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Emergent Biosciences: Positive Outlook After Major Setbacks

January 9, 2022 in Audio, Best Ideas 2022, Discover Great Ideas Podcast, Equities, Ideas, Member Podcasts

A.J. Noronha of Desai Capital Management presented his investment thesis on Emergent Biosciences (US: EBS) at Best Ideas 2022.

Thesis summary:

One of the last places A.J. expected to find a value opportunity is a company that had some of the most direct covid-related negative headlines of 2021. However, after further research, A.J. believes Emergent Biosciences may well be the rare exception and provide a compelling opportunity despite the large setbacks earlier in 2021.

EBS weathered the major vaccine manufacturing contamination event that became front-page news into a stronger partnership with JNJ, trades at a significant discount to intrinsic value, has both a diversified revenue-generating product line and a promising pipeline, and has strong alignment of management and shareholder incentives.

EBS appears prepared to provide vaccine solutions for either a pandemic or endemic situation over the forecast period, and also has travel health products that should benefit from a return toward normalcy.

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About the instructor:

A.J. Noronha, CFA has over ten years of investment management experience, and has worked closely with Mr. Desai since Desai Capital Management’s inception in 2013 with all aspects of the fund, with his primary responsibilities being equity research, due diligence, and developing investment theses for DCM’s portfolio.

He has been ranked as highly as #1 (Value), #6 (Long), and #9 (both Overall and North America) in SumZero’s independent analyst rankings, and his independent research on Dow Chemical was selected as one of their top ideas of 2015.. He served as an instructor for MOI Global’s Best Ideas 2018 and Wide Moat Summit 2018, and was an invited participant (non finalist) in the 2017-2018 Sohn Conference Foundation Idea Contests, 2017 SumZero/Van Biema Value Partners Idea Challenge, and 2019 SumZero Best Short Ideas Challenge.

Prior to DCM, Mr. Noronha gained investment experience working for a mid-market PE/VC fund, and also co-founded and served in a C-level role for a biomedical engineering startup. He earned a degree in Finance, magna cum laude, from the University of Notre Dame, where he was selected to be a member of the prestigious Applied Investment Management honors finance course where students manage a portion of the University endowment under the guidance of the Chief Investment Officer, and also holds a JD with Dean’s List honors & a concentration in business enterprise (selected coursework taken through the Kellogg School of Management) from Northwestern University. He is a proud CFA Charterholder, is an active Candidate Member of the CFA Society of Chicago & serves on its Professional Development Advisory Group Board, and is a member of Irish Entrepreneurs & Harvard Alumni Entrepreneurs.

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

Shopify: E-Commerce Enabler Run By Exceptional Founder/CEO

January 9, 2022 in Audio, Best Ideas 2022, Discover Great Ideas Podcast, Equities, Ideas, Member Podcasts

Ser Jing Chong of Galilee Investment Management presented his investment thesis on Shopify (Canada/US: SHOP) at Best Ideas 2022.

Thesis summary:

Shopify is an e-commerce enabler run by co-founder and CEO Tobi Lütke, a generational business talent. Shopify thinks and acts for the long term and aims to enrich all its constituents. There is a massive market opportunity — in the form of global commerce — for the company to tackle. As a highly innovative company, plenty of new ways exist for Shopify to add value to customers and grow the business over time.

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About the instructor:

Ser Jing Chong graduated in 2012 from the National University of Singapore’s Engineering Science Programme. From January 2013 to October 2019, Ser Jing served in The Motley Fool Singapore as a writer as well as a co-leader of the investing team. One of his career highlights with Fool Singapore was to help its flagship investment newsletter, Stock Advisor Gold, outperform a global stock market benchmark by nearly 2x over a 3.5 year period. In mid-2020, he co-founded and launched Compounder Fund, a long-term focused global equities investment fund.

The content of this website is not an offer to sell or the solicitation of an offer to buy any security. The content is distributed for informational purposes only and should not be construed as investment advice or a recommendation to sell or buy any security or other investment, or undertake any investment strategy. There are no warranties, expressed or implied, as to the accuracy, completeness, or results obtained from any information set forth on this website. BeyondProxy’s officers, directors, employees, and/or contributing authors may have positions in and may, from time to time, make purchases or sales of the securities or other investments discussed or evaluated herein.

