Monday Dirty Dozen [CHART PACK]

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The investment process is only half the battle. The other weighty component is struggling with yourself, and immunizing yourself from the psychological effects of the swings of markets, career risk, the pressure of benchmarks, competition, and the loneliness of the long-distance runner.  ~  Barton  Biggs

In this week’s Dirty Dozen [CHART PACK] we look at investment fads throughout the decades before discussing the *ahem* slight optimism over tech stocks… and then take a look at the valuation metrics for the broader market, talk about what Europe has given to investors over the years, take a peek at EURUSD, and end with a look at bonds, plus more…

Let’s dive in.

***click charts to enlarge***

  1. Every decade has its trendy investment theme. In the 60’s it was all about the Nifty Fifty, then gold in the inflationary 70s, Japanese stocks in the 80s, tech in the 90s, oil in the 00s, and of course FAANG today. Will FAANG continue its dominance into the new decade or will we see a new theme emerge? Chart via Alpine Macro.

 

  1. The thematic has certainly received a helping hand from the pandemic which has forced everyone’s consumption to move to the virtual space. This chart from BofA shows the hockey stick growth in e-commerce as a % of Retail Sales.

 

  1. Sentiment Trader shows that the trade has gotten a bit over its skis though… Their QQQ Optix indicator recently hit decade highs. ST notes that “In bear markets, this was a disastrous sign for equities. In bull markets, it either led to consolidations or pullbacks.”

 

  1. The extreme outperformance by these high-growth stocks versus their boring “value” peers has lead to what I assume is the mandatory end of cycle editorial pieces where we question the point of value investing.

 

  1. After sitting out most of the cycle retail is finally getting into the game and doing so at record levels (chart via Sentiment Trader).

 

  1. The only long-term bull case I’ve been able to come up with for stocks has been that the risk premium on offer is fat (equities are cheap relative to yields) and honestly what’s the alternative? But, BofA points out that if you normalize ERP then stocks are pretty much dead in the middle of the ERP range they’ve been in all decade. BofA goes onto point out that “On a statistical basis, the 20.4x S&P 500 fwd PE puts the market over 1.5x standard deviations above the average of 15.4x and three-quarters of the way to the Tech bubble high of 25x.”

 

  1. And UBS writes that “A significant loosening of liquidity has driven re-rating of the market. But the rise in multiples is disproportionately high relative to the decline in real interest rates and credit spreads. We estimate that even if credit spreads were to go back to their tights, current equity market valuations are too high by around 3x. It is possible that the equity risk premium on offer rises in a non-linear fashion as rates approach zero, but current multiples look stretched even accounting for this.”

 

  1. BofA examined the SPX across 20 valuation frameworks to determine historical cheapness. Red boxes indicate where the market is “richer” than average.

 

  1. You would think that such high valuations would be reflective of stronger than usual fundamentals but, errr…. That’s not exactly the case. BofA shows that “the proportion of non-earners within the Russell 2000 is above levels typically seen heading into recessions (and near all-time highs reached during prior recessions) — and this was largely before the impacts of COVID-19/should only get worse”.

 

  1. If you bought European stocks back in 99’ at the introduction of the euro you’d be down 22% today which is better than the 87% you’d be down if you’d bought European banks over 20-years ago.

 

  1. I was hopeful that we’d see a tradeable bounce in EURUSD. But, alas, I think those hopes have been dashed. EURUSD Relative growth fell through the basement floor recently. FX is driven by speculative flows and speculative flows chase expected risk-adjusted returns which hinge on growth (higher relative growth = stronger EPS and higher yields). EURUSD has been coiling very tightly. Expect a big move soon.

 

  1. I’m fairly bearish on US stocks over the next 12-months. Luckily, there’s plenty of other markets to trade. One of my favorite trades at the moment is to be long bonds. This chart from @macrocharts shows that spec positioning is giving us plenty of fuel for the move higher. Also, all my bond indicators started flashing another buy signal last week. Plus, the tape looks strong.

Stay safe out there and keep your head on a swivel.

Carvana, Peloton & A Cheap Portuguese Company

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Hope you had a great week and weekend. Golf courses in MD finally opened up. When you haven’t hit a golf ball in 3 months, you don’t keep score. You see how many balls you lose. I only lost one ball. It was a good round.

Anyways, we’ve got three great letters for you this week from three of my favorite investment thinkers. But before we get there, I want to give a huge shout-out to Harris Kupperman of Praetorian Capital.

Kuppy came on the podcast last week and set a major record. We passed 1,000 listens in less than a day. And within three days, Kuppy’s episode has over 2K listens. I know, it’s peanuts compared to other larger podcasts. But we’re just getting started.

Thank you to every guest and listener — you make the show.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Tao Value Q1 Letter
    • GreenWood Investors Q1 Letter
    • Hayden Capital Q1 Letter

Vamanos!

May 13, 2020

Valuing Young Growth Companies: One of my favorite hobbies is reading Aswath Damodaran’s valuation white-papers. I know, exciting life I lead, right? My favorite Aswath paper (so far) is Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges.

I’m in the process of creating a long Twitter thread of my favorite bits of information from the paper. If you don’t have time to read all 67 pages, give me a follow on Twitter and I’ll give you the run-down!

Speaking of Twitter, I recently compiled all my favorite Mohnish Pabrai YouTube videos in one thread:

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Investor Spotlight: Emerging Markets & Emerging Managers

GIFs by tenor

Tao Value: -12.96% Q1 2020

Tao’s letters are great because they open me to a new world of equities: China. I’m like a kid that doesn’t want to learn to swim when looking at China. I see the other kids have fun, splashing around. But as soon as I dip my toes in, the pool turns to shark Luckin-infested waters.

Tao mentions numerous stocks, but we’re focusing on the following:

    • China Meidong Auto (1268.HK)
    • Atlassian (TEAM)
    • Bilibili (BILI)

China Meidong Auto (1268.HK)

Business Description: The company is involved in the sale of new passenger cars and spare parts; and the provision of service and survey. It also provides after-sales services, such as auto registration, insurance, auto financing mortgage, auto parts, repair and replacement, sales and maintenance of automotive supplies, etc. In addition, the company engages in the trading of used vehicle and finance leasing activities. Its dealership stores cover various automobile brands comprising BMW, Lexus, Toyota, Hyundai, and Porsche. – TIKR.com

What’s To Like:

    • 30%+ 5YR Revenue CAGR
    • 76% 5YR EPS CAGR
    • Strong balance sheet
    • Reducing Inventory Churn/Payables Outstanding

What’s Not To Like:

    • Chinese auto-dealership
    • Specializes in luxury cars
    • Increase in debt/liabilities as % of assets
    • Approaching Tao’s estimate of fair value (21x normalized earnings)

What’s It Worth (Assuming 10% Discount Rate):

At the current price, Mr. Market expects 33B CNY in 2024 revenue, 1.99B CNY in EBITDA (6% margin) and a 10x EBITDA exit multiple.

Here’s what Tao has to say about valuation (emphasis mine): “On valuation though, I see the price approaching fully valued. It now trades at 25 X trailing EPS, and around 17x forward earning per share.”

That said, Meidong is growing over 30% p.a in top-line revenue while trading at 21x normalized earnings. It may not be cheap, but it doesn’t sound expensive at that growth rate.

Also, a 10x exit EBITDA multiple is quite the compression from its current 16x valuation. If multiples don’t shrink, and Meidong exits at its current multiple, shareholder equity increases to 22B CNY (21.54 HKD/share).

Stock Chart

Atlassian (TEAM)

Business Description: It provides project tracking, content creation and sharing, and service management products. The company’s products include JIRA, a workflow management system that enables teams to plan, organize, track, and manage their work and projects; Confluence, a content collaboration platform that is used to create, share, organize, and discuss projects; and Trello, a collaboration and organization product, which captures and adds structure to fluid fast-forming work for teams. – TIKR.com

What’s To Like:

    • 40%+ 5YR Revenue CAGR
    • Net cash on balance sheet ($859M)
    • 83% Gross Margins
    • FCF Positive
    • Negative Working Capital

What’s Not To Like:

    • Optically Expensive
    • Trading Near All-Time Highs
    • High stock-based compensation
    • Increase in Days Sales Outstanding from 10 days to 21 days

What’s It Worth:

The company’s estimated 27% EBITDA margins by the end of this year. If we assume their 30% revenue growth is correct, that gives us $434M in EBITDA by 2020, $660+ in Cash from Ops and $600M in free cash flow.

That’s great. Unfortunately Mr. Market’s priced that already. At the current price, Mr. Market’s expecting $3.3B in 2024 revenues and over $1B in EBITDA on 30% margins. Is that possible? Of course. But TEAM’s trading at 28x revenues. I would need a serious drop in price to get interested in this name. And I hope it does drop.

It’s a great business that generates loads of free cash flow.

Chart Analysis

Bilibili (BILI)

Business Description: Bilibili Inc. provides online entertainment services for the young generations in the People’s Republic of China. It offers a platform that covers a range of genres and media formats, including videos, live broadcasting, and mobile games. – TIKR.com

Tao’s Take: “I believe BILI has built a moat around its mid-form PUGC platform. It now has 130 million engaging monthly active users, and wide range type of content. The network effect of attracting highquality content creators is evident, as it organically expands user base to older millennials (in their 30s) who has no ACG-related hobby.”

What’s It Worth (emphasis mine): “I estimated BILI’s game business could be worth about $3b on a 15x forward earning, which, at our cost basis, implies $2.8b for the rest operating businesses, or $22 market cap for each MAU. This is very cheap considering such a business should be able to easily monetize at $10/user (using either opportunity-cost-based survey or Chinese video/streaming/social media peers) from current 5 mere $3.7/user when they see appropriate. A reference point is that YouTube currently monetizes at $8/user globally, which is also under-done in my opinion. So, we paid 2.2X “fair” revenue for a YouTube of China, where I think a fair multiple should be between 5 to 10 times (depending how much growth you believe is still left).”

Chart Analysis: Potential Inverse Head & Shoulders

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GreenWood Investors: -22% to -25% Q1 2020

Steven Wood is one of my favorite investors in the game. I love the way he thinks about ideas, situations and portfolio construction. Steven, if you’re out there — I’d love to have you on the podcast! Let’s make it happen!

Wood returned -25.60% during Q1. You can read his letter here.

Let’s review some of the stocks Steven mentioned:

    • Correios de Portugal (CTT)
    • Peloton (PTON)

Correios de Portugal (CTT)

Business Description: Correios De Portugal, S.A., together with its subsidiaries, provides postal and financial services worldwide. The company operates through Mail, Express & Parcels, Financial Services, and Banco CTT segments. It offers addressed mail, transactional mail, international inbound and outbound mail, and advertising mail distribution related services; CTT Logística, a platform for the creation of product catalogue, storage, order preparation, and distribution to the final consumer which allows customers to focus on the development and sale of their products; banking services; courier; transport solutions; payment network management services through Payshop; and documental services. – TIKR.com

Steven’s Take: “The company’s ubiquitous network that touches nearly every house and business almost every day is a fantastic delivery mechanism for the clear bull market in parcels, particularly e-commerce-driven parcels. Express networks are not properly set up for the last mile outside of highly urban areas. That’s why postal companies largely win the last mile of e-commerce. It’s a business that’s somewhat similar to a cement company, local market share matters heavily. As we all learned in geometry, when a truck’s delivery radius shrinks by half, as its market share doubles, the total area driven is reduced by ~75%.”

“Just a few years ago the company launched its own bank, which we estimate has taken almost half of all new accounts in the country since being opened. It has the highest customer satisfaction, and with a labor and physical footprint around one tenth of its competitors, it will have a permanent cost advantage versus peers.”

What’s It Worth:

Steven’s Take: “combined with the bank, and even if we take a major haircut to the bank’s GreenWood Investors LLC www.gwinvestors.com 5 value, the stock with just over a €300 million market cap today and a €32 million net cash position, means the company’s current enterprise value is deeply negative. So investors today are getting paid to take a core business which before the coronavirus, was on track to hit over €90 million in EBITDA in 2020, even after the new lease expenses and banking income are removed.”

