcome. We cannot overemphasize the importance of a thorough assessment of management in situations in which a large pile of unencumbered, liquid capital sits at the discretion of a company’s decision-makers. A strong, liquid balance sheet can easily be squandered if the management/owners put their own interests ahead of those of other shareholders, or if they damage asset value through poor strategic decision-making.
Suffice to say, these are major concerns that must be carefully considered prior to an investment decision. In many cases, such issues cause us to pass on otherwise interesting investment propositions. But uncertainty often brings opportunity with it, and if we are able to gain comfort in our appraisal of management’s skill, ability to create value over time, and integrity, such situations can offer compelling investment propositions.
In Conclusion
We believe that buying at a substantial discount to a bedrock valuation, based on a highly conservative, asset-based methodology, provides downside risk mitigation while also offering attractive upside potential, since favorable scenarios typically are not priced in at such depressed levels. To find these opportunities, one needs to be willing to look where others aren’t. Unusual bargains can sometimes be found in corners where others are biased against looking.
Any investments discussed in this letter are for illustrative purposes only and there is no assurance that Moerus Capital will make any investments with the same or similar characteristics as any investments presented. The investments are presented for discussion purposes only and are not a reliable indicator of the performance or investment profile of any client account. Further, you should not assume that any investments identified were or will be profitable or that any investment recommendations or that investment decisions we make in the future will be profitable. There is no guarantee that any investment will achieve its objectives, generate positive returns, or avoid losses.
THE INFORMATION IN THIS LETTER IS NOT AN OFFER TO SELL OR SOLICITATION OF AN OFFER TO BUY AN INTEREST IN ANY INVESTMENT FUND OR FOR THE PROVISION OF ANY INVESTMENT MANAGEMENT OR ADVISORY SERVICES. ANY SUCH OFFER OR SOLICITATION WILL BE MADE ONLY BY MEANS OF A CONFIDENTIAL PRIVATE OFFERING MEMORANDUM RELATING TO A PARTICULAR FUND OR INVESTMENT MANAGEMENT CONTRACT AND ONLY IN THOSE JURISDICTIONS WHERE PERMITTED BY LAW.
The Phillips Conversations: Lawrence Cunningham
October 30, 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.
Members, log in below to access the restricted content.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
About the interviewee:
Lawrence A. Cunningham is an American scholar, an author of corporate governance and investing books, and the Henry St. George Tucker III Research Professor of Law at George Washington University.
This article is authored by Sean Stannard-Stockton, president and chief investment officer of Ensemble Capital.
Most people think that if something is good, more is always better. But that’s rarely true. One of the most important concepts in economics, The Law of Diminishing Returns, shows us that each new unit of something good tends to produce less good than the previous unit. The easiest way to think about this is eating candy. No matter how much you love chocolate, the 10th piece doesn’t give you as much pleasure as the first piece and the 100th piece makes you sick.
Despite the economic roots of this concept, many economists (and much of Wall Street) think this issue doesn’t apply to the diversification of equity portfolios. But as we’ll show, more is not always better and the value of diversification diminishes much faster than most people think.
The chart below, based on data from the classic book A Random Walk Down Wall Street by Burton Malkiel, shows how adding a third or seventh or fifteenth position to an equity portfolio materially reduces the volatility of returns. However, by the time a portfolio has twenty or so holdings, the incremental reductions in portfolio volatility from new holdings is very small.
Burton Malkiel, a strong proponent of diversification and a skeptic of active management, says in the book:
By the time the portfolio contains close to 20 equal-sized and well-diversified issues, the total risk (standard deviation of returns) of the portfolio is reduced by 70 percent. Further increase in the number of holdings does not produce any significant further risk reduction.
Malkiel’s research was based on randomly selecting stocks, so if an investor builds a portfolio of 20 energy companies or 20 technology companies, their portfolio will exhibit far more volatility than the chart suggests. But so long as the members of the portfolio are companies with diverse end markets, business models, etc, a purposely selected (rather than randomly selected) portfolio of 20 or so companies is very likely to capture the bulk of available diversification benefits.
