This post is excerpted from a letter by Jim Roumell, partner and portfolio manager of Roumell Asset Management.
In May, I attended Berkshire Hathaway’s annual meeting in Omaha, NE. A few weeks later, I gave a presentation at a value investment conference in Zurich, Switzerland hosted by John Mihaljevic’s Manual of Ideas (MOI). MOI is a thoughtful community of value investors from all over the world. At each venue, I spoke to a number of professional investors about their approaches to investing. Buffett’s shareholder meeting, often referred to as “Capitalism’s Woodstock,” is a cult of sorts for investors in search of “great companies.” In fact, most investors, even ones with an overall value orientation, are in search of great companies. I often feel like the odd man out at these events. It’s worth reflecting on why RAM [Roumell Asset Management] does not pursue great companies but rather focuses on finding significantly undervalued securities.
What is a “great company”? A great company is most often viewed as one with a high return on invested capital (ROIC) or return on equity (ROE), and with an opportunity to reinvest its cash flows with high returns as well, which is often referred to as a return on incremental invested capital. Moreover, the reinvestment opportunities should have a long runway. Such companies are often longingly referred to as “compounders.” For example, Coca Cola, a long time Buffett favorite, has an average return on equity of roughly 35% over the past 25 years—clearly qualifying as a great company.
Do great companies make great investments? Yes and no. They certainly make wonderful investment candidates if held for long enough periods of time and if their ROIC/ROE rates remain intact. Over time, these common stocks’ returns will likely track their internally generated investment returns. Thus, the reasoning goes, it’s best to find companies that have strong underlying investment returns because these returns will ultimately be reflected in the investor’s stock returns.
The great company investor faces one overarching challenge—will the company remain great? History has proven that our dynamic, ever-disrupting economy, can humble even the best of companies. Eastman Kodak, accounting for an estimated 90% of film sales and 85% of camera sales in the mid-1970s, filed for bankruptcy in 2012. A & P, with an estimated 75% market share of U.S. grocery sales in the 1950s, filed for bankruptcy in 2015. Today, IBM is struggling in ways not imagined 10 years ago, while Whole Foods is being acquired by Amazon at a price below where its stock traded five years ago. It’s worth asking: How many companies have a true economic moat around their businesses? Remember, investors typically “pay up” for these companies based on the belief that their business models are highly sustainable and consequently there’s often little margin of safety, given the price paid.
An additional challenge for the great company investor is the difficulty of adding value to buying such businesses. In other words, given that the investment demand for company compounders (high return on invested capital and incremental capital investments) is so high, how does one add investment value? Deep value investor and friend Marty Whitman once noted, “No successful investor ever made money buying what is popular when it is popular.” Recent history may challenge Marty on this front, but we believe the basic insight is eminently rational and spot on.
Indexing is the solution commonly put forth to address the difficulty of trying to pick which great companies will remain great and which ones are mispriced. The S&P 500 Index contains many great companies. Some will maintain and/or grow their internal return rates, while others will be disrupted or simply mismanaged. Many believe they should just buy the whole basket at a low fee and go fishing. It’s not an unreasonable idea. Think about it…if a business has stable, reliable cash flows and reinvestment rates, everyone has the basic numbers to appropriately price the security.
To be clear, there are investors who seem particularly adept at determining the strength of a company’s competitive edge and genuine growth prospects, and can thus capture mispricing if the overall market is not sufficiently pricing in the durability of future cash flows. However, it’s not a skill set that RAM possesses. It’s not what we do. That said, as we have often noted, we do episodically find great companies that are momentarily in the dog house and priced accordingly. We have no qualms when it comes to purchasing such securities. After all, Wall Street is mostly comprised of followers best described as individuals trafficking in the average opinion of the average opinion. Collectively, Wall Street tends to fall in love or out of love as a group. Savvy contrarians can periodically exploit this communal tendency to hide out in the safety of crowds.