We can cross-reference Steven’s valuation with our own, simple 5YR DCF model. Let’s make the following assumptions:

We’re also assuming a 10% discount rate and 0% perpetuity growth.

That gets us around $436M in EV ($197M from PV cash flows + $240M in terminal value). Add back our cash + investments and subtracting debt gets us another $540M in equity value for a total shareholder value of $976M ($6.50/share).

Chart Analysis

CTT remains in a clear downtrend and is forming a large symmetrical triangle. Look for a breakout above the 50MA and the upper resistance level to confirm the trend reversal.

Peloton (PTON)

Business Description: Peloton Interactive, Inc. provides interactive fitness products in North America. It offers connected fitness products, such as the Peloton Bike and the Peloton Tread, which include touchscreen that streams live and on-demand classes. The company also provides connected fitness subscriptions for multiple household users, and access to all live and on-demand classes, as well as Peloton Digital app for connected fitness subscribers to provide access to its classes. – TIKR.com

Steven’s Take: “It sells its stationary bikes and treadmills for about 10x the cheapest competitive offerings, yet it still manages to save its 2.6 million subscribers significant sums of cash every month. Because the value of Peloton lies in the millions of hours of content, as well as live exercise classes, the monthly subscription fee of $39 is dwarfed by the monthly bills of boutique fitness studio goers, which number over 30 million in the United States, and who pay over $30 per class for their endorphin rush.”

What’s It Worth:

Honestly, I don’t know what this thing could be worth in five years. We can use a revenue multiple since they don’t generate earnings. But attaching a 4x sales multiple on 2024 estimated revenue of $5.5B gets us a 30x exit EBITDA multiple.

Maybe PTON is worth 30x EBITDA in five years. But they face stiff competition from Apple’s fitness app and Soul Cycle’s new bike.

Chart Analysis: Inverse Head & Shoulders Breakout

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Hayden Capital: +4.10% Q1 2020

Fred Liu, CFA runs Hayden Capital. He invests primarily in Asia/North America. As of Q1 end, he had 56% of his fund in Asian equities.

Liu mentions two stocks in his portfolio update:

    • Interactive Brokers (IBKR) — sold
    • Carvana (CVNA) — owns

Interactive Brokers (IBKR)

Why Liu Sold: In the last year, Interactive has faced several industry-wide headwinds that hindered some of these positive developments.”

What were these developments? Two things:

1. Low net interest margins

Fred’s Take: “For example, net interest margins have declined 15% from a peak of ~1.7% a year ago, to most recently ~1.45%. This means even as accounts have grown, Interactive will make a less money per account, going forward.”

2. Zero commissions

Fred’s Take: “Industry-wide commissions have also been under pressure, as many retail-focused competitors started offering $0 trading commissions last fall. Interactive was one of the original low-price leaders, and was also one of the first to initiate the $0 commission price war via its new IBKR Lite platform, once it was clear the industry would inevitably move in this direction.”

Will the company do well over the next five-to-ten years? Yes. As a user of their product, I hope so!

But they trade around 28x normalized earnings in a low net interest margin world and zero commissions. Like Liu, I believe most of the marginal retail accounts will flow to other shops like Charles Schwab (SCHW). The UI is a bit better and the customer service is top notch.

Plus, the stock remains in a well-defined downtrend.

Chart Analysis

Carvana, Co. (CVNA)

Business Description: CVNA operates an e-commerce platform for buying and selling used cars in the United States. Its platform allows customers to research and identify a vehicle; inspect it using the company’s proprietary 360-degree vehicle imaging technology; obtain financing and warranty coverage; purchase the vehicle; and schedule delivery or pick-up from their desktop or mobile devices. – TIKR.com

Fred’s Take: “Carvana seems to be following a similar playbook. Similar to how Amazon educated the consumer and changed online shopping habits with its own 1P business and Amazon Prime, Carvana is doing the same with its marketing and hassle-free experience. Once they proved the market with their own inventory and built the trust, traffic, and infrastructure, Amazon eventually opened up the platform to 3rd Party sellers and provided them with the tools to succeed.”

What’s It Worth:

CVNA currently trades at 1.5x EV/Sales. This seems cheap given their 100%+ 5YR Revenue CAGR. The company also sees a path towards EBITDA positive by 2023. Let’s use the following assumptions:

Even at modest revenue growth, CVNA reaches over $13B in revenue by 2024. If we keep our 2x sales multiple we get $26B in EV (vs. $8.1B today). That’s over 100% upside assuming no revenue multiple expansion and roughly 30% 5YR revenue growth from here.

Chart Analysis

The stock remains firmly in an uptrend (above 50MA and 200MA).

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Herd Mentality, Mirror Neurons and Solomon Asch

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Herd mentality, as defined by Herbet Simon in the journal article The Concept of Herd Behavior: Its Psychological and Neural Underpinnings is (emphasis mine), “An alignment of thoughts or behaviors of individuals in a group … such convergence emerges through local interactions among agents rather than some purposeful coordination by a central authority or leading figure in the group.”

Sheep, buffalo or middle-aged women at Lululemon. We see herd mentality everywhere. In this section, we’ll discover the physiological mechanisms of herd mentality, cover Solomon Asch’s powerful experiment, and discuss how we can apply Asch’s findings to our own Investment Process. Once finished, you’ll be able to add a new mental model to your lattice-work toolbelt.

Why We Herd

Humans don’t herd because we decided it would be fun. It’s how we survived. We are, after all, the most advanced species on the planet. But we weren’t always like that.

Our hominid ancestors utilized herding to pass their genes to the next generation. For example, if a lion’s chasing you, it makes sense to run as a pack and play the numbers game.

Moreover, the journal offers ideas into how herding arises on a physiological level. A first principles level, if you will. By understanding how we herd, we can better apply these principles to other disciplines (investing, life, relationships, etc.).

Mechanisms of Herding

According to the journal article, herding mechanics fall into three buckets:

    1. Emotional Contagion, Facial Mimicry, and Mirror Neurons
    2. Social Norms, Shared Stories, and Mutual Expectations
    3. Information Cascades

Let’s dive in.

Emotional Contagion, Facial Mimicry and Mirror Neurons

Humans are like chameleons when it comes to showing emotions. Emotional contagion is the act of reflecting someone’s emotional state upon ones-self. It’s ingrained into our physiology. For example, infants begin mimicking emotions by day 21. To help us explain this phenomenon we need to go microscopic, we need to look at neurons.

Mirror neurons are the fundamental building blocks of mimicry and emotional contagion. Coined by Italian neurophysiologist Giacomo Rizzolatti, this neuron is what makes us social creatures. In fact, this gene goes so far back we can study it in chimps.

In his research, Rizzolatti revealed (emphasis mine), “[the neurons] fired both when an animal acted and when the animal observed the same action performed by another.

Moreover, Rizzolatti explained that (emphasis mine), “The same neurons fired when the monkey grasped something with its hand, and when the monkey observed the experimenter grasping it.”

Neuroscientist at the University of California, Marco Iacoboni, used smiling to explain mirror neurons (emphasis mine):

“When I see you smiling, my mirror neurons for smiling fire up, too, initiating a cascade of neural activity that evokes the feeling we typically associate with a smile. I don’t need to make an inference on what you are feeling, I experience immediately and effortlessly what you are experiencing.

This is significant for two reasons:

    1. It proves that it’s easy for us to mimic others’ emotions and in turn show them ourselves.
    2. Beyond showing the emotions of others, we end up feeling the same as they do.

Thinking at the Neurological Level

It turns out mirror neurons impact every aspect of how we interact with others. Even how we process information.

Suppose you spend all day reading headlines of an impending market crash. You check Twitter and voila, the yield curve inverted! Reading other investors’ reactions can pull you towards an altered state of thinking. Mirrored thinking, or their thinking. When the neurons fire, you become preoccupied with processing others’ opinions. You even start feeling those emotions on a biological level. You become trapped in your own neurological web.

We see the same activity occur in individual stocks too. A hedge fund hotel is a collection of fund managers with mirror neurons firing in agreement. Short squeezes experience similar neurological mechanics. The first sellers cover, which triggers more sellers to cover, you get the picture.

Thinking with a mirror neuron framework provides us with a lens at which to view human interaction in financial markets in a brighter light. We know where sell-offs and bull-runs start: at the biological level.

Social Norms, Mutual Expectations and Shared Stories

Social norms exist for a reason. They help us gain and keep friends, garner respect in our communities, and stay within the bounds of ‘rational behavior’. We use mutual expectations and shared stories to develop and grow these social norms. Yet, even though social norms benefit society, they don’t help us profit in financial markets.

To understand social norms and its influence on our decision-making, we must first understand docility. Docility, according to Simon, is our (emphasis mine), “tendency to depend on others’ suggestions, recommendations, persuasion and information obtained through social channels as a major basis of choice.

Let’s unpack this a bit more.

Simon argues that in honoring social norms, we tend to seek out what’s popular amongst the masses. Once we learn what’s popular, we adopt that thing into our standard of being. It becomes our social norm. This has devastating effects when it comes to investing and financial markets.

The Power of News

There are no shortages of opinions on Financial Twitter (or as the cool kids call it, FinTwit). Have an idea you’ve been volleying in your mind? Shoot it out to the FinTwit masses and watch the piranhas attack.

Twitter is a great way to ‘red-team’ a thesis. But if you’re not careful you’ll enter an echo-chamber of confirmation bias. Even worse, your idea might be so unpopular that you throw it out for the sake of becoming a social pariah.

Financial news outlets — *cough cough* CNBC —  fight every day to prey  on your docility-space. They want you to adopt their expectations, share their stories. It’s easy to fall into thinking that what they’re saying matters. After all, they do have flashing headlines and “Breaking News” segments. These channels abuse our innate desire to connect with stories. To share in narratives.

When Stories Become Hindrances

In a similar vein, we leverage stories (narratives) to explain any and every phenomenon. We’re pattern-recognition creatures, and most of our heuristics trace back to our African ancestors. These narratives do more than guide our minds during events in which we have no prior experience. It’s deeper than that. Narratives give us comfort.

Yet its this desire for comfort that harms us the most when we’re investing in public/private markets.

Start-up companies pitch narratives about what the future will hold — even if they can’t yet show it in profits. Venture Capital funds fire-hose cash into these narratives. And who can blame them? It’s ingrained into our most basic genetic fabric. We love a good story.

The problem is that this behavior is value destructive. Our desire for a great story saps investment from good (albeit monotonous) ideas into high-flying stories about the world to come.

Given where we are in the cycle, it’s not surprising that people want to invest in a money-losing company with a great narrative over a cash-gushing business with a boring narrative. Boring businesses don’t make interesting stories for the 24-hour news cycles.

Stories become hindrances when they prevent us from making rational, reasonable investment decisions.

Information Cascades

Information cascades are like avalanches. Not only in that they’re the culmination of the previous examples, but also in their destruction. All it takes is one silent tremor to send life-threatening reverberations further down. Hyperbolic bull runs and manic bear markets feed on information cascades. Even worse, the information doesn’t even need to be correct for the cascade to work!

Let’s take an example from Simon’s journal article on the academic peer-review process.

Peer-reviewed journal articles go through many rounds of approval from fellow academics. Get enough positive remarks on your paper and you’ve got a spot in your industry’s publication.

But what happens if the first peer leaves a poor review?

That decision, the first decision, sends information down to each subsequent reviewer of the paper. Whoever reviews the paper first will influence the opinions of each incremental set of eyes. That’s a lot of responsibility.

Intuitively this makes sense. If you receive a paper for review that has “rejected” on the front page, it subconsciously changes the way you view the paper. All this happens before you read a single word!

That’s the power of information cascades.

The same thing happens with stocks. One person starts selling, which causes another person to sell, which leads to another person to sell … You get the picture. Information cascades happen fast and they take no prisoners. What’s a ‘Greater Fools Theory’ other than an elongated information cascade to the upside?

As we’ll see next, information cascades lead us to act in abnormal, even irrational ways.