Of course, investors do not seek only to reduce risk. They also want to maximize returns. If you are actively picking stocks that you hope will outperform, it becomes clear very quickly that it is quite hard to find a lot of good ideas. A realistic investor knows that even their best idea has a very good chance of underperforming, despite their best efforts. So a smart investor will build a portfolio of a number of stocks that they expect will beat the market. But there are limits to the number of stocks an investor can know well and have a reasonable basis to believe will outperform. So while more stocks will reduce volatility, it also requires adding stocks to the portfolio that the investor believes has less potential to outperform.
A 50th or 100th “best idea” isn’t likely to add much in the way of potential outperformance. But it also isn’t likely to add much in the way of lower volatility or reduced risk. So why do most professionally managed, active investment portfolios own well over 100 stocks?
There are two key reasons for professional active investment managers to own way more stocks that they need to.
The first is because it helps them not underperform by too much, but the price they pay is reducing their potential to outperform. If you own 25 rather than 200 stocks, the volatility of your portfolio won’t be much higher. But the tracking error of your portfolio to the benchmark will likely be higher. That’s because while your portfolio will be diversified from a volatility standpoint, it will be quite different from the benchmark. This is called having a high “active share” and research shows having it is a critical key to potential outperformance. But having a portfolio that is quite different from your benchmark means that while it might not be more volatility, it won’t “track” the benchmark as closely. Most managers don’t have any confidence that their clients (or their bosses) will tolerate any length of time where they underperform, so they own more stocks in order to reduce their tracking error. But this has the effect of greatly reducing their ability to potential outperform over time.
The second key reason is that the collective market cap of the stocks you own in your portfolio places a limit on how much assets you can manage in your strategy. A portfolio of 25 stocks will have a collective market cap that is lower than a portfolio of 200 stocks, so the manager, who gets paid for managing more assets, can make more money if they manage a strategy with more stocks in the portfolio. This is why you see relatively focused funds close their doors to new money, while the typical, excessively diversified fund rarely closes to new investors.
So diversification is great, but its benefits are realized with far fewer stocks that most people realize. If your goal is to match the market performance (which is a perfectly reasonable goal) than buying every stock in the market (ie. broad diversification) makes perfect sense. But if your goal is to beat the market, the level of diversification should be optimized, not maximized. What you want to avoid at all costs is attempting to beat the market by investing in strategies that are excessively diversified.
Thanks to Lawrence Hamtil of Fortune Financial for urging us to address this topic. Read Lawrence’s blog.
download printable version
Readers are encouraged to contact Ensemble Capital directly with thoughts. The information contained in this post represents Ensemble Capital Management’s general opinions and should not be construed as personalized or individualized investment advice. No advisor/client relationship is created by your access of information on this site. Past performance is no guarantee of future results. All investments in securities carry risks, including the risk of losing one’s entire initial investment. If a security is mentioned in this post, you will find a disclosure regarding any position Ensemble Capital currently has in the security. Ensemble Capital is a discretionary investment manager and does not make “recommendations” of securities. Each quarter Ensemble Capital files a 13F, which discloses all of their holdings. Please contact Ensemble Capital if you would like a current or past copy of their 13F filing.
This article is authored by MOI Global instructor Keith Weissman, director of research at Sibilla Capital.
It is well known that investing is not an endeavor where participants garner a perfect record. In fact, the batting average of investors is well below perfect, even for the best investors. It is not something that investors like to admit, but it is the reality of the industry. The marketing machine backing the industry loves to focus on investment process and returns but even underlying those sterling returns and impeccable processes are a slew of bad investment choices. The goal of an investment manager should be to steer clear of poor investments.
The themes discussed in this article attempt to address some of the roadblocks littering the pathway to success. By falling victim to any of these roadblocks, an investor is invariably shifting the odds against themselves, even if they are able to overcome a roadblock in any one individual investment idea. Investing is difficult enough without shifting the odds out of one’s favor, so with this in mind, I will discuss some things to watch out for as one analyzes ideas and manages their portfolio.
