Sunday, September 24, 2017

3 Challenging Scenarios for Quality-Value Investors

One night a few weeks ago, I sketched out my investment philosophy in a “one pager” format. 

I found the process to be useful, so I shared it on Twitter before heading to bed, thinking others might give it a try themselves.



In the morning, I discovered the post was going viral - at least FinTwit's version of viral. 

The feedback on the post was overwhelmingly positive, which, while appreciated, also made me a little nervous. A cheery consensus around a company or a strategy doesn’t lend itself well to outperformance.

That said, there’s a difference between prescription and practice. Advocating regular exercise is sound and non-controversial, yet the temptation to be remain sedentary can be hard to overcome.

Indeed, part of the motivation for doing the one-pager was to hold myself accountable and stay focused during a bull market when there's pressure to relax standards.

The one-pager isn't meant to be a magic formula of any sort. No company will check off all the boxes. Instead, it serves as a personal framework for evaluating businesses and investment opportunities.

Peeling back a layer

Most of the questions I received about the one-pager regarded the three highlighted sections below.



To be a “strong buy,” I want the company to have an economic moat, be managed by excellent stewards of shareholder capital, and trade at an attractive valuation

These opportunities are rare, to be sure, but it's good to know when you might have a "fat pitch" heading your way. 

The highlighted sections address three challenging - and comparatively more common - scenarios that quality-value investors encounter.

In each case, two of the three requirements are present, but one is missing. Here, I’ll address the problem, pitfall, potential, and process for analyzing companies within the three scenarios.


“Quality at any price” (Moat and Management only)

  • ProblemGreat companies don’t always make great investments.
  • Pitfall:  Even if the underlying business performs well, if the company doesn’t live up to high market expectations, you’re in for a bumpy ride. Consider an investor who bought shares of Wal-Mart in September 1999 when the stock traded with a price-earnings ratio over 30 times. Though Wal-Mart as a business grew earnings and dividends per share at an impressive rate over the next decade, the stock price didn't fully follow suit because the business performance wasn’t enough to match lofty initial expectations. Formidable competitors like Costco, Target, and Amazon were also chipping away at Wal-Mart's competitive position. Ultimately, Wal-Mart's price-earnings multiple contracted and the 10-year total return was about 2.4%.
  • Potential: Investors can underestimate optionality in a well-run business. Those that considered Amazon, Facebook, or Google wildly overvalued early in their public market histories, for instance, didn’t foresee the new opportunities these businesses would create or discover in the subsequent years. Similarly, firms with existing moats may look expensive now, but if management can further widen the moat, today's price may look cheap in hindsight. 
  • Process: Don’t rely solely on relative valuation and market multiples. Instead, make explicit forecasts to determine what the market price might imply. Then, consider whether or not you think management is capable of beating those expectations by introducing new products, entering new markets, becoming more efficient operators, or adding new lines of business.

“Beware quality traps” (Moat and Price only)

  • ProblemThe market knows something you don’t.
  • Pitfall:  Though the stock's premium may have diminished, there could be good reason. The company’s legacy moat could be under assault by new and motivated competition or a disruptive technology. If management is incentivized to protect the old cash-flow-rich operations or if the corporate culture is bureaucratic and stagnant, there could be further to fall. Kodak is a classic example – a former blue-chip darling that had a dominant market position, saw the coming of digital photography in plenty of time, but its culture refused to embrace the change.
  • Potential: A management transition could lead to cultural change, which could reinvigorate the business and make it more competitive. To illustrate, a positive cultural change happened at Sealed Air after the board brought in a new executive team following the controversial $4.3 billion acquisition of Diversey in 2011. In the twelve months following the deal's announcement, Sealed Air's stock price dropped about 60%. Despite the poor M&A decision by prior management, Sealed Air (makers of Bubble Wrap) and Diversey still had some durable competitive advantages. The new management team overhauled the corporate culture and got the company back on solid footing.
  • Process: Ask yourself if the company has a culture of innovation and change. Could a new management team realistically step in or is the board too close to the CEO and CFO? Review management’s incentives and the board structure and determine whether or not they have enough skin in the game to want to improve operations.

