Tuesday, February 2, 2016

The Endgame Investor

Below are a couple of sections from the Boyles Q4 letter to investors. Most of it is based on an idea originally mentioned on the blog, which is expanded upon below. 
Disclosure: I am a portfolio manager at Boyles Asset Management, LLC ("Boyles") and the fund managed by Boyles may in the future buy or sell shares of the stocks mentioned below and we are under no obligation to update our activities. This is for information purposes only and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision.

The Endgame Investor

Josh Waitzkin, chess champion at many levels and inspiration for the movie Searching for Bobby Fischer, wrote an excellent book entitled The Art of Learning.  At one point in the book, he mentions that a key difference between how he was taught chess as a young boy and how most of his rivals were taught was his teacher’s focus on the endgame.  By breaking down the complexities of each chess piece during isolated endgame scenarios, he was able to understand the intricacies of the game in more depth, and use that understanding to form a more complete picture of the games he played.  Waitzkin describes the contrasting learning methods used by most of his rivals:

There is a vast body of theory that begins from the starting position of all chess games, and it is very tempting to teach children openings right off the bat, because built into this theoretical part of the game there are many imbedded traps, land mines that allow a player to win quickly and easily—in effect, to win without having to struggle to win.  At first thought, it seems logical for a novice to study positions that he or she will see all the time at the outset of games.  Why not begin from the beginning, especially if it leads to instant success?  The answer is quicksand.  Once you start with openings, there is no way out. Lifetimes can be spent memorizing and keeping up with the evolving Encyclopedia of Chess Openings (ECO).  They are an addiction, with perilous psychological effects.

There’s an analogy to be made between investing and the process of learning chess.  The opening variations in chess are like having a focus on short-term results or on cheapness based solely on backward-looking statistical metrics.  But the endgame is comparable to focusing on long-term results and the qualitative aspects of a company.  It is also about the time one spends studying the great businesses (both current and historical) and how they became that way.  And it’s important because as Waitzkin says, “Once you start with openings, there is no way out.”  While we wouldn’t say “no way out” when it comes to one’s investing process, once you develop certain habits and a certain definition of what you think is worth spending time on, it can be hard to reverse course, so the time spent developing and implementing sound theory and core principles is vital.

Thinking about an investment’s downside before considering its upside may be another aspect of the investing process comparable to studying the endgame in chess.  It’s easy to fall into the trap of thinking about how much one can make before thinking about how much one can lose.  Thinking about that upside scenario can paint a picture in one’s mind about exactly how the future will play out, and that often leads one down the road of being overconfident and misjudging that outcome’s probability.  It can make one forget how uncertain the future is and how often the markets will surprise you.  And it can prevent a person from spending enough time thinking about one of investing’s most important questions: What if I’m wrong?

What are some of the qualities of a good “endgame investor?”  The keys are not to think only about the prices and multiples at which one is buying and the prices and multiples at which one thinks is a reasonable level to sell, but to also think about how the “game” will develop before you sell.  It’s looking at the qualitative aspects of a business that are hugely important but often don’t show up in reported numbers, such as a company’s culture or management’s integrity.  And it’s also about looking for businesses that are thinking about the endgame themselves by foregoing short-term profits in order to strengthen their competitive advantages and increase total profit over the long term.  As Charlie Munger has said, “Almost all good businesses engage in ‘pain today, gain tomorrow’ activities.”  Finding management teams that understand and can execute on this idea can be hugely rewarding.  While we’ve yet to ever own the stock, one great example of this kind of management thinking and execution is Jeff Bezos at Amazon.com.  And Bezos put it best when he said, “If we have a good quarter it’s because of the work we did three, four, and five years ago. It’s not because we did a good job this quarter.”

When it comes to looking at one’s downside, a good endgame investor needs to not just focus on current earnings or stated asset values, but needs to think deeply about how those will evolve over time, and consider worst-case scenarios, especially for asset values that are dependent on outside forces (such as commodity price changes or credit market accessibility).  The good endgame investor will be what Howard Marks refers to as a “second-level thinker.”  As described by Marks in his book The Most Important Thing:

Second-level thinking is deep, complex and convoluted. The second-level thinker takes a great many things into account:

§ What is the range of likely future outcomes?
§ Which outcome do I think will occur?
§ What’s the probability I’m right?
§ What does the consensus think?
§ How does my expectation differ from the consensus?
§ How does the current price for the asset comport with the consensus view of the future, and with mine?
§ Is the consensus psychology that’s incorporated in the price too bullish or bearish?
§ What will happen to the asset’s price if the consensus turns out to be right, and what if I’m right?

While the process of learning to be a good second-level thinker will always be ongoing, and we don’t claim to have anywhere near the ability of someone like Howard Marks, asking the types of questions above did help us make Cambria a decent-sized position just over a year ago.  As we mentioned above, it was our best performer in 2015. One of the key things that drew us to it was that after doing our work and having conversations with management, we came to the conclusion that the earning power of the business was demonstrably above the consensus estimate.  And we also came to the conclusion that the earnings-multiple discount that the market was giving Cambria was unjustifiably low compared to its peers, due to what we believed were better-than-average growth prospects and a management team with exceptional capital allocation skills.

Cambria is also a good example of a management team that, when the price didn’t reflect what they thought the stock was worth, just kept on performing and waited for Mr. Market to eventually take some notice. This reminds us of a comment made by actor and comedian Steve Martin on the Charlie Rose show in 2007.  When asked what he tells people who ask him for advice, Martin responds, “Be so good they can’t ignore you.”  Many management teams focus too much on their stock prices and not enough on their businesses. But if the businesses perform, the stock prices will eventually follow.

A Brief Comment on Oil

Given the volatility of oil prices in 2015, which continued and accelerated at the start of 2016, we thought we’d make a brief comment on the oil space.  A friend of ours (Thanks, Phil) pointed us to a Bloomberg survey of 36 oil analysts that was done around October 1, 2014. Oil had traded just above $100 a barrel in the summer of 2014 and had fallen to around $85 (WTI) and $90 (Brent) per barrel at the time of the survey.  The analysts made estimates of the average price per barrel from the fourth quarter of 2014 through the first quarter of 2016.  In the two quarters following the survey, the actual price of oil was almost half of what even the most pessimistic analyst predicted it would be during that time. And those “Titans of Oil” also predicted an average price close to about $100 a barrel during the first quarter of 2016, with the most pessimistic analyst still predicting a price above $95 a barrel.  That’s a far cry from the $25-35 range it is trading at as we type these lines.

We bring this up not to point out any flaws in those predictions.  The mistake for anyone not required to make these kinds of predictions lies in trying to make them at all.  As Yogi Berra said, “It’s tough to make predictions, especially about the future.”  It is nearly impossible to predict the prices of things such as stocks or commodities over any short period of time.  But that doesn’t mean that companies tied to a commodity price can’t be worthwhile investments.  The key, for us at least, is to explore these areas for potential investments where the downside doesn’t rely on a certain commodity price.  The upside may depend on the price of a given commodity, but if we are confident about the downside protection and we think that any downside risk is more than offset by potential return even if prices remain depressed, then we may get interested.  This often leads us to look at niche service providers with good balance sheets, and while we’ve yet to commit any capital to companies in this space, the recent and significant downturn has us exploring several potential opportunities.