LBW Commentary Q3 2017
HOW LBW SEES IT
At LBW we typically take a contrarian view as it pertains to our industry – it’s built into our culture. However, performance chasing, and the potential harm it can cause, is a subject where sticking with the crowd seems best. Instead of going into a boring definition, here is a quick exercise. Please read the following passage:
Often, we are asked “How are the markets doing?” – well, they aren’t doing too shabby this year. Year-to-date (“YTD”) the S&P 500 is up 12.53%, the Russel 3000, up 13.91%, and the MSCI World ex USA, up 19.31%.
What were your thoughts? Did you immediately think “Did I have exposure to the MSCI World ex USA index? If not, is there a way to participate?” At the very least, the almost 20% YTD return from the MSCI World ex USA index must have caught your eye. The subconscious gravitation towards the highest return number is the starting point of performance chasing and can cause people to chase one excellent return after another. It has been highly researched and the negative effects are cause for concern. For example, Morningstar, a well-known investment research and analytics company, ranks funds by stars – five indicating the best and one indicating the worst. Plenty of research has been done arguing the validity of the rankings and the strategy of buying five-star funds versus other-star funds. Most of the findings come to the same conclusion – past returns are not an indication of future results. Simply put, the rankings are a better marketing tool than a fund selection tool.
Performance and rankings are not the only metrics where evidence of performance chasing can be found. In the past few months we have blogged about cannabis and cryptocurrency due to the sheer number of conversations with others revolving around the future return and growth potential cannabis and cryptocurrencies (bitcoin in particular) may have and our thoughts on how to partake in the future gains. They asked because they saw headlines like “Arcview projects the legal marijuana market will hit $20.6 billion in revenue by 2020, up from $5.4 billion in 2015” or “Cryptocurrency Hedge Fund Returns 2,219%” or “No wonder investors are rushing into cryptocurrencies – average ICO returns are 1,320%”. Even in our blog post “And the PLOT thickens…”, we discussed the potential growth runway for the cannabis industry and argued that because the total addressable market (“TAM”) is so large, it causes individuals to flock to the industry in the attempt to hit the next perceived gold rush. Examples of performance chasing are almost limitless and the common denominator seems to stem from the very definition “Entering or exiting of a trend after the trend has already been well established” (emphasis LBW’s) – trend following. The market place is a zero-sum game making trend following difficult. To effectively execute this type of strategy, one must anticipate an event or catalyst no one, or few people know, is going to occur. For example, the housing crisis of 2008, only a few recognized the inevitable defaults on waves of home mortgages creating a credit crisis that spiraled our economy into the Great Recession. If everyone had a crystal ball and could predict the future, the Great Recession may have never occurred. Furthermore, Ray Dalio, arguably one of the best hedge fund managers of all time, in the early 1980s correctly forecasted the Latin American debt crisis but misjudged its impact on the U.S. Mr. Dalio’s misplaced bet almost sank his fund. We are not positing that Mr. Dalio follows trends, but that even with his in-depth understanding of complex ideas, he sometimes struggles to predict the future. So, why would chasing returns, rankings, or even TAM be any better? Our society is geared towards basing our decisions on a simplification of complex ideas. We want information handfed to us with little to no effort, but as my high school football coach would say “If it was easy, everyone would do it.” If investing was simply following performance, rankings, or TAM, we would all be rich and we wouldn’t have to write about chasing these metrics. Our point, chasing performance is like going into a casino, watching someone hit a jackpot on a slot machine, and then sitting down at the same machine assuming you will hit the jackpot as well. Trends have their place; however, when they become a metric to base a decision upon, they are nothing short of dangerous. At LBW we are mindful of trends, but do not allow them to dictate our investment decisions. Our goal is to read and perform in-depth research on areas we feel our competence lies. This allows us to understand what we own and examine the risk versus reward and invest as we see fit. We would rather hit singles and doubles every day instead of swinging for the fences and hitting a home run once every ten at bats. Taking the time to truly understand the risk versus reward in any opportunity is not easy and does takes time, but it typically produces the best results. Nathaniel's Beautiful Mind The Four Filters As I was trying to figure out what to write about this quarter, I reviewed past commentaries. In doing so, I realized I had never written about the four filters that comprise our investment framework. I can assure you this isn’t by design; it’s not as if they are a trade secret. They are in fact quite well-known throughout the investing community. They are, in ascending order: 1.Do I understand what the company does? 2.Does the company have a sustainable competitive advantage? 3.Does management focus on strong capital allocation and maximizing shareholder value? 