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Highlights from Wide-Moat Investing Summit 2017

September 13, 2017 in Asia, Equities, Europe, Ideas, North America, Wide Moat, Wide-Moat Investing Summit

The following idea snapshots have been provided by the respective instructors or compiled by MOI Global using information provided by the instructors. The following is provided for educational purposes only and does not constitute a recommendation to buy or sell any security.

ROBERT ROBOTTI, ROBOTTI & COMPANY

FINNING INTERNATIONAL (Toronto: FTT) is the world’s largest Caterpillar distributor. It sells, rents, and provides aftermarket parts and service for Caterpillar equipment. Its exclusive distribution territories include the Western Canadian Provinces; Chile, Argentina, and Bolivia in Latin America; and the United Kingdom and Ireland. Undoubtedly in a cyclical industry, Bob views Caterpillar’s products as differentiated and backed by continual product research and advancement that makes it a wide-moat business. Separately, the exclusive geographic distribution of territories that Caterpillar designates provide an even wider moat for its exclusive distributors. In addition to its territorial exclusivity, Bob believes the distribution business, with its focus on aftermarket service and products, moderates the otherwise cyclical nature of the business. As a result, the company is FCF-generative through the cycle. Despite this wide moat, Finning’s return on invested capital has dramatically lagged the only other public “pure play” CAT distributor, Toromont Industries (Toronto: TIH). Bob believes the wide disparity in stock market valuations between Finning and Toromont should dissipate over time as Finning’s financial results should approach those of Toromont. Beginning in 2013, after years of focusing solely on revenue growth and operating margins, Finning hired a new CEO to reshape the company culture to one focused on driving returns on invested capital. The company remains committed to executing on its new set of operational priorities identified in 2013. However, the company’s achievements have been significantly masked by cyclical weaknesses in many of Finning’s exclusive geographies, further exacerbated by the predominance of energy and mining industries in many of those geographies. With a solid balance sheet, good free cash flows despite weak end markets, an improved cost structure, a focus on prudent capital allocation, and a profitable growth outlook, Bob believes that once the cycle turns Finning’s operating leverage will far exceed the market’s expectations.

DAVE SATHER, SATHER FINANCIAL GROUP

BANK OF NEW YORK MELLON (NYSE: BK) is a global investments company and the largest custodian bank in the world, with $27+ trillion in assets under custody. The custodian bank serves as a backbone to the world’s financial markets, servicing 78% of the Fortune 500. Its businesses benefit from global growth in financial assets as well as the continued globalization of capital markets. Because of its long history, dating back to 1784, and wide reach across markets, BNY Mellon is a widely recognized name in the custody space. It has been able to build a moat around its brand, economies of scale, and switching costs. Yet, with ~15% global market share in the asset custody business, there is still room for growth. This business does not care who wins the active vs. passive management argument—as long as securities transactions are occurring and there is a need to store assets for safe-keeping, BNY Mellon will have a place at the table. For the past decade, banks across the world have been stymied by the “zero interest rate policy”, and BNY Mellon is no different in this sense. As the Federal Reserve continues to slowly raise the Fed Funds rate, Bank of New York stands to be a direct beneficiary. Trading at 15 times earnings, BNY Mellon is sitting at its ten-year median valuation point but with catalysts to the upside, which include a ~50% increase in net interest margin over the next three years as the Fed pushes up rates. While not a sexy start-up, continued share repurchases of ~3% of outstanding shares annually should help EPS to grow at least 8-10% over the next several years. A conservative DCF suggests that we can realistically look forward to 10%-20% annualized returns as expected margin improvements take hold.

JIM ZIMMERMAN, LOWELL CAPITAL MANAGEMENT

LANXESS (Germany: LXS) is a specialty chemicals company based in Germany with an investment-grade (“Ft. Knox”) balance sheet and strong cash generation. The company is undergoing rapid transformation into a specialty chemicals powerhouse, with a group of high-margin, cash-generative, and resilient specialty chemicals businesses, under CEO Matthias Zachert. Zachert rejoined Lanxess in early 2014. He has a tremendous track record as former CFO of Lanxess from 2004-2011 when adjusted EBITDA grew close to 20% per year. Under a previous CEO, Lanxess had over-expanded into more commodity-oriented specialty rubber segments and become over-leveraged. Zachert rejoined Lanxess as CEO and has aggressively improved the balance sheet and shifted the focus back to stronger specialty chemicals businesses in less competitive niche markets. Lanxess recently closed a major acquisition of Chemtura, based in the U.S., which makes Lanxess a major player in additive and flame retardant chemicals, alongside Lubrizol (purchased by Berkshire Hathaway in 2011). In fact, Berkshire recently took a 3% stake in Lanxess, and Jim believes Lanxess could eventually be an excellent acquisition for Berkshire. With a full year of Chemtura, Jim believes Lanxess could generate close to 1.3 billion euros of adjusted EBITDA in 2018 (excluding 50% of its Arlanxeo JV) and trade for 9x adjusted EBITDA. Subtracting an estimated 1.7 billion euros of net debt at yearend 2018 and based on 91 million shares outstanding, Jim believes Lanxess could trade for as much as 110 euros per share (versus the recent price of ~66 euros per share).

ARVIND MALLIK AND JONATHON FITE, KMF

AMERISOURCEBERGEN (NYSE: ABC) is a high-quality pharma distribution business trading well below a market multiple. The company has a strong balance sheet and competitive moat, underpinned by best-in-class logistics, working capital management, and regulatory barriers to entry. While the industry landscape is cluttered with complicated payment relationships, ~94% of all drug shipments are processed through pharma wholesalers and distributors like AmerisourceBergen. Macro forces provide strong tailwinds, as baby boomers enter peak drug consumption years, dispensed prescriptions continue to rise steadily, prescriptions comprise a larger mix of overall health spending, and overall health spending continues to rise even as volume shifts to cheaper generics. The pharma distribution arena is dominated by ABC, MCK, and CAH. Arvind and Jonathon sees operational, financial, and macro catalysts driving an increase in EPS at AmerisourceBergen from an estimated $5.85 in 2017 to $9-10 in 2020. Key catalysts include Walgreens deal expansion, distribution center buildout completion, renegotiation of inflationary contracts, share repurchases, accretive acquisitions using strong borrowing capacity, and a tax rate decline from 32% to 25%.

OMAR MUSA, PEREA CAPITAL

WONDERFUL SKY FINANCIAL GROUP (Hong Kong: 1260) is the leading financial public relations firm in Hong Kong. The company was founded in 1996 by Chairman Liu Tianni to provide PR services to corporates going public on the HK stock exchange. The company has 35% market share by number of listings and 70% market share by amount of funds raised. In 2016, each one of the top ten IPOs in HK enlisted Wonderful Sky as its PR advisor. With only one chance to IPO and the cost of PR being a small fraction of total IPO costs, Wonderful Sky has become the standard for financial PR in HK. Following the IPO, the company continues to provide recurring PR services that make up nearly two-thirds of revenue and highlight its extremely high customer retention. Since 2009, Wonderful Sky has compounded earnings at 27% a year with little invested capital. It recently had one-half of its market cap in cash and investments, with the shares selling for 6.5x earnings ex-cash. Insider ownership is 60+%. The company pays generous dividends and occasionally repurchases stock.

ELLIOT TURNER, RGA INVESTMENT ADVISORS

TWITTER (NYSE: TWTR): Mark Zuckerberg once said that, “[Twitter is] such a mess, it’s as if they drove a clown car into a gold mine and fell in.” There is much truth to this. Twitter is one of the most unique and irreplaceable online platforms, yet it has failed to earn a profit since its public debut. Today, Twitter trades at capitalization levels first reached in 2011 or 2013–a time in which it had 1/5th the revenue base. Twitter was rewarded with a rich valuation merely for the “attention” it could command across its user base. This was before there was a business attached to it. Starting points and narrative matter for the perceived value of any company. Investors and analysts, many of whom were active users of Twitter, staked their dollars and reputation behind the young, public Twitter only to be left burnt and frustrated. This has led a vocal contingent of frustrated stakeholders with respect to the platform and stock alike.

The lack of profitability, to date, has been the combination of choice and accident: choice insofar as the company sees a long runway of potential opportunity and wants to capture all of it as quickly as possible; accident insofar as the growth in user-base and revenues stalled before most expected it would. There are signs that the trough of disillusionment will soon end as growth in the user-base has reaccelerated and management has pledged a new discipline with respect to expenses and product development. What Zuckerberg initially observed has not been lost, but the delivery date on the promise of being a profitable entity has been delayed. While people focus on the litany of mistakes plaguing Twitter since going public, the company has cemented its central role in media as one of (if not THE) primary distribution channels with crucial advantages in speed and reach that others cannot compete with. News breaks on Twitter and anyone whose voice needs to be heard in any context needs to maintain a Twitter presence. This makes the company an important strategic asset, with a revenue base that could be reasonably profitable were management to so choose. With the stability of the user-base clear and once again growing, the company will benefit from the luxury of time to figure out yet more things. At recent prices, the stock has thoroughly discounted a multitude of known negatives, leaving contrarian investors a good opportunity to think about what can go right, how much profit the business can drive, and what returns on invested capital could look like for either a public Twitter or an acquirer.

DAVID BARR AND FELIX NARHI, PENDERFUND

BAIDU (Nasdaq: BIDU) is the leading Chinese language Internet search provider. Baidu’s core search platform is a cash cow protected by a deep moat, whose functionality continues to serve a fundamental need for society as more information is digitized. In addition to core search, Baidu owns the leading online video platform in China (iQiyi), a 20% stake in the leading Chinese online travel agency (Nasdaq: CTRP), plus other investments with optionality. On a sum-of-the-parts basis, Dave and Felix estimate BIDU’s core search to be attractively valued in a range of 7-12x normalized pretax profits, depending on the values derived for privately held investments. The stock is attractively priced because of some transitory setbacks in search last year and monetization concerns of non-core segments. This narrative should improve in the coming year as non-core losses fade and search revenues recover. Importantly, Dave and Felix believe Baidu’s status as China’s leading artificial intelligence (AI) enterprise is underappreciated by many investors because there is little to no upside from potentially game-changing initiatives baked into the stock price. In essence, an investor gets Baidu’s AI-driven world-class capabilities, including autonomous driving (Project Apollo), conversational computing (Duer), and enterprise cloud for free at recent prices. Dave and Felix believe the stock’s modest valuation range provides some foundational downside support, while AI provides potentially multi-fold upside over the medium term.

