Antifragile investments

Given the volatility of the market lately, I've been thinking a lot about Nassim Taleb's book Antifragile. One of the major ways it impacted me is that it helped me think about the types of businesses I'd want to own when market valuations are high but some stocks start to look cheap. 

As Chris Cole of Artemis Capital Management has been talking about over the last few years, a large part of the market, value investing included, is implicitly a big short volatility trade. As Cole said in a 2017 interview with Real Vision:

There's nothing wrong with shorting vol if it's done intelligently.... I think the problem is that people don't always understand the risks that they're taking on. 

...I think the problem, at the end of the day, is we're all short volatility. Every institution in the world is. The question is: are you short convexity, or are you massively short convexity? And do you understand that you are because, you know, we have a finite amount of life. At the end of the day...if you have a portfolio of value stocks, in some ways you're implicitly shorting correlation and betting on mean reversion. 

That's a form of short vol. But the margin of safety can be attractive at the right points in time. The question is: do people really understand the risk they're taking on? I think when institutions are entering into a lot of these different strategies, and today this is just indexation to a certain extent, I don't think they...really have a pure conceptualization of all the risks that are going on. 

Now, value investing, if done correctly, is the intelligent way to implicitly be short volatility, but Taleb's book also made me think more about the types of businesses that can turn whatever volatility may come into existence into opportunity. Or in other words, what types of businesses actually create value in tough environments? So as an investor, as long as you have the endurance to hold through whatever Mr. Market may have in store on the downside, you can actually come out on the other side in better position because of the work you did buying right beforehand. Examples from the 2008-2010 time frame would be things like Berkshire Hathaway on the large cap side of things, and Cambria Automobiles on the micro cap side of things.

I'm thinking more about this lately because while markets have come down a bit, they are still at lofty valuations. But I'm seeing more interesting things to look at that seem like they could be very cheap than I have in a long time, which is a bit ironic given that I just exited from the investment business and am not currently managing outside capital. 

At any rate, while I was still at Boyles, we wrote the excerpt below in a 2014 investor letter after finishing Taleb's book, and I think it still reads fairly well, so I included it here for those that are interested. 

**********

Estimating intrinsic value based on cash flows, private market values, and liquidation values is something that should be familiar to those that follow a value philosophy; as is considering one’s downside in a worst-case scenario.  And because these are estimates—and small changes in certain variables can have large impacts on expected values—it’s important to be conservative in those estimates.  Or to use a phrase from Seth Klarman, it’s important to make those estimates “by compounding multiple conservative assumptions.”

Things start to get tricky when it comes to estimating probabilities, which one can’t really do with any degree of accuracy.  It is too hard and too close to guesswork, especially when we consider that, according to Sir John Templeton, “No security analyst is ever going to be right more than two-thirds of the time.”

So if we can’t accurately estimate our probability of winning and losing, what can we do?  What we believe an investor can do is determine whether or not the odds are likely to be in one’s favor.  There are certain things that can increase one’s chance of not losing money on an investment, and certain things that increase the chance of losing should something unexpected or disruptive occur.

In Nassim Taleb’s book, Antifragile, he separates things into three categories:

1) Fragile
2) Robust
3) Antifragile

The fragile is harmed by certain shocks, randomness, and stressors.  The robust is neither harmed nor helped by them.  And the antifragile grows and improves from them.  As Taleb says, “...the idea is to focus on fragility rather than predicting and calculating future probabilities…” 

So while we can’t accurately predict probabilities, what we can do is think about and identify traits that will increase our chances of winning and decrease our chances of losing under a range of scenarios.  And by trying to avoid fragile traits and invest in situations that are more robust or, preferably, antifragile, we decrease our chances of making mistakes due to estimation error.  Below are some examples of these traits among businesses and investments:

“...the fragile wants tranquility, the antifragile grows from disorder,

and the robust doesn’t care too much.” –Nassim Taleb

When the positive traits overwhelm the negative traits, we can be fairly confident that the odds are in our favor. But figuring out which traits are really present and which are illusory takes a lot of work; as does coming up with a proper and conservative estimate of intrinsic value and a worst-case scenario.  The math behind the Kelly Criterion gives a good framework for thinking about the questions: (1) Is my probability of winning greater than my probability of losing?; and (2) Is my upside greater than my downside?  But there is a lot of work that needs to be done in order to answer those questions with decent accuracy.