4.Can I purchase the company (or security) at a Margin of Safety? These filters were conceptualized by Warren Buffett and Charlie Munger, and allow an investor to thoroughly and efficiently dissect a company or security in their determination of whether it’s a worthy investment or not. You may ask, “Why four filters?” or “Why are they so simplistic?” I would argue that the filters are meant to be overarching concepts that can be applied in various ways. As you can see, these filters are posed as questions that appear to be very simple on the surface, when in fact, there can be a great deal buried beneath. Alternatively, the filters are structured such that if I’m being honest with myself, I can be quick to answer them. As I get older and gain more experience, the end goal is to utilize these four filters to make sound investments and avoid unprofitable mistakes. Some Background In the beginning of my value investing education, I subscribed to Value Line’s Investment Survey using the discounted 13-week trial. I went out and bought a printer, and proceeded to print off every issue for the next 13 weeks. I then read every single one-pager on all the companies covered. It was a safe bet to assume that the majority of the covered companies wouldn’t change for a year, so I held on to my printouts to review throughout the year, and waited to do the 13-week trial the following year. I got smarter the second time around, and just downloaded the PDFs and read them on my laptop. I continued this process for virtually the next ten years in various forms. Over the years, my knowledge compounded as I learned about as many companies as I could get my hands on. I began to construct mental models based upon the numbers and business profiles I read that helped me to quickly siphon through companies. Eventually, it got to the point where I could get through an entire issue in less than a half hour. The point of this exercise was to use Value Line’s survey as a jumping-off tool to further dig into companies that caught my eye. This process then led to a further compounding of knowledge as I learned of the four-filter framework in my readings of Charlie Munger, and proceeded to apply it in my in-depth research of those selected Value Line ideas. In some cases, the research didn’t lead to a buying of the company’s security, but I learned a great deal about the company’s economics or moat or lack thereof that could be applied to another company within the same industry or I shelved the pertinent security until it’s price reached a discount to my estimate of its intrinsic value. Do I understand what the company does? Warren Buffett is fond of repeating a quote attributed to Thomas J. Watson, Sr., founder of IBM: “I’m no genius. I’m smart in spots—but I stay around those spots.” One of the major rules I have is not investing in companies I don’t understand, that is, companies that are outside my circle of competence. If I don’t understand what the company’s product or service is or does, or I don’t understand how the company earns its revenues, then I won’t invest in it. As an example, pursuant to my circle of competence, I don’t feel comfortable investing in a company like Gilead Sciences because I don’t know the first thing about drug trials or anything about the drugs Gilead produces and what those drugs do. Sure, I could take a crack at learning about Gilead, but I know based on skimming over Gilead’s 10-k, that I simply don’t have a comfortable understanding of Gilead’s business. With that said, Gilead would not pass the first filter, and would go into the “too hard” pile. I have found over the years that I am becoming more and more comfortable saying “no” to something that I don’t understand – I don’t have to invest in every potential opportunity that comes my way. Does the company have a sustainable competitive advantage? If I understand what the company does, I can then determine if the company has a moat. What is a moat? A company can have multiple moats and a moat is typically classified in one of the following categories: low-cost producer, high switching costs, network effect, and intangible assets. The moat(s) can usually be determined from the company’s financial statements and more specifically certain metrics like gross margin, operating margin, net income margin, free cash flow (FCF) margin, cash return on invested capital (CROIC), incremental cash returns on invested capital (InCROIC), and reinvested FCF. Some of these metrics should be compared against their industry peers like operating margins while others are more relevant on an absolute basis like InCROIC. It is highly critical that I review the company’s financials for at least a ten years’ period. There are a number of indicators throughout the financials that can indicate the type of moat such as “Does the company have negative working capital (current assets are less than current liabilities)?” If yes, they are likely a low-cost producer like Walmart. Due to Walmart’s scale and high sales turnover, they are able to collect their receivables faster than they pay their vendors, hence a negative working capital balance. Once I’ve determined the company’s moat(s), I study its competition and determine if its industry is experiencing any secular trends. Are there any competitors that could threaten the company’s moat? Are there any secular trends acting as tailwinds or headwinds? If so, can I conservatively estimate when the moat may disappear? Alternatively, is the moat growing? Can I forecast how much the company will earn for the next ten years? As an example, let’s take Pepsi-Cola. Pepsi’s moat is based upon an intangible, its brand. Over decades, Pepsi has invested in their brand by spending billions on marketing. They and Coca-Cola maintain a semi-comfortable duopoly, and have a relatively stable moat. What could breach this moat? Today, there are concerns about health and nutrition, and as a result, both Pepsi and Coke have had some headwinds to their respective moats from this secular trend. Pepsi has responded by investing in and adding healthy alternatives to its portfolio of beverages and snacks like organic Gatorade or lowering salt levels in its snacks. Have their investments paid off? The answer can be found in many of the previously-listed metrics as well as asking people what they feel when confronted with Pepsi’s brand (to those who want to know, yes, they’ve done a good job so far). If after determining the company’s moat and stress-testing it, and if I think the company’s moat will be around for at least ten years if not longer, then I move onto the next filter. Does management focus on strong capital allocation and maximizing shareholder value? As I have mentioned in previous commentaries, I place heavy emphasis on management who act like owners, otherwise known as owner-operators. When there are owner-operators at the helm, the odds increase dramatically that shareholder value is being built. To be on the safe side, I want to review management’s capital