Wednesday, October 25, 2017

Figuring out why you’re right and the market is wrong...

I've been slowly reading through the book Pitch the Perfect Investment by Paul Sonkin and Paul Johnson, and have been enjoying it. The authors discussed the book in the latest issue of Graham & Doddsville and I wanted to highlight this exchange, and then briefly comment on some related thoughts:
G&D: What are the big mistakes that young people make when they pitch stocks? 
PJ: A couple of things. Number one is overconfidence, which is a little tricky because you need to be confident in this business. 
PS: We have heard countless students say, “I know the value of the company. In fact, I know the company better than the analysts following it because I’ve worked on it nonstop for an entire two weeks!” We were both judges at a stock pitch competition earlier this year. We were sitting next to each other during the presentations and whispering back and forth about how awful the pitches were. We were shocked at how bad they were. 
The biggest mistake we see is that students spend 90% of their time figuring out what they believe is the intrinsic value of the company. Maybe 95% of the time. And they say, “Okay, I think the stock is worth $50, it’s trading at $42, therefore it's a buy.” They spend 95% of their time explaining why it’s worth $50, but don’t address why it’s trading at $42. They do not explain what the market is missing. They don’t explain why the mispricing exists. 
PJ: One of the key messages in our book is that if you inverted the time allocation and spend 90% of your time explaining what the market is missing and why the stock is mispriced, rather than 90% of your time trying to justify your valuation, we believe that the portfolio manager will listen intently and, might, in fact, clear his desk to eagerly research your stock. If you start your pitch by saying, “The stock’s trading at $42 because investors believe X, Y, and Z are true. I’ve done a bunch a work to know why X, Y, and Z are not true and here is why consensus expectations are wrong,” the portfolio manager is going to give you his full attention. You then need to walk through why X, Y and Z are not true. If you take that approach, the portfolio manager is going to get highly interested in your recommendation and they’re going to say to themselves, “If he’s right, this stock's going to $50.” Now the focus is figuring out why you’re right and why the market is wrong. 
And related to the above, the authors also write in the book:
If the idea offers sufficient return given the level of risk, there is a third factor that needs to be addressed, which reflects the portfolio manager's unease that the opportunity looks too good to be true. The question the manager asks himself at this point is, “Why me, O Lord?” and the analyst will need to convince him that a genuine mispricing exists to answer this question successfully. 
Once this concern is put to rest, the portfolio manager most likely will raise one final issue—“How and when will the next guy figure it out?”—knowing that he will  only make money if other investors eventually recognize and correct the mispricing.
I wanted to bring this up, firstly, because I think it's important and doesn't enough attention. Most of the ideas and pitches I see are based on a near-term story (every company has one) to grow earnings over the next couple of years and a multiple expansion being assumed to justify undervaluation. That's fine as far as a quick summary of something's potential goes, but it's not the thing that can consistently provide an edge without being able to answer the “Why me, O Lord?” question. 

And, secondly, I wanted to bring it up because blog readers occasionally send me ideas and write-ups, which I appreciate, though most of the time I filter things out pretty quickly. In a recent talk, I believe Mohnish Pabrai said something similar, where I think his filter was the intrinsic value estimate needs to be at least 5x the current price for the ideas sent to him, or else he filters it out. While I'm not quite that "unreasonable," discussing what I look for and giving a few examples of the types of valuations I like to accompany mispricing explanations may be helpful and, selfishly, lead to a few interesting ideas being sent my way

In his days running an investment partnership, Warren Buffett categorized investments as: Generals, Work-Outs, and Control situations. As another example, Chris Begg at East Coast Asset Management has categorized his firm's investments as: Compounders, Transformations, and Workouts. Drawing inspiration from them and others, I came up with a completely unoriginal (since I've seen other people use the same names) way to categorize the things I look at and look for: Category 1, Category 2, Category 3, and Category 4. I first mentioned these categories back in 2013 (with an important intro in 2014 to the topic), and while I've added quite a bit of nuance to them since then, the general overview as I described them back then were:
1) Competitively-advantaged, great business at an attractive absolute and relative free cash flow yield. [i.e. similar to Begg's "Compounders"]
2) Good business close to or below tangible book value (after adjustments) 
3) Below liquidation without giving much (or any) weight to fixed assets, especially if they are tied to commodities 
4) Good business, seemingly good price, run by people that seem to understand capital allocation, but where the sustainability of a competitive advantage is hard to determine [or it's still in the process of being built] and there is no downside protection in the asset values
I've updated things a bit since then, with a couple of notable changes being that I want to understand the capital cycle when investing in Category 3 investments, which I also want to be good businesses during the right part of the cycle, and mostly requiring that Category 4 investments be run by owner-operators that I think could potentially fit the intelligent fanatic mold. And before even considering what category an idea may fit in, I need somewhere from a good to great to perfect balance sheet as an initial filter, as well as a business that I can understand.

The key with categorizing things the way I have is that I want to focus on downside first, which for me is coming in either the form of a moat (Category 1) that protects earnings and returns on capital, asset values (Categories 2 and 3) or a lesser (or less predictable) moat protecting a reasonable level of earnings, even if it's lower than current earnings, but where there are also reinvestment prospects and a great owner-operator running the business with plenty of skin in the game (Category 4). And management, especially in smaller companies, is extremely important in all categories, not just the fourth category.

Here are a few quick examples of things I've been a part of investing in post 2008 GFC, at either my previous firm or at Boyles, that I think fit the mold by category:
  • Category 1: Berkshire Hathaway in Q2 2012 at just under 1.2x book value and less than an average market multiple of after-tax earnings, and at a time when Mr. Buffett had openly stated he thought the company was worth much more than the 1.1x book value (later changed to 1.2x) at which Berkshire could start buying back stock. While I normally look at smaller companies both at my previous firm and now, our familiarity with Berkshire and its valuation drove us to buy some shares for the small separate accounts we managed at the time; though probably not enough, as that was a fat pitch down the center of the plate, and a big position size was likely warranted.
  • Category 2: Also at the firm I was previously at, we purchased Record plc in Q1 2012, at just about 1x tangible book value (which was mostly cash, though not all excess cash due to regulatory requirements), and about 5-10x our estimate of earnings (a wide range of estimates was necessary) as many European names were selling off. While there were scenarios where maybe the company could start losing money, they were still decently profitable, had a bunch of cash with no debt, and an owner-operator involved in the business. Charlemagne Capital Limited was another U.K.-traded asset manager with a similar story in 2012. 
  • Category 3: Mastermyne (Australia) bought at various points between 2014 and 2016. We're writing about this at Boyles in our current investor letter, so I'll try and post an excerpt when we're finished, but we bought shares at a big discount to book value, which then became an even bigger discount. But eventually capital cycle dynamics kicked in and things improved in both the business and the share price. Our investment in Thrace Plastics in Greece during Q1 2016 probably fits into this category as well, and it also had what seemed like a clear reason for being mispriced in the market. 
  • Category 4: In early 2016, we purchased shares in both BrainJuicer (renamed System1 Group) as well as Tucows (a small position that we, once again, wish would have been much larger). The market as a whole had gotten volatile, and we believed we paid decent multiples for the more predictable parts of their businesses and that we were partnering with exceptional owner-operators. For more on the former investment, see this excerpt from our investor letter at the time. 
So maybe the above is helpful for a few readers in thinking about your own way to categorize things, and maybe it'll help future readers who wish to pass along ideas....though to be clear, like Mohnish, I also don't mind you passing along the 5+ bagger ideas! I'd just prefer a decent case for downside protection and a reason for the mispricing to be there as well.


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 above 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.