The Solomon Asch Experiment

Solomon Asch was one of the most influential social psychologists of the 20th century. Born in Poland, Asch’s professional work focused on social influences, conformity and impression theory. Yet it’s one experiment in particular that cemented his legacy:

Measuring lines (see photo to left).

The results of this study impact the very essence of what it means to be a stock market participant.

Questions such as, ‘Do you have what it takes to be a contrarian?’ have meaning. The old adage, ‘contrarianism can’t be taught’ has validity. Things we didn’t think measurable, Asch translated into data.

We’ll provide an overview of the experiment, its results and how we can apply those results to our investment process. Another mental model to add to the toolbelt!

Let’s dive in.

Overview of Experiment

Asch’s goal for the experiment was to “study the social and personal conditions that induce individuals to resist or to yield to group pressures when the latter are perceived to be contrary to fact.

Asch believed it was “decisive fact” individuals are born with either the tendency to conform or to act independent. Famous value investor Seth Klarman ascribes to similar beliefs. He’s well known for believing contrarianism isn’t something one can learn.

The set-up was simple: one individual and one group of eight people. Both tasked with matching the length of a given line to one of three unequal lines. Asch then employed a control group. This group would write their answers on a piece of paper instead of saying them out loud and in front of a group.

Here’s where the experiment proves potent. Instructed by Asch, the group would unanimously go against the judgement of the individual. If the individual thought the line was 1 inch, the group argued it was 1 ½ inches.

In his words, Asch wanted to know the “grounds of the subject’s independence or yielding … whether he abandoned his judgment deliberately or compulsively.”

In essence, Asch was studying contrarianism at its psychological foundation.

The Findings

The results of the experiment were, to quote Asch, “clear and unambiguous.” The data backs this up (screenshot from Asch’s journal article):

Observing the data we notice a pull towards the majority. One-third of critical errors made by the individual were either identical to or within the direction of the majority’s incorrect guess.

Phrasing it another way, our thinking is very much swayed by groups.

Things get even more remarkable when you compare the control group results. Nearly 95% of the control group had zero critical errors.

These results weren’t binary, however. Distributions emerged between those that remained confident and those that caved under groupthink.

Asch broke the distribution into two quadrants: independents and yielders.

Independents were confident people, as one would assume. Yet they had a great feel for knowing they didn’t know everything. They were fallible. For example, one of the Independent subjects claimed (emphasis mine), “I would follow my own view, though part of my reason would tell me that I might be wrong.

Asch noted that Independents were generally, “resilient in coping with opposition, … relied on their own perception and effective at shaking off oppressive group opposition.” Sounds like the required mantra when bag holding a contrarian position, right?

Yielders, Asch concluded, lacked confidence and appeared nervous when challenged by the group. One of the yielding subjects explained that (emphasis mine), “If they (the group) had been doubtful I probably would have changed [my answer], but they answered with such confidence.

That last part is key: “but they answered with such confidence.” Excess confidence (especially in financial markets) gets you killed.

Using Asch’s Results to Improve Investment Process

Before implementing this new model into our process, we need to ask ourselves:

What type of investor am I? A yielder or an Independent?

You might be a Yielder if:

      1. You find yourself seeking confirming evidence on your existing holdings.
      2. Sell at the slightest chance your opinion is unpopular.
      3. Only invest in “trending” stocks.
      4. Fail to do proper due diligence on your investments.

What should you do if you found yourself muttering, “damn, I do almost all of those things!”? Below are three ways that helped me turn yielding into independence.

1. Spend more time analyzing a business.

Yielders have confidence issues. They wonder if others think their Axe body spray smells nice. Even worse, they lack conviction in their investments.

One way to reduce a lack of confidence is through deep diligence into one’s holdings. Don’t get me wrong, there will always be unknown unknowns. Yet understanding a business on a deeper level enables you to withstand the inevitable drawdowns.

If you really understand a business, you’ll know the difference between a fire sale and an actual fire. You’ll know if a 30% drop screams “buy!!!” or if it screams “GET TO THE CHOPPA!”

2. Buy illiquid stocks

Want to kick-start your ability to generate confidence and conviction? Buy shares of very illiquid companies. Illiquid stocks force you to think more like a business owner.

There’s two factors that allow this.

First, there isn’t much public information out on some of the smaller, more illiquid names. This requires you to dive deeper and investigate like a real business owner. You can’t just pull  up the latest analyst report.

Second, you can’t move in and out of illiquid positions with ease — hence the name, illiquid. It takes a while to build a position, and as long to unwind the position. Selling an entire position at once could turn you from investor to market-maker. Doing this ruins your chances of getting the price you want.

Because of these factors, your time-frame shifts from short-term to long-term, if nothing else for the sake of cost basis.

3. Protect Your Downside

It’s easy to be a Yielder when you’re frightened of losing your skin on an investment. But it doesn’t have to be that way. The margin of safety principle applies to your confidence levels. If you’re betting the farm and sport a risk-averse personality, of course, you’re going to yield at the slightest chance of being wrong. This is where downside protection comes in.

Downside protection manifests in various forms. It could be cash on the balance sheet. You could buy at less than liquidation value. On top of these, you could use stop-losses, which literally cap your losses.

Beyond these more quantitative measures, confidence is easier to keep if you’re investing with a high margin of safety. If you can be wrong and still make money, it’s easier to sleep. There’s nothing better than investing in a net-cash business where even if you’re dead wrong about the future, you can still make money.


What to watch if you’re an Independent

One would assume that it’s better to be an Independent than a Yielder. And while that is true in theory, it doesn’t mean Independents skate through without issues. In fact, if left unattended, Independents could lose significantly more sums of money than their yielding counter-parts.

Here are two red flags to watch if you’re Asch’s Independent:

1. You discount any opinion / news contrary to your current thesis.

Confidence can manifest into arrogance. Where yielders struggled to hold any conviction, Independents can’t think of a world where they’re wrong. All their models are the truth, and their EBITDA multiple is without error. This isn’t optimal and can lead to portfolio destruction.

Cure: Read short theses on your longs, and try to keep an open mind. You can be wrong.

2. You refuse to sell because ‘I’m right and it’s going back up.”

Nothing’s guaranteed in financial markets — and it goes for valuations too. That a company is cheap doesn’t mean the stock price will ever reflect that intrinsic value.

John Meynerd Keynes said it best, “Markets can remain irrational longer than you can remain solvent.” Sometimes the market doesn’t reward your idea on your desired time frame … or at all for that matter.

Cure: Be okay with selling. There are other opportunities out there. Don’t get hung up on the one that didn’t work.

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Monday Dirty Dozen [CHART PACK]

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Politics is the art of looking for trouble, finding it everywhere, diagnosing it incorrectly, and applying the wrong remedies. ~  Groucho Marx

In this week’s Dirty Dozen [CHART PACK] we look V-shaped, L-shaped, U-Shaped and other alphabetical themed paths for the recovery in growth. We then dive into more fiscal stimulus graphs, look at some indications of growing inflationary pressures, before covering gold drivers, wretched market sentiment and investor flows, and more.

Let’s dive in.

***click charts to enlarge***

  1. BofA wrote in a recent report that “global stabilization of daily case growth rates near 0% (Chart 1) tells us phase 1 of the COVID crisis is over. US daily growth rates have been in the 1%-2% range, a little elevated but well below the 7%-9% daily growth rates of a month ago. Phase 2 started on May 1, as the US began the reopening process.”

 

  1. The phase 1 lockdown caused quite the drop in GDP. For all of those assigning various parts of the alphabet to the describe the shape of the coming recovery, Morgan Stanley says there’s only one, writing “If history is a guide, ‘U’ may actually stand for ‘Unicorn’ because U-shaped recoveries coming out of a recession really never happen.”

 

  1. I know I keep sharing graphs of the fiscal and monetary response in these pages but I’ve got some more today. The size of the responses to date have been enormous… absolutely gargantuan. Like maybe enough to stop a bear market dead in its tracks kind of size — I’m not saying that’s the case here, just that it’s a possibility we all need to entertain.

This chart from GS shows the US fiscal easing measures to date compared to those of the last crisis.

 

  1. Much of this spending has already taken place but we can rest assured that plenty more will be coming down the pipe. I don’t think there’s a single hawk left within a 1,000 miles of D.C.

 

  1. Last one on the fiscal side. US federal debt is set to take out WW2 highs within the next couple of years.

 

  1. All this money flooding the market has a lot of people talking inflation. BofA writes that “like stagflationary 1970s we see clustered, volatile, low real & nominal returns coming decade, higher volatility, weaker US dollar; we also think deflationary drivers of excess debt, aging demographics, tech disruption to fade; QE to MMT, globalization to localization, Wall St. capitalism to Main St populism via Keynesianism, central bank subservience, trade/capital/wage controls) means inflation hedges must be sought by asset allocators via real assets over financial assets, long gold and small-cap value, volatility.”

I concur.

 

  1. On that note, a good indicator of inflation, the commodity/bond ratio, recently hit 3std oversold. Typically, when the ratio hits these levels it tends to mark an intermediate to long-term bottom (green lines below show past signals). And a rising commodity/bond ratio means rising inflationary pressures.

 

  1. Here’s some info for you homeowners. BofA points out that the “long term history of the spread between the 30y mortgage rate and the 10y treasury yield. The average is 175 basis points versus 262 basis points today. If the spread normalizes, as it typically does after a refinancing wave, and treasury yields remain relatively stable, this suggests the 2.5% area for the 30y mortgage rate is a possibility in the next 3-6 months.”

 

  1. DB shared some good charts outlining the bullish gold case over the weekend.

 

  1. Over the last few weeks, I’ve been pointing out the lackluster sentiment despite the vertical rise in the market. The recent BofA Bull&Bear indicator is case in point. It’s nailed to zero… This bearishness is fuel for the trend up.

 

  1. From that same BofA report, here’s the notes on investor sentiment/positioning. Summary: Consensus is bear market, no V-shaped rally, and tidal wave of flows into cash…

 

  1. Finally, here’s the Asset Quilt of Total Returns for the year. We have gold up on top with USTs right behind them. And commodities and MSCI EAFE bringing up the rear. I would not be surprised if this relative performance completely flips by year’s end.

Stay safe out there and keep your head on a swivel.

Mechanical Technologies (MKTY): $6M Company Secures $3.3M Purchase Order

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MTI Instruments (MKTY) is a supplier of precision linear displacement solutions, vibration measurement and system balancing solutions, and wafer inspection tools. These tools and solutions are developed for markets that require the precise measurements and control of products processes for the development and implementation of automated manufacturing, assembly, and consistent operation of complex machinery. 

The company has decades of experience in working with OEMs and their subcontractors in the supply of sensor, instruments and systems technology to incorporate into OEMs’ equipment and major companies’ manufacturing processes as they develop and implement new process, quality and automation controls. MKTY targets leading companies in specific market segments including the industrial and consumer electronics, automotive and other precision automated manufacturing industries, turbo machinery and the research and development aspects within these markets for both product and process improvements. 

As of this morning (05/08), MKTY locked-in their largest contract in the history of the company. Over $3M in orders from the US Air Force. MKTY will churn through this order by the end of 2020. That one order represents 50% of the company’s market cap.

What They Produce

  1. Automated Monitoring & Precision Automation Manufacturing

Allows companies and engineers to rectify system problems before they become costly repairs and maintenance costs. 

MTI Solution: Non-magnetic paper-thin probe that allows users to measure and monitor gaps in high power generators, wind turbines and other auxiliary equipment. 

MTI provides advanced linear displacement solutions for OEMs. These solutions are incorporated into a tool or equipment manufactured by a company to monitor performance and/or achieve control. These products are also placed into a process to control manufacture of parts or to measure critical parameters of parts as they leave the process. 

In other words, they’re a small but critical part of larger assemblies. This creates stickiness with their suppliers. Suppliers know the quality of work and the reliability of MKTY’s products. It’s going to be hard to switch over even if a competitor is lower cost. 