allocation track record using at least the same period’s financial statements, if not longer, from the second filter’s process. Management typically have five possible avenues to allocate capital and create shareholder value: 1.Issue / pay back debt 2.Retain and reinvest earnings 3.Issue / buy back stock 4.Issue dividends 5.Acquire / invest in companies Metrics used to determine management’s record of utilizing the above avenues include ROIC, return on equity (ROE), return on assets (ROA), return on retained earnings (RORE), and CROIC. As you can see, some of these metrics can be applied to multiple filters. The core question you want answered is, “For every dollar of capital invested, is the company generating greater than one dollar in returns?” For our purposes, let’s use a simplified example: if a company earns $1 FCF and management chooses to reinvest that $1 back into the business and the reinvested capital produces 20% annual returns, management has successfully created shareholder value because for the one dollar invested, 20 cents is produced. In addition to measuring management’s capital allocation record, I also like to read quarterly and conference transcripts and investor letters to see if management is holding themselves accountable to statements that they have made in the past. You can gain a good understanding about management from such sources, especially over long periods of time. Once I have determined that management has exhibited a strong capital allocation record and maximized shareholder value, I can move onto the fourth and final filter. Can I purchase the company (or security) at a Margin of Safety? If a company has passed all three of the prior filters, we come to the most important filter of them all. This is a concept that we speak of daily amongst ourselves, with you our clients, and in our past commentaries. I would be willing to call this concept the bedrock of our investing framework. A typical company’s common share market price experiences high levels of volatility throughout the year. However, it’s intrinsic value, what I believe the security to be worth, experiences far less volatility than its market price. My job is to purchase a security at a substantial discount to its intrinsic value. The difference between the two is known as the “Margin of Safety” (MoS) (Intrinsic Value – Purchase Price = Margin of Safety). The MoS allows for imprecision, analytical error, or systemic risk in my intrinsic value calculations. In essence, the MoS acts as a barometer of my comfortability with my analysis of the company / security and of the industry in which it operates, and can determine a security’s concentration across our clients’ accounts. If I am not too comfortable with my analysis, I may assign a larger MoS to the security, say 50%, versus a security’s analysis that I may be more comfortable with, like 25%. If the security is trading at a large discount to my intrinsic value estimate, I’ll buy it. If not, that doesn’t mean that I’ll forget about the company / security. Instead I’ll add the company / security to my monitoring list, from which I will keep tabs on it, and will buy it if the opportunity were to present itself. Conclusion As I stated previously, these filters are well-known throughout the industry. The secret to investing is not the filters themselves, but the interpretation and execution of them. It is critical that an investor create processes around the filters that work best for them. There is no one set path; this is the framework that works best for me. Ultimately, when the filters are utilized in a rational manner, an investor is far more likely to succeed in not only making profitable investments, but also in omitting investment mistakes.
 http://www.investopedia.com/terms/c/chasingthemarket.asp http://performance.morningstar.com/Performance/index-c/performance-return.action?t=SPX®ion=usa&culture=en-US as of 9/30/2017. http://performance.morningstar.com/Performance/index-c/performance-return.action?t=XIUSA000O6®ion=usa&culture=en-US as of 9/30/2017. https://www.msci.com/documents/10199/99459e68-5e21-4888-ace6-72a3ffe9b1ab as of 9/29/2017.  http://www.morningstar.com/content/morningstar/en/home/about-us.html  http://www.businessinsider.com/legal-marijuana-market-revenue-2016-9  http://www.zerohedge.com/news/2017-08-22/cryptocurrency-hedge-fund-returns-2129-ytd  http://www.businessinsider.com/ico-mangrove-capital-average-returns-crypto-icos-2017-10  http://lbw-wealth.weebly.com/blog/and-the-plot-thickens  http://www.investopedia.com/terms/c/chasingthemarket.asp https://www.bloomberg.com/news/features/2017-08-10/bridgewater-s-ray-dalio-has-a-plan-to-outlive-himself  Companies may have multiple securities based upon them. These include common stock shares, preferred shares, bonds, rights, and warrants. All of these security types have different terms, and vary in where they belong in a company’s capital structure. For this commentary, the terms “company” and “security” will be used interchangeably or in tandem as circumstances warrant.  This is a concept I learned from Charlie Munger’s writings. Too much information to go into here, but perhaps we can write about them in future commentaries.  More on this below.  Watson Jr., Thomas J. & Petre, Peter. Father, Son & Co.: My Life at IBM and Beyond. U.S.A: Bantam Books, 1990. Print (page 218.  Annual report that a publicly-listed company must file with the SEC.  This metric is particularly important in deciding if management focuses on building shareholder value.  There are exceptions like special situations or companies rising out of bankruptcy.  Due to its high sales turnover, Walmart consistently buys large volumes of product. Because they buy such large volumes, Walmart can use this as leverage to stretch out their payables to their vendors.  This isn’t Pepsi’s only moat. They also have an incredible distribution system and economies of scale.  This answers the competition question. There are other competitors like Dr. Pepper Snapple Group, but Pepsi and Coke are the biggest ones.  For those interested, awhile back I wrote up everything I look at when reviewing a company’s financials. It’s too long to send out with this commentary as I’ve added to it over the years, but if you’re interested, I’m happy to send out copies upon request.