The Barrier to Entry to Finding Great Investments

January 7, 2022 in Best Ideas Conference, Equities, Letters, Special Situations

This post is authored by MOI Global instructor Sam Sheldon, research analyst at Punch & Associates Investment Management, based in Saint Paul, Minnesota.

Sam is an instructor at Best Ideas 2022.

Great investors seek out businesses with strong and sustainable competitive advantages, giving these companies the opportunity for sustained success without too much competition. The challenge is that many investors are looking to own these types of businesses, and when priced for perfection, these shares may offer little value. A simple screen will uncover some of the widest-moat companies in the market: however, these often are companies with the richest valuations. Perhaps “wide moat plus easy-to-fi nd” is not the best formula for identifying opportunities across the market cap spectrum.

Beware of Buying Great Companies

To be successful for our clients, we fi nd what we believe are great businesses and hold them long enough for others to arrive at the same conclusion. We generally hold companies for three to five years. Also, to minimize risk, we should be reluctant to overpay.

Many investors construct portfolios using companies identified through quantitative screens with limited consideration of any qualitative factors. Anyone can run a screen, and this overly simplistic approach is perhaps the reason for the proliferation of the ETF. By contrast, it is more difficult to identify the companies that these screens might miss. An example of a company a screen may overlook is one that allows a mature legacy product to run off while seeding a dynamic growing business. The only way to determine whether to invest in a business or not is to develop a deeper understanding of the business and its prospects.

When we think we have found a compelling investment at a discount, we are repeatedly asking ourselves questions like, “What am I missing?” (Or, alternatively, “What am I getting away with?”) The best way to fi nd answers is to talk to management and research the company’s competitors. Many investors don’t bother to take this qualitative step, and quantitative screens only go so far. Our goal is to have other investors gravitate toward our idea overtime as our company gains recognition, because a permanently undiscovered company is of no value to our clients.

Usually, there is a clear reason for finding a company so cheaply priced. Have we considered all the reasons? How temporary or permanent are the reasons? Of course, investors will never have perfect information; part of an investor’s job is to make an assessment with imperfect information. But, to skew the odds in our favor, we look in areas where we know there are structural reasons that result in mispriced, higher-quality businesses.

Small companies and forced selling situations are fertile hunting grounds. Index kick-outs, company spin-offs, taxloss harvesting, and companies emerging from bankruptcy are also examples where owners’ reasons for selling are not tied to the underlying fundamentals of a business. Finally, companies in transition and those recovering from a failed initial public offering can present steep discounts to their intrinsic value.

Smaller Small Caps

Small cap companies – and, more specifically, the smallest small caps – can offer compelling opportunities that few investors are willing to research because of liquidity concerns and a lack of information about the company. Investors willing to do the hard work of reviewing SEC fi lings, talking to management and competitors, and methodically building a position can uncover many great businesses in this market cap range. With less capital targeting this segment of the market, stocks are less efficiently priced, and often opportunities are more plentiful. On the other hand, an investor needs to be more patient and willing to tolerate a higher level of volatility. The data below confirms our belief that smaller companies, in the aggregate, outperform over time.

Source: Kenneth French Library, value weighted returns from 1927-2020.

Kick-Outs

Every June, the Russell 2000 Index reviews its holdings and will drop or add approximately 100 to 200 stocks. Companies usually fi nd themselves on the kick-out list after, for example, a decrease in their market cap. This decrease could either be due to challenges the company is experiencing in its business or something like a stock buyback (which reduces the outstanding share count and, therefore, the market capitalization of the company) or some other shareholder-friendly action. Dropped securities come under selling pressure from passive funds and active managers who may be restricted from owning companies that are not in the index. Opportunity arises from substantial selling pressure that is not directly tied to the underlying fundamentals of these businesses (which may not be deteriorating as much as the falling share price would suggest).

Spin-Offs

A spin-off occurs when a parent company determines that a subsidiary is better off as an independent entity and distributes the business unit to current shareholders. The new company may be so small that its new shareholders might sell it indiscriminately. This selling could be due to constraints of time, capital, or the number of positions allowed in a portfolio. Portfolio managers might also sell the new shares because they do not align with the manager’s objectives. The new company might have attractive characteristics which previously went unrecognized because it was part of a larger organization. As a standalone company, the newly created entity has the freedom to focus on its core business.