“Avoid turnaround traps” (Management and Price only)

  • Problem: Even excellent capital allocators can struggle to fix a broken business.
  • Pitfall: Turnarounds have low odds of success. Ultimately, management facing such a situation needs to identify a potential moat source and attack it full force. Then, hope for a lucky break or two. When there are massive secular headwinds in place, this becomes a near-impossible task, even for great management teams. Eddie Lampert at Sears Holdings is a good example. Lampert has done a remarkable job playing a tough hand, but the long-rumored turnaround has struggled as department stores face immense competitive pressures from changing consumer tastes and from online retail.
  • Potential: When turnarounds happen, the rewards can be enormous. Steve Jobs' second stint at Apple is one of the best – if not the best – turnaround story of our generation. Though the full story is more complex than this, what Jobs did was make Apple (traditionally a beloved niche personal computer maker) into a premium global consumer brand, starting with the iPod and later the iPhone and iPad. Jobs' efforts, along with the rest of Apple's staff, spawned a brand (intangible asset) advantage that, when paired with the switching costs created by the iTunes platform, led to a solid economic moat.
  • Process: Is management facing secular headwinds in their core operations? Are industry dynamics stable and asset growth slow or is capital flooding the industry? Does management attempting a turnaround have to reckon with a debt-laden balance sheet or an under-funded pension plan? 
Bottom line

Rarely will the stars align so that management, moat, and price are all clear and a strong buy is evident. Much more frequently, quality-value investors must wrestle with one of these three scenarios where one factor is missing - or at least isn't obvious. 

As such, it's helpful to approach the scenarios with both the pitfalls and potential in mind. Weigh the pros and cons, make a decision, and then be patient!

Stay patient, stay focused.

Best,

Todd

The opinions expressed here are the author's and not those of his employer. Todd's family owns shares of Amazon and Costco. For a full disclaimer, please click here



Saturday, July 1, 2017

Moats & Knights, Part Deux

In December, I wrote about the rare and powerful "moat and knight" combination - a company with a defensible competitive advantage led by top-notch capital allocators. 

Since coming across that concept a few years ago, I've wrestled with the relative importance of the two factors. What's more important: moat or knight?

In a recent post, my former office mate at Motley Fool UK, Maynard Paton (who you should follow), paralleled my current thoughts on the subject quite well:

Years ago I used to believe that traditional business ‘moats’ — such as brands, patents, regulations, economies of scale, network effects, and so on — were the most critical feature of any investment . 
But these days, such ‘barriers to entry’ appear increasingly at risk of being challenged by intrepid startups that can use the Internet to gain customers much more quickly than ever before. This investment paper cites a good example of Gillette and Dollar Shave Club. 
Over time then, I have become far more convinced about the importance of management to an investment. 
Put simply, I’d like to think a business is more likely to enjoy long-term success — and fend off intrepid startups — with a loyal and committed executive at the helm. 
(Indeed, a company’s positive and adaptive working culture — instigated by a loyal and committed boss — can in itself be a difficult-to-replicate ‘moat’.) 
On the other hand, I am no longer so sure about professional ‘salarymen’ executives, who may be quite happy to run things in a customary way and risk becoming complacent when it comes to fresh competition.
Spot on.

There was likely a time when the advice to "go for a business any idiot can run" made sense. Find a wide moat business and be patient. All management had to do was look the part and not screw things up too badly.

That time has passed.

Today's raiders have new siege weapons and it's critical to have a knight - or ideally, a number of knights - implementing nimble defenses.

Run away! Run away!
This isn't to diminish the importance of economic moats - a knight defending a grass hut doesn't do anyone much good - but it is worthwhile to spend more time considering who is manning the ramparts.

Here are five questions you can ask about management before making your next investment.

  1. Has management been forthcoming about competitive challenges or do they downplay the threat of new entrants?
  2. Does management have the right financial incentives in place or has the board set up low hurdles to make sure large bonuses are realized, regardless of performance?
  3. Does management know what the company's advantages are and have plans in place to extend and strengthen those advantages?
  4. Does management have meaningful personal ownership in the business (and thus have skin in the game) or are they akin to mercenaries? 
  5. Does management have a track record of sacrificing short-term results for long-term results or do they seem to play the quarterly earnings game?
Stay patient, stay focused.