The company has a long-standing track record of excellence with Automated monitoring. MKTY is the preferred supplier for applications that require complex and extremely precise measurement tools of intricate targets and assemblies.

  1. Axial Turbo Machinery

MKTY is a leader in the development and commercialization of vibration measurement and system balancing for axial engines. 

You can find axial engines on medium to large aircrafts (military and commercial). 

These measurement and balancing systems are designed to pinpoint engine vibration issues for improved fuel efficiency, lower maintenance cost and general safety. 

Once again, small but critical components to larger products. 

The company sells the axial products to major aircraft engine manufacturers, US and foreign militaries, commercial airlines and gas turbine manufactures. 

  1. Industrial and Academic R&D

This is an interesting business. The company has a dedicated line of various instruments, testers and tools that help other, private R&D teams conduct research. 

According to the 10-K, these customers include testing and R&D departments in large industry and academia. They also include process development labs focused on automotive, electronics, semiconductor, solar and material development. 

On the surface it looks like a cap-ex light, high-margin business. The company produced these tools once, and then “leases” them out to other R&D teams for their individual research objectives. 

Product Manufacturing & Operations

Unlike most companies in the sensor, instrument and systems markets, MKTY is a 100% US-based manufacturing company. 

The company thinks their US based operations provide them with the following advantages: 

  • Reducing risk of inadvertent technology transfer
  • Ability to control manufacturing quality
  • Much more effective customer management and satisfaction process

So far it’s paid off. MKTY sports long-term relationships with vendors, and they believe most raw material used in their products is readily available. 

Customer Concentration

MKTY’s largest customer is the US Air Force. The company also has long-standing relationships with businesses in the electronics, aircraft, aerospace, automotive, semiconductor and research industries. 

The Air Force accounted for 20% of total revenues in 2017. 

Going Dark (March 19, 2018)

The company filed a Form 15 on Mach 19, 2018, voluntarily deregistering from the SEC. Here’s MKTY’s reasoning behind deregistering: 

“We expect the deregistration of our common stock to result in significant cost savings to MTI in the near term from the elimination of complying with SEC reporting requirements. Also, the deregistration of the common stock will allow the Company to avoid the substantial additional costs associated with the compliance and auditing requirements of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and to focus its resources on increasing long-term growth.”

Although not required, the company will maintain quarter/annual financial statements on the OTC Markets Group website. 

The Balance Sheet (Hidden Assets)

As of Dec. 2018 the company has around $52M in NOL carryforwards. This is a huge asset that’s not acknowledged on the balance sheet. In fact, $52M in NOLs is 6.5x the current market cap. $737K will expire in 2020. The remainder? They’ll expire in 2037. That’s 17 years of NOL carryforwards. 

MKTY carries a robust balance sheet. As of Q3 2019 the company sports $5M in assets with $1M in total liabilities. Asset levels dropped in half due to a one-time special dividend of nearly $4M in July of 2019. If you add back the dividend the company maintained above $8M current assets. 

Management

The company’s run by Frederick Jones. Jones is a younger CEO (49), but incentives appear aligned. 26% of his total compensation in 2017 came from Incentive Plan Compensation (based on performance objectives). 

Directors and officers own 45% of the common stock. Brookstone Partners, LLC owns another 40%. This leaves 15% free float for remaining shareholders. Brookstone Partners looks like solid capital. Take a look at their investment strategy (per their website):

“To invest alongside founding families and management teams in companies that offer significant opportunities for value creation through organic growth, strategic acquisitions and improvements in operating performance.”

This feels like permanent capital, not a quick turnaround as with most PE firms. Another thing I like about Brookstone Partners is their skin in the game. All the principals commit their personal money into each investment. Here’s their reasoning:

“Brookstone’s principals have personally committed a significant portion of the firm’s equity capital, making them true owners rather than investors of third party capital. As owners, Brookstone’s principals understand the nuances of building successful businesses and have the flexibility to make long-term decisions that are right for the business. As major investors in every deal, our principals pride themselves in having their interests perfectly aligned with those of management teams.”:

Financials

The company generated $1.54M in EBIT in 2018. Adding the $392K in NOL tax benefit, the company ended 2018 with nearly $2M in income. MKTY also generated close to $2M in free cash flow, giving it a 25% FCF yield. 

MKTY ended the year with $5.7M in cash on their balance sheet. That’s a lot for an $8M market cap company. So, in July of 2019, management paid around $3.5M in special dividends to shareholders. That was a 37% dividend yield at the time of issuance. Not bad!

One thing to note about MKTY is the variability in revenues. The company admits that their revenue streams are lumpy in nature. They depend on various contracts with militaries and commercial enterprises. These contracts can come in waves. One quarter they earn a ton. The next quarter, not so much. This is important when we look at valuation and realistic expectations of the future. 

Valuation

MKTY is cheap. The company trades for less than 5x earnings (25% yield), and if you add back their one-time dividend issuance they trade at a 7.5% premium to NCAV. At the July 2019 dividend price, a mere three special dividend issuances would cover the original purchase price. You’d get your initial investment back in dividends and retain the business for free. Moreover, that free business can generate over $2M in free cash flow per year over the next five years.

If they’re able to maintain consistent cash-flows, you’d end 2023 with close to $12M in cumulative free cash flow (compared to $7M market cap) and $24M in Enterprise Value. Adding back the net cash we get a market cap of $27M (vs. $7M current market cap). That’s $2.82/share in equity value (257% increase). 

As nice as the above picture sounds, it likely won’t look like that. The company’s revenues and earnings are lumpy in nature. It’s important we look at downside cases. Let’s assume the company generates $5M in revenue in FY 2019. Note that the company’s already generated this $5M as of their Q3 report. So we’re assuming zero 4Q revenues. On top of that, let’s assume the company loses another $1M in revenue in FY 2020. Then generates steady-state $4M in revenues until 2023. 

In this scenario, we’re anticipating a 50% revenue decline in less than three years, and a 50% decline in operating income. We’re also going to assume a 1M share dilution over the next five years. The company has a history of issuing shares, so I want to make sure that we account for such possibilities in the future. By the end of 2023, we get $4M in annual revenue, $750K in pre-tax cash flow and $950K in free cash (thanks to NOLs). That’s a cumulative $7.34M in free cash flow over the next five years, which equals the current market cap. 

But remember that share issuance. For this scenario, we’re dividing our $15M market cap by 10.57M shares. This gives us an equity per-share value of $1.44 (80% upside). 

We also have balance sheet protection. MKTY has enough cash to cover all liabilities three times over. And if we assume a smaller current asset profile (based off continued dividends), we’re still left with around $0.40/share in NCAV as downside protection. 

Risks

There’s four main risks with MKTY:

  • Wide Bid/Ask Spreads

Shares are rather illiquid and there’s a large bid/ask spread. For example, as of writing, the Bid is $0.81/share. The ask is $0.99. That’s a wide divergence. This makes establishing positions a bit difficult with limit orders. But you don’t want to place a market order for fear of getting poor cost-basis. 

  • Customer Concentration

MKTY generated 28% of its product revenue from the US Air Force. This is part of the company’s $9.5M contract with the Air Force that’s set to expire halfway through 2021. Besides the Air Force, the company recognizes 11% of its revenue from a semiconductor manufacturer in Asia. A breach in one (or both) of these contracts would mean a significant loss in revenues. 

  • Share Issuance

The company’s increased share count by 200K over the last four quarters.  We looked at what the valuation would look like with 1M shares issued over the next five years. Regardless, I’d like this trend to reverse.  

Disclosure: As of writing this I/we do not hold shares in MKTY. 

The “No Sense” Algorithm

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My buddy Chris D. likes to point out that a characteristic of a “Bull Quiet” regime is when the best sell setups fail time after time. That’s what we’re seeing now.  The market is frustrating the bears by buying every dip grinding the market higher in its micro-bull channel with the 3,000 level and 200-day moving average acting as attractors.

Bearish sentiment is providing plenty of fuel for the move. The AAII Bull-Bear spread rarely gets as low as it is now. It’s tough for markets to top when sentiment is this dour.

My base case continues to be that we’re in the early stages of an extended sideways trading range/bear market. The left tail bear case has become less probable due to the extreme willingness of policymakers to flood the market with money. We also have to remain open to the possibilities of a renewed bull market however unlikely — this is not the time for having strong convictions.

While the current rally has been strong, so was the selloff that preceded it. And we’re still well within the norms of past bear market rallies.

Credit has not been confirming the move in stocks. But… while credit leads equities, the lead time can persist for quite a while before a convergence. So while this is something we need to keep an eye on it’s not an immediate sell signal.

@bennpeifert shared this extraordinary chart of DARTs for the largest retail brokerages (DARTs stands for Daily Average Revenue Trades). Apparently, retail investors have been stepping into the breach to buy the market en masse, at record-breaking rates. Maybe that’s where everyone is putting their $1,200 stimulus checks?

That’s usually not the kind of behavior you see near long-term bottoms…

Anywho, if you’re of a longer-term bent and don’t feel like jumping in and out of stocks then you may want to check out bonds and precious metals which continue to catch a strong bid.

Silver is breaking out of a month-long wedge and positioning is favorable to a move higher.

The gold vs. silver ratio recently hit its highest level in history. Perhaps it’s time for the less barbarous relic to play catch up?

There’s also some interesting action going on in some dollar pairs, many of which have been coiling tightly over the last few months.

Check out this chart of the Mexican peso (MXNUSD). I love the fundamentals of this trade long-term. Whether or not this is the start of that LT trade is anybody’s guess but it does look like it’s going to at least see a short-term pop. Relative equity momentum also recently moved in the peso’s favor, which is what you want to see if you’re buying here, which I am.

EURUSD is showing similar action… The chart looks to me like it wants to break higher.

That’s all I’ve got for now. Let’s see how the week ends. Oh, and lastly, if this market has you scratching your head. Give these wise words from Adam Robinson a read.

When someone says, “It makes no sense that…” really what they’re saying is this: “I have a dozen logical reasons why gold should be going higher but it keeps going lower, therefore that makes no sense.” But really, what makes no sense is their model of the world, right? So I know when that happens, that there’s some other very powerful reason why gold keeps going lower that trumps all the “logical reasons.”

…Things that don’t make sense are an Algorithm for finding opportunities. Where do we find good ideas? Look where no one looks. When thing’s don’t make sense, get into the trade.

Things that make sense are often already discounted in the price. The things that make you go hmmm… aren’t, which is why the “no sense” algorithm is quite powerful. Markets are funny like that.

More Letters From Your Favorite Investors

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If you’re like me, you missed Berkshire Hathaway’s annual shareholders cult-gathering meeting. The weather was too nice and I’ve been cooped up inside my house too damn long not to enjoy the day. Instead of watching 3rd-grade level slide-shows, I played corn-hole.

My buddy beat me 21-0 in the third game. I know, I need to step my game up.

Anyways, before we dive into this week’s letters, check out our newest podcast episodes below.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Laughing Water Capital
    • Alluvial Capital
    • Alta Fox Capital

Let’s get to it!

May 06, 2020

Books on Credit / Bond Investing: Last week I linked to an Elliott Management report about Perspectives. In it, Elliott noted vast opportunities in the credit space. This prompted me to think about various credit/bond books that might be useful to investors new to the credit side (myself included).

Here’s a list of books I found via Amazon. Note this isn’t an exhaustive list. It’s merely my own meandering through the loins of Amazon’s recommendations:

If you know of any more please shoot them my way. Trying to add to this list if I can.

Alright, let’s get to the letters.

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Investor Spotlight: Three More Bangers

GIFs by tenor

Laughing Water Capital: -26.77% Q1 2020

Matt Sweeney runs Laughing Water Capital (LWC). His fund lost 26.77% during Q1. Matt’s one of my favorite investors to follow. I always get amped when I see a new quarterly letter.