MATTERSIGHT (Nasdaq: MATR) provides SAAS-based behavioral analytics solutions that are deployed in enterprise call center environments. The company was founded in 2006, however its current business emerged out of a call-center consulting and solutions business sold in 2011. Using its own proprietary database of 1+ billion recorded and analyzed calls, Mattersight’s value proposition is to reduce call center times and increase sales conversion for its enterprise customers through personality-based call routing and analytics. Over 95% of the company’s revenue is recurring, with a “blue chip” Fortune 100 client base and backlog growing 20+% year over year. Market mispricing is due to the company’s size of ~$100 million market cap, lumpy growth due to long enterprise sales cycles, and customer concentration. Looking forward Dave and Felix believe the company will operate at scale within three to four years and have the ability to generate 15+% EBITDA margins through the inherent operating leverage of the business. In Dave and Felix’s view, the company is worth nearly double the recent share price, which roughly equates to 3-4x forward revenue. This valuation is justified given Mattersight’s revenue quality as described above, its leadership position in an emerging market, highly valuable proprietary dataset, and near-cash flow breakeven inflection point.

TODD SULLIVAN, RAND STRATEGIC PARTNERS

HOWARD HUGHES CORP. (NYSE: HHC) is a land development. It has three main segments: master planned communities (MPCs), operating assets, and strategic developments. In each of the MPCs, the company controls all development rights and the speed of development. This effectively gives the company a monopoly over all development in MPCs that individually are the size of Manhattan. The company’s Woodlands, Bridgeland, and Summerlin MPCs are ranked as the best in the nation and the Ward Village MPC was named “The Best Place to Live in the US”. With current entitlements and works in progress, the company has no need for acquisitions to continue to fuel growth. A sums-of-the-parts valuation shows the company trades ~40% below NAV. Additionally, as NOI continues its impressive ramp (up nearly 400% since the end of 2010), the company at some point may spin off operating assets or consider a complete or partial REIT conversion.

HENRIK ANDERSSON, DIDNER & GERGE

ASHMORE GROUP (London: ASHM) is typical of the holdings Henrik seeks out. It is owner-operated with a genuinely strong corporate culture, positioned well in an attractive marketplace that offers meaningful reinvestment opportunities. The company’s excellence has shown over the last “seven lean years”, when emerging markets debt suffered massive outflows, but the company kept up margins, never lowered the dividend, and kept making long-term decisions. Everyone in the organization “eats, lives, and breathes” emerging markets, and we think the management team is exceptionally bright. Even though EM debt constitutes 30% of all outstanding debt, it feels as if the marketplace is just beginning to gain traction, “one scare at a time”. It is increasingly heterogeneous but makes up only ~5% of institutional investor allocations. Henrik and his team believe the valuation is attractive in light of the opportunity to be part of a listed “private partnership in spirit”.

KEITH SMITH, BONHOEFFER FUND

Keith’s session focuses on shipping companies that generate good returns through the shipping cycle (compounders). He has observed three types of compounders: opportunistic, recurring revenue, and logistics providers. He shares an idea of each type, which he considers compelling at recent prices:

SIEM INDUSTRIES (OTC: SEMUF) is a holding company with interests in the oil and gas services industry and renewables sector; ocean transportation of refrigerated cargoes and automobiles; and potash mining and finance, which includes loans and guarantees, credit advisory services and investments. Siem is run and majority-owned by Kristian Siem. Kristian is a master capital allocator who has compounded Siem’s book value by 23% per year for 29 years. The shares recently traded at a P/BV ratio of 46%, look-through P/E of 7.6x, and look-through EV/EBITDA of 4.4x. Reasons for the discount include lack of sell-side coverage, lack of trading liquidity, and depressed oil and gas services and shipping industries. Since the 1970s, Kristian has opportunistically bought and sold shipping assets, from oil and gas rigs to cruise ships. Kristian is 68 years old and still has the desire to buy cheap and sell dear. Future catalysts for Siem shares include improved oil and gas prices; better shipping conditions as sources of ship financing become less numerous; and sales of assets as the recovery unfolds. If the shares traded at book value, the stock would be a double, not including any earnings gains from a turn in the oil and gas services or shipping markets.

OCEAN YIELD (OSE: OCYO) is a ship finance company affiliated with the Aker Group. Originally focused on oil and gas vessels, Ocean Yield has diversified its fleet to include car carriers, chemical tankers, gas carriers, and container ships. All of Ocean Yield’s vessels have long-term leases (11.4 years on average) with mostly credit-worthy shipping companies. A majority of these companies are not affiliated with the Aker Group. Ocean Yield is run by the former CEO of the first publicly traded ship finance company, Ship Finance International. Since the IPO, Ocean Yield has generated a change in book value plus dividend return of 13% per year and has had quarterly ROEs ranging from 12-18%. The shares recently traded at a yield of 9.8%, P/E of 8.4x, and EV/EBITDA of 7.3x, despite the recent loss of an oil and gas lessee. Given the current pull back in financing of vessels from the KG system, new leases can be initiated at favorable terms for the lessor. Ocean Yield has initiated leases on these favorable terms over the past few years and plans to initiate more leases in the near future. If Ocean Yield traded at the same multiples as its nearest competitor or aircraft lessors, the stock would sell for 50% more and a holder would collect a ~10% dividend yield.

WILH. WILHELMSEN HOLDING (OSE: WWIB) is a holding company with interests in firms that provide shipping and logistics services for car and roll-on/roll-off (ro-ro) customers, marine products, ship agency service, marine safety, marine time logistics, and ship management. Wilh. Wilhelmsen is majority-owned by the Wilhelmsen family and is run by a 5th-generation owner-operator CEO. Over the past ten years, Wilh. Wilhelmsen has generated average ROE of 11.6% and BV-plus-dividend growth of 9% per year. The shares recently traded at a P/BV ratio of 60%, look-through P/E of 6.5x, and look-through EV/EBITDA of 4.5x. Reasons for the discount include a perception of a peak auto market and a depressed shipping industry. Wilh. Wilhelmsen is actually more of a vehicle logistics provider that uses shipping to transport vehicles as opposed to being a pure shipper. Future catalysts for the shares include stable auto demand, increased equipment demand, better shipping conditions as sources of ship financing become less numerous, and sales of assets as the recovery unfolds. If the shares traded at NAV with a holding company discount, the stock would be a double, not including an earnings gains from a turn in the shipping markets.

For those interested in learning more about the shipping industry, Keith Smith recommends Maritime Economics by Martin Stopford.

MARK WALKER, SEVEN PILLARS CAPITAL

TRIPADVISOR (Nasdaq: TRIP) shares have fallen by ~60% over the last two years due to a business model augmentation that is temporarily depressing profits but reinforcing the strong competitive position and improving the long-term prospects of the business. With consecutive quarterly earnings reports missing analysts’ short-term forecasts and causing share price declines of roughly 20% on both occasions, TRIP shares were recently available at a market quotation that considerably undervalues this exceptional reinvestment moat business.

JOHN HUBER, SABER CAPITAL MANAGEMENT

TENCENT HOLDINGS (Hong Kong: 700, OTC: TCEHY) is a Chinese Internet company with one of the most powerful network effects in the world. The company operates in numerous businesses that generate significant free cash flow, take very little capital to grow, and have long runways for growth in China and around the world. These businesses and investments consist of video game publishing, music and video subscriptions, ecommerce, mobile payments, and online advertising, among other assets. But the company’s crown jewel is WeChat, a mobile app that is unlike any application that exists in the West. WeChat is used for just about everything in China including messaging, work communication, calls, social networking, online shopping, paying bills, transferring money, and much more. WeChat is an asset that has barely been monetized yet, but is in prime position to capitalize on numerous fast-growing industries worth hundreds of billions of dollars. Tencent is growing free cash flow at 40+% per year, and given its unique competitive position and the markets in which it operates, there is likely a very long runway ahead for the company, despite already being one of the most valuable companies in China.

CHARLES HOEVELER, NORWOOD CAPITAL

COMMERCEHUB (Nasdaq: CHUBA, CHUBK) is a cloud-based software application that enables dropship e-commerce for the world’s largest retailers. CHUBA spun out of Liberty Interactive in the summer of 2016 with little fanfare despite a high-teens organic revenue growth profile and 40-50% EBITDA margins. CommerceHub’s economic castle is protected by a strong network effect, long-standing positive customer relationships with the world’s most sophisticated retailers, and a compelling value proposition for both retail and supplier customers. Chuba trades at ~21.5x/18.0x Charles’ 2018/19 free cash flow per share estimates. This for a business that Charles forecasts will compound free cash flow per share 20-30% annually for the foreseeable future.

Artem Fokin, portfolio manager of Caro-Kann Capital, also presented on CommerceHub.

KEITH ROSENBLOOM, CRUISER CAPITAL

EVINE LIVE (Nasdaq: EVLV), formerly known as ValueVision Media, operates as a multiplatform video commerce company in the U.S. The company markets, sells, and distributes products to consumers through television, online, mobile, and social media in various merchandise categories, such as jewelry and watches, home and consumer electronics, beauty products, and fashion and accessories. It has access to ~87 million cable and satellite television homes. The company has revenue of $650+ million, adjusted EBITDA of $18-22 million, and an FCF yield of 10+%. Keith sees a clear path to improving profitability. The enterprise trades at ~6.2x 2017E adjusted EBITDA, or ~5.6x excluding TV assets held for sale. Capex is essentially completed ($8 million ongoing, after $57 million – used cash to expand distribution facilities and transition to HD channels). Most of the debt is working capital-related (PNC Bank vs. “hard money” lenders in 2016). Management turmoil and related expenses are completed, and Keith regards the current team as solid. The logical exit for EVINE might be an acquisition by Amazon, Walmart, Google, Apple, or Macy’s. Amazon recently tried to enter the space via their “style code” live show, which they cancelled after a year.

SHAWN KRAVETZ, ESPLANADE CAPITAL

DYNAM JAPAN HOLDINGS (Hong Kong: 6889) is a U.S. regional casino in ninja’s clothing. If you like suburban Ohio slot halls with a uniquely Japanese twist, you will take notice of Dynam, which owns and operates the largest portfolio of pachinko halls throughout Japan. If Dynam traded on a U.S. exchange, it would be benchmarked to regional casino operators such as PENN, PNK, BYD, and RRR, which trade at 8-11x EBITDA. However, Dynam trades in Hong Kong, operates solely in Japan, and remains largely ignored by the sell- and buy-side, trading at ~4.2x EBITDA. Despite operating in a market offering superior scale, similar customer focus, modest growth, and similar margins, Dynam trades at a steep discount while paying a ~6.6% dividend yield. Recent regulatory tightening of “high volatility” machines has created temporary disruption to industry fundamentals and has provided an attractive entry point for Dynam investors. The market recently valued Dynam as secularly declining (despite relatively stable results). Investors completely ignore the potential Integrated Resort opportunity. After years of failed proposals, Japan’s Diet finally passed the Casino Promotion Bill in December 2016. Equipped with ample land in Yamaguchi and one of the largest gaming customer databases in Japan, Dynam is positioned well to attract high-profile international IR development partners and to secure a license in the upcoming RFPs. With a 6.6% dividend yield, durable core pachinko operations, and a potentially transformational Japan IR opportunity, Shawn sees Dynam as worth ~HK$29 or >125% upside in his base case and ~HK$44 or ~240% in his high case.

