Thursday, January 25, 2018

Boyles Asset Management – Q4 2017 Letter Excerpt

Incentives and Reality

“For if a person shifts their caution to their own reasoned choices and the acts of those choices, they will at the same time gain the will to avoid, but if they shift their caution away from their own reasoned choices to things not under their control, seeking to avoid what is controlled by others, they will then be agitated, fearful, and unstable.” - Epictetus 

On a recent episode of “The Knowledge Project” podcast, former Federal Bureau of Investigation negotiator Chris Voss quoted a line used often by a boss he once had: “There’s no guarantee of success, but what we guarantee is the best chance of success.”  As he described it, that quote implies that there are things that are often outside of one’s control, and that the best one can do is to control, and be committed to, a given process.  And it’s a quote relevant to the business and investing world as well.

There is only so much we can control.  We can control our improvement—more accurately, our effort to improve our process by learning the correct lessons from our own successes and mistakes, as well as from those made by others.  We can control the types of businesses in which we invest, making sure we’re investing in areas we can understand, and in businesses with futures far brighter than the stories told by their stock prices.  A wide and growing “moat” protecting that brighter future from competitors would be nice, but competitive advantages are rare, under constant attack (especially in the internet age), and usually fully reflected in stock prices. 

We can control the work we put into understanding our investments, but as outside investors, we also have to remember that there are things we can’t know.  Changes may occur within a business, or a new competitor may emerge (possibly a large one with substantial resources), and the world is messy, ever-changing, and unpredictable enough to always throw up a few surprises.  In his 2017 year-end letter, Brent Beshore, CEO of the private investment firm, discussed a dinner he was lucky enough to have last year with Berkshire Hathaway CEO Warren Buffett.  A quote from Buffett stuck firmly with Beshore after the dinner: “Price is my due diligence.”  We need to know what we know when looking at a potential investment, and know what we don’t or can’t know, but we also need to remember that what we need to know can change depending on price.  We control the prices we pay for our part-ownership of businesses, and the discipline we show in leaving ourselves enough margin for error in those prices.

“I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it.” — Berkshire Hathaway Vice Chairman Charlie Munger 

We also control the decision to invest in the particular CEOs and management teams that are our partners while we own shares in a given business.  The people running the show are incredibly important, especially amongst the smaller companies of the world, which currently comprise all of the holdings in our portfolio.  Former New York Yankee great Yogi Berra said, “In theory, there is no difference between practice and theory.  In practice, there is.”  And in the competitive business world, things don’t always go according to plan.  Conditions change.  People change.  And sometimes customers don’t always think your new product is as great as you do.  So as an outside investor, it’s nice to have someone on your side who is incentivized to wake up every day and make the business they are running better and more valuable, and who will also make the tough decisions that need to be made when things don’t go according to plan.  As part-owners of a business, we want management teams to prosper when we prosper—and feel the pain when we feel the pain—because they are owners too.  It’s why we pay a lot of attention to management incentives and insider ownership, which is reflected in the fact that at year end, the average ownership stake by company insiders for investments in our portfolio was just more than 44%, and much of that ownership resides with the CEOs making the decisions—both the easy ones and the hard ones—at ground level.

As an example, at System1—the company responsible for much of the fund’s volatility throughout the year—founder and CEO John Kearon owns more than 26% of the company’s shares outstanding.  At the company’s peak share price in May 2017, this stake was worth more than £34 million.  At the year-end share price, this stake was worth about £12 million.  He felt the pain along with all of us other shareholders, though you may not know it by speaking with him.  He’s making the tough choices that need to be made, but he’s also laser-focused on where the company is heading during the next 5-10 years so that, if he accomplishes what he has set out to do, we will likely all have forgotten the short-term blips that occurred along the way.

While not an end-all-be-all, we firmly believe that incentives matter, in a big way.  People don’t always do what is good for them, and it’s not always easy to intelligently design an incentive system, but partnering with management teams that have significant skin in the game—both financial and reputational—is an important aspect of what we look for when trying to align our process and portfolio with the reality, and messiness, of the world.


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 any 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.