We are pleased to feature the following interview with MOI Global instructor Robert Leitz, managing director of iolite Partners, based in Switzerland. Robert is an instructor at Best Ideas 2018, the fully online conference featuring more than one hundred expert instructors from the MOI Global membership community.
Q: Active managers are increasingly being replaced by artificial intelligence. What is your view on this development?
A: To some extent, investing is a game of pattern recognition, probabilities and emotional discipline. Intelligent machines are good at digging through vast amounts of data, finding correlations, and sticking to predefined strategies. This undoubtedly makes them very skilled quantitative investors. Humans tend to get swayed by social, emotional, and cognitive biases. It has already become quite difficult to compete against machines with simple quantitative strategies that worked in the past such as fishing for net-nets, low P/E, or magic formula stocks.
However, machines are limited to the data they are being fed. Most algorithmic value strategies are essentially based on some kind of “reverse to the mean” thesis. The question is: what is the mean and what if the future will be different from the past? I have seen countless examples of where a machine identified patterns and correlations that turned out to be random or only held up until a certain trend broke. Similarly, stocks that look cheap based on statistical averages may not be cheap if an industry is getting disrupted by a new technology or a powerful market entry.
I look at a multitude of data points and at criteria that are difficult to quantify (e.g. quality of management, alignment of interests, background of key shareholders, potential to fix value leaks, changing market dynamics, etc.). It will take many more years for machines to capture humans’ ability for innovative thinking or cognitive breadth and depth.
On another note, about 80% of the market’s capital is now “trapped” in passive and/or reactionary vehicles such as ETFs, pension funds, closet-indexing mutual funds, and automated strategies. In my mind, this is a dangerous development. Aside from the inherent technical risk given various self-reinforcing dynamics, why would a company’s management care about shareholder rights if a company’s stock price is driven by passive capital and ownership rights are not being exercised?
Q: How do you source ideas and what does your portfolio look like?
A: I look at many companies and pick those that I deem most attractive. I search top-down and bottom-up but invest bottom-up only. My portfolio is highly concentrated and five stocks frequently make up 80% of the assets.
As most readers will know, value investing can be defined as buying a business for less than what it is worth, whereby the value of a business is defined by the value of all future cash distributions. With this in mind, I look to buy great businesses at fair prices, bad businesses at very low prices, or assets under liquidation value. I also look to invest in asymmetric situations where the upside is a multiple of the downside. My valuation work routinely focuses on these questions:
1. Do I sufficiently understand the business model?
2. What is the visibility into the company’s ability to generate cash flows going forward?
3. What is the liquidation value of the company’s assets?
4. Is management allocating capital efficiently and in the interest of minority investors?
If I find an opportunity with an attractive risk/reward profile, I will rank this opportunity with the positions in the portfolio and those that I see in the wider market before making an investment decision.
Q: Discuss your research process in more detail. What are the research methods you employ, given that you run your fund entirely on your own?
A: I spend a lot of time reading annual and quarterly reports, listening to earnings calls, and studying the target’s industry. I do use screeners, but they are just one tool out of many. KPIs can be incredibly misleading – just because a company is trading at a low P/E or EV/EBITDA ratio does not tell me if it is a great investment opportunity. I follow other investors that I admire, and I look at markets and industries that have recently seen a steep decline in valuations. I may discuss an industry or a specific target with fellow investors that I trust, but I am also careful to avoid social biases. Lastly, I tend to dynamically model my ideas to get a better grasp of the relevant levers.
Q: How essential is management interaction in your view?
A: It is very important to find businesses run by capable, honest and driven CEOs who are incentivized to act in the best interest of shareholders. However, in my experience, very few CEOs will give you any real insight unless you either have power over them or they know you well. I also believe that great entrepreneurs and leaders are not necessarily good investors. I categorize CEOs into three types: (1) business builders (Steve Jobs, Bill Gates), (2) capital allocators (Warren Buffett) and (3) those that rose through corporate ranks by positioning themselves smartly and with luck.
1. A business builder might be a good leader for a business with space to grow for the core product, but he may not be the best capital allocator of excess cash flows.
2. A good capital allocator can create enormous value to shareholders, but he may fail to provide enough direction and leadership in terms of business organization and corporate culture. Over time, this usually erodes the value of the acquired assets. It’s also crucial to distinguish between those capital allocators who just got lucky riding a certain trend and those who repeatedly created value over many transactions across the cycle.