He starts with two questions that every investor should ask right now:

    1. If a company is essentially a box of cash, plus a ~50% ownership stake in a business where cash inflows typically don’t slow all that much during downturns, but cash outflows typically slow dramatically, why should the stock trade at a market cap that is a fraction of the company’s cash?
    2. If a company is in the business of selling a recession proof essential service online, and their main competitors rely on personal interaction, why should the stock of the online business get cut in half at a time when face to face interaction has all but stopped?
    3. If a company is in the business of manufacturing recession proof goods from domestic locations, and pundits are calling for the re-shoring of similar goods due to potential shortages during a pandemic, why should the stock of the domestic businesses get cut in half?

From a rational perspective, the answer is easy: no these businesses shouldn’t be cut in half. But Mr. Market doesn’t care in the short-term.

Sweeney didn’t mention any specific investments, but he provided a three-pronged framework for thinking about markets in the current state.

Framework #1: Balance Sheets > Income Statements

Balance sheets should always matter. But sometimes, they matter more than nearly everything else in a company’s financials. Now is that time. Sweeney expands on this idea, saying (emphasis mine):

“While I always focus on owning businesses that can survive or even thrive during a weak economy and thus generally eschew leverage, I admit I had not considered the possibility of revenues at any of our businesses temporarily going to zero. The market has been swift to punish companies with leverage, but it is also a fact that the more predictable a business is, the better it is, and the more debt it can handle.

Read that last sentence again. Leverage in-and-of itself isn’t evil. Instead, one should think about the dangers of leverage as a function of the durability of the model and the allocation skill of management.

How do you manage leverage and cyclical businesses? Mid-cycle earnings. Mid-cycle earnings paint a picture of what a leveraged / cyclical earns on a “normalized” basis. Like any cyclical, there will be times of plenty and times of famine.

Not doing this brings in the risk of buying a company at peak earnings — or buying right at their cyclical top.

Remember: cyclical stocks are cheap when they look expensive, and expensive when they look cheap.

Framework #2: Pick Businesses That Improve Themselves in Downturns

This framework is one of the most powerful tools at an investors disposal. Strong businesses that survive economic downturns usually clean house when the recovery rolls around. Why is that? Let’s look at Sweeney’s explanation (emphasis mine):

“Almost all businesses are feeling pain in the current environment, but by focusing on strong balance sheets, strong competitive positions, and properly incentivized management teams, we are focusing on businesses that are likely feeling less pain than their competitors, meaning that our businesses can take market share or otherwise improve their position vis a vis their competitors during this downturn.”

If you’re buying a great, competitively advantaged business, downturns are exciting. Your business has a chance to scoop up over-leveraged competition and expand market share.

That said, notice how Sweeney didn’t say “strong stocks.” He said strong businesses. Stocks of great businesses get hammered just as hard (and in some cases, harder) as stocks of bad businesses.

Mr. Market’s a voting machine in the short run, after all. Yet over time, as the economy comes back, the market will realize the company’s dominant share and value it appropriately.

Framework #3: Getting To “Enough” on Future Potential Returns

Humans are hard-wired to focus on the short-term. As Sweeney explains, “If our paleolithic ancestors did not place more weight on meeting their immediate needs such as food, water, and shelter, then any long-term plans would be completely useless.

But how cheap is cheap enough? Can we pick the bottom-tick in the markets? Nope. And if we happen to, credit it to luck — not skill.

Let’s revert to Sweeney’s example of buying a company at 3x mid-cycle earnings. If that company goes from 3x to 2x earnings, how bad do we feel? We thought it was cheap at 3x. Seeing it at 2x makes us nervous — and that short-term mindset takes over.

The point is you can’t pick bottoms and you can’t wait until the dust settles. Take credit card stocks during 2009 as an example (from the letter, emphasis mine):

“For example, during the financial crisis, credit card delinquencies did not peak until 6-8 months after the March 2009 low. By the time the worst of the data presented itself, credit card stocks had rallied 300-400%.

Here’s a recap:

    1. Focus on balance sheet strength over income statement profits
    2. Pick businesses that improve (survive) during economic downturns
    3. Don’t try and pick bottoms

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Alluvial Capital: -17.70% Q1 2020

Dave Waters runs Alluvial Capital. His letters are frequent guests during our quarterly letter review. And for good reason. Dave hunts for stocks in places few fund managers venture. His letters bring to light stocks living in the dark corners of the market.

If you haven’t had a chance, check out my podcast with Dave here.

One thing I like about Dave’s letters is the amount of actual stock/business discussion. I don’t know if it’s COVID-19, but I’ve read a ton of letters with pages on herd immunity rates and nothing on stocks.

Dave features myriad stocks in his letter, so we’ll focus on the following:

    • Tower Properties Corp (TPRP)
    • Crawford United (CRAWA)
    • Intred S.p.A. (ITD)

Let’s roll!

Tower Properties Corp (TPRP)

Business Description: Tower Properties Company engages in owning, developing, leasing, and managing real property. It owns office buildings, apartment complexes, a warehouse/office facility, and land held for future sale or development. – TIKR.com

What’s To Like:

    • Well-run business
    • Produces normalized funds from operations of $3,400 per share, fully taxed (5x FCF)
    • Highly illiquid

What’s Not To Like:

    • Highly illiquid
    • Low share count
    • High share price ($17K/share)

Here’s the chart …

Look at that illiquidity. As a proxy, one share traded yesterday. One. Do you notice that huge tail on the end of March 27th’s candle? Here’s Dave’s commentary (emphasis mine):

“On some of the worst market days in March, the fund was able to acquire shares of Tower at prices ranging from $12,500 to $13,500.”

It pays to have limit orders in, folks! I bet Dave had a limit order of around $13K and never dreamed he would get filled at that price again. But markets are strange things!

Crawford United (CRAWA)

Business Description: Crawford United Corporation, together with its subsidiaries, engages in aerospace components, commercial air handling, and industrial hose businesses in the United States. The Aerospace Components segment manufactures precision components primarily for customers in the aerospace industry. This segment provides complete end-to-end engineering, machining, grinding, welding, brazing, heat treat, and assembly solutions. The Commercial Air Handling segment designs, manufactures, and installs large-scale commercial, institutional, and industrial custom air handling solutions. TIKR.com

What’s To Like:

    • Insider Ownership (Skin in the game)
    • Down 30%+ from Feb. highs
    • Great business model with long runway
    • Highly illiquid
    • High ROE

What’s Not To Like:

    • Cyclical business
    • High deferment rate with products/services in downturn
    • Steady gross profit margin decline

I chose as part of the list because it’s such an interesting company. In short, CRAWA buys small, niche players in the HVAC industry, rolls them up, and uses the cash to buy more of those businesses.

Here’s Dave’s take (emphasis mine): “With the application of a judicious amount of debt financing, the returns on equity can be impressive and value compounds quickly. There are thousands of these acquisition candidates, many of them run by founders approaching retirement age and looking for an exit.”

Here’s the chart …

At $13.30 you can buy CRAWA for 9x 10YR normalized earnings. That includes a few years of negative earnings as well. If you zoom in, say the last five years, you’re looking at roughly 4x normalized earnings.

Given their “buy and build” strategy, it’s important to look at debt and balance sheet health. CRAWA has $14M in long-term debt and another $4M in current short-term borrowings. They have over $16M in receivables against that debt, and another $2M in cash.

The company generates enough EBIT to cover interest expense 9x over.

Intred S.p.A (ITD)

Business Description: Intred S.p.A. provides various telecommunication services in Italy. The company offers broadband connectivity services, including ADSL and HDSL connections; ultra-broadband connectivity services, such as fiber to the home and fiber to the cabinet connections; and RDSL connectivity services. It also provides landline telephone services; cloud services comprising hosting, such as domain registration, email, Web, etc., as well as data center and virtual services; and ancillary services consisting of rental services for line termination equipment, technical support, ancillary charges, etc. TIKR.com

What’s To Like:

    • 20%+ 5YR Revenue CAGR
    • 70% Gross Margins
    • 27% Operating Margins
    • $9M Net Cash

What’s Not To Like:

    • Low float
    • 78% owned by insiders/company

Let’s take a look at the chart …

ITD did an IPO in Italy at 6x EBITDA with net cash on the balance sheet and 20%+ top-line revenue growth. That’s the power of venturing outside the US. You’re not going to find many IPOs with those metrics here. Heck, if an IPO is profitable it’s a reason to celebrate — let alone cheap.

_________________

Alta Fox Capital: -26.77% Q1 2020

Connor Haley runs Alta Fox Capital. Since inception, he’s generated 7.98% annual returns. This compares favorably to the S&P and Russell indices.

Haley’s fund lost nearly 27% in Q1. You can read his letter here.

Connor covers three names in his letter:

    • Mamamancinis Holdings (MMMB)
    • Gan, Plc. (GAN)
    • Evolution Gaming (EVO SS)

Let’s dive in.

Mamamancinis Holdings (MMMB)

Connor’s Take: “They provide meatballs and other pasta/Italian products to grocery stores. It is a boring and non-sexy business. It is also an “essential service” and sells items that can be stored in freezers around the country as people hunker down in their homes. We bought it at 6x our estimate of forward earnings despite revenue growing 30%+ organically. The stock is already up 60% from our publish date, but we believe there remains potential for 100%+ upside over the next three years in an eventual sale of the company.”

What’s To Like:

    • Insider ownership (skin in the game)
    • 20%+ top-line revenue growth
    • 30% EBITDA growth
    • Leveraging fixed costs to improve operating margins
    • CEO has successful history of operating businesses

What’s Not To Like:

    • Current high customer concentration
    • Promises of high growth & failed in past
    • Key man risk (CEO)

Here’s the monthly chart …

What’s It Worth: Here’s Connor’s estimate of future value:

At current prices ($1.02) we have the business trading at 6.1x our FY2021 EPS (calendar year 2020) which we believe is far too cheap for a business showing this type of growth and margin expansion. Note that the business has ~$9.7m in NOLs, which we expect them to fully utilize by 2023.

Gan Plc. (GAN)

Business Description: GAN plc provides enterprise online gaming software, operational support services, and online game content development services to the casino industry. The company operates through Real Money Gaming Operations (RMG), and Simulated Gaming Operations (SIMGAM) segments. It licenses GameSTACK, an Internet gaming system to online and land-based gaming operators for regulated real-money and simulated gaming online.TIKR.com

Connor’s Take: “GAN grew revenue 114% in 2019 yet traded at a high single digit FY20E EBITDA multiple when we entered our position. We then increased our position significantly when the stock sold off sharply amidst the cancellation of sports and broader COVID-19 induced panic selling. While sports betting is roughly 10% of GAN’s revenues and its cancellation would be a headwind, the market was reacting as if all of GAN’s revenues were at risk.”

What’s It Worth (from the letter): “GAN recently issued market guidance of $100M in sales in three years with EBITDA margins of 30%+. Their sales in 2019 were ~$30M and EBITDA was ~$8.4M. Today investors can buy GAN prior to listing on the Nasdaq at <10x our estimate of FY22E EBITDA. This seems very cheap given their strong growth, scalable model, and the valuation of other US internet gambling focused peers”

Here’s the chart:

Evolution Gaming (EVO SS)

Business Description: “Evolution Gaming Group AB (publ) develops, produces, markets, and licenses live casino solutions to gaming operators primarily in Europe and the United States. The company runs the game from a casino table, which is streamed in real time and end users make betting decisions on their devices, such as desktops, smartphones, tablets, etc. It also runs on-premise studios at land-based casinos in Belgium, Romania, the United Kingdom, and Spain.” – TIKR.com

Connor’s Take: “This is a phenomenal business with 50%+ EBITDA margins and 35%+ organic revenue growth in each of the last three years. It is also very under the radar for a ~$7B EUR market cap, likely due to the lack of any U.S. research coverage. EVO is a B2B provider of live casino games. They work with land-based and online casino operators to enable casino games played with a live dealer that are streamed from one of EVO’s many global studios.”

What’s It Worth: “We were able to purchase EVO at 9x FY22E EBITDA. With increased investor awareness and given EVO’s competitive advantages, attractive unit economics, and high growth, the business could easily trade at double the valuation today (12x FY22E EBITDA), even after the recent rally.”