“It’s not supposed to be easy. Anyone who finds it easy is stupid.” –Charlie Munger

Using the Kelly framework to explain our current outlook on the investment climate, we can say that we see plenty of things with attractive upside ($W), but the main issue is that we also think there is plenty of downside ($L) in those investments.  To optimize one’s capital over time, one should consider more than just the upside if things go right.  One must be in the game long enough for the odds to work out favorably over time.  The main reason we have so much cash today is that we see a lot of downside coupled amongst the upside.

We look for situations where, if we ran through the Kelly Criterion using conservative assumptions, it would tell us to take large position sizes.  Our actual position sizes will, in practice, be much smaller than Kelly, as we manage risk and account for the uncertainties and errors that come with investing.  But the idea behind taking big positions in one’s best ideas—especially when one’s downside is well protected—is one in which we firmly believe. 

In the Ed Thorp article mentioned earlier, he also wrote that “Computing [F] without the context of the available alternative investments is one of the most common oversights I’ve seen in the use of the Kelly Criterion. Because it generally overestimates [F] it is a dangerous error.”  And as we contemplate our alternatives to cash, we think not just about the current opportunity set, but also about opportunities that may possibly develop over the next several months.  We’ve been and are still close to buying several things; and we continue to build our list of prospects.  While we can’t know when Mr. Market will give us the opportunity to put our cash to work, we are ready to move in quickly when we think the odds and payouts are overwhelmingly in our favor.

An Update and The Future of this Blog

Thank you all so much for your interest in Value Investing World. As a couple of astute readers of this blog have guessed, my day job is about to change. The fund I co-manage at Boyles is being closed, as more than one of you have figured out through the ownership filings we’ve been required to make as we’ve sold some of the micro-cap stocks we held in our portfolio.

I’m still in the process of figuring out exactly what I’ll be doing next, but my hope is to keep the blog going in the same fashion and format. Depending on what I end up doing for work, maybe the blog will contain more notes on companies and ideas, and possibly fewer posts overall; but I think the most likely outcome will be to have no change whatsoever. And if you have any thoughts or suggestions, feel free to email me at ValueInvestingWorld@gmail.com. Note: During the next couple of weeks, my internet access will be limited. I have scheduled some quotes and other items in advance, but the links compilation posts will be few and far between during that time, and I will be especially slow responding to emails.

As regular readers will know, I’m a big fan of the philosophy of stoicism and the importance it places on focusing on the things one can control—and being fairly indifferent to the things outside of one’s control. I’m also a believer in Charlie Munger’s advice that “the best way to get what you want is to deserve what you want.” So I’ve tried to focus my process and education on 1) becoming a better investor; and 2) being a more multi-disciplinary thinker. Both of those are attainable through my own efforts. This blog and many of you whom I’ve met through the blog (either in person or digitally) have helped me progress in those areas. Thank you, again!

While I don’t know exactly how the next few months will unfold, I’ll end this post with the words from Marcus Aurelius that have been a guide not only for me, but also for many others throughout history: “The impediment to action advances action. What stands in the way becomes the way.”

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 adventur.es, 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.

Boyles Asset Management – Q3 2017 Letter Excerpt

Classifying, Cataloguing, Collecting…and the Capital Cycle

“The stamp collecting is important.  ‘Even Darwin’s Journal was just a scientific travelogue, a pageant of colourful creatures and places, propounding no evolutionary theory,’ wrote David Quammen.  ‘The theory would come later.’ Before that came a lot of hard graft. Classifying. Cataloguing. Collecting.” 

- Ed Yong, “I Contain Multitudes: The Microbes Within Us and a Grander View of Life”

Warren Buffett has compared the investing process to investigative journalism, and it is that process of learning, collecting facts (and opinions), and trying to tie a story together into a theory about a business and its valuation that makes the effort an enjoyable one for us.  The investing business is one in which the knowledge that a person learns on a given day may never be put to practical use; but it’s also one in which the lessons a person learns have the potential to be put to use continually throughout one’s career.  Done correctly, the learning process is one of continuously classifying, cataloguing, and collecting information in a way that allows one to eventually connect the dots that lead to useful insights. 

