Sunday, March 30, 2014

Lessons learnt from value act capital

“We prefer No. 2 or No. 3 in consolidated industries with stable, predictable cash flows”
-          Jeff Ubben, Value Act capital

Active value investing:
Jeff Ruben sums up in this interview sums up his approach in fairly easy terms:
  •  Buy from an uniformed seller at a significant discount in the public markets
  • Clean up the business and improve public perception
  • Sell the whole or parts of the business with the support and co-operation of management

How his approach is different from others?
Public shareholding, private actions

  • Low profile: Unlike other activist investors like Carl Icahn or Bill Ackman, who are in the headlines practically every day, Jeff Ubben has maintained low profile and believes a lot more in silent, behind the scenes dialogue with the board and management. Having been a private market investor, I quite like this approach.
  • Co-operation with passive investors: Unlike corporate raiders like Carl Icahn, whose views are typically the diametric opposite of the existing management and the passive shareholders, Jeff Ubben and his team have a unique ability to build rapport with everyone.
  • Team orientation: Unlike other hedge funds which are helmed by a public, visible superstar, Value Act has six partners, four of whom have been together since the beginning. This also shows in the rapport they build with the rest of the board members

Investment thesis:
  •  Underdogs in consolidated industry: Prefer to focus on mature industries that are consolidated with stable free cash flows.  This allows for even small movements to result in a disproportionate movement in profitability, cash flows and consequently, shareholder value. This was quite a revelation to me - think of pepsi (not coke), think samsung (not apple) - for all you know the No.2 might be better at execution and hence at growing shareholder value - since there is no pressure to keep up market leadership and often this means, the tougher, costly lessons of innovation could be left to the market leader.
  •    Focus on IP/brands: Jeff Ubben likes strong franchise businesses that have minimal SG & A costs year after year.  Case in point being, Microsoft (Value Act is bullish on the Microsoft enterprise business that includes servers and tools). This operating leverage ensures that turnaround is quick and adds to disproportionate increases in profitability and cash flows - FCF, especially.
  •  Patient accumulation of stake:  It takes more than a year for them to accumulate a 4-5% stake (which necessitates filing a 13-D).
  • Focus on getting “welcomed” into the board room:  This allows them to focus on getting information only privy to the board which helps make informed, evolutionary decisions that carry the stakeholders along.  

Post investment Action:

Separation/restructuring leads to value creation:

Often a lot of companies are bucketed into different categories – For eg., in Value Act’s own words, Microsoft has been branded as a “PC growth led” business. The market completely ignores the value attached to its Enterprise division – Servers, sharepoint, software which is an incredibly sticky, high margin, recurring revenue business.

Value Act, in my opinion, simple provides for better visibility into the crown jewel  - this could be done through spin-offs, selling the loss leaders (that drag down the profitability of the overall company) or restructuring the management (grapevine has it that Value Act pressured the board to find a replacement for the legendary Steve Balmer).

Sample portfolio companies:

Name of company
Value Act’s action to unlock value
Leader in breast implants
Professionalize management
Sell urology business
Catalina marketing
Monopoly in gather Point of Sale promotions – coupons, mobile apps. Undervalued because of accounting issues related to revenue recognition

Created strategic interest for the company and resulted in company getting bought by Hellman & Friedman – a digital marketing firm
Allison transmission
Market leader in the automatic transmission space for large CV’s, mining, fracking and buses
Non activist thus far- play on the revival in heavy commercial vehicle markets in North America

Lessons to learn from Value Act:

The interview and the consequent research I did on Value Act was quite an eye opener to me. It made my universe that much smaller - a No. 2 or No.3 in a consolidated industry has everything to gain and much less to lose,making the risk-reward equation asymmetric. Also, hopefully, given the learnings from the leader, the No.2 or No.3 should have an easier job of execution resulting in superior capital efficiency. The lessons I learnt are:
  •  Focus on the No. 2 or No.3 in  consolidated industries – such companies trade a significant discount to the leader  and often, offer better value
  • Look for strong franchise businesses that can grow with very little incremental capital

Monday, March 24, 2014

The big short – the need for an externality in a short

“In the short run, the market is a voting machine. In the long run, it is a weighing machine”

Said Warren Buffet.  