Here’s the chart …

__________________________________________________________________________

That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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Monday Dirty Dozen [CHART PACK]

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The joy of winning and the pain of losing are right up there with the pain of winning and the joy of losing. Also to consider are the joy and pain of not participating. The relative strengths of these feelings tend to increase with the distance of the trader from his commitment to being a trader. ~  Ed Seykota

In this week’s Dirty Dozen [CHART PACK] we look at supply overhangs and market retracement odds before diving into the virus’ second-order economic impact, then we tally up all the many fiscal and monetary actions taken to date, discuss the poor health of our state finances, and end with a deep cyclical value play. Plus more…

Let’s dive in.

***click charts to enlarge***

  1. The market ran into a supply overhang at the end of last week. A supply overhang is a price point where many players had previously accumulated shares before prices moved against them, making them underwater on their positions. It’s their breakeven point or close to where they can dump their holdings at only a small loss and breathe a sigh of relief.

Odds now favor 1-2 weeks minimum of sideways to down action from here.

 

  1. The NAAIM Exposure Index shows that managers have brought their risk level nearly back up to pre-sell off levels. Nothing like price to change sentiment…

 

  1. Deutsche Bank put out a report over the weekend talking about some of the second-order economic impacts of the virus; one of them being tourism and what the lack of travel means for GDP. They noted that “According to the UNTWO, a couple of years ago, tourism was directly the source of 9% of all jobs globally — and for every job in tourism another 1.5 jobs are created.”

 

  1. Nomura has created a number of “lockdown trackers” to show how much of the global economy is in shutdown. Here’s the tracker showing how much of the global populace “should” be on lockdown in accordance with government mandates.

 

  1. And this one uses alternative data to show what people are “actually” doing.

 

  1. BofA reported that “The number of countries (> 50 cases) reporting a new high in daily cases in the preceding five days is down from 102 (March 27th) to 49 (April 26th). A risk to monitor is a second wave of new cases as measures to slow the spread of the virus are eased”.

 

  1. Morgan Stanley detailed the aggressive monetary and fiscal policy to date, writing (with emphasis from me) “Since mid-January, all of the central banks we cover have eased monetary policy. The global weighted average policy rate has declined to below post-GFC lows — rates have fallen by 64bps since December 2019 and 177bps since December 2018. G4 central banks have announced aggressive quantitative easing programs. We estimate that G4 central banks will make asset purchases of ~ US$13 trillion in this easing cycle. The Fed alone will make cumulative asset purchases of ~US$7.8 trillion.”

 

  1. Here’s a running tally from them of all the global monetary and fiscal measures announced to date (click chart to enlarge).

 

  1. Thank Zeus the money spigots are on or else we would have seen massive credit cascades. This chart shows a lot of companies are raising a lot of money as IG new issuance crushes the former records.

 

  1. While at the same time companies are slashing buybacks and dividends. Buybacks have been an important source of equity demand this cycle and so this trend matters a lot going forward. While many people rightly point out that there’s not a one-for-one relationship between buybacks and the market’s performance, it’s the long-term impact to the supply/demand equation for the market where this shows up.

 

  1. Morgan Stanley pointed out the troubling state of many State finances due to lockdown measures. They wrote, “Joblessness is reducing taxable income, declining retail activity impedes sales tax, weak stock markets stunt capital gains tax revenue, and the decline in the price of oil hurts severance (natural resources extraction) tax revenue.”

 

  1. There’s always a bull market somewhere as Jimmy Buffett would, I’m sure, say if he were an investor. Natural gas is a case in point. Look out past the near-term futures and the charts look good. Antero Resources (AR) is one of a number of good plays on this theme. Capped downside and LOTs of upside, which is what I like to find in a trade. I’m in the process of doing a deep dive into the space that I hope to share with fellow Collective members later this week.

 

Stay safe out there and keep your head on a swivel.

Lessons From Business Greats: Bernard Arnault

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Bernard Arnault is the third richest man alive. You wouldn’t know it since he shuns the spotlight. A recluse who got his start in engineering and construction but made his fortune through a collection of “high society” luxury consumer brands. A soft-spoken man with a history of brutal takeovers and scorched earth restructurings.

In this piece, we’re going to analyze and dissect exactly how Arnault made his fortune. We’ll dive into the unique perspectives that helped Arnault create the greatest collection of brands in the world. And we’ll end with the unique tips, tricks, and lessons learned that can be gleaned from studying this titan of industry.

Let’s dive in…

Early Life

After graduating from a prestigious engineering school, Arnault joined his father in working for the family’s civil engineering business where he worked on the construction side.

Filled with grand business ideas at a young age, Arnault was able to convince his father to sell the engineering company and focus on real estate and hospitality. Arnault would run the real estate business, which focused on holiday accommodations. The business was called Férinel Inc and Arnault ran it quite successfully.

His fascination with Dior (and perhaps luxury brands as a whole) started with his mother. As a child, Arnault remembered his mother’s fascination with various Dior perfumes.

This is where we see Arnault’s first awareness in the power of a brand.

The story goes that Arnault came to the US and hopped in a taxi. His cabbie, upon hearing Arnault’s accent, revealed his love for French culture and politics.

Arnault asked the driver if he knew the name of the sitting French president. The cabbie’s response rocked Arnault’s world:

“I do not know the name of your President, but I do know the name, Christian Dior.”

That moment changed Arnault’s thinking, career, and passion forever.

Construction Engineer Turned Hostile Takeover Artist

Arnault obsessed over Dior and the brand recognition the company had created. Dior was a hidden asset inside a failing textile mill operation. It’s an intriguing story and a powerful testament to finding value in obscure places. Let’s go back in time, to 1946.

Marcel Boussac was a serial entrepreneur and founded Dior in 1946. He started with a single-factory shirt business. From there, he bought 60 textile mills and grew his empire, employing 30,000 people at its peak. Along with Dior, Boussac owned a stud farm, horses and two newspapers.

Then the debtors called. Boussac’s company was in serious trouble. Bankruptcy was all-but guaranteed. So, Boussac did what he had to do. He sold off assets. The court ordered the sale of the Boussac Group (which held the profitable Dior business) to another holding company, Agache Willet, Inc.

Agache Willet paid $164M for Boussac with promises to repay the substantial debt burden in 15 years.

But Agache Willet couldn’t pay the debt. They too, were on the verge of bankruptcy when our “hero”, Bernard Arnault stepped in. In 1984 Arnault bought the failing Agache-Willot-Boussac for $15M. Four years later, this snippet appears in a 1988 New York Times article (emphasis mine):

“Mr. Arnault renamed the company Financiere Agache, and nursed it back to health. He sold some ailing operations and cut costs in others. As a result, Agache earned $112 million on revenue of $1.9 billion last year.

This single purchase catapulted Arnault from family businessman to luxury-brand kingpin. Solidifying his place amongst France’s highest-status operators. But Arnault was only getting started.

And we see this across a myriad of investor success stories. Whether it’s Buffett’s big bet on AXP or The Chandler Brothers pouring their entire net worth into four Hong Kong investment properties.

Our next story shows Arnault’s relentless desire to be the best, and to own the best. It doesn’t matter how he gets the brands, as long as he’s in full control when it’s all said and done. It’s where Arnault earns the moniker “The Wolf in Cashmere”.

The LVMH Takeover Saga

We know Arnault as the leader and head-operator of LVMH. But what many don’t know, is how Arnault got that role. The story is worthy of an academy award for best drama screenplay. The New York Times called Arnault’s LVMH takeover a “corporate duel to the death.”

It all started in the Spring of 1987. Chevalier, manager of luxury spirits company Moet-Hennessy, noticed a peculiarity in his company’s stock price. Someone was buying a lot of shares causing the stock to rise, “mysteriously.”

Chevalier feared a takeover bid was behind the silent accumulation. He needed a white knight. After consulting with his investment advisers he picked one man, Henry Racamier. Racamier, at the time, was the owner of the most luxurious leather goods brands in the world — Louis Vuitton.

The NYT article describes the union, writing, “The merger aimed to prevent a takeover by creating a more expensive, harder-to-grab target in which the four families would control 51 percent of LVMH’s stock.

The Moet-Hennessy / Vuitton marriage didn’t last long. Let’s head back to the NYT article for the details (emphasis mine):

“Within weeks, however, the love affair turned sour. Racamier, now in the No. 2 spot, had some stationery printed on which his name appeared above Chevalier’s. Chevalier had the stationery destroyed. Racamier said he wanted to bring the former head of the Chanel fashion house to Vuitton as his potential successor; Chevalier rejected the idea, asserting that there was already enough managerial talent in-house.”

Sounds like something straight out of a Netflix special.

Despite their public feud, Chevalier had other things to worry about — particularly the company’s stock price. It was heading higher which meant someone was still buying a large position.

Chevalier had to act quickly, again. He needed another white knight. This time, he chose Guinness PLC. Chevalier initially proposed a 3.5% stake in LVMH to Guinness. But such a small amount wouldn’t provide adequate protection against a hostile takeover.

Chevalier upped the stake to 20%.

Seeing these actions from his corporate enemy, Racamier phoned a friend — Bernard Arnault. According to the NYT article, Racamier saw a younger version of himself in Arnault:

“When Racamier invited Arnault to be his ally in the summer of 1988, he must have viewed Arnault as a potential protege, a younger version of himself. Racamier suggested that Arnault bid for 25 percent of LVMH’s stock, which, with the Vuitton family holdings, would give the two groups majority control.”

The tale of the tape: Arnault and Racamier vs. Chevalier and Guiness. Then Arnault switched sides. Like Pippen leaving the Bulls, Arnault left Racamier. Chevalier and company persuaded Arnault to join their side, with promises of a greater share in LVMH.

The new team — Arnault, Chevalier and Guinness — bought 24.5% of LVMH for $1.5B.

This infuriated Racamier. As it rightfully should! After all, it was Racamier that brought Arnault to the evening’s dance. Racamier’s frustration resulted in aggressive buying. Vuitton’s master bought more and assumed 33% control.

The Wolf retaliated. Like clockwork, Arnault bought another $600M worth of stock in three days to gain 37.5% control. This made Arnault the largest shareholder in the battle. Not Racamier. Not Chevalier and Guinness. Arnault.

Such attrition warfare continued for months on end. When it was all said and done, Arnault left the arena the victor.

The Oracle of Luxury

The Wolf in Cashmere has been on a global buying spree of top quality brands since 1984. Arnault’s added brands such as Givenchy & Fendi, Donna Karan, and Marc Jacobs. He’s also added a few retailers, including Sephora, DFS, Bulgari, and TAG Heuer.

Arnault’s acquisition strategy boils down to the following: Hard-nosed dealing and extreme aggressiveness in going after top brands.

It’s no surprise that Arnault mentions the name “Warren Buffett” on his list of mentors. Arnault is the Buffett of the luxury brand world. He buys high quality, strong brand name companies, with the aim of holding them forever.

Both got their start by buying a failing textile business.

The similarities also bleed into the management of the failing enterprises. Both Buffett and Arnault closed operations, fired hundreds of workers, and reaped personal profits. To Buffett’s credit, he at least attempted to keep the mill in operation.

Both have very long-term investment horizons. Arnault cares little about quarterly financials or short-term profits. Take this excerpt from an article about Arnault in GeniusWorks (emphasis mine):

“Indeed, [Arnault’s] motivation is much less about financial results, and much more about brand legacy, saying he is much less interested in quarterly results than he is in brand health and growth.”

This is critically important in understanding the mind of a master business leader. Arnault knows that what ultimately pays him (and in turn, his shareholders) is brand loyalty. That’s it. It’s not one segment’s margins. It’s not top-line revenue growth. Brand loyalty and having the customer still crave every new product — that’s what matters.

We see this from Jeff Bezos at Amazon. What does his first shareholder letter discuss most? Obsessing over the customer. Or watch this video where Bezos says the phrase “obsess about the customer” ad infinitum.

Warren Buffett also doesn’t care what a stock price will do in the short-term. The stock can do whatever it wants. But over the long-term, the stock should perform in-line with the quality of the business (i.e., how well the business generates returns on its cash).