Falling prey to personal biases
It is easy to fall in love with a company based on a positive experience with the company’s product or service as much as it is easy to form a negative opinion based on a bad experience. These individual experiences should not play into one’s investment opinion about the company. Even the opinions of those around them should not make much difference either. In analyzing a company a completely unbiased view should be formed based on what the facts and circumstances dictate about a company’s business model and competitive environment. A relative of mine who does not work in investing or finance told me that he bought shares in Shake Shak. When I asked about his rationale, he said that he likes the company and that they are expanding quickly.
While I could not argue with the popularity of the product (almost cult-like) and the high flying expansion plans, what I could not help but notice was the wild expectations by the market reflected in forward estimates and the valuation multiple. Now this is an extreme example of an inexperienced investor investing for the wrong reason. It is not to say that professional investors would be this flippant, but it is easy to let personal biases stand in the way even at the highest level of investing. One must go beyond the product or service and one’s own perception of a company and understand the business model and competitive positioning to best begin analyzing the company for investment.
Fighting the trend
Have you ever tried running against a stiff wind? You wind up expending much more energy and running more slowly, and likely end up not achieving the desired distance without excessive effort. Running with the wind rather than against it can tremendously improve performance and results. Investors need to proceed in the same manner. When there are demographic, regulatory, technology, health, consumer preference trends at work, these are not to be ignored. Investing against these trends makes picking a winner an uphill battle. It might seem obvious not to bet against a trend, but it happens.
Typically, the investor is not ignorant to the trend, rather they become overconfident in their thesis. Sometimes, the components of the thesis can overcome the trend, however this is about putting the odds in one’s favor, and this is not a way to do so. The “trend is your friend” is the old saying, and it should not be forgotten.
Falling in love with valuation
I can’t tell you how many times I hear an investment thesis where valuation is the lead point. A company’s valuation level is not likely to change unless there is a repricing of all stocks, driven by macro factors, or something changes with the company. Therefore, the focus of the thesis and analytical work should be on determining what is going to change at the company and how much difference this will make in earnings and cash flow rather than wondering what will be the uptick in the multiple of the stock.
The idea that a stock is cheap based on a low multiple is a fallacy and needs to be accompanied by a more cogent argument surrounding expectations for improved margins, growth, and/or ROIC. These are the components that drive multiples on top of a determination of risk.
Many times valuation multiples are evaluated based on historical context. One needs to consider that companies and industries evolve over time with the growth, margin, and ROIC characteristics of the business changing over time. This could cause a permanent shift in the multiple making historical comparisons moot. Unless something is changing in the business which should lead the thesis anyway then the multiple should not be the impetus for investing.
Ignoring what is priced into a stock
Successful investing entails knowing what the market doesn’t know. Benjamin Graham coined the phrase “Mr. Market” to identify the irrational decision making among market participants suggesting the current market price may or may not represent fair value for a company. I would argue that this concept ignores that there are many rational investors included among Mr. Market and their opinions are included in the observed price as well. Subscribing too strongly to the Mr. Market theory will cause one to ignore what is priced into a stock.
Rather than focusing on intrinsic value versus market value and justifying investment that way, one would be better served being able to differentiate their outlook for the company versus how the market expects the company to perform. This is not an easy exercise since the market is a conglomeration of many different views of the future, but it is a worthwhile endeavor. The benefit of this is that the investor will have a stronger thesis as the difference in price will have a more specific explanation behind it rather than simplistically being a function of an irrational market.
Not considering other scenarios
In determining a thesis, some investors spend all of their time refining their view of they think will happen to the company. They will even highlight some of the key risk factors. However, these risk factors rarely seem to get quantified such that the investors knows how the company might perform financially and ultimately what is the valuation under other scenarios that may unfold because of the aforementioned risk factors. Most investors spend most of their time talking about what is right and sometimes what is misunderstood. However, understanding what can go better or worse than expected can help make better investment decisions. People naturally want to talk about why they are right and don’t want to think about being wrong.
Margin of safety, prevalent among value investors, is one way to deal with this uncertainty. However, deciding on a margin of safety is arbitrary and it still does not allow an investor to distinguish between ideas. Two ideas can have the same margin of safety but have very different risk-return profiles. By running scenarios, one can assess which opportunities offer positive asymmetric returns, thereby increasing the odds of success.