One of the things about which we continue to study and collect information is how the capital cycle has worked in various industries over time.  The best treatments of the capital cycle that we’ve come across (though we’re open to other recommendations) are the letters of London-based investment firm Marathon Asset Management.  There are two books containing the selection of letters we’ve read: 1) Capital Account, which covers the period leading up to and following the Technology, Media, and Telecom boom and bust of the late 1990s and early 2000s; and 2) Capital Returns, which covers the boom and bust leading up to and through the Great Financial Crisis that hit its apex in 2008.  Ed Chancellor, editor of the collections of letters, provides a good summary to Marathon’s work:

“The key to the ‘capital cycle’ approach – the term Marathon uses to describe its investment analysis – is to understand how changes in the amount of capital employed within an industry are likely to impact upon future returns. Or put another way, capital cycle analysis looks at how the competitive position of a company is affected by changes in the industry’s supply side.”

So the key to capital cycle analysis is to focus heavily on the supply side within an industry, as opposed to the drivers of demand that normally get most of the attention.  This dynamic is especially important in capital-intensive industries; and among companies that can be good businesses in the right part of a cycle, but that don’t have the wide-moat characteristics that are most desirable—and rare to find, especially at an attractive price. 

While we enjoy the cataloguing and collecting of historical examples of things such as the capital cycle to help us navigate the future, the lessons that one experiences first-hand usually stick the best.  And during the quarter, we exited our investment in Mastermyne Group Limited, which we have both followed and owned during the bottom portion of the current mining cycle.  As we’ve followed it over the years, and had conversations with management—from the tough times on through the tougher “darkest before dawn” times—we’ve gained a vivid example of how the capital cycle can unfold in the real world. 

We bought shares of Mastermyne at various points from the middle of 2014 through December 2016, and sold the last of our shares in September.  The average cost on our Mastermyne holding was approximately A$0.24 per share, and our average selling price was approximately A$0.53 per share, with dividends received pushing our average exit price up close to A$0.55 per share.  Our initial interest in the company was driven largely by a valuation that had the company trading at a discount to book value, a business that was still profitable, high insider ownership, and the mining services industry (especially underground coal mining, in Mastermyne’s case) becoming unloved.  Companies throughout the industry were trading at close to 52-week lows, with many down 50-75% from the highest share prices they had reached during the boom that had peaked a couple of years earlier.  As an illustration of how boom can turn into bust, the market cap of Mastermyne at its low point during 2016 was below its net income achieved in each year from 2011 through 2013. 

As is often the case with value investors, we likely bought too soon, and sold too soon.  The lack of interest from the investment community was evident last year as the stock price was trading in the range of A$0.11-A$0.23 per share from January 2016 through the end of September 2016, and the volume of shares traded was quite low.  But just more than a year later, as there was some improvement and a little light at the end of the tunnel, the company was able to increase its share count by about 11% by issuing 10 million new shares of stock at A$0.60 per share in a placement that “was heavily oversubscribed.”

Some new work, a better business pipeline, and some renewed interest in coal from China this year on the demand side helped lead to the improvement in the business.  But the catalyst for the dramatic change in sentiment and stock price for Mastermyne has its roots in the capital cycle.  While the company has a number of competitors in different areas of its business, it had four main competitors in underground coal mining services, which comprise its core.  One of those competitors left the industry a couple of years ago early in the cycle due to problematic contracts; another started to shift away from underground work as conditions became difficult; and yet another is fairly small and has become less active in the tendering process for new work.  But the last of the four competitors served as the key catalyst to Mastermyne’s improving fortunes, as that competitor, after a period of struggling, went into administration (Australia’s equivalent of bankruptcy) earlier this year.  Besides the decrease in competition, Mastermyne was also able to take over the work that this bankrupt company had been performing for its key remaining project. 

The word “compounders” is the term often used to describe the types of businesses we prefer to own: high-return-on-capital businesses with reinvestment prospects and competitive advantages that protect those high returns on capital.  But, we firmly believe that almost everything can be a good value at one price and a bad value at another, and that the best opportunities often come by looking at things that are unwanted and unloved by most.  So, we’re willing to venture into other areas and “non-compounder” types of businesses, especially when attractive prices are combined with well-incentivized management teams and conservative balance sheets to create situations in which significant upside might be available with little or no ultimate downside.  We believe this mental flexibility can be an important advantage to us as investors.  We hope that our experience with Mastermyne and observations about how the management team was able to navigate the extreme lows that followed an extreme boom will help us going forward.  And while it would be nice to see the cycle starting to turn before investing in similar types of businesses, the market often re-prices things before one has a chance to see the turn.  Or as Warren Buffett wrote in October 2008, about five months before the U.S. stock market hit its low, “...if you wait for the robins, spring will be over.”