3. Lastly, I would be very wary of CEOs that made it to the top through politics. They will continue to be driven by opportunistically growing and protecting their own power rather than looking after the shareholders’ best interests.
CEOs of large companies tend to have it easier than their fellows at smaller companies, as it takes longer for their mistakes to become visible. Look at Apple: Tim Cook has largely failed to add any meaningful value to the company since he became CEO; he is still mainly benefiting from the tremendous momentum that Steve Jobs built. Very few small companies are able to create momentum strong enough to camouflage years of stagnant product innovation as well as overly expensive and business-irrelevant acquisitions. That said, even big ships can sink very quickly – as is illustrated by the story of Enron.
Q: What has been your average holding period for investments?
A: Generally speaking, I believe an investment thesis should play out over a five-year period, but in individual cases, the timing of realizing value can swing widely and is ultimately due to chance. A few times, my investments were taken private or went through a value-creating event very shortly after I committed capital. At other times, I had to wait years for a thesis to play out. For example, I have a small position in a company with no debt but a mild cash burn, trading at 1/3 of its cash. Absolutely nothing has happened to either the company or its share price over the last three years.
I shift investments if (a) a company went through a market re-rating and is now exceeding my fair value estimate, (b) I had to re-assess an investment thesis or (c) I found an even more appealing investment.
Q: What are your investors like?
A: My website has a section titled “reasons not to invest with me” and it is mandatory reading for all potential investors. I want to have a patient capital base because I think this is the most important foundation for sustainable performance. I am growing the business a lot slower than I could if I would be willing to accept anybody, and I have turned people down that I believed were not the right fit for my philosophy.
Many fund managers have to buy what is currently in vogue to attract capital and to avoid outflows. This might work in the short run, but is unlikely to result in sustainable outperformance. For example, most retail investors in Fidelity’s Magellan Fund in the 1977-1990 period (while it was run by Peter Lynch) lost money by churning into and out of the fund – even though the fund generated an average annual return of 29% during this period! It’s tough to be patient, but true value investors find it incredibly rewarding, as most other market participants are either passive or short-term in nature.
Q: What led you to become a value investor?
A: Upon graduating from university, I was looking for a job that offered me exposure to a wide variety of companies and industries to develop my practical business skills. I became a restructuring consultant and quickly learned about what makes companies succeed and fail. Later, working at a bank’s proprietary trading desk and subsequently a private equity-backed hedge fund, I was exposed to a value-driven approach that immediately and intuitively made sense to me. I learned to assess the value of a security’s underlying asset as well as value across the capital structure. I would typically spend most of my days digging through the small print of bond prospectuses to assess risks and value-triggers leading to low-risk but high-return opportunities. In hindsight, I could not have asked for better training. Bond markets are more complex than equity markets, and I learned to not only find mispriced assets, but to find mispriced pieces within the capital structure as well.
With my own firm, I am building on this experience. My goal is to sustainably compound capital at the highest rate possible. Investing is an intellectually stimulating exercise, and there is a certain purity in building one’s own track record. I shall be a happy man if history will show that in analysing the world and coming to my own conclusions, I was right more often than I was wrong.
Q: How do you differentiate yourself from the thousands of fund managers following the same investing principles?
A: I manage my clients’ money alongside my own – which aligns my interests with those of my clients and frees me from institutional pressures faced by most fund managers. My capital base is stable and patient, allowing me to be contrarian and to swim against the tide. The small size of my fund gives me the liberty to fish in small ponds, where the big funds cannot go. I have observed that large funds have their own guidelines for investing in stocks, such as a threshold market capitalization and liquidity, among several other factors. As a result, large funds often miss out on attractive opportunities, such as smaller micro caps, where there are a lot of market inefficiencies. With growing assets, I will look to take full control of smaller businesses.
Q: Investing can sometimes be stressful. What do you do to relax?
A: I try to find balance by spending time with my family, meeting friends, enjoying the Swiss countryside, and doing work around the house. I also love road trips and a dream I have is to circumnavigate the world on an extended road trip. While investing can be stressful and emotionally straining, I am aware that I live a very privileged life compared to most other people in this world. Being an ambitious and intrinsically motivated person makes it difficult for me to rest, but I try to find inner peace by keeping perspective.
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