Trusting too much in the turnaround story
One of the most popular investment ideas in the value investing world is the turnaround story. Every turnaround story sounds great and hope springs eternal. The price at which one can buy into these stories typically looks “attractive” to investors, hence the allure. However, the reality is most turnaround stories fail. In a lot of cases, the problems at the company cannot be solved no matter the good intentions of management. While these turnaround stories can offer big upside as investors throw in the towel on the underperforming company, these companies can also terminate leading to a total or near total loss of investment.
Having a near total loss in a portfolio can take a long time to overcome which is why one needs to tread carefully here. Successful portfolio management entails putting the odds in one’s favor and part of that is minimizing downside on adverse positions. Now, management will communicate a grand plan in these turnaround situations, however investors must properly assess this plan and really identify exactly what is going to change and why it will be different going forward. Too often the words of management are accepted at face value and the entire thesis gets wrapped up in those words.
An investor who runs blindly into these turnaround stories is potentially setting themselves up for a big loss. There needs to be a highly selective in these situations, but based on how often I see investment thesis built on turnaround stories, it seems that many are being taken at face value too often.
Relying too heavily on international growth
How often do you hear company management trumpeting their international growth strategy? Most companies have unexplored areas outside of their home country and it is easy to proclaim these unchartered waters as a growth opportunity. It seems to be the magic elixir for what ails a company when a company is struggling to grow in its current markets.
It is very easy to speak about international growth opportunities and it is another thing to execute on this strategy. For investors, international growth is an easy add on to an investment thesis, because who is to argue with an unexploited growth opportunity. GARP investors seem enamored with these particular opportunities, however international growth is fraught with risk. This is due to competitive factors, cultural differences, lack of brand recognition and less favorable regulatory environment among the many landmines that companies face in other markets.
Netflix, Target, Ebay, Yelp, Disney, and Best Buy are among the many companies that have had missteps in international expansion showing that even the best companies are not immune to the risks faced in international markets. International growth is generally a high risk proposition and unless the upside warrants it, one needs to be real careful about falling on the crutch of international growth to support an investment thesis.
This is not a proclamation that companies which tout international growth should be avoided, rather that investors must approach with caution given the high degree of uncertainty. Ultimately, one must consider the risk-reward of investing in a company dependent on international growth and this refers back to a previous point about considering various scenarios.
download printable version
Watch an excerpt of our conversation with Keith on idea generation:
Members, log in below to watch the full video.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
The Partnership Years and Warren Buffett’s Ground Rules
October 29, 2017 in Diary, Full Video, Video ExcerptIn a 1993 talk to Columbia University students, Warren Buffett described three early Buffett Partnership investments:
“When I got out of Columbia the first place I went to work was a five-person brokerage firm with operations in Omaha. It subscribed to Moody’s industrial manual, banks and finance manual and public utilities manual. I went through all those page by page.
“I found a little company called Genesee Valley Gas near Rochester. It had 22,000 shares out. It was a public utility that was earning about $5 per share, and the nice thing about it was you could buy it at $5 per share.
“I found Western Insurance in Fort Scott, Kansas. The price range in Moody’s financial manual…was $12-$20. Earnings were $16 a share. I ran an ad in the Fort Scott paper to buy that stock.
“I found the Union Street Railway, in New Bedford, a bus company. At that time it was selling at about $45 and, as I remember, had $120 a share in cash and no liabilities.”
Jeremy Miller, renowned author of Warren Buffett’s Ground Rules: Words of Wisdom from the Partnership Letters of the World’s Greatest Investor, explains the evolution of Warren Buffett in this exclusive interview with MOI Global:
A House Rises, summarizing The Snowball, chronicles the following early Buffett investments:
Greif Bros. Cooperage; originally purchased for the B&B partnership in the early 1950s.
Western Insurance; purchased for Buffett’s personal portfolio in the early 1950s, Buffett actually sold his GEICO position to raise money to invest in this company earning $29/share and selling for $3/share, “He bought as much as he could”.