GARY MISHURIS, SILVER RING VALUE PARTNERS

GILEAD SCIENCES (Nasdaq: GILD) is a pharmaceutical company with two main revenue streams – Hepatitis C and HIV medications. The former is in a state of decline, as the company has been able to bring a cure to market. The Hepatitis C business peaked in 2015 and is now best thought of as a runoff book of business with the main question being about the rate of its decline. The HIV revenue stream on the other hand is likely to grow. The company commands over 75% market share in this category, and has recently launched a new generation of drugs that will extend its patent protection for over a decade. While competition is a potential risk, the market is growing and the company has pricing power in this market. These two businesses, plus substantial excess cash on the balance sheet and the value of the R&D pipeline make-up the four components of the company’s intrinsic value. Gary believes Gilead to be an excellent business due to its strong competitive position and long-term patent protection, with an excellent balance sheet, and an above-average management team. His estimate of the company’s intrinsic value, arrived at via DCF analysis, puts the recent market quotation at less than 65% of Gary’s base-case value. The non-linear nature of the two revenue streams makes this a more difficult-than-usual situation for most market participants to analyze, as the overall earnings stream is declining due to the runoff of the Hepatitis C business. This, combined with pessimism about the R&D pipeline and skepticism regarding realizing value from the company’s cash position, is leading the market participants to misprice the stock.

JOHN HELDMAN AND DAVID HUTCHISON, TRIAD

SS&C TECHNOLOGIES (Nasdaq: SSNC) is a leading provider of embedded, mission-critical accounting and reporting systems for both institutional investors as well as private client advisory firms, with leading offerings including Geneva, Axys, and Black Diamond. These platforms are entrenched in customer workflows and have high switching costs. It is also pursuing a rollup of the fund administration services industry, where it has #2 overall market share with a continued runway of future acquisitions ahead. SS&C is #1 in the private equity fund administration segment. Founder and CEO Bill Stone maintains a 16% interest in the business he has grown since 1986. 93% of revenues are recurring in nature. Overlaying both businesses is a commitment to R&D spending (1,100+ R&D employees) to continue to offer best-in-class solutions as well as a focus on rational capital allocation. The company is paying down debt after acquisitions to free up capacity for additional M&A. As hedge funds have been in the news for outflows, John and Dave believe this has made the stock more attractive to buy, with the potential to reach $75 per share per their estimates over the next three to five years as organic and acquisition-driven revenues increase on a double-digit basis per year. John and Dave also see margins increasing moderately as the company realizes synergies in building increased scale in both businesses.

STEPHEN DODSON, BRETTON FUND

PPG INDUSTRIES (NYSE: PPG) is one of the largest coatings and paint manufacturers in the world. Over the past decade and a half, it has transformed itself from a diversified chemicals and glass manufacturer into a pure coatings and paint company with growing volumes, high margins, and large returns on capital. The paint business is deeply insulated from new competition, with no significant new entrant in decades. PPG has complemented organic growth with smart acquisitions and is one of the rare acquirers able to maintain high returns on capital with minimal goodwill write-offs. Management buys back a fair amount of stock and consistently raises the dividend. In other words, they are thoughtful, savvy capital allocators in a growing, highly defensible industry. PPG trades at 16x 2018 EPS estimates and 13x 2018 EBIT estimates.

SCOTT MILLER, GREENHAVEN ROAD CAPITAL

YATRA ONLINE (Nasdaq: YTRA) is a special-purpose acquisition company (SPAC) and one of India’s leading online travel companies. It provides information, pricing, availability, and booking facility for domestic and international air travel, domestic and international hotel bookings, holiday packages, buses, trains, etc. As a leading platform of accommodation options, Yatra provides real-time bookings for 64,500+ hotels in India and 500,000+ hotels around the world. While the market may be focused on the poor historical returns of SPACs, Scott expects secular tailwinds to fuel growth, margin expansion, and multiple expansion. Yatra, with 16% market share of online travel in India, is a distant #2 to MakeMyTrip.com. Management owns 10% of Yatra while the SPAC sponsor and Norwest Ventures control roughly 15% and 20%, respectively. The enterprise sells for ~3x current-year net sales, which Scott consider low in light of a 25+% growth rate.

MICHAEL MELBY, GATE CITY CAPITAL

PICO HOLDINGS (Nasdaq: PICO) owns water rights in the southwestern United States and participates in the U.S. homebuilding market through a 56.7% economic interest in UCP, Inc. (NYSE: UCP). PICO owns significant water assets in key metropolitan areas such as Reno, Phoenix, and Las Vegas, which should increase in value due to population growth and shortness in water supplies. UCP recently agreed to merge with Century Communities (NYSE: CCS), with UCP shareholders expected to receive cash and stock compensation of $11.35 per share. PICO is set to receive nearly $120 million in value from the transaction, including $55 million in cash. PICO’s adjusted enterprise value after subtracting the consideration in the UCP transaction is ~$225 million, a sharp discount to the value of PICO’s water assets. Michael’s sum-of-the-parts analysis values PICO at $580 million, or $25+ per share. PICO’s corporate governance has improved dramatically in recent years as the company replaced its prior CEO, modified the incentive compensation structure, and installed a new board of directors. PICO is expected to return a significant amount of cash to shareholders, including cash held on the balance sheet as well as cash proceeds from the sale of UCP and future water assets. Overall, PICO provides an opportunity to invest directly in water assets at a sharp discount to both book and intrinsic value.

RYAN O’CONNOR, CROSSROADS CAPITAL

CISION (Nasdaq: CLAC) at Wide-Moat Investing Summit 2017. Cision is a market-leading provider of cloud-based earned media solutions that is well positioned to benefit from the coming disruptive wave. The business was originally cherry-picked by prominent private equity firm GTCR in 2014 in hopes of building Cision into a global, comprehensive software-as-a-service (SAAS)-based platform capable of managing the entire life cycle and evolving needs of communications professionals. The next phase in the company’s ongoing “big data” evolution commenced with a “back-door” IPO on June 29, 2017 via a complicated SPAC transaction with Capitol Acquisition Corp III. Analyzing the deal requires attention to detail and “special situations” investment skill, leaving it “opaque” and temporarily uninvestable to most investors. Cision is a stable, high-quality cash flow business with underappreciated economics and durable competitive advantages, operating in an attractive niche of the PR software and services market (resilient demand, secular tailwinds, and GDP+ growth). It is rare to find such an attractive, capital-light company with growing recurring revenues and expanding margins trading at a significant discount to peers, despite more compelling financial metrics, better growth, and superior leadership. While the equity is mispriced, the warrants are even more so, in Ryan’s opinion, creating an attractive, hugely asymmetric, levered bet on a temporarily under-the-radar high-quality business.

MATTHIAS RIECHERT, POLLEIT & RIECHERT

THE GYM GROUP (London: GYM) is rolling out low-cost, no-frills gyms in the UK. Similar to Ryanair and Easyjet in their early days, The Gym is applying a low-cost disruptive innovation playbook. It offers a cheaper, more convenient and simpler-to-use product, which appeals to a new segment and to a large segment of less demanding customers. Customers who switch to low cost rarely move back up. Traditional incumbents cannot compete on cost and typically move further upward, or close. The Gym trades on 12x owner earnings. Free cash flows are reinvested in the rollout of new gyms at a pretax ROCE of 30%. Matthias sees land-grabbing potential of great locations for the next four to six years, which should allow for great compounding of intrinsic value per share. Matthias’ current estimate of value is 50% above the recent stock price.

CHRISTOPHER KARLIN, AQUITANIA CAPITAL

VERSUM MATERIALS (NYSE: VSM) provides innovative solutions to the global semiconductor industry involving the development, manufacturing, transportation, and handling of specialty materials. The business has operated for 30+ years. It was spun out of Air Products (APD) on October 1, 2016. While Versum has performed well since the spinoff, Chris believes there is further upside. There is reasonable visibility into the business, it has low capital intensity, strong cash flow generation and benefits from macro tailwinds relating to semiconductor growth. The stock recently traded at reasonable multiples in light of its quality and growth characteristics: EV/EBITDA of 11.6x and P/E of 16.8x. With base upside of 22-35% over the next two years and reasonable downside of 11%, Versum offers an asymmetric reward-to-risk ratio of more than 2.6 to 1, or 4.6 to 1 when incorporating the upside case.

WILL THOMSON, MASSIF CAPITAL

LUCARA DIAMOND (TSE: LUC, OTC: LUCRF) is one of the world’s leading diamond miners. The firm has a single operating mine in Botswana, which produces a large number of high-quality, exceptionally large rough diamonds with sizes greater than 50, 100, and 200 carats. The mine has been operating since 2013. In that time it has yielded ~17% of the world’s known 200+ carat diamonds, has had average ROIC of ~50%, and an average earnings yield of ~21%. The balance sheet is pristine, with no debt and $43 million in cash. The management team is led by Lukas Lundin of the Lundin Family. The family owns and operates twelve publicly traded natural resource companies and maintains a 50% ownership stake in Lucara. Management is committed to paying regular dividends and has returned $188 million to shareholders since 2013. Lucara management continues to invest in the mine, upgrading the already cutting-edge processing facility for increased recovery and reduced processing costs. The shares recently traded at 14x LTM free cash flow, 11x P/E, and 3x tangible book value. TBV, as calculated by Will, adjusts inventory value to account for the 1,111 carat Lesendi La Rona diamond. The value was adjusted to $61 million, the highest bid the company has publicly received for the diamond. Will’s bear case DCF, which assumes no top line growth and no tangible return on this year’s capital investments, results in value of ~$2.40 per share, a margin of safety of ~15%. Will’s base case DCF assumes more realistic and achievable 1% revenue growth and 1% improvement in costs, which yields a value of ~$2.61 per share, a margin of safety of ~21%.

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Simple Psychological Denial

September 13, 2017 in Human Misjudgment Revisited

“The reality is too painful to bear, so you just distort it until it’s bearable. We all do that to some extent, and it’s a common psychological misjudgment that causes terrible problems.” –Charlie Munger

This article is part of a multi-part series on human misjudgment by Phil Ordway, managing principal of Anabatic Investment Partners.

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Munger recalled the mother whose son disappeared while flying off an aircraft carrier in the north Atlantic, or the mothers of obvious criminals.

Update

Consider something short of full denial – call it partial delusion – that can be just as damaging. It often ties to cognitive dissonance and confirmation bias. Also, the impossibility of proving a counterfactual is often used as a straw man argument but it can actually be a very useful tool for problem solving.

There are many types of denial: denial of fact, denial of responsibility (blaming, minimizing, justifying), denial of impact, denial of chronology or preceding events. But they all get back to the original principle of being unable to accept reality as it is. We all play the ostrich at times and bury our head in the sand rather than face the ugly world around us.