However, what he did not say was not quite how long the short run would last.
Given the froth in today’s market and how “concept stocks” like Tesla, Netflix continue to scale new highs.  In an artificially created world of euphoria , (The Truman show as Seth Klarman calls it), it is easy to get burnt by short positions.
Again, as someone who is endlessly interested in the intersection of philosophy, physics and finance (read that as behavioural economics), I find it extraordinary as to how the market for a long time continues to “vote” for “talk” rather than the “walk” – viz., valuations increase with announcements and introduction of concepts/prototypes, no matter what the impact on cash flows)
  • The market is ultra focussed on one metric that it tracks – all else, is irrelevant. For Amazon, it is revenue growth (no matter what the cost of the growth), for Netflix (it is the number of subscribers), for Tesla (the number of new cars)
  • The CEO is a visionary and has had past success – there is a “halo” bias. Infact, a study that was run earlier showed that CEO’s who look good, talk glibly and can talk the language analysts want tend to push up stock prices higher (now, isn’t that obvious ?)
  •  The business model has operating leverage because :
    •  Network effect
    • Creation of  a strong brand
    • Marginal costs of servicing are ostensibly low no matter how high the cost of acquisition  (how many SaaS companies that burn money to acquire customers are eventually believed to become “cash flow” fountains once operating leverage kicks in)
    • At one point, there is a serious threat of the company taking over the world. Think of all the "high fliers" at one time - Web van at one time threatened to wipe out all retailers, AOL was touted as the dark knight that would wipe out all media houses.

One of the bitter lessons that I learnt from my experience of shorting “high momentum, high growth stocks“ is that they enter into what George Soros calls the “zone of reflexivity”.  Where new actions reinforce the earlier actions resulting in the stock price climbing higher and higher.  

This results in one of the greatest paradoxes that you will see in stock market history – fundamentals driven investors get burnt, get out only to see the stock coming down finally.

Why does it happen?
While in the long run, a stock price is determined by fundamentals, on a day to day basis it is determined by the transient demand and supply. As long as there is someone (“the bigger fool’s theory”) to pay higher for the same piece of paper, the price would climb and vice versa.

The wisdom of crowds - "Crowds do not listen"

The trouble with that is that investors have a huge herd mentality (much like the Great Beest migration) and it is easy for a lion or a tiger to get crushed by the sheer momentum of the beest. Modern day philosophy too espouses the same thing  (Charles Mackay’s  book – Extraordinary popular delusions and madness of crowds)
It's warmer and safer inside the herd !

         "Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one."

So what’s the solution ?
Is the momentum broken ?
No matter, how tempting it is, I have learnt never to short a stock unless I am sure that momentum is broken.  Ironically, the answer might lie with technical analysis and a little bit of common sense.

External validation & discountinuities

Look at what happened with the recent Herbalife tug-of-war. Each point of discontinuity comes whenever there has been a material event that has led to a loss of momentum. If FTC is investigating herbalife, the stock falls 3-4%. If its has been cleared, it goes up 3-4 %. Have the fundamentals changed ? Not in the least.As a corollary, I have found that it is easier to short a stock which has far more externalities than one that operates in a free market.

Cases in point :

  • Regulatory interference : Herbalife – which operates in a regulated industry and comes under the purview of FTC and the business model comes under the laws of the land

  • Quantitative externality: Allied capital/Lehman – financial services companies intrinsically have a lot many linkages that makes it easier for the market to sense triggers that can break momentum. For eg., increase in cost of funds (which happened when markets froze in Sep ’08),  ability to validate the value of an investment from external sources (like David Einhorn did with the portfolio of allied capital).
  • Fraud/misconduct:  Even in case of shorts, often the most profitable ones have been fraud/misconduct. In most cases, frauds/misconducts are the lids that keep the “blackbox” of secrets closed (because frauds by their very nature are ones easy to establish). These often are the key points for reversal of momentum that allows for gravity to take over and allow a falling knife.

This gets compounded by the fact that shorts are typically for a year and have to be rolled over frequently. In a summary, it might actually be worth it to follow:
·         An activist investor (who can expose the flaw – Einhorn in Allied/Lehman, Ackman in MBIA/Herbalife)
·         Wait for break of momentum (material event that is bound to cause irreversible damage to the fundamentals – eg., adverse preliminary findings from a FTC probe, margin calls/cost of funds going up for a financial institution)

And then jump in to the short.

If ever there were reasons to follow a "falling knife" (unlike the conventional worry about "catchign a falling knife"), a big short would be on.

In summary,

"Never ever short a stock just based on valuation. The market can stay irrational for longer than you can stay solvent. Remember to use the wisdom of crowds to your advantage."

Sunday, March 16, 2014

Capital raising & law of diminishing returns

An article that I had published on my one of my passions - Capital efficiency got published in :

I feel humbled to be recognized by Beyond proxy - "The manual of ideas" is a valuable website for all fundamental driven investors.

I hope you enjoy the article and my thoughts. It intrigues  me how little emphasis is paid to if the company can continue to deploy capital at rates of return above the cost of capital. This is often a key factor while companies that continue to grow topline/revenues eventually get strapped for liquidity/bankruptcy.

Combined with the analogy to Heisenberg's uncertainty principle, a lot of investors pay a lot of attention to growth (of EPS, topline) but seldom to capital efficiency. Remember that if you are making a 1000 mile trip, it is not just the speed of the car that matters, but also its fuel efficiency and consequently the time and effort spent on pit stops.