A Tale of Two Companies

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

You may think that you are immune to the story that management tell you about their companies. However as charities & marketing professionals know, the reality is we are hard-wired to respond to stories far more than facts & figures. The market votes for the stories it likes with capital flows and it can take a long time for those stories to be weighed by actual future results.

Take for example the tale of two companies that I know well. Both are in the business of designing & manufacturing technology products (although in different fields.) Both have recently gone through a difficult period due to increasing commoditisation of their markets. Consequently both companies have undergone restructuring including outsourcing of manufacturing to China to reduce their production costs. However they have taken very different approaches to their accounting treatment of this period. Company A has presented all of their restructuring costs as exceptional costs to be removed from reporting. Company B has presented only a small bad debt as exceptional. Company A has also been regularly capitalising development costs whereas Company A has expensed theirs’. If you took the adjusted figures at face value you would likely conclude that Company A has been the most successful in their turnaround:

And looking at both the company fundamentals & chart the market appears to have voted this way:

(Blue is company A, Grey is company B, compared from the start of 2014)

However let's do a bit of weighing.

When we adjust for the capitalised development & exceptionals we get a different story:

Although the net margins for both companies clearly indicate companies undergoing challenges it is Company B that appears to have better navigated those challenges.

Net margins are of course not the only factor to consider. The story that the management of company A are telling is one of strong operational gearing. However when we compare gross margins we see that although company A has done well to increase theirs’ over the last few years they are still 10% below those of company B:

It would seem that company B is likely to have better operational gearing and a greater competitive advantage.

Free Cash Flow margins also seem to be the same or better for Company B:

What company A has been successful in doing is driving higher revenue higher, particularly in 2016H2:

(For ease of comparison revenue of company B has been normalised to company A 2014 H1.)

Although looking at the previous charts we see it has been at the expense of Net Margins & Free Cash Flow.

In these times of low economic growth in developed markets & record low interest rates the market has been paying a high price for revenue growth. Could this be the source of the difference in rating? I don’t think so since it is company B that has double the broker forecast revenue growth of company A:

All in all it would appear that company A is overvalued or company B is undervalued. Maybe both. It really does matter what story you tell investors and certainly at the moment investors are willing to ignore the adjustments made to tell the story. I think it is telling that company B is run by highly paid turnaround specialists with large stock option grants whereas company B is run by a long term managers. I look forward to the market weighing. 

Know Your Competitive Advantage

It’s a feature of a competitive market that over the long term a company without competitive advantage will not earn a return above its economic cost of capital. Even if a company has a competitive advantage those supra-normal profit margins will attract competitors who will try to erode that competitive advantage over time.

It is for this reason that so much of successful investing is about identifying companies that possess a sustainable competitive advantage. That is a competitive advantage that cannot be attacked by competitors or it’s difficult to do so due to network effects or legal monopolies like patent protection. A lot of literature is written on the subject. Warren Buffet has become a multi-billionaire mainly due to his ability to identify companies with a wide competitive moat. Even more quantative investors like Joel Greenblatt try to use metrics like ROCE to identify those companies that possess a sustainable competitive advantage, with varying degrees of success.

While understanding the competitive advantage of companies can be a vital part of success as a stock-picker many people forget to apply the same principle to their own investment practice. Simply put if you are a good analyst but don’t have any competitive advantage in investing then you will earn the market return minus costs. If you are an active investor these costs are likely to be large enough for you to underperform the market. If you are a bad analyst you will significantly underperform the market.

As an individual investor (and for most professionals too) the following are NOT sustainable competitive advantages:

I am more intelligent

You may be clever. Most investors I know are. However you are unlikely to be the cleverest person to trade stocks. If your strategy requires you to know a large cap company (even the one you work for) better than a full time analyst with a PhD and access to the management you will lose.

I am quicker

However quick a decision-maker you are, you will never compete with a high-frequency trader. In this realm microseconds are becoming the norm for news reaction and machine readable news aggregation is becoming the way that economic news like interest rates or non-farm payrolls are integrated into pricing. Very few hedge funds even can afford to compete in this space and the incremental returns to speed have probably already reached a plateau. If you are not already one of these few you are unlikely to become one of them. They possess the moat not you.

I work harder

If investment returns were proportional to the man-hours put into it then you are always onto a loser. No matter how many hours a week you personally put in another investment firm can simply hire more analysts to out-work you.