Source: Bloomberg data. Cumulative returns as of December 27, 2021.

Investors end up dismissing businesses with great potential without much thought, and some businesses trade at illogical valuations temporarily. In addition, the opportunity can remain undiscovered for an extended period, as spin-off s typically don’t “screen” well. Also, the financial information for the company is not always easy to find and therefore not accurately entered into financial databases. While the effect of spin-off s is well-documented, they continue to outperform the market in general as shown above.

Tax-Loss Harvesting

A common practice among certain investors is tax-loss harvesting. This is the practice of selling a security that fell in value since the initial purchase, waiting the necessary time to avoid tripping IRS “wash sale” rules, and then repurchasing the same securities at a later date. The goal for investors is to realize the losses in a portfolio to help off set any gains. During the last few months of the calendar year this practice can accelerate, as investors naturally start to think about their tax liability. This practice meaningfully impacts small cap stock prices, and opportunities can arise from selling pressure not tied to the underlying fundamentals.

Source: Bloomberg data and Punch & Associates.

Phoenixes

Companies emerging from the ashes of bankruptcy usually have new shareholders that once were creditors. Given that many managers of credit strategies have a mandate to only hold debt in their portfolios, they have an eagerness to sell out of the equity as soon as practical. It is worth noting that some companies go into bankruptcy because of a capital structure issue and not a permanent impairment of the underlying business. Post-bankruptcy, balance sheets are usually much improved, and selling by unwilling equity holders can temporarily depress the valuation of a solid business with a much-improved capital structure. The new cost structure is usually not easily discovered by a simple screen and can take several months before the improvements are readily apparent.

Broken Deals

What behavioral finance refers to as “anchoring” also creates a pocket of investment opportunity. When a company sells shares to investors in an offering, the price at which the transaction occurs can stick in the minds of both parties. If a share price falls below the initial public offering price, post-offering it becomes known as a “broken deal.” Often, broken deals can be caused by miscommunication during the deal’s marketing process or inexperienced public executives’ faux pas on early earnings calls as a public company and not a deterioration of the business fundamentals. Rather than patiently own an immature company that may be going through some growing pains, many investors will decide that the initial buy thesis was “wrong” and arbitrarily sell the position rather than risk further losses.

Metamorphosing Enterprises

Businesses in transition may also create an investment opportunity. Many companies that have mature legacy products or services provide the cash for another part of the business that is growing. Because these mature product lines are shrinking, the company likely won’t “screen” well during the transition. Revenue growth may not reach expectations, resulting in some investment managers avoiding the company in search of faster-growing companies. Profitability may look compressed as the company is feeding its undiscovered growth engine, sometimes resulting in value managers avoiding the investment. If the pivot is a success, the tangential business can become a meaningful contributor to overall profits, and the market may eventually reward this effort. We recognize that there is a risk to investing in businesses in transition and, instead of value, we may find “value traps.” However, the only way to know if the pivot is likely to be a success is to fully understand the transition inside the company, which often requires old fashioned boots on the ground research of meeting with management teams, touring facilities and speaking with competitors. These qualitative insights cannot be found on a screen.

Conclusion

Active investing is difficult work, and there is no guarantee of success. If you screen for perfection, you may overpay for an investment, which is why investors should be suspicious of the “obvious” opportunities. Looking in underresearched or overlooked areas of the market can increase the probability of identifying a great business with a suboptimal valuation but identifying where to look is only step one of the process. Our job is to find companies where mispricing might be temporary, and we gain confidence when we fi nd companies with positive characteristics which are not currently reflected in financial databases. Most importantly, we must make a judgement call as to whether the company might someday exhibit the same characteristics as others with which we’ve enjoyed success in the past (healthier balance sheets, simplified business models, better predictability, more transparency, and, ultimately, greater recognition from a broader audience). If a company becomes better recognized by other investors, it can turn into an attractive investment for our clients.