“The absence of definite information concerning the outcomes of actions one has not taken is probably the single most important factor that keeps regret in life within tolerable bounds….We can never be absolutely sure that we would have been happier had we chosen another profession or another spouse…. Thus, we are often protected from painful knowledge concerning the quality of our decisions.” -Danny Kahneman, The Undoing Project

Denial seems to be having a resurgence. “Truthiness” and “alternative facts” and “fake news” may be obvious tools of political manipulation, but they’re also ways for ordinary citizens to cope.

The Penn State football scandal stands out. For many years a handful of very powerful people simply denied the problem, and now the former president of the university and a few others are going to jail. And legions of the famously loyal fans insist it was some sort of “us versus them” witch-hunt. These are normal, sincere, often intelligent and well-meaning people who committed no crimes of their own, but they’ve invested some portion of their lives – from the time they’ve spent publicly supporting the football team all the way up to the career academics whose entire lives revolve around the school – and denial has swamped all other factors.

“The first principle is that you must not fool yourself, and you are the easier person to fool.” – Richard Feynman.[17]

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[17] Richard Feynman: Surely You’re Joking, Mr. Feynman!

Yield on Cost: Useful Concept or Inconsequential Statistic?

September 12, 2017 in Commentary, Skills

This article is authored by Adam Mead, president of Mead Capital Management.

The concept of yield on cost is simple to explain but its usefulness as a tool is less clear – at least to me. My goal in writing this memo is to offer some of my thoughts on the subject, and to solicit feedback from others.

The Concept

Yield on cost is simply a security’s current dividend or earnings expressed as a percentage of the price paid for the security. A simple example will illustrate: Imagine you paid $100 for a share of a company that this year earns $20 and pays out 50% or $10 as a dividend. In this case your dividend yield on cost would be $10 / $100 = 10%; similarly, your earnings yield on cost would be $20 / $100 = 20%. This appears to be a great return. But what if you paid that $100 five years ago? Does that matter? What if there were an opportunity to invest in another security today, using the proceeds raised from selling your current investment, that would increase your absolute dollar returns (both earnings and dividends) but decreased your yields on cost – would that matter?

Deciphering the Master

I find myself with these questions as a result of pondering a couple of Warren Buffett’s comments on the subject. The first, from the 2010 Berkshire Hathaway Chairman’s Letter (emphasis Buffett’s):

Coca-Cola paid us $88 million in 1995, the year after we finished purchasing the stock. Every year since, Coke has increased its dividend. In 2011, we will almost certainly receive $376 million from Coke, up $24 million from last year. Within ten years, I would expect that $376 million to double. By the end of that period, I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment. Time is the friend of the wonderful business.

The second is from a December 15, 2016 Fortune Magazine article. Buffett was responding to a question about Berkshire Hathaway’s seemingly low returns from BH Energy:

We paid $35 a share for the utility [in 2000]. And this year it’ll earn something around $30 a share after tax.

So, is yield on cost just an interesting but otherwise meaningless statistic, or is there real insight to be had? To use Buffett’s example of Coke, its 1995 cost was $1,299 million. (I’m ignoring the fact that Berkshire’s stake was built up to this level starting in 1988, and instead assuming it was all acquired in 1995.) Using Buffett’s assumptions, in 2020 Coke would pay Berkshire $752 million and Berkshire’s share of Coke’s total earnings would amount to $1,299 million. Berkshire’s Coke investment would therefore have a 100% earnings yield on cost, and a 58% dividend yield on cost.

We can adjust the yields on cost above to account for the time value of money. Assuming a 10% discount rate over 25 years the present value factor is 0.923, or 9.23%. The resulting earnings yield on cost would be 9.2%, and the dividend yield would be 5.3%. Both seem more “reasonable” compared to the double and triple digit returns assuming original cost.

Another way to look at it would be to invert the situation and look at the 1995 cost as a 2020 future value. Making this adjustment (10%, 25 years = 10.8 times) Berkshire’s cost increases to $14,074 million which, again, appears more “reasonable” to have claim to $1,299 million in earnings.

Buffett has given us clues over the years into his thinking. I’m referring to his “business-as-a-bond” mindset. Buffett and some value investors consider equity as simply a bond without known coupons. Using this framework, the yield on cost concept becomes somewhat clearer. Assuming your going-in earnings yield is satisfactory, like a bond investor holding to maturity would, anything above and beyond your starting yield could be considered gravy.

In 1995, the 30-year Treasury Bond yield ranged from about 6.0% to 7.8% – I’ll assume an average of 6.9%. If Berkshire, instead of buying Coke, used its $1,299 million to purchase a bond yielding 6.9% it would still be paying Berkshire about $90 million a year in 2020. Adjusting for the same present value as above (10%, 25 years) that sum diminishes to a paltry $8.3 million. Instead of purchasing a “risk free” 6.9% that would decline by 3.1% per annum compared to an estimated 10% discount rate, Buffett instead went with the “risky” business (Coke) that had the ability to increase its output over time.

Still Confused

So how useful as a tool is the concept of yield on cost? Under the bond-as-a-business framework the idea seems to make sense. However, when viewed from the vantage point of an equity holder the notion appears to ignore one of the fundamental ideas of finance – namely, the time value of money. The ideas should reconcile. I’m still confused. What say you?

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This commentary is the opinion of the author. It is neither investment advice, nor an offer to buy or sell securities, nor a substitute for your own thinking.

Academics vs. Operators: Why the EMT Comes Crashing Down

September 12, 2017 in Commentary, Curated, Equities, Featured, Risk Management

This article is authored by Massimo Fuggetta, MOI Global instructor and ‎director of Bayes Investments. The article includes two posts from Massimo’s Bayes blog.

As he wrote his Challenge to Judgment on the first issue of the Journal of Portfolio Management in 1974, Paul Samuelson expected ‘the world of practical operators’ and ‘the new world of academics’ – which at the time looked to him ‘still light-years apart’ – to show some degree of convergence in the future.

On the face of it, he was right. The JPM recently celebrated its 40th anniversary. The Financial Analysts Journal, started with the same bridging intent 30 years earlier under Ben Graham’s auspices, is alive and well on its 73rd Volume. Dozens other periodicals have joined in the effort and hundreds of books and manuals have been written, sharing the purpose of promoting and developing a common language connecting the practice and the theory of investing.

Academic vs. Operator

While presuming and pretending to understand each other, the two worlds are still largely immersed in a sea of miscommunication. At the base of the Babel there are two divergent perspectives on the relationship between risk and return. Everybody understands return. You buy a stock at 100 and the price goes up to 110 – that’s a 10% return. But this is ex post. What was your expected return before you bought? And what risk did you assume? The practical operator does not have precise answers to these questions. I looked at the company – he would say – studied its business, read its balance sheet, talked to the managers, did my discounted cash flow valuation and concluded that the company was worth more than 100 per share. So I expected to earn a good return over time, roughly equal to the gap between my intrinsic value estimate and the purchase price. As for risk, I knew my valuation could be wrong – the company might be worth less than I thought. And even if I was right at the time of purchase, the company and my investment might have taken wrong turns in myriads different ways, causing me to lose some or all of my money.

Is that it? – says the academic – is that all you can say? Of course not – replies the operator – I could elaborate. But I couldn’t do it any better than Ben Graham: read his books and you’ll get all the answers.

But the academic would have none of it. As Eugene Fama recalls: ‘Without being there one can’t imagine what finance was like before formal asset pricing models. For example, at Chicago and elsewhere, investment courses were about security analysis: how to pick undervalued stocks’. (My Life in Finance, p. 14). Go figure. Typically confusing science with precision, the academic is not satisfied until he can squeeze concepts into formulas and insights into numbers. I don’t know what to do with Graham’s rhetoric – he says – I need measurement. So let me repeat my questions: what was your expected return exactly? How did you quantify your risk?

Give me a break – says the defiant operator – risk is much too complex to be reduced to a number. As for my expected return, I told you it is the gap between value and price, but I am under no illusion that I know it exactly. All I know is that the gap is large enough and I am prepared to wait until it closes.

Tut-tut – Fama shakes his head – Listen to me, you waffly retrograde. I will teach you the CAPM. ‘The CAPM provides the first precise definition of risk and how it drives expected return, until then vague and sloppy concepts’. (p. 15).

Risk vs. Return

The operator listens attentively and in the end says: Sorry, I think the CAPM is wrong. First, you measure risk as the standard deviation of past returns. You do it because it gives you a number, but I think it makes little sense. Second, you say the higher the risk the higher is the expected return. That makes even less sense. My idea of risk is that the more there is the more uncertain I am about my expected return. In my view, the relationship between risk and expected return is, if anything, negative. So thank you for the lecture, but I stick with Graham. As Keynes did not say (again!): It is better to be vaguely right than precisely wrong.

Writing ten years after Samuelson’s piece, Warren Buffett well expressed the chasm between academics and practical operators: ‘Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model or covariance in returns among securities. These are not subjects of any interest to them. In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value’. (Buffett, Superinvestors, p. 7).

But operators are rarely so blunt. Such is the intellectual authority of the Efficient Market Theory that the identification of risk with the standard deviation of returns – a.k.a. volatility – and the implication that more risk means higher returns are taken for granted and unthinkingly applied to all sorts of financial models. Hilariously, these include the same valuations that investment practitioners employ to justify their stock selection – an activity that makes sense only if one rejects the EMT! It is pure schizophrenia: investors unlearn at work what they learned at school, while at the same time continuing to use many of the constructs of the rejected theory and failing to notice the inconsistency.

Beta and CAPM: Unethical?

But here is the biggest irony: after teaching it for forty years – twenty after Buffett’s piece – Fama finally got it out of his system: ‘The attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk. Unfortunately, the empirical record of the model is poor – poor enough to invalidate the way it is used in applications (Fama and French, JEP 2004). Hallelujah. Never mind that in the meantime the finance world – academics and practitioners – had amassed a colossal quantity of such applications and drawn an immeasurable variety of invalid conclusions. But what is truly mindboggling is that, in spite of it all, the CAPM is still regularly taught and widely applied. It is hard to disagree with Pablo Fernandez – a valiant academic whose work brings much needed clarity amidst the finance Babel – when he calls this state of affairs unethical:

“If, for any reason, a person teaches that Beta and CAPM explain something and he knows that they do not explain anything, such a person is lying. To lie is not ethical. If the person ‘believes’ that Beta and CAPM explain something, his ‘belief’ is due to ignorance (he has not studied enough, he has not done enough calculations, he just repeats what he heard to others…). For a professor, it is not ethical to teach about a subject that he does not know enough about.”

Two books that I think are particularly effective in helping operators move from practical unlearning – erratic, undigested and incoherent – to proper intellectual unlearning of the concept of risk embedded in the EMT and its derivations are David Dreman’s Contrarian Investment Strategies: the Next Generation (particularly Chapter 14: What is Risk?) and Howard Marks’ The Most Important Thing (particularly Chapters 5-7 on Understanding, Recognizing and Controlling Risk).

The Example of Amazon: Volatility = Risk?