**********

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.

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.

Boyles Asset Management – Q2 2017 Letter Excerpt

Cockroaches, Margins of Safety, and Knowing Thyself

“In general, survival is the only road to riches. Let me say that again: Survival is the only road to riches.” --Financial historian, economist, and educator Peter L. Bernstein (2004 interview with Jason Zweig)

As he did in his 2007 book, A Demon of Our Own Design, Richard Bookstaber returns to the story of the cockroach with his 2017 book, The End of Theory.  The cockroach has survived and thrived for about 300 million years, thanks in large part to a simple survival mechanism.  As described by Bookstaber: 

...the cockroach simply scurries away when little hairs on its legs vibrate from puffs of air, puffs that might signal an approaching predator, like you.  That is all it does.  It doesn’t hear, it doesn’t see, it doesn’t smell.  It ignores a wide set of information about the environment that you would think an optimal system would take into account.  The cockroach would never win the “best designed bug” award in any particular environment, but it does “good enough” and makes it to the finish line in all of them.

This brings to mind the saying that in order to finish first, one must first finish.  But the broader point being made is that it is often simple, coarse rules that lead to survival advantages.  While these rules, or heuristics, may not be the optimal traits for an organism to reach its maximum potential for thriving in an environment, given a specific set of conditions, it allows the flexibility needed to stick around to see the finish line should the conditions change.  The observation credited to Charles Darwin about a surviving species being not the strongest nor the most intelligent, but the one most responsive to change is applicable here.  Uncertainty and change are inherent in nature, as they are in business and life in general, and it is often simple heuristics and ideas that, if pursued with discipline and consistency, can allow one to survive whatever the future may have in store. 

What are some of the candidates for an investing rule that rivals the survival rule of the cockroach?  It is probably a question that one could ask 10 different investors and get 10 different answers, but for those who follow a fundamental, value philosophy, the concept of margin of safety has to be one of the key contenders for a place at the top of any list.  Even the best investors over long periods of time make plenty of mistakes along the way, and so we as investors must accept that things won’t always turn out the way we expect them to, no matter how much effort we put into trying to understand something.  Building in some margin for error in our process can help us reach the long-term survival necessary for success. 

Another candidate for a key rule of survival comes from a more ancient piece of advice: know thyself.  At a recent Talk at Google, investor Mohnish Pabrai told a story about a dinner he attended with Charlie Munger.  At the dinner, Munger talked about the investment firm Capital Group, and an experiment it performed with its investment team. Capital Group assigned teams to manage different portions of its capital under management.  On several occasions, the firm set up a “best ideas fund,” in which it took the highest-conviction stock picks from each of its managers.  But each time it set up one of those funds, that fund underperformed and ultimately failed. After telling this story to his dinner guests, Munger asked the group if they could guess the underlying reason why those funds did not do well.  But dinner was then served, and the riddle was left unsolved. 

Years later, Pabrai remembered the story; when he was with Munger on another occasion, he asked about the Capital Group story.  It turned out that the reason the best ideas funds failed is because of the common feature among each manager’s pick: it was the idea that he or she had spent the most time studying. 

In a 2007 speech at the USC Gould School of Law, Munger warned against the dangers of drifting into intense ideologies, and made the point that as “you start shouting out the orthodox ideology, what you’re doing is pounding it in, pounding it in, pounding it in.”  And there’s a similar effect when it comes to investment research.  When there’s a decent story for a company to tell about its prospects, the more time one spends with it, the more likely one is to believe in its merits. 

The solution to this psychological tendency is not to spend less time on ideas.  We feel that one of the long-term advantages that we can have in the investment world is knowing more about the companies in which we are invested than almost anyone else.  Rather, the mechanism to fight this bias is to try to suspend judgment and opinion about a company’s investment merits until one can thoroughly state the cases both for and against that company’s prospects.  We need to be aware of our own psychology, and how it is affected by the ways in which we spend our time.  And if we ever catch ourselves spending too much time preaching about the ideas we’ve spent the most time on, or not spending enough time trying to understand the case against our best ideas, then—like the puffs of air hitting the hair on a cockroach’s legs—we need to recognize that there may be something amiss.

**********

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.