Best,

Todd

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The opinions expressed here are the author's and not those of his employer. For a full disclaimer, please click here


Friday, May 19, 2017

Making the Leap from a Liberal Arts Major to a Finance Career

I recently heard a presentation by Paul Smith, the president of the CFA Institute. One of the data points he shared was that, among CFA Charterholders over the age of 50, about half had liberal arts undergraduate degrees. For those under 50, liberal arts degrees were just a small minority.*

As one of those liberal arts Charterholders, I found this statistic troubling - but not at all surprising.  

There are many reasons for this shift - more majors today, more specialization, etc. - but there's a massive opportunity for liberal arts majors to make an impact in the investing field today. 

Namely, the quantitative side of the business is becoming increasingly industrialized and overwhelmed by computing power. What's still missing are the "softer" skills (e.g. critical thinking, reasoning, writing, etc.) that are cultivated in liberal arts courses. 

Just as important - investing is a liberal arts major's dream job. In fact, there's a thoughtful book written on the topic: Robert Hagstrom's, Investing: The Last Liberal Art. As you develop as an investor, you'll increasingly call on a vast array of knowledge sources - drawing from the sciences, history, philosophy, etc. - in an attempt to weave them together into original ideas.

For these reasons, I'm an advocate for more liberal arts majors in the investing field. When I speak with college students who are undecided on a major or liberal arts majors wanting to make the leap into finance, here's the advice I give.

Minor in business (or audit an accounting course)

If it's not too late, major in a liberal art (something that you're passionate about) and minor in business. The reason I recommend a liberal arts major is two-fold.

First, the vast majority of what you need to know about finance you'll learn on the job. Minoring in business will show companies that you're not completely clueless.

Second, once you graduate, you're unlikely to find a company that will pay you to study ancient philosophy. They will probably, however, help you pay for an MBA or a valuable industry certification. Capitalize on the precious time you have to study liberal arts as an undergrad. 

If you're a senior or just out of school, at least audit an accounting course. Accounting is the one subject companies will struggle to teach you on the job, but it's absolutely critical to know if you want to work in the field.

Start looking into the CFA or CFP programs

Employers should look favorably on the fact that you've started down the path toward a professional certification. It shows that you're committed to the industry and are less likely to jump ship your second week on the job. 

Take a bottom rung job and make an impression

One of my early mentors explained that your undergraduate achievements are like a Christmas present to the company - wrapped up nicely, with a big bow, and full of promise. What really matters is what happens once the present is opened on day one. 

If you don't have a shiny finance resume, your present might appear wrapped in old newspaper to the employer. But that's okay. The key is getting in the door, even if it means starting at the bottom. Once you're in, you can show off your qualitative skills.

For example, with the benefit of hindsight, the best thing I did at my first job (working as a registered rep at one of Vanguard's call centers) was to write a research paper on currency risk. I hadn't the slightest idea what currency risk was before I started, but I knew it was a major topic being asked by investors. It made an impression and led to more opportunities for advancement. 

Focus your first job search on larger financial institutions

It's much easier for a liberal arts major to get an entry level job at a large financial firm. Small firms don't have the resources to let you learn the job on the fly - they'd prefer to hire someone who can hit the ground running. Large firms typically have dedicated training staff and are comfortable with developing talent for the long term.

Bottom line

Making the leap from a liberal arts major to a finance career isn't easy, but then again, nothing worthwhile in life is. The key is to not get discouraged by the fact that you have a liberal arts degree. The businesses that you'd want to work for in the first place should embrace cognitive diversity and value your background.

Stay patient, stay focused.

Best,

Todd

*The CFA Institute is working to get me the actual data. I'll share it if/when I receive it.

Some of you have asked why I haven't updated the blog in a while. I've been helping launch my employer's blog, writing a monthly column here, as well as doing some writing for Monevator and Investors Chronicle. Thank you for your interest - and my apologies for not communicating this better.

The opinions expressed here are the author's and not those of his employer. For a full disclaimer, please click here