I have a good gut feel

The problem with basing an investment strategy on your feel for the markets is that it is very hard to get effective feedback on how good you actually are. We all suffer form a form of attribution bias where we remember the successful investments we make and forget the losing ones. Even if you keep detailed performance records of your investments it takes a lot of data to be able to show that your gut feel adds any value. And since the market is a complex adaptive system your gut feel may stop working. You can lose a lot of money until you realise that things have changed.

Although it is unlikely that you will be a successful investor unless you are clever, work hard and are able to make quick decisions based on your accumulated experience, these are only necessary conditions not sufficient.

In his latest book ‘David & Goliath’ [1] Malcom Gladwell points out the underdog doesn’t always lose. When the David’s of this world choose to fight unconventionally rather than face a much stronger opponent head on they win a surprising number of battles.

So what are the unconventional sustainable competitive advantages that an individual investor can possess?

I am able to invest with a longer term horizon

This is an area where a private investor can have a real advantage. Most professional investors bear significant ‘career-risk’. That is they are likely to be fired or lose mandates if they have a period of long underperformance. Outperforming the market by definition requires doing something different to everyone else and hoping that you are both right and that the market comes round to your viewpoint. This takes time and the more different you look to everyone else e.g. by refusing to buy tech stocks in 1998/9 the more likely you are to be fired for a period of underperformance. As Lord Keynes said ‘worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.' For this reason most professionals prefer to chase small relative short term outperformance than true long term outperformance. When you manage your own money you don’t report to anyone but yourself. You can focus on mis-pricings that may take years to correct without the fear that short term under-performance will hamper your ability to retain capital or your job.

Find areas where the market is excessively myopic. For example a company may warn on profits dues to delayed contracts and be marked down significantly. However the reporting period of a company is essentially arbitrary. If you can be confident that the contracts are delayed not cancelled and the delay won’t cause financial issues for the company you may be able to buy at an undervalued price from investors who are overly focused on the next set of financial results only.

I am willing to bear risk that others aren’t

Bearing risk alone doesn’t guarantee return since if it did then everyone would bear more risk to get that return and the excess return would be arbitraged away. What we are looking for is situations where other investors won’t take a given risk at any price. One example is that historically if you bought non-Investment grade bonds after they have been downgraded from an investment grade they outperform. The reason is that a lot of bond funds have rules that say they can only own investment grade bonds so after the downgrade you have forced sellers. An individual bond is still risky (hence the downgrade) but on average across all recently downgraded bonds the forced selling has taken the price below the level that balances risk & reward.

It is price insensitive sellers in spin-offs that Joel Greenblatt describes taking advantage of in ‘You can be a stock market genius.’ You have shareholders who end up with a small spun-off holding that is insignificant compared to their other holdings and in an industry they maybe didn’t want to own. The spin off company will also have limited financial history so few new investors want to bear the risk of buying the spin-off immediately creating a price anomaly.

Find areas where price insensitive sellers and a lack of buyers willing to bear risk creates opportunities.

I can invest in smaller and less liquid stocks.

This is an area where hard work can pay off. When you get to the small and micro cap part of the market then professional investors would struggle to get enough stock to make any meaningful impact to their performance no matter how compelling the investment case. Hence it is simply not worth them researching these smaller stocks and equally it is not worth brokers producing research since no one will pay for it. Although the previously held belief that smaller stocks outperform simply due to being small is probably weak [2] it is that lack of competition that means being willing to work hard in this area can pay off.

Academic studies suggest that the average individual investor makes very bad investment decisions [3] . So if these are your only competitors you stand a good chance of success. Assuming of course that you don’t fall for the same poor behaviours and biases that lead this set of investors to underperform on average. e.g. [4]

Find good companies that are not well understood by the average small cap investor and are priced cheaply. Work hard to understand those companies better than the market.

So you see that the individual investor ‘David’ can win against the professional ‘Goliath’, but if you want to be successful you have to learn to fight unconventionally - where you have the competitive advantage.

[1] http://gladwell.com/david-and-goliath/

[2] http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2553889

[3] http://faculty.haas.berkeley.edu/odean/papers%20current%20versions/behavior%20of%20individual%20investors.pdf

[4] http://www.dangercapital.co.uk/2015/08/RuleYourPortfolio.html

The Big Short

I recently caught the film in the cinema. I’d read the book a few years ago but none the less the film was both entertaining and thought provoking. As one would expect from a film about financial markets it had a lot of relevance to investing.