Intelligent Investing in a World of Accelerating Growth

January 7, 2022 in Best Ideas Conference, Commentary, Letters

This post is authored by MOI Global instructor Ser Jing Chong, portfolio manager and co-founder of Compounder Fund under Galilee Investment Management, based in Singapore.

Ser Jing is an instructor at Best Ideas 2022.

The following article has been excerpted from a letter to Compounder Fund investors.

In 2016, Michael Mauboussin co-wrote a research paper entitled The Base Rate Book. Mauboussin and his co-authors studied the sales growth rates for the top 1,000 global companies by market capitalization since 1950.

They found that it was rare for a company — even for ones with a low revenue base — to produce annualized revenue growth of 20% or more for ten years. For example, of all the companies that started with revenue of less than US$325 million (adjusted for inflation to 2015-dollars), only 18.1% had a ten-year annualized revenue growth rate of more than 20%. Of all the companies that started with inflation-adjusted revenue of between US$1.25 billion and US$2.0 billion, the self-same percentage was just 3.0%.

The table below shows the percentage of companies with different starting revenues that produced annualized revenue growth in excess of 20% for ten years. You can see that no company in the dataset that started with US$50 billion in inflation-adjusted revenue achieved this level of revenue-growth.

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Investment Decisions: The Nexus Between Accounting and Valuation

January 7, 2022 in Best Ideas Conference, Idea Appraisal, Letters, Skills

This post is authored by MOI Global instructor Javier Lopez Bernardo, portfolio manager and senior investment analyst at BrightGate Capital, based in Madrid, Spain.

Javier is an instructor at Best Ideas 2022.

This following article has been excerpted from a letter to BrightGate investors.

I think it is the right time to write some words on how I think about the nexus between accounting and valuation, and how such a framework informs my investment decisions. The summary metrics that I provide [in my letters] usually go unreported in other funds, and here I will argue why these metrics have more informative content than the traditional ones, and how they are indissolubly tied both to a firms’ core business and their accounting. In other words, these metrics are the ones I would like to receive if I were in your place trying to obtain a clear overview of the Fund’s portfolio.

Although it is usually argued that valuation is not a differential part of the investment process, for “everything has already been invented”, I cannot but disagree with such a statement. Although in the end the success of an investment boils down to the knowledge of the business and its own future dynamics, a correct study of the valuation and the accounting allows a better understanding of the business and to avoid serious mistakes later.

The exposition that follows is necessarily a simplification of our financial models, but it will be enough to grasp the conceptual framework. The method that I employ to value business is the residual income model (or economic profits, as they are known in the academic literature), which says that the value of every asset is given by its current book value in the balance sheet plus those future discounted earnings obtained above the cost of capital – residual or economic earnings. If we have an asset with a book value of 100€, and we expect it will yield returns of 7% (7€ of profits at perpetuity), and our cost of capital is 7%, the asset should be valued at book value – no more, no less.

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Highlighted Tweet by JMihaljevic

January 5, 2022 in Twitter

Value-Oriented Investing in the Sustainability Revolution

January 5, 2022 in Best Ideas Conference, Commentary, Letters, Macro

This article is authored by MOI Global instructor Alex Gates, director of research at Clayton Partners, based in Berkeley, California.

Alex is an instructor at Best Ideas 2022.

It has become evident that the public and private sector are now remarkably aligned to achieve the goals of the Paris Climate Accords and a zero carbon economy by 2050. Investment strategies focused on carbon reduction will have a tailwind for the next thirty years. This prompts the question:

Outside of expensive renewables pure plays, and ill-conceived or suboptimal ETFs, how can investors participate in the decarbonization transition?

We found the options to be lacking in both return potential and direct impact to carbon reduction. In response, we created the Clayton Partners Sustainability Strategy (CPS). CPS will invest in a portfolio of companies focused on achievable carbon reduction and value creation based on those initiatives.

A major reason for starting CPS is that the current options for climate investing are not focused on profitability or where the greatest benefit is being created. For most investors, ETFs are the main way to participate. This leaves two options: (1) Environmental, Social and Governance (ESG) focused ETFs and (2) Clean Technology ETFs.