Besides the EMT’s predominance, unlearning is necessary because, at first glance, measuring risk with the standard deviation of returns makes intuitive sense: the more prices ‘fluctuate’ and ‘vibrate’, the higher the risk. Take Amazon:

Amazon.com Stock Price (logarithmic scale, 1997-2017)

Source: Massimo Fuggetta, Bayes blog.

If you had invested 30,000 dollars in Amazon’s IPO in May 1997 (it came out at 18 dollars, equivalent to 1.50 dollars after three splits), after twenty years – as the stock price reached 1,000 dollars (on 2nd June this year, to be precise) – your investment would have been be worth 20 million dollars. Everybody understands return. But look at the chart – in log scale to give a graphic sense of what was going on: 1.50 went to 16 in a year (+126% in one month – June 1998) to reach 85 in November 1999. Then in less than two years – by September 2001 – it was down to 6, only to climb back to 53 at the end of 2003, down to 27 in July 2006, up to 89 in October 2007, down to 43 in November 2008 and finally up – up up up – to 1000. Who – apart from Rip van Winkle and Jeff Bezos – would have had the stomach to withstand such infernal rollercoaster?

So yes, in a broad sense, volatility carries risk. The more violent the price fluctuations, the higher is the probability that, for a variety of psychological and financial circumstances – he may get scared and give up on his conviction, or he may need to liquidate at the wrong time – an investor might experience a catastrophic loss. But how can such probability be measured? The routine, automatic answer is: the standard deviation of returns. Here is the picture:

Cumulative Standard Deviation and Twelve-Month Rolling Standard Deviation

Source: Massimo Fuggetta, Bayes blog.

The graph on the left is the cumulative standard deviation of monthly returns from May 1997 (allowing for an initial 12-month data accumulation) to May 2017, for Amazon and for the S&P500 index. The graph on the right shows the 12-month rolling standard deviations. The cumulative graph, which uses the maximal amount of data, shows that while the monthly standard deviation of the S&P500 has been stable at around 5%, Amazon’s standard deviation has been, after an initial peak, steadily declining ever since, although it still remains about four times that of the index (18.4% vs. 4.4%). The 12-month rolling version shows a similar gap, with Amazon’s standard deviation currently about three times that of the S&P500 (5.1% vs. 1.8%).

What does this mean? Why is it relevant? What can such information tell us about the probability that, if we buy Amazon today, we may incur a big loss in the future? A moment’s thought gives us the answer: very little. Clearly, today’s Amazon is a completely different entity compared to its early days in the ’90s. Using any data from back then to guide today’s investment decision is nothing short of mindless. Amazon today is not four times as risky as the market, as it wasn’t five times as risky in November 2008. Nor is it three times as risky, as implied by the 12-month rolling data. The obvious point is that the standard deviation of returns is a backward-looking, time-dependent and virtually meaningless number, which, contrary to the precision it pretends to convey, has only the vaguest relation to anything resembling what it purports to measure.

The same is true for the other CAPM-based, but still commonly used measure of risk: beta. Here is Amazon’s beta versus the S&P500 index, again cumulative and on a 12-month rolling basis:

Amazon.com Beta vs. S&P 500

Source: Massimo Fuggetta, Bayes blog.

Again, the cumulative graph shows that Amazon’s beta has always been high, though it has halved over time from 4 to 2. So is Amazon a high beta stock? Not according to the 12-month rolling measure, which today is 0.4 – Amazon is less risky than the market! – but has been all over the place in the past, from as high as 6.7 in 2007 to as low as -0.4 in 2009. Longer rolling measures give a similar picture. What does it mean? Again, very little. According to the CAPM, Amazon’s beta is supposed to be a constant or at least stable coefficient, measuring the stock’s sensitivity to general market movements. But in reality it is nothing of the kind: like the standard deviation of returns, beta is just an erratic, retrospective and ultimately insignificant number.

Higher Risk = Higher Return?

Volatility implies risk. But reducing risk to volatility is wrong, ill-conceived and in itself risky, as it inspires the second leg of the CAPM misconception: the positive relationship between risk and expected return. ‘Be brave, don’t worry about the rollercoaster – you’ll be fine in the end and you’ll get a premium. The more risk you are willing to bear, the higher the risk premium you will earn.’ Another moment’s reflection is hardly necessary to reveal the foolishness – and to commiserate the untold damage – of such misguided line of reasoning. The operator’s common sense view is correct: once risk is properly defined as the probability of a substantial and permanent loss of capital, the more risk there is the lower – not the higher – is the probability-weighted expected return. This also requires unlearning – often, alas, the hard way.

Despite Samuelson’s best wishes, then, there is far less authentic common ground between operators and academics than what is pretended – in more or less good faith – in both camps. Operators are right: there is much more to risk than volatility and beta, and actual risk earns no premium.

Investment risk is the probability of a substantial and permanent loss of capital. We buy a stock at 100 expecting to earn a return, consisting of appreciation and possibly a stream of dividends. But our expectation may be disappointed: the price may go down rather than up and we may decide to sell the stock at a loss, either because we need the money or because we come to realise, rightly or wrongly, that we made a mistake and the stock will never reach our expected level.

How does investment risk relate to volatility – the standard deviation of past returns, measuring the extent to which returns have been fluctuating and vibrating around their mean? Clearly, we prefer appreciation to be as quick and smooth as possible. If our expected price level is, say, 150, we would like the stock to reach the target in a straight line rather than through a tortuous rollercoaster. On the other hand, if we are confident that the price will get there eventually, we – unimpressionable grownups – may well endure the volatility. In fact, if on its way to 150 the price dropped to 70 it would create an inviting opportunity to buy more.

Volatility increases investment risk only insofar as it manages to undermine our confidence. We might have rightly believed that Amazon was a great investment at 85 dollars in November 1999, but by the time it reached 6 two years later our conviction would have been brutally battered. Was there any indication at the time that the stock could have had such a precipitous drop? Sure, the price had been gyrating wildly until then, up 21% in November, down 12% in October, up 29% in September and 24% August, down 20% in July, and so on. The standard deviation of monthly returns since the IPO had been 33%, compared to 5% for the S&P500, suggesting that further and possibly more extreme gyrations were to be expected. But to a confident investor that only meant: tighten your seatbelt and enjoy the ride. A 93% nosedive, however, was something else – more than enough to break the steeliest nerves and crush the most assured resolve. ‘I must be wrong, I’m out of here’ is an all too human reaction in such circumstances.

Therefore, while volatility may well contribute to raise investment risk, it is not the same as investment risk. It is only when – rightly or wrongly – conviction is overwhelmed by doubt and poise surrenders to anxiety that investment risk bears its bitter fruit.

Amazon is a dramatic example, but this is true in general. Every investment is made in the expectation of making a return, together with a more or less conscious and explicit awareness that it may turn out to be a flop. Every investor knows this, in practice. So why do many of them ignore it in theory and keep using financial models built on the axiom that volatility equals investment risk? As we have seen, the reason is the intellectual dominance of the Efficient Market Theory.

What Prevents Academics from Seeing the Obvious?

Why is it that, according to the EMT, investment risk coincides with volatility? The answer is as simple as it is unappreciated. Let’s see.

If the EMT could be summarised in one sentence, it would be: The market price is right. Prices are always where they should be. Amazon at 85, 6 or 1000 dollars. The Nasdaq at 5000, 1400 or 6400. At each point in time, prices incorporate all available information about expected profits, returns and discount rates. Prices are never too high or too low, except with hindsight. Therefore, an investor who buys a stock at 100 because he thinks it is worth 150 is fooling himself. Nobody can beat the market. If the market is pricing the stock at 100, then that’s what it’s worth. The price will change if and only if new information – unknown and unknowable beforehand and therefore not yet incorporated into the current price – prompts the market to revise its valuation. As this was true in the past as it is true in the present and will be true in the future, past price changes must also have been caused by no other reason than the arrival of information that was new at the time and unknown until then. Thus all price changes are unknowable and, by definition, unexpected. And since price changes are the largest components of returns – the other being dividends, which can typically be anticipated to some extent – we must conclude that past returns are largely unexpected. At this point there is only one last step: to identify risk with the unexpected. If we define investment risk as anything that could happen to the stock price that is not already incorporated into its current level, then the volatility of past returns can be taken as its accurate measure.

Identifying investment risk with volatility presupposes market efficiency. This is part of what Eugene Fama calls the joint hypothesis problem. To be an active investor, thus rejecting the EMT in practice, while at the same time using financial models based on the identification of investment risk with volatility, thus assuming the EMT in theory, is a glaring but largely unnoticed inconsistency.

The False Assumption That Crashes the EMT Edifice: Common Priors

What is it that practitioners know and makes them behave as active investors, and EMT academics ignore and leads them to declare active investment an impossible waste of time and to advocate passive investment?

Again, the answer is simple but out of sight. In a nutshell: Practitioners know by ample experience that investors have different priors. EMT academics assume, by theoretical convenience, that investors have common priors.

Different priors is the overarching theme of the entire Bayes blog. People can and do reach different conclusions based on the same evidence because they interpret evidence based on different prior beliefs. This is blatantly obvious everywhere, including financial markets, where, based on the same information, some investors love Amazon and some other short it. In the hyperuranian realm of the EMT, on the other hand, investors have common priors and therefore, when faced with common knowledge, cannot but reach the same conclusion. As Robert Aumann famously demonstrated, they cannot agree to disagree. This is why, in EMT parlance, prices reflect all available information.

Take the assumption away and the whole EMT edifice comes tumbling down. This is what Paul Samuelson was referring to in the final paragraphs on the Fluctuate and Vibrate papers. More explicitly, here is how Jonathan Ingersoll put it in his magisterial Theory of Financial Decision Making, immediately after ‘proving’ the EMT:

In fact, the entire “common knowledge” assumption is “hidden” in the presumption that investors have a common prior. If investors did not have a common prior, then their expectations conditional on the public information would not necessarily be the same. In other words, the public information would properly also be subscripted as φk – not because the information differs across investors, but because its interpretation does.

In this case the proof breaks down. (p. 81).

Interestingly, on a personal note, I first made the above quotation in my D.Phil. thesis (p. 132). A nice circle back to the origin of my intellectual journey.

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RIB Software: Early-Stage Value Investment Opportunity

September 12, 2017 in Equities, Europe, European Investing Summit, Ideas, Small Cap

This article by MOI Global instructor Thomas Karlovits, ‎chief executive officer of Blackwall Capital, previews an idea presentation at European Investing Summit 2017.

RIB Software (RIB GY) is a German building and construction software vendor with a market capitalization of about EUR 750 million (EUR 150 million net cash), operating in the field of building information modeling, adding “time and cost” (“5D BIM”) to traditional 3D CAD software. The sector benefits from structural growth due to 1) the construction industry’s need to invest more in IT to correct massive historical underspending (causing productivity growth to lag other industries), and 2) EU regulatory changes taking effect in 2020 that require 5D BIM software for public buildings with the use of such software mandatory in Germany from 2020. Although still in the early stages, the BIM software market recently passed the point of inflection. We anticipate significant acceleration of growth going forward.