Philadelphia and Reading Coal & Iron Company; controlled by Graham-Newman, Buffett has discovered it on his own and had invested $35,000 by the end of 1954; it was not worth much as a business but was throwing off a lot of excess cash; Buffett learned about the value of capital allocation with this company.
Rockwood & Co.; controlled by Jay Pritzker, the company was offering to exchange $36 of chocolate beans for shares trading at $34, a classic arbitrage opportunity; unlike Graham, Buffett didn’t arbitrage but instead bought 222 shares and held them, figuring Pritzker had a reason he was buying the stock, “inverting” the scenario; the stock ended up being worth $85/share, earning Buffett $13,000 vs. the $444 he would’ve received from the arbitrage.
Union Street Railway; a net-net he discovered through Ben Graham, had about $60/share in net current assets against a selling price of $30-35/share, Buffett ultimately made $20,000 on this investment through sleuthing and speaking to the CEO in person.
Jeddo-Highland Coal Company (mentioned as an idea Buffett investigated on a road trip).
Kalamazoo Stove and Furnace Company (mentioned as an idea Buffett investigated on a road trip).
National American Fire Insurance, earning $29/share, selling for around $30/share, Buffett first bought five shares for $35/share, and later realized that paying $100/share would bring out the sellers because it would make them whole (financially and psychologically) after being sold the stock years earlier.
Blue Eagle Stamps, a failed investment scheme between Buffett and Tom Knapp, they eventually spent $25,000 accumulating these “rare” stamps that weren’t worth more than their face value ultimately.
Hidden Splendor, Stanrock, Northspan, uranium plays that Buffett described as “shooting fish in a barrel”.
United States & International Securities and Selected Industries, two “cigar butt” mutual funds recommended to him by Arthur Wisenberger, a well known money manager of the era; in 1950, represented 2/3 of Buffett’s assets.
Davenport Hosiery, Meadow River Coal & Land, Westpan Hydrocarbon, Maracaibo Oil Exploration, all stocks Buffett found through the Moody’s Manuals.
Sanborn Maps, in 1958 represented 1/3 of his partnerships’ capital; the stock was trading at $45/share but had an investment portfolio worth $65/share; Buffett acquired control of the board in part through proxy leverage; ultimately he prevailed over management and had part of the investment portfolio exchanged for the 24,000 shares he controlled.
Dempster Mill Manufacturing, sold for $18/share with growing BV of $72/share, Buffett’s strategy as with many net-nets was to buy the stock as long as it was below BV and sell anytime it rose above it and if it remained cheap, keep buying it until you owned enough to control it and then liquidate at a profit; he and his proxies gained control of 11% of the stock and got Warren on the board, then bought out the controlling Dempster family, creating a position worth 21% of the partnership’s assets; the business was sliding and at one point he was months away from losing $1M on the investment, but was ultimately rescued by Harry Bottle, a new manager brought in on Charlie Munger’s recommendation; the business eventually recovered through strict working capital controls and began producing cash, which Buffett augmented by borrowing about $20/share worth of additional money and used it to purchase an investment portfolio for the company; he later sold the company for a $2M profit.
Merchants National Property, Vermont Marble, Genesee & Wyoming Railroad, all net-nets he later sold to Walter Schloss to free up capital.
British Columbia Power, selling for $19/share and being taken over by the Canadian government at $22/share, this merger arb was recommended by Munger and Munger borrowed $3M to lever up his returns on this “sure thing”.
American Express, one of Buffett’s first “great company at a good price” investments, the firm’s reputation was temporarily tarnished in the aftermath of the soybean oil scandal; Buffett did scuttlebutt research and realized the public still believed in American Express, and as trust was the value of its brand, the company still had value; Buffett eventually invested $3M in the company and it represented the largest investment in the partnership in 1964, 1/3 of the partnership by 1965 and a $13M position in 1966.
Texas Gulf Producing, a net-net Buffett put $4.6M into in 1964.
Pure Oil, a net-net Buffett put $3.5M into in 1964.