ESG focused ETFs utilize exclusionary criteria to eliminate companies with larger carbon footprints. That results in them being overweight asset-light businesses, like technology companies, and underinvested in heavy industry where the most meaningful change is happening. For example, one of the largest “ESG” mandated ETFs, has a 29% weighting to large cap technology stocks, more than the S&P 500. Most technology companies are inherently low carbon, so supporting them with investment capital is not very impactful.

Clean Technology ETFs focus specifically on environmental or renewable technologies. While a seemingly obvious choice, most of these ETFs are concentrated in unprofitable, unproven, and expensive companies. In fact, the second largest clean tech ETF by market value, has nearly half of its investments in unprofitable companies.

CPS uses an entirely different approach. Our strategy is focused on carbon reduction for the benefit of climate change. We do NOT have a formulaic approach that excludes certain industries or includes them regardless of valuation.

CPS focuses on profitable companies enabling dramatic carbon reductions using quantifiable methods. The companies will become more profitable and valuable as a direct result of their emissions reductions.

Our focus is on key areas of emissions reduction where valuations generally have not caught up with the opportunity.

A few examples:

Utilities in “Transition”: The need to decarbonize the electric grid and electrify sectors like transportation will require the current world electricity supply to triple by 2050. Utilities will be the ultimate change agents for this thirty-year transformation. Green, or 100% renewable utilities, trade at high prices relative to their peers with diversified generation sources. CPS will focus on the utilities that are making the fastest pivots to 100% renewable power because they offer the highest appreciation potential and the most impact from a net carbon reduction standpoint.

Solar, Wind and Storage: Considered the workhorses of the new electric paradigm, these technologies drive the decarbonization of the world’s electric grids. Although they have grown quickly in the past, wind and solar will need to be deployed at over three times the current pace to reach a decarbonized US grid by 2035. CPS will focus on supporters of these technologies including energy storage, which makes renewable energy projects more viable.

Low and Zero Carbon Fuels: Decarbonizing the transportation sector is a universal goal for all governments focused on net zero emissions. Electric vehicles will play a massive role in this transition, but sectors like heavy trucking, shipping and aviation are decades away from full electrification. CPS will focus on companies enabling scalable biofuels that are ready to deploy today.

Carbon Capture and Waste Solutions: The transition will require large amounts of CO2 removal and storage in the coming decades. This will create opportunities for direct carbon capture and storage (CCS), as well as new recycling and waste infrastructure needs. CPS will focus on companies investing in profitable projects with proven technologies involving CCS, biomass, digesters and waste-to-energy.

Conclusion: A great way to contrast the CPS approach with the alternative options is to compare one of our large holdings, AES Corp, and a large holding of the more popular strategies, Google. AES and Google are both committed to sustainability; however, the magnitude of their impact is quite different.

Google plans to use 10.5GW of green energy to power its data centers by 2030. AES produces over 11GW of green power TODAY and has a pipeline to produce 37GW more, almost five times the amount Google intends to deploy. AES has a market cap of $16B vs. GOOG at $1.9T, more than 100x larger. An incremental dollar invested in AES will clearly have a larger climate impact compared to Google. Regardless, Google is in many sustainable ETFs and AES is not in any. Yet!

Our focus on profitable value creation and the magnitude of environmental benefit positions us to participate in a strong secular trend and support companies making the greatest contributions to the sustainability transition.

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Our Approach to Investing in an Age of Below-Inflation Interest Rates

January 5, 2022 in Best Ideas Conference, Commentary, Equities, Letters

This post is authored by MOI Global instructor Michael Melby, founder and portfolio manager at Gate City Capital Management, based in Chicago.

Mike is an instructor at Best Ideas 2022.

“It’s my money, and I need it now!” –J.G. Wentworth tagline

Readers might recall J.G. Wentworth television advertisements from the early 2000s where actors shouted from windows to encourage viewers to exchange their structured settlement or annuity for upfront cash. While J.G. Wentworth customers all needed cash on the spot, many investors today are often so flush with cash that they are doing the opposite.

Investors continue to lend their cash to the government in exchange for a historically low rate of interest and a promise to return the investment principal at maturity. Not only are investors relinquishing the opportunity to use their cash, but they are also accepting an interest rate that is currently well below the expected rate of inflation, ensuring a loss of purchasing power when their cash is returned.