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How Bad Mistakes Arise: A Good Idea Taken to the Extreme

September 11, 2017 in Commentary, Equities, Financials, Ideas, Large Cap, Letters, North America, Wide Moat

This article by Tom Russo has been excerpted from a letter of Semper Vic Partners.

I would like to take a moment to highlight the allegations against Wells Fargo… and to share my rationale for retaining a relatively unchanged investment exposure to Wells Fargo shares (at roughly 6 percent of portfolio assets). I believe that the misconduct arose from a conduct which is often cited by Berkshire Hathaway’s chairman, Warren Buffett, when he is periodically asked how seemingly well-run enterprises fall off their well-oiled rails. In situations like this, Mr. Buffett often observes that “bad mistakes” on Wall Street and in business are more often likely to arise from “good ideas” taken to an extreme than from bad ideas from the outset. Bad ideas suffer from early mortality. Capital and talent quickly leave ideas early deemed to be bad, tying up little social resources or capital. Good ideas, however, can survive and flourish for a very long time, even though at the end sticking to the seemingly good idea ends badly. Capital that flows into such ideas, while they seem good, can end up being lost later on when such ideas no longer provide positive results.

The good idea in the case of Wells Fargo began with the realization decades ago that if Wells Fargo adopted a more orderly approach to marketing of their products they could increase the number of banking products which their banking clients engaged. In the early 1990s, they mastered the practice of direct mail banking, realizing, for instance, that if they followed up an unanswered direct marketing letter with an invitation for that person to come to their nearby office to meet with a personal banker, odds would increase sharply that that person would take on additional banking products.

Since there were economies of not having to underwrite the same clients with each new product, the bank could share savings by offering, for instance, checking account clients a premium to the rate that the man-off-the-street would receive for the same deposits. Increasing the number of relationships generated relationship leverage, with both revenue and profit per banking client increasing with each additional product taken.

These early stages of delivering better margins through techniques to better direct bank customers to value-added products started with some deep and valued insights as described below. The fact that the desire to secure such benefits to profits without focus on making their banking clients succeed financially is what I believe led Wells Fargo over time to focus increasingly on the outcome that eventually became referred to as simply “cross-selling”. The good idea of customer- centered marketing morphed over time to a “bad idea” of relying increasingly on cross-selling quotas.

“Why are you here?”

In addition to developing direct marketing best practices, Wells Fargo under the early reign of former CEO, Richard Kovacevich, developed in the 1990s metrics for improving the effectiveness of their associate hiring. They engaged third party service firms (like the Gallup organization) to develop recruiting practices and procedures to increase the likelihood that the person hired for a job had proper character for the job into which he/she was hired.

Mr. Kovacevich described to me in the early 1990s how this more scientific recruiting process added value through a story about a teller. He described how he approached one of Wells Fargo’s associates in the back of the main vault at the California Avenue main Wells Fargo banking branch. When asked who she was and what she was doing eating lunch in the back depth of the vault, his associate described how she liked the bank vault because it was quiet and because she really liked being away from people. When she described her position as bank “teller”, Kovacevich realized that Wells Fargo still had room to grow with fitting personality and character to work.

Wells Fargo learned from such examples and early on employed increasingly appropriate recruitment filters that would recruit for the appropriate jobs. Telemarketers, for instance, were selected from people who not only responded “yes” to their first question, e.g., “Do you like to talk on the phone?” In fact, they looked for those who would follow up their affirmative answer to the first question with an observation of how much they liked to “talk to their mother on the phone over lunch” and not retreat to the comforting silence of a bank vault.

“How can we better serve you, Mr. Smith?”

A related insight shared by former CEO, Kovacevich, at the same time as Wells Fargo applied science to recruiting involved Wells Fargo’s somewhat unorthodox belief in the value of the retail bank branch network. Whereas many of Wells Fargo’s competitors at this time were closing bank branches due to the desire to reduce fixed costs and attempt to engage the first flurry of internet banking services, Wells Fargo, by contrast, considered their bank branches to be the financial emporium where they could “earn lifelong relationships that help people succeed financially.”

Wells Fargo’s historic bank branches were unusually productive due to several important reasons. First and foremost, Wells Fargo relied upon the branch bank environment to recruit their single most critical relationship – the checking account. Wells Fargo retains the belief that the bank which has the checking account relationship into which their clients’ salaries are directly deposited has the best chance to successfully market additional relationships. Second, Wells Fargo invested in sophisticated teller-assist technology. When banking clients come for checking account activities, Wells Fargo tellers automatically know which relationships with each customer might be open for new product offerings in light of the client-specific details which tellers view on their monitors. This assisting software allows tellers to see if/whether a Certificate of Deposit should be rolled over, student loan extended, home improvement loan adjusted, 401(k) investment made, etc. Such advice historically yielded to Wells Fargo enormous client product competitive advantages, resulting with industry record setting productivity.

Third, Wells Fargo considered their bank branch managers to be their main bankers to small business clients in their neighborhoods. This meant that bank branch heads were encouraged to travel extensively away from the bank to meet with prospective/existing clients at client offices. This hands-on lending helped Wells Fargo to develop, over the decades, the extraordinary interest- free demand deposit base which stands at the heart of its successful commercial lending. During times when competitors have to pay for high-cost deposits, Wells Fargo has enjoyed the longstanding advantage of low-cost demand deposits that arose from the fact that their borrowing base has felt loved and well served.

I have long admired how deeply thoughtful Wells Fargo was about how they recruited, trained, equipped, and incented their tellers and their sales force. Wells Fargo recognized that added relationships beyond the platform checking account were crucial to securing additional banking revenue from existing relationships. The purpose behind tellers’ banking client product pitches was not to simply meet a quota of “cross-sold” products, but was designed to help Wells Fargo’s client-facing representatives to have products to help their clients “succeed financially”. With the passage of time, many of the functions which helped build the success of Wells Fargo’s great consumer lending/retail branch banking systems have been adopted by its fast-growing, nationally leading internet banking platform.

Danger of Single-Variable Analysis

As you can see above, very little adversity arose from the thoughtful ways in which the bank, under CEO Kovacevich over many years, applied technology and intelligent inquiry into the building of a client-focused culture defined by informed selling practices. Nonetheless, bank communication with investors, bank incentives and salary reward package designs seem to have over time become increasingly monodimensional. The scorecard for employee compensation and the yardstick by which Wall Street investors were asked to grade senior management success became increasingly channeled into the single variable – cross-selling. This move towards a simplistic reference merely to cross-sell, I believe, accelerated during the period immediately following the most recent global financial crisis when management throughout Wells Fargo’s ranks, from the top to the retail branch, were consumed and distracted by smoothly and completely integrating the largest bank merger in American history, i.e., the Wells Fargo acquisition of Wachovia Bank.

Whenever performance in complex cultures is reduced to single-frame references, investors must realize risks that likely will arise for corporations and their leaders who might attempt to game the system to show that they met such single-frame referenced objectives. Even though the bank’s success grew, due to the skills it had put in place to increase the number of relationships each client might have had with the bank, by late 2009, communication about reasons for Wells

Fargo’s superior performance no longer referred to the full basket of insights that drove the success, such as those Kovacevich shared with me described above, but simply turned into a body count of how many products a banking representative could cross-sell.

The full value of the progression from hiring well, training well, locating well in effective retail branches, and increasing available tools and analytics to increase the suitability of additional relationships began to unravel around the time that Wells Fargo shifted its attention to bringing under wing the acquisition of Wachovia, which in one transaction nearly doubled the size of all aspects of the bank. Beginning around this time, Wells Fargo management seemed to have embarked upon a far more single-focused approach to bank management, designed to drive single- variable, bank-wide retail cross-sells per employee per year.

I hope that you find my summary of how I believe Wells Fargo slipped into the risk of focusing simplistically and singly on one variable (i.e., cross-selling) to track its economic progress to have been informative. Regardless of how they found their way into such single focus, the consequences that were revealed this September show how dangerous such pressured metrics can become. I have several observations which I share in addition to the many which I am sure that all of my investors have followed in financial and popular press alike:

1. Management. It would appear that management failed to drive proper incentives. Cross-sell targets became formulaic and burdensome enough that some associates claim that they felt the need to fabricate “new accounts” to meet “quota”. The CEO and most senior management had knowledge that their system surfaced a small percentage of their associates (roughly one percent per year) involved in such defalcation over the past five or six years. They seemingly addressed the instances with associate terminations, but failed to more deeply investigate where systemic conditions may have led to such pressured misconduct in the first place. Moreover, they failed to notify investors of the issue that they faced and, more troubling, failed to protect investors by failing to take steps to subsequently police against such known risks.

2. Political Fury. Wells Fargo fell right into the hands of politically charged House and Senate Banking subcommittees which convened to seemingly allow for the collective vetting of emotions that so few “heads had fallen” and so few “personal financial costs” have been borne by all executives of other banks from which collectively so much Wall Street misconduct arose as early as 2006.

3. Terrible Optics. Much like the pressure placed upon the tobacco industry during the 1990’s tobacco wars, so too is immense pressure from threatened litigation, regulation, class actions, etc., being placed upon Wells Fargo. Indeed, as I write, Wells Fargo is receiving notice of one class action lawsuit after another for any number of claims including wrongful termination, credit score degradation, emotional distress, fraud, etc.

However, much as we endured as tobacco industry investors during some of the most-dark days of the 1980s and 1990s, I have adopted a similar interpretation of our risks with our holdings in Wells Fargo shares. These risks reflect both company-specific risks and commercial banking industry risks.

Wells Fargo-Specific Risks

My attitude with our Wells Fargo holdings starts from my continued faith in the legal process. Just as with the tobacco industry litigation, every defendant, regardless how socially reviled they may be at a given time, is entitled to their day in court before a jury of their peers, in a trial presided over by an impartial judge. Such courts have to determine if and whether actual harm exists. In the case of Wells Fargo’s creation of fictitious client accounts, actual harm identified and already reimbursed by Wells Fargo amounted to just under $5 million.

To date, actual direct financial harm has been modest. Countless allegations regarding wrongful termination, required reinstatement of associates, housing-related losses due to credit impairment, etc., have been suggested during House and Senate subcommittee hearings. However, such allegations become far harder to survive summary judgment if plaintiffs, either singly or by class action lawsuit, cannot establish sufficient actual harm.

It is my belief, that the lack of abundant or obvious harm should go a long way to reduce the extent of financial harm, adverse judgments, etc., that will await Wells Fargo. While the conduct of those let go was deplorable and has caused the firm deep reputational harm, so too has been the conduct of senior management for not having taken sooner and more decisive action to investigate why the low percentage level of fraud was allowed to persist for six or seven years.

We, as investors in Wells Fargo, will have suffered deeply due to the reputational harm to the firm that has followed. Fortunately, however, I do not believe that our firm faces the magnitude of losses experienced by the major money center banks whose shareholders have suffered collectively over $30 billion in fines for financial product misconduct that led to the near collapse of our banking system and consequential enormous financial losses suffered as a result of failing real estate-related derivative instruments which they fabricated.