Berkshire Hathaway, the company was selling at a discount to the value of its assets ($22M BV or $19.46/share) and Buffett’s original intent was to buy it and liquidate it, which he started accumulating 2000 shares for $7.50/share; the owner, Seabury Stanton had been tendering shares with the company’s cash flow, so Buffett tried to time his transactions, buying when it was cheap and tendering when it was dear; he continued purchasing stock assuming Seabury would buy him out via tender offers, the two eventually agreed to a $11.50 tender but Seabury reneged at the last moment, changing the bid to $11 and 3/8, sending Buffett into a rage and causing him to abandon his original strategy in favor of acquiring the entire company; he eventually bought out Otis Stanton’s two thousand shares and had acquired enough to gain control with 49% of Berkshire.
Employers Reinsurance, F.W. Woolworth, First Lincoln Financial, undervalued stocks he found in Standard & Poor’s weekly reports.
Disney, which he bought after meeting Walt Disney and being impressed by his singular focus, love of work and the priceless entertainment catalog.
A portfolio of shorts to hedge against a potential market collapse in the mid 60s, totally $7M and consisting of Alcoa, Montgomery Ward, Travelers Insurance and Caterpiller Tractor.
Near the end of 1968, as the market became more and more overvalued, Buffett relented and bought some of the “blandest, most popular stocks that remained reasonably priced” such as AT&T ($18M), BF Goodrich ($9.6M), United Brands ($8.4M) and Jones & Laughlin Steel ($8.7M).
Blue Chip Stamps, a “classic monopoly” Buffett and Munger discovered in 1968, the company was involved in a lawsuit that the pair thought would be resolved in the company’s favor, and it also possessed “float” which could be invested in more securities, Munger and his friend Guerin each purchased 20,000 shares while Buffett acquired 70,000 for the partnership, in part through share swaps with other companies that owned Blue Chip stock for their own stock; the lawsuit was eventually resolved and the $2M investment produced a $7M profit.
Illinois National Bank & Trust, a highly profitable bank that still issued its own bank notes, it was managed by Eugene Abegg, an able steward of the company whose retainer was one condition for Buffett’s investment in the company.
The Omaha Sun and other local newspapers, which Buffett figured he’d make an 8% yield on, his motivation for buying seemed to be primarily connected to his desire to be a newspaper publisher.
The Washington Monthly, a startup newsmagazine that Buffett lost at least $50,000 on, again, as a vanity project.
With clever Google searching it’s possible to track down the original Moody’s Manual reports for many of these investments.
Expert Jeremy Miller’s favorite early Buffett Partnership case study is Dempster Mill, explained below:
Members, log in below to watch the full video.
Not a member?
Thank you for your interest. Please note that MOI Global is closed to new members at this time. If you would like to join the waiting list, complete the following form:
Discover the best ideas of more than 50 value-oriented investors, including Bill Chen, Sid Choraria, Chris Crawford, Jeremy Deal, John Lewis, Phil Ordway, Barry Pasikov, Bob Robotti, David Rolfe, Keith Rosenbloom, Jim Roumell, Sean Stannard-Stockton, Glenn Surowiec, Amit Wadhwaney, and other great investors — LIVE online on January 11-12 at Best Ideas 2018, our largest online investment conference ever. Stay tuned for additional featured instructor announcements in the coming weeks.
We are grateful to have assembled the most impressive instructor line-up in the history of ValueConferences, the MOI Global subsidiary that pioneered fully online investment conferences starting in 2012.
The convenience with which instructors share their best investment ideas and the ease with which our members discover those ideas — and then connect with the instructors — have fostered strong growth in uptake of the Best Ideas annual summit.
For the first time ever, the conference is available exclusively to members of MOI Global — as a complimentary member benefit. Members also enjoy unlimited session replays, putting a large library of compelling ideas and in-depth equity research at their fingertips.
Not an MOI Global member? Add your name to the waiting list and we’ll keep you informed should an opportunity to join become available.
To get a taste of the Best Ideas summit, enjoy selected presentations by Scott Miller of Greenhaven Road Capital. Also, read highlights of Best Ideas 2017.