Rather than agreeing to an interest rate that compensates the lender for both inflation and the time value of money, investors seem to be relying on the Federal Reserve for guidance regarding the interest rate they should be earning.

While individuals could continue to choose to lend money at interest rates below the rate of inflation for the time being, it is unlikely that this wealth-destroying behavior can continue in perpetuity. Given the choice between spending money in exchange for a basket of goods today or lending the money only to receive a smaller basket of goods in the future, most individuals would spend the money today. Consumers with access to credit have the additional opportunity to purchase durable goods such as new homes today by borrowing at low interest rates and repaying the loan in the future with inflated money.

As investors and economists ponder the path of future inflation, it is important to note that central bank policies continue to incentivize spending over savings. Individuals with excess cash or the ability to borrow will look to spend the cash now rather than wait for inflation to erode its value, further contributing to the short supply of goods and services. We find it highly unlikely that these utility-maximizing actions will prove to be transitory.

Our primary macro-economic concern is that market forces will eventually push interest rates higher, resulting in a reduction in lending activity and higher costs of capital for both debt and equity investors. While it would be extremely challenging to eliminate the risk that higher interest rates would have on equity markets, we continue to attempt to mitigate the risk when constructing our portfolio.

We invest primarily in companies with owned assets including, land, buildings, and equipment. This focus served us well in 2021 and should continue to benefit our investors if inflation exceeds expectations.

We also value all portfolio companies on a discounted cash flow basis and have maintained our required rates of return at 12.5% or higher even as long-term interest rates hover near all-time lows.

Historically, we have found some of the worst investment decisions result from either lowering required rates of return or relying on relative value analysis in an overvalued market. We look to mitigate the negative impact that rising discount rates could have on asset prices by maintaining consistent return requirements regardless of the interest rate environment.

Stay Cognizant of Market History, Focus on Cash Flow Over Stories

January 5, 2022 in Best Ideas Conference, Commentary, Equities, Letters

This post is authored by MOI Global instructor Jeff Auxier, president of Auxier Asset Management, based in Lake Oswego, Oregon.

Jeff is an instructor at Best Ideas 2022.

A young generation of investors who have seen essentially nothing but good times for the market are speculating on exciting and high-risk stories. Instead of valuing sustainable earnings and consistent cash flows, many new investors are focusing on small penny stocks and options, hoping for substantial price appreciation in a short period of time.

In February 2021, over-the-counter markets saw 1.9 trillion transactions, an increase of 2,000% from the previous year. As a result of the influx of cash into the markets throughout the year, there were record levels of mergers and acquisitions (M&A) and Initial Public Offering (IPO) activity during the quarter.

Global M&A activity during the [third] quarter [of 2021] was over $1.5 trillion, up 38% over Q3 2020, and was the highest ever recorded for a single quarter (NASDAQ). Year-to-date, M&A transactions surpassed $4.3 trillion which is higher than the $4.1 trillion in annual M&A in 2007.

In just the first nine months of 2021, there have been 770 US IPOs, over three times the 10-year average of 205. The capital raised through US IPOs has surpassed both 1999 and 2008 levels. This means a plethora of supply.

Just as fossil fuels are starved for capital today, many areas of new innovation and technology are incredibly exciting but also lead to dangerous levels of competition and supply. Thematic ETFs like ESG (environmental, social and corporate governance) can lead to gluts and shakeouts.

The euphoria surrounding the legalization of marijuana led to irrationally excessive planting, which has decimated growers.

The history of transportation bubbles dates back to canals, railroads, airlines, bicycles, etc. The first electric car was developed in 1890 and ended by the 1930s. From 1900 to 1919, two thousand companies were involved in the production of autos in the US. Today, largely due to government mandates, many manufacturers are committing to a fully electric future. The massive mandatory capital investment required make it a very high-risk proposition.

In 1999 two popular themes were internet hosting and fiber optic. We flooded the market with fiber optic supply and ended up using less than 20% of the capacity. In the decade from 1999-2009, the S&P 500 was down 9%, but the biggest and most exciting tech stocks fell over 50% during that same time (Financial Times).