As a result of my belief that Wells Fargo will be able to satisfy adjudicated claims and that likely settlements will ensue, I believe that, based on what I now know, Wells Fargo shares represent value. The shares declined in value ten to fifteen percent upon the recent news leaving their valuation compelling in light of other similarly positioned banking entities. I believe that the bank will continue to enjoy benefits from its nationwide banking footprint, possessing as it does over 11 percent of nationwide bank deposits. I believe that once the bank stabilizes its options, it will again likely continue its focus on retail and consumer banking, with reinvestment likely to continue into new areas such as credit cards, mortgage lending, and wealth management.

As for credit cards, Wells Fargo’s client base still offers opportunity to deliver significant card growth as currently less than 50 percent of Wells Fargo’s retail customers, on average, have a Wells Fargo credit card. Moreover, those that currently have credit cards take them out of their wallets all too infrequently. Similarly, Wells Fargo remains underdeveloped in wealth management, a key component for their plans for future growth.

On top of investments underway designed to grow credit and debit card penetration, increase mortgage lending, and grow wealth management, Wells Fargo management understands that they will likely have to return funds to owners increasingly to sustain attractive shareholder total returns. Wells Fargo can no longer grow as it has to date through added commercial bank acquisitions, as they have met the ten-percent bank regulatory threshold of national deposits, preventing any future acquisitions. So limited, Wells Fargo will very likely remain committed to returning a high percentage of distributable funds each year to shareholders through dividend increases (already nearly a four-percent dividend yield) and through share repurchases.

Banking Industry-Specific Risks

I will continue to leave the Wells Fargo investment at roughly the same portfolio weighting with which we entered into September’s challenges. I believe that the equity market valuation undervalues Wells Fargo’s banking franchise and its high-dividend payment will help to support a decent return.

However, I will remain alert to degradation that could arise in the political arena in which it will have to address allegations of misconduct. I will also have to remain attuned to the impact that the political fallout of Wells Fargo’s misconduct may have on furthering industry-challenging legislation and regulation.

Industry prospective returns on capital have been increasingly compromised by not only the well-known near-term challenges posed by our monetary situation and by the effects of QE, but they also are impacted by increasing requirements impacting capital adequacy and permissible business activities allowable to commercial banks. Rumors of a revival of a Glass-Steagall-styled separation of banking activities have arisen in the wake of recent bank misconduct. New demands are constantly considered of the industry by the newly emboldened Consumer Financial Protection Bureau. Even the Department of Labor’s recent pronunciations regarding fiduciary standards that must now be assumed for wealth management activities may diminish the appeal of the bank’s growing wealth management area.

The list of banking industry factors posing threat of systemic change is long. The political climate in which such proposals are created is severe. Unfortunately, those with the loudest voices and most clout today have as hostile a view towards the banking industry’s important role in the economy as did the trial lawyers and regulators of the tobacco industry over the past twenty-five years. During this period of declining tobacco industry standing, the industry was able, nonetheless, to eke out attractive returns to investors. Part of the returns have arisen from the fact that expectations were so low for tobacco-industry returns due to confiscatory steps that tobacco company shares became attractively priced and dividend yields generous. Much the same risk aversion exists today when many other investors size-up prospects for Wells Fargo. I believe that risk reward remains attractive for Wells Fargo shares.

Deposits into the “Bank of Goodwill”

A wise, investment colleague of mine recalled a conversation which he had earlier with a corporate relations crisis consultant that I thought bore upon many of the firm threatening crises that loom over companies today. This corporate relations crisis consultant had told him that she typically found one thing missing amongst the businesses that found their way to her door during periods when their firm’s goodwill and survival were imperiled.

She suggested that she typically observes with management from such threatened firms that their common shortcomings were that they failed to prepare for such reputation-threatening moments. She typically asks such managements when they seek her help or expertise in reputation triage, “When was the last time you made a deposit into the bank of goodwill?”

You see, she would explain, successful companies “bank goodwill” during periods when things are going smoothly for use when things go awry. Such banked goodwill comes in handy when times turn tough. However, for businesses that have not sufficiently deposited into their needed bank of goodwill when business runs smoothly, they will find an “Insufficient Funds” notice posted when they attempt withdrawal when crisis hits.

It is ironic, however, that our portfolio company most impacted by insufficient funds in their own bank of goodwill has turned out to be a bank. This is all the more striking because the banking business is, at its heart, so commoditized and competitive that the very best banks realize that the one thing that does distinguish them from competitors is the trust and loyalty that they can build during good times to avoid having “funds insufficiency” during bad times.

Wells Fargo may find itself with insufficient funds at present for a few reasons. First, I believe it is because of Wells Fargo’s march towards relying increasingly just on the existence of cross-sell to define their success. Second, I believe that they did not wish to invest heavily out of their reported income to deliver a regular message that reassured their banking clients that Wells Fargo partners with them for financial success. Just doing well by clients is not sufficient. Companies need to do well by their clients, as well as celebrate publicly that they are doing so.

I have long felt that the entire banking industry and Wells Fargo in particular would have benefited from a 360-degree advertising and communication campaign designed to reassure their depositors and customers that they are part of the solution for Americans’ financial services needs and not part of the problem.

For the past two decades, because of the well-documented misconduct of several of the largest money center banks, banking has allowed itself to be boxed into the corner of adverse public sentiment, allowing others to vilify their motives and discredit their contributions to society. As recently as two years ago, I shared with senior Wells Fargo management at an investor gathering my belief that the banking industry needed to get behind a reputation-restoring advertising campaign to restore the overall reputation of banking. I had in mind campaigns like America’s “got milk?”, “America Runs on Dunkin’”, and “Freight Rail Works” by the US railroad industry. Clearly, investing in advance of specific crisis simply to fortify reputation by making deposits into the bank of goodwill did not seem pressing nor urgent enough at the time to Wells Fargo management. Clearly, management did not seem impressed enough at that time to justify the potential burden on reportable levels of income to direct a portion of income to investments designed to fortify goodwill.

Despite not having made sufficient “deposits” over the past, I believe that Wells Fargo will be able to restore its bank of goodwill. Doing so will be expensive and will take hard work and time to complete. They will have to take important near-term and long-term steps. Along the way, they simply must engage far more frequently in publicly celebrating the good that the bank can offer its served communities. They must tell their story. They must deposit back into the bank of goodwill.

Wells Fargo has already taken important near-term steps. Important management changes already have put in place new talent to address prior problems. The roles of CEO and Chair have been separated at this time. Senior management has had compensation forfeited. Changes have occurred at the operational level. Wells Fargo no longer rewards its employees based on meeting cross-sell quotas. Wells Fargo confirms to all banking customers by e-mail whenever a new account is established. Wells Fargo has commenced a television advertising campaign to publically declare its commitment to behave well by its banking customers.

Wells Fargo has more to do over the long term. First and foremost, Wells Fargo must reach out to both House and Senate banking subcommittees to insure that Wells Fargo provides answers to remaining questions. They must be honest and direct in their responses. They must be clear about the actual numbers of accounts affected. PricewaterhouseCoopers (PwC) suggested that out of 93 million accounts, only in the case of 2 million could PwC not certify that products were requested by bank customers. This number, 2 million, is unfortunately misrepresented as the number of affected accounts rather than representing just the pool of accounts that upfront could not be definitively dismissed.

To succeed long-term, Wells Fargo must extricate itself out of Congress’ and its industry regulator’s penalty box. To do so, Wells Fargo must be firm on the facts and forthcoming on all details. They cannot stonewall. For instance, during the Senate banking subcommittee hearing, when Wells Fargo’s former CEO was asked whether “other banks focused on cross-sell”, he essentially replied that he was not aware of what other banks do. Wells Fargo will have to deliver less lawyerly minded answers in their efforts to respond head-on to politicians and to its own industry’s regulators.

To succeed long-term, Wells Fargo will have to publicly celebrate its investments to drive long-term banking customer satisfaction. They will need to celebrate advances in internet banking, servicing tens of millions of their banking customers now online. While many startup banks suggest that they will unseat traditional banks in light of generational moves to digital activities, it is safe to say that cyber security protection, customer appreciation of their ability to interact both digitally and through branches, etc., will likely encourage Wells Fargo’s management to continue to promote their extensive digital and mobile banking offerings.

Work remains to be done. For instance, it appears that Wells Fargo could likely benefit from a revised board. Wells Fargo’s new chairman might consider ways to reshape the board, possibly by reducing in number, acquiring more diversity in backgrounds, while being simultaneously more skilled in the issues that will most press Wells Fargo going forward (e.g., banking industry knowledge, social network marketing, internet banking, and regulatory environment skills).

Wells Fargo will have to publicly atone. They must meet Congress and regulators directly. They must answer questions about past conduct, nothing hidden. They must be prepared to make full financial restitution where warranted, tackling head-on even arguments concerning alleged adverse impact on mortgages that may have arisen due to credit bureau issues that could have arisen due to fabricated accounts.

Finally, Wells Fargo must invest much more deeply behind their goodwill. They must advertise about the good work underway. Their communication should not be cryptic nor evasive. It should deal directly with past mistakes, honestly accepting deserved criticism and honestly recognizing they fell from their historic standards of earned trust.

Wells Fargo must speak publicly about the good the bank is doing along with communities and with its banking clients. They must celebrate their associates’ support of non-profits (nearly $300 million in 2015). They must continue their support of minority small businesses (procuring as Wells Fargo did in 2015 over 12 percent of its banking supplies and services from small businesses). They must celebrate the bank’s support of the environment (over $15 billion of loans extended in 2015). They must celebrate loans to small businesses (over $20 billion extended in 2015). Finally, they should celebrate rewards received for Wells Fargo’s workplace environment (e.g., 2015 workplace award from DiversityInc as the #1 company for LGBT employees, 7th top company for veterans and 11th top company for diversity). Their communications should be honest, sincere, and not written by counsel.

We must recognize that the issue of the bank of goodwill extends far beyond just the example of Wells Fargo when reviewing our portfolio holdings more broadly. For instance, we do have in our portfolio examples of companies that have prioritized “making deposits into the banks of goodwill” as a matter of course for their businesses, helping to win their shareholders benefits that come from sustained goodwill. Unilever supports carbon emissions impact reduction, affordable clean water, consumer self-esteem (e.g., Dove’s “Real Beauty” campaign), and environmental protection through reduced energy, plastic, and water consumption during product manufacturing. Heineken, likewise, has publicly celebrated their investment over the years to cut water and electricity consumption by over 40 percent over the past two decades even while their production volumes increased by over 40 percent.

As with so many such developments, both Heineken and Unilever celebrate how their companies have done very well by “doing good”. They save costs of manufacturing by reducing materials consumed by reworking manufacturing flows. Eliminating waste by manufacturing redesign also means paying less for ingredients otherwise costly to dispose thus increasing our operating profits!