Best Ideas 2017 — Scott Miller on EnviroStar and Limbach:
Scott’s original thesis: ENVIROSTAR (NYSE: EVI) and LIMBACH (Nasdaq: LMB) are two sub-$200 million market capitalization companies. Investor’s typically underestimate the power of compounding and overestimate the value of “sexy”. These two “boring” companies provide the opportunity for significant capital appreciation despite not “screening well”.
EnviroStar is a commercial laundry equipment distributor engaged in a buy-and-build strategy led by a highly aligned CEO with experience at an incredibly successful buy and build company, Watsco. The industry has attractive geographic monopoly dynamics with opportunity for expansion. With the stock trading at 12x EBITDA and an acquisition pipeline at 4-6x EBITDA, the company can potentially double earnings with minimal share dilution through the combination of share issuance and debt.
Limbach is one of the largest commercial air conditioning contractors in the U.S. It is a fundamentally healthy business that is growing revenue and backlog by 30%. The company has the opportunity to grow organically, expand margins through increased service offerings, and opportunistic acquisitions. Both the common stock and long-dated warrants provide an interesting risk-reward proposition.
Best Ideas 2016 — Scott Miller on Fortress Investment Group and Associated Capital:
Scott’s original thesis: Many investors, when looking at asset managers, underappreciate the balance sheet. Here are two asset managers at compelling valuations when the balance sheet is factored in:
FORTRESS INVESTMENT GROUP (NYSE: FIG) is an alternative asset manager that is 50+%-owned by insiders. More than half the value of the company is in cash and investments. There is another 15+% in earned but unrealized incentive fees. Despite the headlines of a closed macro hedge fund, the business grew in 2015 and has a very stable management fee revenue stream. The stub (factoring out cash, investments, and earned but unrealized incentive fees) trades at approximately 2x distributable earnings.
ASSOCIATED CAPITAL GROUP (NYSE: AC) is a spinoff from Mario Gabelli’s GAMCO. Associated Capital Group has no sell-side coverage and has not been written up in any of the traditional value investing forums. Shares trade at a 25% discount to adjusted book value while sitting on attractive assets with the opportunity to grow. Sometimes spinoffs are garbage barges filled with toxic waste that the parent company cannot get rid of fast enough. This is not one of those situations. Mario Gabelli owns 75% of the outstanding shares and has announced a substantial buyback.
Finally, here’s a terrific insight by Best Ideas 2018 instructor Chris Crawford into stock market values “hiding in plain sight”. Chris is an impressive equity analyst and portfolio manager whose research presented at MOI Global online conferences has been absolutely top notch (e.g., Ritchie Brothers in early 2016).
Mark Hammonds on His Zurich Project Book Recommendation
October 28, 2017 in Diary, Reading Recommendations, The Zurich ProjectMark Hammonds, based in London, a member of MOI Global and returning participant in The Zurich Project, is a value investor with an abiding interest in deep value and special situations.
Mark has put together some notes on his Zurich Project book recommendation, The Lean Startup, by Eric Ries. A few highlights:
“The function of entrepreneurship is to learn what customers want.”
“Learn by running experiments to see how customers behave.”
“Knowledge gained will suggest new experiments to run.”
“Don’t just take what customers say they want at face value – customers may not know what they want or be able to imagine the solution.”
“Anything not providing benefit to the customer is waste. Systematically eliminate it.”
Read Mark’s full notes.
Watch Eric Ries discuss The Lean Startup at Google:
About The Zurich Project Book Club
The Book Club was conceived as a way to foster informal discussion of impactful books during the Zurich Project workshop.
With the input of Zurich Project members, we occasionally select books that, in one way or another, advance the mission of “building a great investment firm”. They may address topics such as scaling a business, hiring great people, building a brand, creating an in-bound marketing strategy, reaching our own full potential (e.g., stoicism, meditation), etc.
We have drawn some great insights thanks to the Zurich Project Book Club. One selection has been Talk Like TED: The 9 Public-Speaking Secrets of the World’s Top Minds, by Carmine Gallo. This terrific suggestion originated with Thomas Karlovits who also led a discussion on key takeaways from the book at The Zurich Project 2017. The book helped Thomas shape the marketing story of Blackwall Capital. Here is Thomas introducing the book:
Another Zurich Project Book Club selection has been How to Fail at Almost Everything and Still Win Big, by Scott Adams. Special thanks to Anuj Didwania and Ahmed Husain for this terrific suggestion and to Anuj for leading a discussion of the book at The Zurich Project 2017.
