This article by Matthew Sweeney is excerpted from a letter of Laughing Water Capital.
“Gamblers bet on possibilities. Pros bet on probabilities.”
–Bob Dancer, Professional Gambler
Our investment process entails identifying companies that pass a four-part framework before we ever consider the fifth piece, which is price. The four questions I seek to answer are:
1) Is it a good business? (what will it look like in 5-10 years)
2) Who are we partnering with? (is management capable and properly incentivized)
3) Why does the opportunity exist? (are sellers irrational or shortsighted)
4) What happens when something goes wrong? (because it will eventually)
Each of these questions is deliberately open-ended, and meant to encourage careful analysis and deep thought, not quick answers. When followed properly, this process should lead us to better than average companies, with better than average management teams, that we buy at better than average prices, that will do better than average when the economy hits a rough patch. While nothing is guaranteed, if we can simply stick to this process, the result should be a portfolio that has a high probability of performing better than the averages (ie the SP500 or R2000) over time.
However, while it sounds simple, when spending a week off the grid I had little else to do other than run our businesses through this framework, and I came to realize that one of them fell short.
Points International (PCOM)
In the 1H ’17 letter PCOM was introduced as a mid-sized addition to our portfolio. This was a mistake, and we sold our shares well below my multi-year price target. Thankfully, the combination of a large margin of safety from our initial purchase price, our short holding period, and an aggressive move in the stock led to us realizing an IRR of almost 90%. This is not cause for celebration. Rather, this should be viewed as a pyrrhic victory, and not only because it comes with painful short-term capital gains.
In the case of PCOM, I came to realize that our investment was based on a short-sighted answer to question 1 (putting too much weight on the possibility that the company would be sold), and an insufficient answer to question 2 (management does not own much stock, and after repeated questions on this topic, the CFO and President both responded by buying a measly 1,000 shares). Our portfolio is concentrated; we only need a few good ideas a year to perform well. There is no reason to own stock in a business that fails to impress at 2 points during our process.
Analytical mistakes are a simple fact of life in the investment business. Even the world’s very best investors have batting averages in the mid .600s, and we are guaranteed to have investments that simply don’t work out the way we thought they would (such as DNOW). However, PCOM was less an analytical mistake, and more a mistake in process. Mistakes in process are much more worrisome and much less forgivable than analytical mistakes because over an investment lifetime, a repeatable process well-followed is much more important than any individual investment. Thus, our successful outcome in PCOM should be viewed no more favorably than a drunken bachelorette who screams “Black Jack!!!” upon being dealt a 3 after hitting on 18. Winning one gamble doesn’t make you successful. Diligently following the process in order to put the probability of success on our side is our only chance for long term success.
Disclaimer: This document, which is being provided on a confidential basis, shall not constitute an offer to sell or the solicitation of any offer to buy which may only be made at the time a qualified offeree receives a confidential private offering memorandum (“CPOM”) / confidential explanatory memorandum (“CEM”), which contains important information (including investment objective, policies, risk factors, fees, tax implications and relevant qualifications), and only in those jurisdictions where permitted by law. In the case of any inconsistency between the descriptions or terms in this document and the CPOM/CEM, the CPOM/CEM shall control. These securities shall not be offered or sold in any jurisdiction in which such offer, solicitation or sale would be unlawful until the requirements of the laws of such jurisdiction have been satisfied. This document is not intended for public use or distribution. While all the information prepared in this document is believed to be accurate, Laughing Water Capital, LP and LW Capital Management, LLC make no express warranty as to the completeness or accuracy, nor can they accept responsibility for errors appearing in the document. An investment in the fund/partnership is speculative and involves a high degree of risk. Opportunities for withdrawal/redemption and transferability of interests are restricted, so investors may not have access to capital when it is needed. There is no secondary market for the interests and none is expected to develop. The portfolio is under the sole trading authority of the general partner/investment manager. A portion of the trades executed may take place on non-U.S. exchanges. Leverage may be employed in the portfolio, which can make investment performance volatile. The portfolio is concentrated, which leads to increased volatility. An investor should not make an investment, unless it is prepared to lose all or a substantial portion of its investment. The fees and expenses charged in connection with this investment may be higher than the fees and expenses of other investment alternatives and may offset profits. There is no guarantee that the investment objective will be achieved. Moreover, the past performance of the investment team should not be construed as an indicator of future performance. Any projections, market outlooks or estimates in this document are forward-looking statements and are based upon certain assumptions. Other events which were not taken into account may occur and may significantly affect the returns or performance of the fund/partnership. Any projections, outlooks or assumptions should not be construed to be indicative of the actual events which will occur. The enclosed material is confidential and not to be reproduced or redistributed in whole or in part without the prior written consent of LW Capital Management, LLC. The information in this material is only current as of the date indicated, and may be superseded by subsequent market events or for other reasons. Statements concerning financial market trends are based on current market conditions, which will fluctuate. Any statements of opinion constitute only current opinions of Laughing Water Capital LP, which are subject to change and which Laughing Water Capital LP does not undertake to update. Due to, among other things, the volatile nature of the markets, an investment in the fund/partnership may only be suitable for certain investors. Parties should independently investigate any investment strategy or manager, and should consult with qualified investment, legal and tax professionals before making any investment. The fund/partnership is not registered under the investment company act of 1940, as amended, in reliance on an exemption there under. Interests in the fund/partnership have not been registered under the securities act of 1933, as amended, or the securities laws of any state and are being offered and sold in reliance on exemptions from the registration requirements of said act and laws. The S&P 500 and Russell 2000 are indices of US equities. They are included for informational purposes only and may not be representative of the type of investments made by the fund.