Boyles Asset Management – Q1 2017 Letter Excerpt

Delayed Gratification

“You’re looking for people who will delay gratification; who will focus on building a moat; who will focus on building a franchise; who will focus on the longevity of the business.” -Sanjay Bakshi, Adjunct Professor of Finance, Management Development Institute, India

In a recent podcast interview, when discussing the importance of investing in businesses and management teams that are willing to forgo near-term earnings in order to increase long-term value, Professor Sanjay Bakshi mentioned the compound interest formula as being a useful tool to help one think about building that kind of long-term value.  

That formula is:

where

a = the total amount after n years

p = the principal investment amount

r = the annual interest rate (or annual return)

n = the number of years the rate is earned

All too often, companies and their shareholders focus too much on the r variable in the equation.  They want instant gratification with high profit margins and high growth in earnings per share without having to wait.  This causes many management teams to pass on investments that would create long-term value, but look bad in the short run.  It can cause companies to make as much money as they can off of their present customers in order to report good quarterly numbers, instead of offering a fair price that creates goodwill and a long-term win-win relationship with those customers.

Some companies, however, are able to look past maximizing short-run r and instead focus on maximizing n in order to create maximum long-term value, and happy customers.  Amazon and Costco are probably two of the most commonly cited examples.  As they’ve grown and achieved economies of scale over time, they’ve continued to share those benefits with customers by keeping prices low and by continuing to add benefits to their respective membership bases, with little to no increase in the price of membership.  This not only makes for happy customers that then spend more with those companies, it makes those businesses harder to compete with over time.  As Amazon.com CEO Jeff Bezos said in a 2011 interview with Wired:

           

“If everything you do needs to work on a three-year time horizon, then you’re competing against a lot of people.  But if you’re willing to invest on a seven-year time horizon, you’re now competing against a fraction of those people, because very few companies are willing to do that.  Just by lengthening the time horizon, you can engage in endeavors that you could never otherwise pursue.”

We are often asked about the traits we look for in the businesses in which we invest, and near the top of our list are management teams that understand capital allocation and are willing to take a long-term view in building a durable business.  This is especially true among many of the smaller businesses that we’ve spent much of our time analyzing, and it is why we place so much emphasis on making sure that management incentives are aligned with us as shareholders.  System1 Group is a great example of a company with the desired traits we look for, and that’s why we continue to hold shares despite their rise and increased position size in our portfolio.  We believe the company is both benefiting from past investments, as well as continuing to make new investments and do the things it needs to do to become a much more valuable business a decade from now than it is today.  We are happy being partners with a skilled and well-aligned management team.

Capitalizing on businesses that operate on a long timeline of value creation is only possible if we operate with a long-term view as well.  We have to judge our investments, and potential investments, on their actions and business results, not the movements of their stock prices.  If the business performs, the stock price will eventually follow; whether that happens in five months or five years is hard to predict.

But a long-term investment horizon must also be married with an investment process willing to continually question investment theses.  All too often long-term investments are the names given to things that don’t work out in the short-term.  When one spends a lot of time getting to know a business and management team before investing—as we do—it can be hard to change one’s mind quickly, or at all, as one doesn’t want to feel like all that time was wasted learning things one didn’t act upon.  But staying intellectually honest while looking at many businesses, and only investing in the few where we think the odds are significantly in our favor, is how we think we can gain an advantage over time.

**********

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.

Links

This week's episode of the Value Investing Podcast features a conversation Matt and I had with Oliver Mihaljevic about the idea generation process during the 2014 Berkshire Hathaway Annual Meeting (LINK)

The Economics of Airline Class (video) [H/T Kevin Rose] (LINK)

Stunning astrophotos: Orion in context, and in detail (LINK)

Links

Things That Don’t Make Sense (LINK)

To quote Jason Zweig: "An extraordinary & exemplary note from Danny Kahneman" (LINK)

Morgan Creek Capital Management's Q4 Letter (LINK)

A new spike in mortgage delinquencies spells trouble (video and article) [H/T Matt] (LINK)

a16z Podcast: Securing Infrastructure and Enterprise Services (LINK)

Daniel Dennett: "From Bacteria to Bach and Back: The Evolution of Minds" | Talks at Google (video) (LINK)

***

Some early notes from today's Daily Journal Annual Meeting, via the following people on Twitter: @BrentBeshore, @TheCharlieton, @AlexRubalcava, @EricJorgenson.