We also have had examples of portfolio companies, even some whose company-wide standards recognize the need to make such deposits, but which have tripped up in given markets only to discover when that occurred that they had, for whatever reason, failed to make needed “deposits” in specific markets.

The case of Nestlé India has been quite instructive as to how normally caring companies can confront reputational attacks. In this case, Nestlé India experienced “a run” on its bank of goodwill when ill-founded rumors surfaced that its Maggi noodle soup could pose harm to children due to trace elements of metals and other harmful elements allegedly discovered to be present in their product. Nestlé discovered as they attempted to respond to such questionable allegations that their Indian division had underinvested in building and sustaining its goodwill. Lacking the ability to “withdraw funds” to counter allegations, that quickly swirled throughout India’s extraordinary tabloid press, Nestlé India quickly found that its national goodwill for its trusted brand in India quickly plummeted from 98-percent brand trust to 8-percent brand trust. Subsequently, after costly product disposals and other brand support steps that cost in excess of $350 million, Nestlé has been able to begrudgingly rebuild its brand trust back to 88 percent, still sadly short of the esteem earlier enjoyed.

While Nestlé was unable, as described above, to make any early “withdrawals” when the Indian Maggi soup crisis hit to forestall reputational damage, they were able to largely build back their consumer trust in that important market. Moreover, in keeping with their posture as a “learning company”, Nestlé has evidenced more recently growing skills in confronting early any attempts by others to deplete its bank of goodwill as well evidenced by an article that recently appeared that deflected “potentially” bad news impacting Nestlé’s investment in a biotech company whose product failed to meet regulatory approval and whose share price collapsed thereafter.

In the face of similar, potentially troubling press, Nestlé was able to deflect the effect of this isolated incident by dipping into its bank of goodwill and responding directly to the press about how that adverse experience was acceptable in the broader context of a company that has developed ongoing extensive efforts to harness the power of health and wellness across its extraordinarily broad portfolio. Clearly, Nestlé bumped up against specific setbacks but they avoided the reputation costs by directly engaging with journalists and laying straight the record. Such skills sadly remain called upon regularly from firms like Nestlé who must counter claims that potentially could impact goodwill with direct and honest answers and engagement rather than retreat.

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How Do We Know We Are Right

September 11, 2017 in Letters, Skills

This post is authored by Gary Mishuris, managing partner of Silver Ring Value Partners.

A first-level answer I heard early on in my career from some portfolio managers is something along the lines of, “If the market price of the security that you bought goes up more than the index, then you were right, if it doesn’t, then you were wrong. Period.” This is a naïve and in my opinion flawed view of both the investment process, and what market prices tell us about a security. To elaborate, it is helpful to reduce the investment process to a simplified mental model.

The “urn and ticket” mental model for an investment

Suppose you are offered an opportunity to buy a ticket that gives you the right to draw one ball from an urn. That urn is filled with eight green balls and two red balls, a fact that you have no reason to doubt. The process of choosing a ball from the urn is purely random. If you draw a green ball then you will be paid $100 with certainty, and if you draw a red ball you will get nothing.

It is your lucky day–the seller of the tickets has offered you a ticket for $50. You quickly calculate that the expected value of that ticket is $80, and make the purchase. The drawing is to happen three months from now, and so you eagerly await your opportunity to win the prize. At the end of the first month, you observe that John, who bought an identical ticket,sold it to Bob for $40. You weren’t the only one to observe that–Mike, your ticket value administrator, also happened to notice this transaction.Since it is the only one available, he helpfully sends you your statement with the month-end Net Asset Value (NAV) of your ticket “marked” at $40.

Unperturbed by the news from Mike that the market price of your ticket has declined, you finally reach the end of the three month period and have an opportunity to draw ball from the urn. One of two things can happen –you draw a green ball and get paid $100 or you draw a red ball and get nothing. Before you get the chance to draw your ball,however,you encounter another participant, Jim, who on the way to the drawing tells you that he paid $90 for his identical ticket. As you wait in line, Jim confides in you that the reason he made the purchase was that he “had too much cash, and his clients weren’t paying him to hold cash as they had already made the capital allocation decision for him.

Drawing Realized Outcomes

Hopefully you would agree that you made a good decision by buying the ticket well below its expected value, even though 20% of the time you will have an unfavorable outcome that will result in a realized loss on your investment of $50. Similarly, Jim made a decision to pay more than the expected value of the ticket, yet 20% of the time he will have a realized gain on his investment of $10 even though his decision had negative expected value before the outcome was known. This illustrates why even with realized results after an investment has been exited, the outcome itself doesn’t necessarily tell you if the investment was a good one.

The “urn and ticket” mental model in the real world

There are two main differences between the simplified example above and the real world of estimating the value of a business. If we were to continue with the example of an urn with different colored balls as an analogy for a business with different potential financial outcomes, the two main differences would be:

In the real world, the number of the balls in the urn –the financial outcomes of a business –usually cannot be known with certainty ahead of time. That being said, there are various ways that we can go about estimating what is in the “urn”. In some cases this may lead to a reasonable range of what is inside, but in other cases,no matter how often we rattle the urn or try to peek inside, we cannot obtain a reasonable estimate of what is within. This is why a key tenet of my investment process is to only attempt to value businesses that possess characteristics that make their long-term economics sufficiently predictable so as to yield a reasonable range of values.

In the real world, the number and type of balls in the urn can change over time. Competitive dynamics and the results of management’s capital allocation decisions can both either increase or decrease the financial outcomes of the business in the future. So even if you knew with certainty the contents of the urn at the time you purchase the ticket, the contents would likely be different by the time the drawing is held. This highlights the importance of my focus on businesses whose value I believe is likely to increase over time as a result of a strong competitive position and management that is likely to undertake value creating capital allocation decisions.

How can we know whether an investment decision was a good one at the time that it was made? Unfortunately, there is no answer that is as clear cut as our urn and ticket example. Sometimes an undesired financial outcome will happen, and it will still be a matter of opinion as to whether the initial investment decision was a good one or not.We will not always know if we paid a good price for the ticket but happened to draw an unlikely unfavorable ball from the urn. Other times, the passage of time will make it clear whether we were correct or not in our initial decision to invest.

Here are some signs that my initial investment decision was wrong:

The worst-case value estimate has declined materially over time. While we can’t know the future precisely, estimating the lower bound of the likely value range correctly is a key part of my investment process.Therefore, getting the range of values wrong is a much bigger mistake than being incorrect with respect to where the Base Case lies within the range.

The assessment of the quality of the business or management team needed to be materially revised downward. Since I rely on these quality assessments both for deciding whether to invest and for sizing the investment, getting one of these judgments wrong is a process error.

Making a mistake in analyzing the balance sheet in a way that causes a material unexpected impairment of the value of the business. There are situations where other factors can make a decision to invest in a security where the balance sheet has room for improvement correct as a function of other considerations such as the risk-reward ratio. However, taking on that risk without realizing it and without demanding commensurately higher expected return is a mistake.

Key economic variables that were identified as material to the value range are tracking worse than expected for a prolonged period of time.

My investment thesis used to justify the value range continues to evolve over time, and I find myself making statements such as “yes, my initial thesis did not pan out, BUT…,” with the end of that statement usually referring to how inexpensive the security is now.

Here are some signs that our initial investment decision was correct:

An acquirer purchases the business at a price consistent with my value appraisal.

A fixed-income security I analyzed as likely to continue fully paying interest and return the principal matures, and we get the expected interest and principal.

My intrinsic value range goes up over time, at least in line with the 10% discount rate that I used in deriving it. Importantly, this is supported by visible fundamental improvements in the business, not vague or unsubstantiated estimates about the distant future.

Key economic variables that were identified as material to the value range are tracking as or better than expected for a prolonged period.

You might observe from the above that only in a few scenarios does one get near-certainty that the initial investment was a good one. In other cases, the odds begin to move in one direction or the other, with the judgment still far from certain. Ultimately, that is why as I recommended in the Owner’s Manual in the short-term the best thing to track is the investment process, but in the very long-term the majority of the weight should be placed on the outcome. Over a period of many years the outcome should converge with the process, and room for subjective judgment regarding the quality of one’s decisions should greatly diminish.

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The information contained herein is confidential and is intended solely for the person to whom it has been delivered. It is not to be reproduced, used, distributed or disclosed, in whole or in part, to third parties without the prior written consent of Silver Ring Value Partners Limited Partnership (“SRVP”). The information contained herein is provided solely for informational and discussion purposes only and is not, and may not be relied on in any manner as legal, tax or investment advice or as an offer to sell or a solicitation of an offer to buy an interest in any fund or vehicle managed or advised by SRVP or its affiliates. The views expressed herein are the opinions and projections of SRVP as of September 30, 2016, and are subject to change based on market and other conditions. SRVP does not represent that any opinion or projection will be realized. The information presented herein, including, but not limited to, SRVP’s investment views, returns or performance, investment strategies, market opportunity, portfolio construction, expectations and positions may involve SRVP’s views, estimates, assumptions, facts and information from other sources that are believed to be accurate and reliable as of the date this information is presented—any of which may change without notice. SRVP has no obligation (express or implied) to update any or all of the information contained herein or to advise you of any changes; nor does SRVP make any express or implied warranties or representations as to the completeness or accuracy or accept responsibility for errors. The information presented is for illustrative purposes only and does not constitute an exhaustive explanation of the investment process, investment strategies or risk management.The analyses and conclusions of SRVP contained in this information include certain statements, assumptions, estimates and projections that reflect various assumptions by SRVP and anticipated results that are inherently subject to significant economic, competitive, and other uncertainties and contingencies and have been included solely for illustrative purposes. As with any investment strategy, there is potential for profit as well as the possibility of loss. SRVP does not guarantee any minimum level of investment performance or the success of any portfolio or investment strategy. All investments involve risk and investment recommendations will not always be profitable. Past performance is no guarantee of future results. Investment returns and principal values of an investment will fluctuate so that an investor’s investment may be worth more or less than its original value.

Publity: Owner-Operated German Real Estate Asset Manager

September 11, 2017 in Deep Value, Equities, Europe, European Investing Summit, Ideas, Real Estate, Small Cap

This article previews an idea presentation at European Investing Summit 2017. It is authored by Alejandro Estebaranz, co-investment advisor with Jose Luis Benito of True Value (ISIN: ES0180792006), a fund based in Spain. True Value has €100 million in assets under mangement and has generated an annualized return since inception (2013) of 16%, net of fees, with volatility of 6.8%. The fund invests in underfollowed small and mid-cap companies. Alejandro looks for good businesses, with growth at a reasonable price, and with good management in place.

Publity AG (PBY) is a German real estate asset management company with three lines of business: retail, mid-size, and institutional. The company generates a blended management fee of around 1.3% (retail is higher, institutional is lower). They seek to invest like value investors, buying undervalued assets and waiting three years, on average, to sell them at a premium. In the meantime, they collect rent. Publity focuses on the German commercial real estate market, mainly offices.

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