Our investment mantra lies in pursuing value not by searching for great companies, even ones that might be reasonably priced, but rather in sourcing “Out of favor, overlooked and misunderstood” securities. The rationale is simple enough to us — the odds of discovering mispricing are far greater in such an arena. Admittedly, the inputs for RAM securities are not as neat and formulaic as the inputs for great companies. While the vast majority of investors are focused on near-term company cash flow or earnings, we are decidedly interested in areas where investor interest is low because of poor current outlooks or uncertainty— two things which frighten most investors who are comforted by identifiable positive characteristics. RAM is comforted by bargain prices. The fact remains that most investors chase the same investment characteristics and therefore reduce the probability of adding investment value.
In other words, our securities possess “hair,” i.e., their current profit profiles often look terrible. They definitely don’t screen well, which is precisely why mispricing is much more likely. The inputs are more complicated. To properly analyze such securities, one must possess a rich ecosystem of industry contacts. Walking trade show floors often proves to be invaluable. Assessing probabilities and suitably weighing odds are the tricks of the trade. Thus, while math is at the center of what we do, deep value is not the domain of accountants, economic forecasters, and those never wanting to leave their offices. Deep value investing, as practiced by RAM, more accurately relies on the skill sets of detectives, investigative journalists, and insurance underwriters. Insurance is a game of pricing probabilities and investing similarly boils down to probabilities, not certainties.
It is important to highlight that RAM’s approach is anchored in viewing businesses not strictly as going-concern entities, but also as owning assets that are potentially desirable to larger companies operating in the same industry. In fact, building a business most often involves buying smaller ones. Generous premiums to market prices are often paid because the cost to recreate the asset(s) would be even greater, while also consuming the precious commodity of time. RAM’s north star has always been driven by answering a simple question: Would we take this company private, in a heartbeat, at its current price? The answer to this question is deeply informed by whether we believe the business could be sold at a materially higher price.
For RAM, resource conversions have always been source of value creation. In the past eighteen months, for instance, we have had five of our holdings bought out by larger companies: WCI Communities (WCIC), Sizmek (SZMK), Fortress Investments (FIG), Atwood Oceanics (ATW) and Covisint (COVS).
RAM mitigates the risk of buying unloved securities in several ways:
- Balance Sheet Strength—Provides time for investment optionality to play out and ability to average down
- Unique Assets—If the company cannot segue to profitability as a going-concern, the assets are desirable to competitors
- Multiple Shots on Goal—Like to have several ways to win, providing investment redundancy
- Alignment of Interests—Management and board incentives
- Price—Demand a sizable discount to our calculation of intrinsic value
Additionally, we add to our investment differentiation by greater portfolio concentration (often 5% to 7% positions compared to typical portfolios with 2% company weightings). It is in our DNA to be highly opportunistic. As such, we are disciplined enough to hold cash in the absence of compelling investment candidates, and are willing to average down our cost basis. Finally, it is worth noting, as we have done previously, we are committed to maintaining a modest level of assets under management that allows us to optimally execute our strategy, focusing as it does in micro and small cap securities. Simply put, large pools of money seem to be highly correlated with diminishing returns.
We believe RAM’s results since inception give credence to our approach of buying out of favor, overlooked and misunderstood securities, despite the significant underperformance in 2014 and 2015. Since inception, the annualized return of the RAM Opportunistic Value composite is 7.98% vs the S&P’s return of 5.73%. However, the pure returns don’t tell the whole story. Since our inception we have averaged 26% cash. We compare ourselves to the S&P 500 because that seems to be the general public’s premier benchmark and the one pundits most often refer to in arguing the case for passive investing. As an aside, an investment in Berkshire Hathaway stock on January 1, 1999 (RAM’s inception date), has compounded at 7.25% through June 30, 2017, below RAM’s annualized return.
There is another factor worth noting when viewing our returns against benchmarks. Indexes are comprised of leveraged companies since most capital structures combine equity and debt financing. RAM is typically holding a basket of unleveraged companies. For example, the current median debt to EBITDA ratio for non-financial companies in the S&P 500 is roughly 2.3x (it’s the highest ratio since 2000). Our top ten equity holdings, on the other hand, collectively not only have no debt, but also hold significant amounts of cash. Our top ten holdings as of June 30th have an average cash balance equaling roughly 40% of their market capitalizations. Company leverage flows through to underlying company investment returns as a company’s ROE is a function of its return on assets and the degree to which those assets are leveraged.