[Below are some of the quotes that stood out to me. They are from the notes above, and thus possibly not exactly as Charlie Munger said them...]

"Deferred gratification really works if you want to get better and better."

"I've never succeeded in something I wasn't interested in."

"The success of Berkshire came from making two decisions a year over 50 years."

"Diversification is great for people who know nothing...one (investment) will work if you do it right."

"You only need one cinch. When you get the chance, step up to the pie cart with a big pan."

"We're too soon old and too late smart. That's the biggest problem we have."

"I don't think operating over many disciplines is a good idea for most people...get good at something that society rewards."

"Even if you specialize, you should still spend 10-20% of your time learning the big ideas of the major disciplines."

"I do not want a proctologist who knows Schopenhauer. On the other hand, a life devoted solely to proctology isn't much of a life."

"If you think you know what the state of the payments system 10 years out you're in a state of delusion."

"Both Warren and I know you can't trust numbers put out by the banking industry."

"We have a lot of businesses that neither Warren or I could run, but we've gotten good at judging which people can succeed."

"One of the reasons I don't go around talking about how the Fed should work is because I'd mostly be pounding my own ideas into my head."

"Am I comfortable with a non-diversified portfolio? Yes. The Mungers have three stocks: Berkshire, Costco, and Li Lu's fund."

"Arrange your affairs so you can handle a 50% decline with aplomb...if it never happens to you, you're not being aggressive enough."

"The value of my partnership went down 50%...it's a mark of manhood. You better be able to handle it without much fussing."

"I like the Buffett system (0% fee, 6% hurdle, 25% gain-share). I'm looking at at Mohnish Pabrai who still uses it. I wish it would spread."

"In many areas of life the only way to win is to grind away and work hard for a very long time."

Boyles Asset Management – Q3 2016 Letter Excerpt

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.

***

Resisting Change and Searching for New Ideas

“Out of every hundred new ideas ninety-nine or more will probably be inferior to the traditional responses which they propose to replace.... It is good that new ideas should be heard, for the sake of the few that can be used; but it is also good that new ideas be compelled to go through the mill of objection, opposition, and contumely; this is the trial heat which innovations must survive before being allowed to enter the human race.” - Will and Ariel Durant, The Lessons of History

We are often asked how we find new ideas. While we discussed the specifics in detail in our Q1 2014 letter, the short summary is that we read a lot, run both quantitative and qualitative screens, and continually try to develop a network of philosophically like-minded investors with whom we can discuss ideas and learn. Basically, we turn over a lot of “rocks” in our search for worthy investment ideas. And of those many rocks, we deem only a select few worthy of being attractive enough to dive deeply into, and fewer still worthy of actual investment.

There’s a certain attraction to new things, especially when it comes to investing, where the prospect for profits often comes attached with a management team that can tell a good story. But most of the time, when new potential investments turn up, the right course of action is to do nothing at all, as far as putting capital to work is concerned. Investing is a field in which knowledge is cumulative, so objective work properly done doesn’t get wasted. It builds a base for potential future investment, even if nothing gets done when that knowledge is gained.

Overall, we’ve been managing a fund for just about ten years, mostly focused on finding small companies, so we’ve gotten to know quite a few businesses we’d like to own, should they ever get down to the price at which we’d like to own them. When we do decide to swing the investment bat, it may occur after years of following and getting to know those companies and management teams well, as was the case with two of our larger holdings in BrainJuicer and Cambria Automobiles.

“People say that you should change your mind when the data changes; but I change my mind even when the data doesn’t change, because I reanalyze the situation every day and sometimes I just come to a better analysis. And I think actually what I said yesterday I don’t believe anymore.” - Jeff Bezos, CEO, Amazon.com

We’re fans of reading good business biographies, and one of the books we recently read was the story of a company called Linamar in Canada. One thing that stood out in the story was a mistake the company made when it entered a new line of business that was not as good as the company’s core business. This particular venture took a lot of time and energy of the management team and, ultimately, didn’t work out. When discussing the venture, Frank Hasenfratz (founder of Linamar) said, “How do you measure the aggravation and the time it took me and some of our other people away from doing more productive things?”

Investing is often the same way. It is easy to spend time and attention on ideas that look cheap but that maybe aren’t ideal, and even if something may be undervalued, there is an opportunity cost of spending too much time thinking about an idea and industry that might not be worth the effort required to understand and keep up with. For us, we decided that Richardson Electronics, which we discussed in our Q3 2015 letter, was one of those ideas, and have since sold the shares we held.