Arnault travels that same wavelength — but with brand quality and durability — not stock price. Arnault judges his business by the staying power of its brands. Not whether it exceeds quarterly earnings forecasts (emphasis mine):

“Money is just a consequence. I always say to my team, don’t worry too much about profitability. If you do your job well, the profitability will come … When we discuss a brand, I always tell them my real concern is what the brand will be in five or ten years, not the profitability in the next six months. If you take a brand, like Louis Vuitton, which is the number one luxury brand in the world, what I am interested in is how we can make it as admired and successful in ten years as it is today. It’s not how much we’re going to make next year.”

That’s the point. It’s not about hitting quarterly earnings estimates or margin targets. It’s about doing what you know drives long-term value for the customers and the company. Oftentimes, this idea wages war with the what-have-you-done-lately crowd. God forbid a company loses a bit of money in the short run to reap long-term competitive advantages.

But if you want to be the best — and if you want to invest in the best — you must think like they do.

Running A Company The Arnault Way

There’s little luck involved in Arnault’s success. It’s built upon these three pillars

    1. Always Act Like A Start-Up Company
    2. Let Creators Run Wild
    3. Create Products That Create Customers

Act Like A Start-Up

One of the secrets to LVMH’s success lies in its decentralized operations. Arnault explains this concept in an interview with HBS (emphasis mine):

“LVMH is, as a company, [is] so decentralized. Each brand very much runs itself, headed by its own artistic director. Central headquarters in Paris is very small, especially for a company with 54,000 employees and 1,300 stores around the world. There are only 250 of us, and I assure you, we do not lurk around every corner, questioning every creative decision.”

Decentralized leadership explains how LVMH — a multi-billion dollar company with thousands of employees — retains its creative flow and small-business feel. That’s on purpose.

Arnault hammers home the importance of thinking small. In Arnault’s eyes, LVMH isn’t this massive conglomerate machine with miles of red tape. But a nimble, flexible speed boat. One that can succeed and fail quickly.

Here’s his take on the importance of staying small (emphasis mine):

“I often say to my team we should behave as if we’re still a startup. Don’t go to the offices too much. Stay on the ground with the customer or with the designers as they work.  I visit stores every week. I always look for the store managers. I want to see them on the ground, not in their offices doing paperwork.”

Think small. Move quickly. Small boats can turn faster than large tankers. This brings us to LVMH’s second success factor: decentralized command.

Total Creative Control

Arnault doesn’t believe in micro-managing. He lets them do what they do best: create.

From Arnault:  “You don’t “manage” John Galliano, the wildly iconoclastic head of the House of Dior, just as no one could have “managed” Leonardo da Vinci or Frank Lloyd Wright.” 

By surrendering control, Arnault unlocked the true creative power of his designers. Designers weren’t worried about budget cuts, red tape, or management oversight. In the Dior example, Arnault remembers (emphasis mine):

“Indeed, unlike many executives who oversee the work of creative types—be they engineers, writers, or designers—Arnault does not believe in managerial limit setting. Artists must be completely unfettered by financial and commercial concerns, he insists, to do their best work.”

In other words, Arnault’s designers are the “Dreamers” branch in Walt Disney’s classic thinking tool: Dreamers, Realists, Critics. Let your designers be dreamers. Restrict them in any way and you risk placing a tourniquet around their minds.

Again we see similarities between Arnault and Buffett. When asked about management, Buffett often says he lets them “do their job”. After all, if he’s right in his investment, he won’t need to interfere with management.

Arnault explains his management process after he adds a company to his portfolio (emphasis mine):

“We try to keep the people at the brands, especially the artisans—the seam-stresses and other people who make the products—because they have the brand in their bones—its history, its meaning. At the stores, too, many of the salespeople have the brand in their bones. Most companies clean house when they acquire a new brand. We don’t do that because we have found it hurts quality terribly.”

Another aspect of Arnault’s creative genius lies in portfolio management.

How does one manage a portfolio of fashion designers? The same way great investors manage their portfolios: position sizing.

Arnault explains (emphasis mine):

Well, we don’t like failures. We try to avoid them. That is why, with many of our new products, we make a limited number. We do not put the entire company at risk by introducing all new products all the time.

Arnault spreads his bets. In doing so, he minimizes his risk of total ruin while maximizing the potential for new sales.

This is (in a nutshell) textbook portfolio management. Don’t let one company (or product) ruin your entire portfolio (or company).

Create Products That Create Customers

Marketing analyzes what the customer wants. Follow what they’re doing. Create a product and then test to see if the customer likes the product.

Arnault does things differently. LVMH creates products that create customers. He admits this strategy fails at times. But to Arnault, it’s not about sales. It’s never about sales. It’s about creating desire.

The way to put products in contact with consumers is to create a desire within the customer to buy.

In other words, it’s leading from the front. Arnault wants his brands to embody the “first mover” advantage. Remember, Arnault isn’t creating essential or necessary goods. Consumers could live without buying the latest Louis Vuitton handbag. But that’s what makes Arnault’s success all the more impressive.

He creates a sense of essentiality — a fever for fashion.

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It’s at this point where we pivot into Arnault’s thoughts on star brands. This is the most powerful section for investors in public and private companies. Arnault’s ideas on what makes a business great, and what you should look for in business are timeless.

Arnault cuts to the heart of a business’ purpose with surgeon-like precision.

How To Invest in Star Brands

Arnault invests in “star brands”. These brands have the following traits:

    • Timeless
    • Modern
    • Fast-growing
    • Highly profitable

That’s the beauty of Arnault’s approach to business and brands. You don’t have to operate in the luxury goods industry to create star brands.

A star brand has no set industry.

A plumber with exceptional craftsmanship, deep industry knowledge, and a high margin service business is a star brand. A landscaping company that takes pride in the way each client’s yard looks can be a star brand.

It’s a mindset.

And it’s these four qualities that make up great investments. Nobody would disagree with Berkshire, Apple, or Disney being star brands.

Possessing all four of these qualities at the same time is challenging. Even Arnault admits that. In his words, companies that desire star brands should “be sure you have mastered a paradox.”

Let’s break these attributes down in Arnault’s words.

Question: “What do you mean by timeless”

Arnault: It means the brand is built, if you wish, for eternity. It has been around for a long time; it has become an institution. Dom Pérignon is a perfect example. I can guarantee that people will be drinking it in the next century. It was created 250 years ago, but it will be relevant and desired for another century and beyond that.

Investor Application: While most of us won’t have the capacity to buy Dior or Dom Perignon — we can apply this idea of “timeless” to our own investment process. For example, if you’re focused on the timeless quality, look at companies with long operating histories. Think late 1800s into early 1900s. These are the timeless companies. It’s no small feat being in business for over 100 years.

Question: Why should you focus on such old companies?

Because companies take years honing their brand. Arnault expands on this idea (emphasis mine):

“The problem is that the quality of timelessness takes years to develop, even decades. You cannot just decree it. A brand has to pay its dues—it has to come to stand for something in the eyes of the world.”

But for the investor, it goes beyond time. As Arnault suggests, this company’s product or service needs to be in demand for the next century and beyond. Remember Brent Beshore’s take on swimming pool companies:

“As long as people dip their bodies in water for pleasure, we think the pool building business will do well.”

It’s not enough for a company to be timeless. If they want star brand status — they must grow. Fast.

Arnault: “Without growth, it is not a star brand, as far as I’m concerned.”

It’s crazy to think but in 2000, Arnault’s superstar Louis Vuitton grew sales 40%. Louis Vuitton is the largest luxury brand in the world. They grew 40%.

There’s a reason Arnault stresses high growth for his brands:  balance. Here’s what he means:

“Growth shows the shareholders that you have struck the right balance between timelessness and fashion and that you have been able to charge a premium price because of that correct balance.”

Investor Application: Growth matters. In fact, I’m writing this for myself more than anyone. I hate paying for growth if I don’t have to. But the problem with that mindset is I might miss out on amazing, star brand companies. Why? Because growth is a sign that you’re doing something right by your customers. As Arnault says, “growth is a function of high desire. Customers must want the product.”

One way of incorporating high growth into your process is to simply screen for higher growth. Look at companies that have generated a long-term revenue CAGR higher than the market average.

Remember, you should add this high growth filter on top of your existing “timeless” filter.

One of the benefits of luxury brands is their high-profit margins. Louis Vuitton gushes cash because their brand commands an exorbitant price. But price is only one part of the profit margin function. The other side — cost of goods sold — has Arnault’s un-devoted attention.

Arnault: “High profitability comes at the back end of the process and behind the scenes. It comes in the atelier—the factory.”

The factory is where high-profit margins are made. And nobody scrutinizes the intricacies of a factory-like Arnault.

Don’t believe me? Listen to how he thinks about each individual factory process (emphasis mine):

“Every single motion, every step of every process, is carefully planned with the most modern and complete engineering technology. It’s not unlike how cars are made in the most modern factories. We analyze how to make each part of the product, where to buy each component, where to find the best leather at the best price, what treatment it should receive. A single purse can have up to 1,000 manufacturing tasks, and we plan each and every one.”

Arnault lives in the paradox better than anyone in his industry. Creative, free-flowing and laissez-faire with his creators. Dogmatic and authoritarian with his manufacturing process. It’s this blend that creates true cash-gushing margins.

Investor Application: Profit margin health is industry dependent. Costco, for example, would be a star brand in many investors’ eyes. Yet they have razor-thin net margins. A good filter for profitability is cash flow margins or EBIT margins. Companies with above industry-average EBIT margins are stronger businesses. They generate more cash than their competitors.

Wrapping Up

There’s so much we can learn from Arnault. We learn how to run a business, sure. But we also learn how to spot businesses that have star brand potential.

Arnault shows us how to run a business by:

    • Always acting like a small company
    • Letting creators run wild
    • Creating products that create customers

We learn what to look for in star brand companies:

    • Timeless
    • Modern
    • Fast-growing
    • Highly profitable

The solution is simple in theory and difficult in practice. Our job as investors is to find companies that are run by Arnault-like CEOs that possess star brand qualities. And then we hold them and let management do their thing.

Like Arnault, if you find one of these companies, one of these star brands run by exceptional management — buy big. Be a Wolf in Cashmere.

More Letters From Your Favorite Investors

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We hope you and your family are safe and healthy during this COVID-19 season. Many states are opening up their economies, neighborhoods and beaches in the coming weeks. Stay healthy, remain cautious and keep your head on a swivel.

The markets etched higher since last week and the Russell 2000 broke out of a symmetrical triangle on the daily chart (see below):

There’s the argument that this is merely a bear market rally — and a face-ripping sell-off is around the corner. Continue to invest and trade with caution.

In times like these, it’s survival that matters.

Our Latest Podcast Episodes:

Here’s what we cover this week:

    • Greenhaven Road Capital Q1 Letter
    • Maran Capital Q1 Letter
    • RF Capital Q1 Letter

Let’s get to it!

April 29, 2020

Perspectives & Opportunities: If you haven’t already, give Elliott Management’s Perspectives piece a read. It’s 14 pages of gold. Where does Elliott see the most opportunity right now? Credit. Here’s a snippet from the letter (emphasis mine):

The potential opportunity set is primarily in credit. Of course,equities that have fallen 20%, 30%or50% in a very short time can provide substantial upside, but in periods like this one, we prefer the additional downside protection of carefully researched debt. The Holy Grail (which presented itself in size in 2008 )is to have credit positions in which we have so much confidence and which have  so  much convexity (asymmetric  return  profiles;  much  more  upside  than  downside) that hedges  are  either  not  needed  or  can  be  relatively  small.

I’m itching to learn more about the credit space. If anyone has book recommendations on credit/bond investing, please email me or shoot me a Twitter DM.

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Investor Spotlight: Keep On Rolling With Q1 Letters

GIFs by tenor

Greenhaven Road Capital: -32% Q1 2020

Scott Miller is one of my favorite investors, and yes, I get excited when he releases his quarterly letter. The reason is simple. Scott is a dynamic value investor. He doesn’t confine himself to the traditional value box. He’s not afraid to invest in companies that don’t screen well, nor garner much credibility with a Graham & Dodd disciple.