Firstly what a great trade it was. The main characters in the film spotted an asset that was priced as if its components were uncorrelated (as they always had been in the past) and realised that they were in fact highly correlated. The best thing was that the trade had a very high pay out. By buying Credit Default Swaps on Mortgage Backed Securities Derivatives they were paying an insurance premium and getting the principle in return if they were correct. These sort of opportunities don’t come around very often but when they do they are highly lucrative.

The film showed really well why value investing is hard. Buying or selling something because its market price varies significantly from a conservative estimate of true value sounds great but the only reason that you get mis-pricing is because very few people agree with this assessment. It can be psychologically hard to go against the consensus opinion with your own money. The film showed that when you do it with other peoples’ money there’s always a chance they will call you up, shout at you and then threaten to sue you.

Short selling is hard. When you take a short position you are essentially betting that something will fail. This often has real world consequences like people losing their house or jobs. I think this is one of the reasons that a lot of short selling focuses on frauds. Yes a fraud is usually a zero which is the best return you can hope for as a short seller. But I think there may be something deeper too. By exposing fraud it is quite clear that justice is being done whereas it is less clear cut with a business that is merely overvalued or fails due to management incompetence. That said I do believe that for good businesses to succeed, some bad business need to be starved of capital and fail. I personally have never had a moral issue shorting a company. But as the character Ben Rickert points out in the film, when they do fail sober reflection is probably a more fitting reaction than triumphalism.

Despite being a great trade I do think the film showed all the participants making mistakes.  Mike Burry in particular was too early putting his trade on in 2005. This is always a difficult part of investing, particularly for those of us of a ‘Value’ bent so I’m not sure really what he could have done to prevent being early. Where I think he did go wrong was with position sizing. He thought that his history of past returns was enough for his investors to stick with him through all short or medium term under-performance as long as he was right in the end. He suffered from the illusion of permanent capital and in the end had to gate his fund to get the permanent capital he needed to see the trade through. I reckon a lot of value investors who took large positions in specific stocks and underperformed in 2015/2016 may find that they were suffering from the illusion of permanent capital. We all sometimes underestimate how long it will take for a particular investment thesis to play out and we would be wise to treat each investment like a DIY project. Think how long it should take, then double it…and double it again.

I think the final mistake that most of them made was underestimating the counterparty risk in the trade. The character Mark Baum’s hedge fund was part of Morgan Stanley so had exposure to the financial crisis despite his short position. All the others had bought their CDS from investment banks so would have been potentially valueless had the investment banks failed while they still held them. If they truly saw the scale of the coming financial crisis they should have had CDS on each counterparty and maybe even a long government bond position to protect themselves further.

And as always in investing luck played a part. Several of the characters found the trade because someone else introduced them to it. And the founders of Cornwall capital were able to access CDS because of a former neighbour.

The secret of finding the next Big Short? Be open to new ideas, bet on value, look for asymmetric returns, focus on position size, consider counterparty risk up front and practice humility when it pays off.

Portfolio Construction Part 2 – The Matrix Revolution

In my previous post I looked at the sort of factors you need to consider when deciding what level of diversification is right for you. In this post I’m going to look at a way of improving how you weight those assets within your portfolio.

There is actually a mathematical method for determining what proportion of one's portfolio you should allocate to certain investment opportunity. It's called Kelly criterion and is based on the expected return and the odds of receiving that return.

https://en.wikipedia.org/wiki/Kelly_criterion

This can be shown mathematically to maximise one’s return over the long term. Unfortunately, although mathematically optimal, applying the Kelly criterion to portfolio construction has a few issues:

1. It is based on a consecutive series of events which you can determine the odds and payoff for. It doesn’t generalize well to portfolio management where you are choosing between competing concurrent investment opportunities.
2. Probably the biggest issue with applying the Kelly criterion is the level of draw-downs you can expect. These would be enough to end most investing careers if realised. For this reason even practitioners that use the Kelly criterion explicitly use a fraction of the amount that the Kelly criterion suggests.
3. The final issue is that the Kelly criterion assumes that one can accurately assess the odds of success and the payoffs. If you get the odds wrong or have a large level of uncertainty (as is likely when investing in individual stocks) there is a big variation in what proportions you should apply.

So rather than give a specific mathematical formula I suggest the following simple framework based on similar principles to help you allocate assets or test your portfolio in a logical way.

The first principle is that you should hold more of stocks that you believe to have the greatest upside.

It is perfectly valid to have a portfolio where you believe a set of stocks as a group to be fundamentally undervalued but you are not able to determine any difference in potential between them. This would be akin to a simple quant strategy e.g. buying the cheapest decile of stocks. In this case it makes sense to equal weight your portfolio. However for the rest of this post I’m going to assume that there is an ability to at least roughly assess the potential upside of a company and that you want to make the most of that potential upside.