Richardson was trading for what appeared to be a deep value price, though the cash balance does deserve a footnote because much of it is overseas and not necessarily quickly available to be put to work in the U.S. But the negative aspects of the company—lack of profitability, high management compensation, a dual class share structure, questionable capital allocation, etc.—made us decide that even though it still looked undervalued, it was no longer worth it to continue holding and spending the time staying up-to-date on the company and industry for an investment to which we’d never allocate a large amount of capital. So we sold, moved on, and wish them luck on accomplishing the things they hope to accomplish as they continue to transition their business to what they hope is a more profitable future.

Our experience with this investment, and the quote from Jeff Bezos above, also remind us of a story told by personal finance author Jason Zweig about Daniel Kahneman. Kahneman, one of the pioneers of behavioral economics, is known by those who have worked with him to be completely willing to change his mind and throw away all of his, and his collaborators’, previous hard work in an instant if he suddenly realizes it is incorrect. This is something that is often hard to do psychologically, as the more one works on something, the more committed one tends to get—wanting that work to mean something and to lead to action. But if one can get over the mental hurdle, developing the skill to remain completely objective at all times is one of the more valuable skills one can have in any field, especially investing, where significant time is spent learning and preparing for a climax that may never come.

Zweig, in his first taste of witnessing this trait in Kahneman, asked him how he had started afresh on the research that he and his colleagues had been working on, as if all the previous work had never happened. Kahneman replied with words that Zweig said he’s never forgotten, and that we as investors should also never forget: “I have no sunk costs.”

Links

The Latticework blog has posted some excerpts from the Boyles Q2 letter, where we discussed Brexit as well as our new Greek holding.

Mental Model: Bias from Envy and Jealousy (LINK)

The Insurance Industry Has Been Turned Upside Down by Catastrophe Bonds (LINK)

Without Freddie and Fannie, could 30-year mortgage be a thing of the past? [H/T ValueWalk] (LINK)

Miamian Bruce Berkowitz has taken on a fight few would dare: He’s suing Uncle Sam. 

Berkowitz — whose mutual fund Fairholme Fund owns 14 percent of Fannie Mae and Freddie Mac preferred stock — is among a group of investors suing the U.S. government over the two government-backed mortgage insurance giants. They claim the U.S. Treasury Department illegally confiscated the companies’ earnings after their bailout, gutting the firms when it was supposed to rehabilitate them and setting a dangerous precedent for shareholders’ rights.

Mark Zuckerberg on the next 10 years of Facebook [H/T Barry Ritholtz] (LINK)

Jim Koch: "Quench Your Own Thirst" | Talks at Google (LINK)

Related book: Quench Your Own Thirst

Barry Ritholtz interviews Daniel Kahneman (podcast) (LINK)

Related book: Thinking, Fast and Slow

TED Talk - Anthony Goldbloom: The jobs we'll lose to machines — and the ones we won't (LINK)

Iridium: story of a communications solution no one listened to (LINK)

Related book: Eccentric Orbits: The Iridium Story

New Hardcore History podcast: Episode 58 – Kings of Kings III (LINK)

Long on Epictetus (Part 1, Part 2)

Related book: Epictetus: A Stoic and Socratic Guide to Life

Links

Two great additions to the value investor's library were just released:

Concentrated Investing: Strategies of the World's Greatest Concentrated Value Investors 

Warren Buffett's Ground Rules: Words of Wisdom from the Partnership Letters of the World's Greatest Investor

Latticework has posted an excerpt from the Boyles Q1 letter, where we discussed our largest new purchase during the quarter (LINK)

Stop Crashing Planes: Charlie Munger’s Six-Element System (LINK)

Warren Buffett recalls the craziest question ever asked at Berkshire Hathaway’s annual meeting (video) (LINK)

An article about Bruce Greenwald's comments at the Minsky Conference [H/T ValueWalk] (LINK)

Raghuram Rajan’s Frank Careers Advice for Graduating Students [H/T @jasonzweigwsj] (LINK)

Constellation Software's elusive CEO (2014 article) [H/T @LockStockBarrl] (LINK)

How To Use Fear Before It Uses You (LINK)

Seneca: on the firmness of the wise person (LINK)

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.