What is it that we might be doing right wherein unlevered ugly ducklings are beating the debt-enhanced beautiful swans? Notwithstanding our research process and risk mitigation strategies, we believe the answer lies in one word—price. Paying a bargain price has added value. The sizable mispricing that results from the institutional and psychological bias to own what’s pretty, combined with the parallel fear of being seen hanging out with the unpopular kids, can be put to profitable use. While others long to belong with the in-crowd, we long to buy cheap.
Finally, a word on the current environment’s pricing of corporate assets: plant and equipment, inventory, intellectual property, etc. The compound annual growth rate in book value for the S&P 500 is 4% over the past five years, but the index itself has compounded at nearly 15% during the same period. Notwithstanding the shortcomings of book value as an analytical tool, this fact strongly suggests that prices have outstripped the growth in corporate net worth by a considerable amount in the past five years.
Yes, in the current environment, deep value securities are difficult to find…but it’s not impossible. With regularity, the degree to which some security and/or industry is being taken out to the woodshed is often too dramatic. Our job is to find these situations. We feel confident that patience and discipline will pay off and feel well-positioned to take advantage of possible market disruption. However, if valuations stay elevated— a clear possibility if interest rates remain super low— our ability to find pockets of value, and to own them in meaningful size, will provide ample return optionality, in our opinion.
Roumell Asset Management, LLC claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Roumell Asset Management, LLC has been independently verified by Ashland Partners & Company LLP for the periods January 1, 1999 through December 31, 2016. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. The Balanced Composite has been examined by Ashland Partners & Company LLP for the periods January 1, 1999 through December 31, 2016. The verification and performance examination reports are available upon request. Roumell Asset Management, LLC is an independent registered investment adviser. The firm maintains a complete list and description of composites, which is available upon request. Results are based on fully discretionary accounts under management, including those accounts no longer with the firm. Past performance is not indicative of future results. The U.S. dollar is the currency used to express performance. Returns are presented net of management fees and include the reinvestment of all income. Net of fee performance was calculated using actual management fees. From 2010 to 2013, for certain of these accounts, net returns have been reduced by a performance-based fee of 20% of profits, paid annually in the first quarter. Net returns are reduced by all fees and transaction costs incurred. Wrap fee accounts pay a fee based on a percentage of assets under management. Other than brokerage commissions, this fee includes investment management, portfolio monitoring, consulting services, and in some cases, custodial services. Prior to and post 2006, there were no wrap fee accounts in the composite. For the year ended December 31, 2006, wrap fee accounts made up less than 1% of the composite. Wrap fee schedules are provided by independent wrap sponsors and are available upon request from the respective wrap sponsor. Returns include the effect of foreign currency exchange rates. Exchange rate source utilized by the portfolios within the composite may vary. Composite performance is presented net of foreign withholding taxes. Withholding taxes may vary according to the investor’s domicile. The annual composite dispersion presented is an asset-weighted standard deviation calculated for the accounts in the composite for the entire year. Dispersion calculations are greater as a result of managing accounts on a client relationship basis. Securities are bought based on the combined value of all portfolios of a client relationship and then allocated to one account within a client relationship. Therefore, accounts within a client relationship will hold different securities. The result is greater dispersion amongst accounts. The 3-year annualized ex-post standard deviation of the composite and/or benchmark is not presented for the period prior to December 31, 2012, because 36 monthly returns are not available. Policies for valuing portfolios, calculating performance, and preparing compliant presentations are available upon request. The investment management fee schedule for the composite is as follows: for Direct Portfolio Management Services: 1.30% on the first $1,000,000, and 1.00% on assets over $1,000,000; for Sub-Adviser Services: determined by adviser; for Wrap Fee Services: determined by sponsor. Actual investment advisory fees incurred by clients may vary.