Learn more about The Zurich Project.
Do you have an invitation code? Enter it here to register.
This article by Jim Roumell is excerpted from a letter of Roumell Asset Management.
We wrote about LQDT in our second quarter letter of this year. LQDT’s stock dropped during the second quarter and we added to our position. We find LQDT’s shares to be very attractive given that we believe the value of one of its business lines — GovDeals — currently exceeds the company’s valuation.
Here’s a simple way to think about LQDT. GovDeals is an online surplus goods marketplace exclusively serving North American municipalities. It has been growing at about a 17% CAGR since FY09. Management estimates the total addressable market for state and local government is close to $3 billion. Even if they’re overestimating by a factor of 3x, GovDeals can still comfortably triple its revenue from here. Let’s assume it grows at only 13% over the next five years (a 20% plus drop in its growth rate) off of today’s $30 million revenue run rate. In five years GovDeals would have $55 million in revenue. With 90% gross margins and a double-digit growth rate, let’s assume a value of 4x revenue, which equates to $220 million, or $6.90/share. Assume even 3x revenue and the value goes to $165 million, or $5.15/share.
Let’s assume LQDT’s retail supply chain business has a value of $50 million (2022 value), a fraction of retail competitor Optoro’s last capital raise valuation. Retail’s gross margin is 30% (with 5% GMV growth in the last quarter), but it should benefit from growing online purchases, and the 3x return rate of goods purchased online compared to brick and mortar store purchases. We assume the company’s commercial assets business is worth $32 million, or $1/share, since we can’t see a clear picture of profitability. IronPlanet’s purchase by Ritchie Bros suggests our valuation for this company business line is conservative. Finally, we give LQDT’s DoD and IronDirect business lines each zero value. Additionally, let’s take total net cash down to $100 million from currently $124 million.
The above analysis sums to $402 million, or $12.50/share; that’s a 15% CAGR on one’s investment (and we’re holding retail and commercial assets verticals at today’s washed-out values). Thus, LQDT provides multiple shots on goal anchored by the GovDeals gem, which is buried in the haystack and receiving no respect…today. Our strong belief is that the value will be unlocked as GovDeals continues to execute with both high margins and growth in revenue. The GovDeals vertical is effectively a monopoly for online municipal liquidation and benefits from a two-sided network effect. It appears GovDeals is the “go to” municipal liquidator as the community members talk amongst each other and increasingly move away from weekend onsite auctions (which they all seem to hate). There are now over 9,000 municipal customers and the number grows quarterly.
During the summer, we sat down with Bill Angrick, CEO, for a two-hour one-on-one and walked away with our confidence fully intact that Bill understands the opportunities and challenges of LQDT’s various business lines. Moreover, we gained comfort that he well understands the importance of capital allocation decisions. Bill remains the company’s largest shareholder, owning roughly 17% of the company. We also spoke to more LQDT GovDeal clients and have thus far been unable to find even one unsatisfied customer. In fact, the additional customers we’ve spoken with are quite effusive in their praise of the company’s value proposition to their liquidation efforts. Customers we spoke with rated their level of satisfaction from 8 to 9.75 (on a scale from 1 to 10 with 10 being highest). One state we spoke with indicated that selling online through GovDeals reduced its operational costs by $1 million per year.
Pessimism is high regarding LQDT’s turnaround efforts — a great environment for a buyer. The investment thesis is not complicated. The company is exceptionally well-capitalized with over $100 million in cash and no debt. It possesses the important and necessary RAM ingredient of having time on its side while it segues to returning to a cash-generative business.
download printable version
Disclaimer: The specific securities identified and described do not represent all of the securities purchased, sold, or recommended for advisory clients, and the reader should not assume that investments in the securities identified and discussed were or will be profitable. The top three securities purchased in the quarter are based on the largest absolute dollar purchases made in the quarter.