This chart from Bloomberg demonstrates how, despite having compelling stories in the year 2000, some of the biggest companies were materially overvalued and experienced substantial multiple compression in subsequent years. In referencing this chart, I remember the period like yesterday. In March of 2000 the level of greed, envy and frenzy was the highest I had ever witnessed. The technology fundamentals looked like they would be growing for years into the future. Then the supply caught up with demand; many stocks with exciting concepts went bankrupt leading to a bursting of the bubble and subsequent 80% decline in the NASDAQ.

The Auxier Focus Fund was up over the three years 2000-2002 while many funds that had doubled in the late 1990s went out of business. As mentioned in our prior letter, AOL and Yahoo, two of the most popular stocks at the time, were sold this past year by Verizon after declining 95% from their 2000 peak.

During the 1999 tech bubble, those who looked past the bubble priced companies and focused on value were rewarded. For example, the deeply discounted energy sector gained nearly 150% during the decade from December 1999 to 2009. That was also the best ten-year period for the Fund in relation to the market, with a gain of 84% vs. -4% for the S&P.

Cryptocurrency Risks Could Lead to Regulation

The cryptocurrency market has exploded in 2021 and reached a total market cap of nearly $2 trillion, a year-to-date gain of 156%. Much of the crypto boom has been due to the growth and popularity of Bitcoin, but alternative options have gained traction as the year has progressed.

At the start of 2021, Bitcoin accounted for approximately 70% of the entire market but it now accounts for only 43%. Companies like Visa and Mastercard have begun to embrace the technology with an eye on potential disruption in the future. Visa has partnered with over 50 crypto platforms to allow their customers to eventually use Visa cards to pay with cryptocurrency. Mastercard has partnered with cryptocurrency firm Bakkt to allow their users to hold and pay for card purchases with cryptocurrencies.

However, even with increased adoption from reputable businesses, the rapid growth and unpredictability of cryptocurrency has brought with it the risk of increased regulation. In September, the Chinese government announced that all cryptocurrency transactions in the country were illegal. The US has taken a less aggressive approach with Fed chair Jerome Powell saying that he has no intention of banning cryptocurrency. Increased regulation is critical to build confidence and credibility. We are carefully studying the evolution of the blockchain. The decentralized digital ledger could potentially be a disrupter to many centralized cloud-based models.

China Fundamentals

China has $52 trillion in bank assets or 56% of world GDP. Their number two real estate developer, Evergrande, binged on easy money. With $300 billion in liabilities, it now faces bankruptcy. Other major developers are facing a similar challenge. 29% of China’s economy is tied to real estate and construction, with most savings in apartments. Vacant apartments could house as many as 80 million people.

The Chinese government has been aggressive in reigning in excessive borrowing, poor accounting and monopolistic behavior by many of the major platform companies. In addition, they are suffering from severe energy shortfalls. This has led to some bargains in powerful franchises such as Alibaba.

In Closing

We are on pace to see over 104 management teams this year. We strive to know the fundamental earnings power of the companies we own. There is good value in smaller and midsized businesses with high integrity management teams. Most businesses we talk to are seeing robust demand, strong pricing and good margins.

Inflation appears to be up across the board with labor increasing 3.5%. For restaurants, wages are growing around 5.5% and over 10% in hospitality. Government mandates for vaccines and green energy are adding to the shortages for labor and fossil fuels. The service side of the economy is very robust. Companies with strong franchises are able to raise prices and so far, the customers are paying up. Inflation seems to be more persistent as wages are hard to retract and we are seeing rents, which are a large part of the consumer price index, showing double-digit increases coast to coast.

Companies that are executing with proven business models have been rewarded with huge premium valuations. However, higher inflation historically acts to compress valuations for all stocks, especially those speculative names with little earnings. With vaccinations widely available and the potential for the Merck antiviral, economic conditions should continue to recover from the worst pandemic in 100 years.

Politically there remains a sharp divide. Gridlock can be a good thing, as it can mitigate the potential damage of unconstrained government spending and onerous taxation.

A Case Study in Primary Research: Indentifying an Inflection Point

January 3, 2022 in Best Ideas Conference, Equities, Idea Appraisal, Letters, Skills

This article is authored by MOI Global instructor Ari Lazar, senior research analyst at RGA Investment Advisors. Ari is an instructor at Best Ideas 2022.