The second principle is that you would like to bear the least amount of risk in achieving that upside.

Now when I say risk here I do not mean, as academics often do, just volatility or the co-variance of price movements. These can matter to investors. Particularly professional money managers who bear career or asset flow risk during periods of low returns. Or the private investor who bears ‘volatitility risk’ by explaining to a spouse why they are going to Blackpool on holiday this year not Barbados! However these are not the only forms of risk. What I am talking about here is an honest assessment potential downside if things go wrong or the risk of a permanent loss of capital. Forms of risk on top of volatility one may want to account for are:

Financing risk – Companies with high levels of debt will be less able to weather a period of poor trading. A heavily loss making company may struggle to raise extra capital.

Management risk – Management with a history of poor capital allocation may not act in the best interests of shareholders.

Product risk – Companies with one product or a few products serving only one market are more exposed to the performance of that product or market. Typically, but not exclusively, this makes smaller companies riskier.

Liquidity risk – The risk of not being able to sell near the published price when you want to. Typically, but not exclusively, this makes smaller companies riskier.

Commodity risk – Companies without a sustainable competitive advantage to control pricing are more likely to be exposed to commodity, economic growth, inflation or obsolescence factors.

Correlation Risk – I don’t mean the mathematical co-variance of stocks but the common exposure they have to factors that are out of your control. For example if you already have an oil explorer in your portfolio adding a second one should be considered higher risk (all other things being equal) than adding an equally undervalued oil consumer such as a plastics manufacturer.

By assessing the stocks in your portfolio & watch-list on these principles you can then use the following matrix to determine portfolio weightings:

• If you find investments that are both low risk and high potential return then you should invest heavily in these.

• For low risk investments with a good return potential or slightly riskier stocks with an excellent expected return you can hold a reasonable amount.

• If you find very high return stocks that are also risky and a conservative assessment of the expected return is positive you should invest. It’s just that you should limit yourself to small positions in these types of opportunities. If they come off the returns will be high even from modest positions.

• Finally why would you choose to hold any investment if it’s going to generate a low return whatever the risk level?

The precise percentage values will vary depending on your chose diversification level (see Part 1) and the availability of good investment ideas however these sorts of levels tend to work for me with a typical 25 long positions:

If this seems simple to you it is because it is. And if we all invested our capital fresh every day we would probably naturally gravitate towards something like this. However typical portfolios evolve over time. Capital is added or removed at different times. Stock prices change and with them our portfolio weightings. Because we all suffer from anchoring effects and ownership bias our portfolios can quickly vary from the ideal without us taking action. Therefore the real power of applying this framework is being able to assess your current portfolio against it. Too often we buy a high risk position that goes up significantly and becomes a large position. Typically this then has same or increased downside risk but reduced upside as its valuation becomes stretched yet it has become one of our biggest positions. Often we hold on without selling as it becomes a small position weight again! Conversely when we really have found a low risk investment with a very high return we may fail to put enough into it to really take advantage.

One of the common objections to rebalancing portfolios is ‘I like to run my winners and cut my losers.’ However this only works as a strategy because share prices exhibit medium term positive serial correlation i.e. they have momentum. And you’ll notice that I’ve specifically not mentioned valuation in my assessment of potential upside. As a value investor my primary method for assessing potential upside is valuation metrics however yours may be something different like technicals. Whatever your method the matrix still gives a good logical framework for asset allocation. There is good academic for momentum i.e. that prices that have risen for 6-12 months tend to keep on rising therefore it can be right to include the price momentum in determining the potential upside. Just that one should be consciously doing this and if that is the primary component of upside that remains one needs to sell when momentum fades. Like all other forms of excess return it requires disciplined execution to capture effectively.

For advanced investors you can expand the matrix to include shorting high risk stocks that have low expected returns. And the high risk but very high return potential of options strategies.

But like all complex investing strategies they should be used cautiously with small diversified positions and only after getting the basics right.

So in summary, good position sizing can seem less exciting than choosing your next winning stock however it is equally important to acheiving consistently good returns. It makes sense to apply the principles that you want to maximize your upside and minimize your downside to all your portfolio positions. I believe that creating your own risk-reward matrix, and consciously assessing your portfolio against this, will provide a framework that will keep you in line with these over time and lead to better long term returns.

In the last part of this trilogy I will look at some simple rules that can help avoid other behavioral biases creeping into our portfolios.