And his Q1 letter showed that.

Before diving into the names mentioned, I want to highlight this portion from Miller’s letter (emphasis mine):

“There is a greater focus on balance sheets because the duration of the pandemic and timing to recovery could be quite extended. Therefore, to own a company today, we have to believe they will very likely ride this out and make it to the other side. Sufficient company cash and liquid assets provide invaluable insurance.”

Alright, onto the names.

SharpSpring, Inc. (SHSP)

Miller’s Take: “SharpSpring sells software that enables marketing automation, primarily to digital marketing agencies for small and medium-sized businesses. Fortunately, SharpSpring does not have large exposure to travel, retail, or restaurants. However, if a business stops all marketing or ceases to operate, they will cancel their SharpSpring contract. Marketing budgets are some of the first to be cut during difficult times. On the more positive side, SharpSpring pricing compares very favorably to competitors, so they may be more likely to win new business for those seeking a high-quality, lower-cost marketing automation solution.”

What’s It Worth: “SHSP shares ended the quarter trading at an EV/Sales of less than 2. Absent a multi-year depression, the opportunity exists to see very substantial returns from here.”

SHSP is losing money on a GAAP basis. This makes sense though as they’re aggressively spending to grow their market and reach new customers. At some point, the profit nozzle should turn on. Until then, the company needs to finance operations externally — namely via share issuances.

The company issued $16M worth of shares last year.

Let’s take a look at the chart …

SHSP looks like it wants to break out above $7.20. You might get away with calling this an inverse head and shoulders as well. Regardless, it’s a bottoming pattern.

Digital Turbine (APPS)

Miller’s Take: “Digital Turbine serves as a neutral third party that works with wireless carriers to preinstall apps on new cell phones, then sells the slots to app-driven companies like Uber, Amazon, and Netflix. In the long term, Digital Turbine’s success will be driven by the number of Android phones it controls (carrier/manufacturer partnerships) and the revenue per device it receives.”

What It’s Worth: “APPS ended the quarter with a market capitalization of approximately $400M, which is less than 2X estimates for FY2021 revenue and 6X adjusted EBITDA. Thanks to the Mobile Posse acquisition (done without issuing shares) and gains in the core business, revenue will likely grow at a rate of 35% or higher.”

Sub-2x revenues for a company growing its top-line 35% doesn’t sound like a bad deal. But Miller notes a few issues with APPS path forward, such as:

    • Recession extends upgrade cycles
    • People locked in their houses are unlikely to activate new phones.
    • Lower sales volumes

Here’s the chart …

PAR Technology (PAR)

Miller’s Take: “They own a defense contracting business, not impacted by Covid-19, which is worth approximately $100M and will likely be sold in the next year. The company also has a hardware business that sells $100M+ of equipment to large chains like McDonalds and Taco Bell, plus the Brink software business. Brink should end the year with 12,000 locations paying in excess of $2,000 per year”

What’s It Worth: “PAR may well see a share price significantly below $13, but in the long term, people will return to fast food restaurants for eat in, take out, drive thru, and delivery, and a share of PAR will no longer be available for the price of a couple of happy meals.”

The bet here appears to be that PAR’s Brink technology is vital to a QSR (quick-service-restaurant) daily operations. If these restaurants remain open (in any capacity), PAR gets paid. The shorter the shutdown lasts, the quicker PAR gets back on the growth path.

Delayed revenue, not lost revenue is the hope.

KKR & Co., Inc. (KKR)

Miller’s Take: “KKR is well positioned to benefit from the pandemic in the longer term. The firm has in excess of $160B of fee-paying capital that is “locked up” and will continue to pay fees through the slow down. KKR can also call an additional $60B of capital (dry powder) from LPs to further increase management fee income, and the pandemic will likely improve the returns for capital deployed during this period.”

What’s To Like:

    • Strong balance sheet
    • High insider ownership
    • 40-year track record
    • Investing mountains of capital at distressed prices

KKR’s Drivers of Growth:

    • Balance sheet investments
    • Management fees
    • Incentive fees
    • Capital market fees

Here’s the chart …

If we get a breakout above the horizontal boundary we could see prices retest the February highs.

Rope Out: Optiva, Inc. (OPT)

Miller’s Take: “Optiva is investing in building the next generation of cloud-hosted billing solutions for telecom companies. The cost savings for the telecom companies can be significant because they do not have to build data centers for maximum capacity as public cloud allows for dialing capacity up and down. Optiva estimates their customers will receive an 80% cost savings and a 10X improvement in performance.”

What’s It Worth: “In the last 12 months, they generated USD $14.5M in EBITDA while investing USD $11M in their cloud product, implying a valuation of a little more than 1X revenue, 9X EBITDA or 5X EBITDA ex cloud investment.”

OPT is a highly illiquid business. Miller notes that shares often go hours without exchanging hands — even post-earnings announcements. Alex and I worked on this name a couple years ago. It’s about time to dust off the old research deck and look with fresh eyes.

Here’s the chart …

Miller’s New Basket: Roku, Pinterest & Carvana

Here’s why I love Miller’s investment style. He added Roku (ROKU), Pinterest (PINS) and Carvana (CVNA) to his portfolio. These are not traditional value investments. But that’s the beauty of value investing. It’s not low P/E or low P/B. It’s buying something today whose cash flows are worth more in the future discounted back at an appropriate rate.

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Maran Capital: -17.50% Q1 2020

Dan Roller is the portfolio manager of Maran Capital. He’s wicked smart and remains (brutally) underfollowed on Twitter. The fund returned -17.50% during Q1. Dan starts the letter by reminding readers what really matters (emphasis mine):

“I am sticking to our fundamental guiding principles: margin of safety, conservative underwriting, alignment of interests, a long time horizon, and investment as ownership in a piece of a business.

This is a value investor’s “true north”. Stick to those above principles and you should do okay.

Roller mentions three of his top-five portfolio companies:

    • Clarus Corporation (CLAR)
    • Scott’s Liquid Gold (SLGD)
    • Standard Diversified (SDI)

Let’s take a look.

Clarus Corporation (CLAR)

Business Description: Clarus Corporation focuses on the outdoor and consumer industries in the United States, Canada, Europe, the Middle East, Asia, Australia, New Zealand, Africa, and South America. The company develops, manufactures, and distributes outdoor equipment and lifestyle products focusing on the climb, ski, mountain, sport, and skincare markets. – TIKR.com

What’s To Like:

    • Growing top-line revenue 10%+ on average last three years
    • P/E shrunk from 164x to 15x in three years on increased earnings
    • Cash from operations grew from $3.7M in 2015 to $9.5M in 2019
    • Market cap only $60M higher than 2015 despite massive earnings growth

What’s Not To Like:

    • It’s a retailer
    • Increased debt while reducing cash (Quick ratio from 5x in 2015 to 1.8x in 2019)
    • Increase in Average Cash Conversion Cycle (173x in 2015 vs. 198x in 2019)
    • Isn’t crazy cheap

Here’s the chart …

That’s a beautiful breakout from a tight consolidation range. If the stock holds the breakout price it would signal a close above the 50MA, another bullish indicator.

Scott’s Liquid Gold (SLGD)

Business Description: Scott’s Liquid Gold-Inc. and its subsidiaries develop, market, and sell household and personal care products in the United States and internationally. The company operates in two segments, Household Products and Personal Care Products. – TIKR.com

What’s To Like:

    • High insider ownership (CEO owns 24% of the company)
    • Trading at 0.53x EV/Sales
    • Zero long-term debt and $24M in Net Asset Value ($20M market cap)
    • Highly illiquid

What’s Not To Like:

    • Consistent revenue and margin decline
    • Negative cash flow from operations over last two years
    • Increase in Average Cash Conversion Cycle from 75 in 2015 to 161 in 2019
    • Increase in Days Sales Outstanding from 12.85 in 2015 to 36.83 in 2019

SLGD’s negative cash from operations looks bad at first glance. Looking deeper, it appears transitory. The company increased inventory each of the last two years, potentially in anticipation of higher product sales. Interested investors should watch that closely.

Here’s the weekly chart …

Standard Diversified (SDI)

Business Description: Standard Diversified Inc., a diversified holding company, through its subsidiaries, engages in the other tobacco products and outdoor advertising activities in the United States. Its Smokeless Products segment manufactures and markets moist snuff and contracts for and markets chewing tobacco products. – TIKR.com

What’s To Like:

    • Holding company whose primary asset is Turning Points Brand (TPB)
    • Insiders own 90% of the company
    • Compound mis-pricing
    • Smart and talented management
    • Consistent cash-flow from operations

What’s Not To Like:

    • Increase debt burden by $100M (from $202M – $334M)
    • Bet on tobacco industry staying solvent
    • Recent decline in revenues, margins and earnings

What’s It Worth:

Here’s a screenshot from Dan’s 2018 presentation on TPB and SDI outlining the value proposition:

For what it’s worth, SDI still trades around $13/share today. TPB, however, trades near $24/share.

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RF Capital: -27.13% Q1 2020

Roger Fan runs RF Capital. I’ll leave it to you to figure out the inspiration behind the Fund’s naming. Roger returned -27.13% during Q1. Here’s his Q1 letter.

Roger disclosed his top holdings as of the end of Q1:

    • GrafTech International (EAF)
    • Aimia, Inc, (AIM.TO)
    • Foot Locker (FL)

Let’s break down Roger’s views on each position.

GrafTech International (EAF)

Roger’s Take: “[W]e believe Graftech is well-positioned to handle this difficult environment. Not only is Graftech the only company in the industry that employs LTAs, but they also produce ~70% of the required needle coke through Seadrift, their subsidiary. Graftech’s competitors have to buy all of their needle coke on the spot market, thus creating greater variability in input costs. Given its vertical integration with needle coke, Graftech provides more earnings visibility and stability than its competitors.”

What’s To Like:

    • Long-term take-or-pay contracts
    • Vertical integration with needle coke supply
    • Locked in contracts at high spot and market prices
    • Clear path towards substantial cash flow generation

What’s Not To Like:

    • Commodity-dependent company
    • Performance linked to steel industry
    • Renegotiation (or default) of long-term contracts with customers

Here’s the chart …

Aimia, Inc, (AIM.TO)

Business Description: Aimia Inc., together with its subsidiaries, engages in loyalty solution business in Canada, the United Kingdom, the United Arab Emirates, the United States, Australia, and others. – TIKR.com

Roger’s Take: “Although the cash burn continues, management expects positive adjusted EBITDA and breakeven FCF in 2020. If the company achieves those targets, it would certainly help move the stock price. However, the value in Aimia continues to be its cash and assets. The company still trades at a large discount to NAV.”

What’s To Like:

    • Crazy cheap based on NAV and net cash
    • Decent business providing a needed service to airlines and customers
    • Positive changes on the board

What’s Not To Like:

    • Cash burn creates melting ice cube
    • Long-standing distrust in management’s ability to unlock value

AIM is basically a box of cash with the potential to have a decent, cash-flowing operating business attached. Shareholders of AIM don’t need the company to generate a ton of free cash to win. They can simply see their shares trade on par with net cash in the bank.

Here’s the chart …

Foot Locker, Inc. (FL)

Business Description: “Foot Locker, Inc., through its subsidiaries, operates as an athletic shoes and apparel retailer. The company operates in two segments, North America and International.” – TIKR.com

Roger’s Take: “Fortunately for the company, they have a strong balance sheet and are in a better position than most other retailers to weather the storm. The company ended 2019 with $907 million in cash versus $122 million of debt on the balance sheet. When stores reopen for business, the share price is likely to recover.”

FL churns out roughly $480M in annual free cash flow. The company sports a strong balance sheet and generates enough EBIT to cover interest expense 71x over.

FL’s also reduced its Average Cash Conversion cycle from 87 days to 75 days — almost two full weeks of improved cash conversion.

Here’s the chart …

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That’s all I got for this week. Shoot me an email if you come across something interesting this week at brandon@macro-ops.com.


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