A major part of my job as an investor is to piece together a view of how the future will play out amidst a backdrop of uncertain information. I, like all humans and investors, have a very limited and clouded view of the future. People who physically struggle to see wear eyeglasses to improve their vision. The equivalent to eyeglasses for me, as an investor trying to see a blurry future, is primary research. It allows me to improve my perception of the future through unique insights that can be gleaned through primary research.

Primary research takes me beyond SEC filings, management presentations, and industry reports. It is rolling up my sleeves to verify or seek out information for myself. Examples include site visits, channel checks, and conversations with employees (present and former), customers, suppliers, competitors, and/or partners. Information uncovered in this manner leads to a clearer and potentially differentiated view into how events may play out. If primary research can lead to strong conviction in a differentiated view, why doesn’t everybody do it?

Unfortunately, primary research is time consuming, expensive, and difficult. It often requires me to filter vast amounts of information. There are many potential conversation paths, and I must, through a combination of luck and skill, arrive at relevant tidbits of information. This must be done within the confines of my professional (or expert) network. I am always working to expand my professional network to get the information that I need. Performing primary research is very similar to being a detective.

I am still sharpening my abilities to effectively perform primary research. For me, some companies and industries are easier than others to obtain insights in. So far in my career, I have found the most success (and luck) finding unique insights on Cognex. My primary research on Cognex allowed me to gain conviction in a revenue inflection ahead of its occurrence.

For those that are not familiar, Cognex provides machine vision hardware and software. Their products capture and analyze visual information needed to automate distribution and manufacturing. Cognex is well positioned as a leader in the machine vision industry alongside Keyence. It is important context that machine vision is traditionally used in cyclical end markets, like consumer electronics and automotive, where large manufacturers employ machine vision engineers to maintain Cognex (or competitor) products. Additionally, logistics was Cognex’s third largest end market in 2019 (low double digit % of revenue).

My primary research on Cognex began unexpectedly on LinkedIn. LinkedIn is an excellent source of insights into product features that are not typically available within SEC filings. Through LinkedIn, I become aware of the Cognex In-Sight ViDi D900 (“D900”) product launch webinar. This webinar opened my eyes to the advanced deep learning product capabilities and sparked a strong motivation to learn more. Following the webinar, a Cognex sales employee called me to see if I had any questions or interest in purchasing the product. This call is part of an excellent sales strategy to fully utilize a webinar designed for potential customers. With full honesty around my intentions as an investor rather than a customer, I was able to have an incredibly helpful conversation with a Cognex employee about the D900.

Over time, I realized that after each Cognex webinar that I signed up for, a different employee or external sales partner would reach out to me directly. This allowed me to have many useful conversations about Cognex and piece together tidbits of information related to the company. Some of the calls were very insightful while others were dead ends. Finally, I was also able to use my professional network to commence a conversation with an employee of a competitor to verify some of the information that I had learned. The culmination of my traditional research on Cognex, the LinkedIn webinars, and my primary research was summarized in the following tweet thread eight months ago.

I had gained high levels of conviction that Cognex was on the verge of an inflection to revenue growth. When @TheMuffinMan28 asked me “Why would rev growth accelerate from pre Covid levels? I know everyone has been hoping for that for a while” I provided five reasons supporting my prediction. The following two insights were essential to my conviction and learned directly from my primary research.

Four months after posting this thread, my research received feedback. Cognex reported “substantial revenue growth” and described the D900 product launch as “among our most successful new product launches ever” in their Q3 2020 earnings release. The strong momentum has continued into Q4 2020 and through Q1 2021 guidance. The primary research that I performed greatly helped clarify my view on Cognex’s future. I enjoyed the process and hope to continue to improve both my research abilities and my network. My goal is to obtain the same level of insights and conviction behind every company that I cover.

As a final thought, it is important to remember that luck always plays a role in determining how events play out. Luck can be good or bad. I humbly note that my thesis was aided by good luck because at the time, I had no insights into the increased consumer electronics end market demand until the company mentioned as much in July. I believe that this was a secondary factor in how events played out. It is a great reminder that luck can just as easily be negative and more than offset positive insights from excellent primary research. In the long run I have to believe that luck cancels itself out and that doing high quality primary research will improve investing results.

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