Learning, idea generation and newsletters

I read a couple of newsletters on a monthly / quarterly basis to get new investment ideas and to learn more about the thought processes behind some of the best in the industry.

My favourite is Value Investor Insight (“VII”), which is co-founded by Whitney Tilson of Kase Capital. The VII format interviews several fund managers in the value and growth investing circles on a monthly basis, where the interviewees share their history, investment philosophy, processes and the thesis behind a few current ideas they are vested in. The newsletter is usually less than 20 pages long and the drawback to VII is that it is a paid service. However, considering the value I extracted from it, the price of the newsletter has been paid many times over. It was from VII’s Sep 2013 issue which interviewed Jim Larkins of Wasatch Advisors that I found Ebix as an idea that turned out to be a really good investment. Sapiens was another which I found in VII and invested in. The idea was pitched by Ori Eyal in the Aug 2016 edition.

Another newsletter I read is ROE Reporter by noted Canadian investor, Jason Donville. It is published free on a quarterly basis and he covers his thoughts and the stocks within his portfolio. I first came across the newsletter in February 2016 and more recently, read an interview with Donville in the wonderful book that profiled Canadian investors – Market Masters – by Robin R. Speziale. Donville’s philosophy is that ROE is probably the single best indicator of whether a company is going to be a great compounder. In the newsletter, he ranks listed Canadian companies by highest ROE and lowest P/E ratios in his list of shortlisted opportunities which somewhat reminds me of Joel Greenblatt’s much talked about Magic Formula. Although the newsletter is usually just a couple of pages, I enjoy reading them and am going through the past ones currently. In the last one year, his fund has taken a drubbing from his stock picks such as Concordia (the smaller version of Valeant) and Home Capital Group. Both have high ROEs and are highly leveraged (Home Capital Group’s business is in mortgages) but each have their own set of unique problems that contributed to their downfall. The underlying lesson for me is that while debt may not be the single factor that kills you, it is what will fuel the flames to spread across the rest of your business if any part of the business blows up. That said, Donville’s long term track record remains good and I am sure he will bounce back from this. It was from ROE Reporter that I found an investment opportunity – CRH Medical Corporation, a Canadian company in the gastrointestinal part of the healthcare industry, more specifically in the treatment of hemorrhoids and provides anesthesia services.

The other free newsletter I read on a quarterly basis is the excellent Graham & Doddsville newsletter, an investment newsletter from the Columbia’s Student Investment Management Association (Columbia Business School). The name of the newsletter is of course a play on the term used by Warren Buffett who wrote the seminal letter in 1984 called ‘The Superinvestors of Graham-and-Doddsville’. In each issue, the newsletter profiles investors, a number of whom are alumni of the mecca and school of the original value investors – Columbia Business School, following which the newsletter sometimes include stock pitches by current students. It is a great read each and every time and at about 50 pages for each issue, holds plenty of wisdom and investing nuggets for readers.

I hope you will enjoy reading the above mentioned newsletter as much as I have. If there are any great ones, do feel free to share!

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Dead Companies Walking – Scott Fearon

 

I finished another book recently, in which the author is a hedge fund manager who specialises in shorting “frauds, fads, and failures”. It is a fairly interesting book with some quotable quotes and points worth reflecting upon.

“It’s okay to be wrong; it’s not okay to stay wrong.”

“Self-delusion is a powerfully democratic force. It cuts across all social classes. You can be richer, smarter, and more successful than anyone else. But if you’re not brutally honest with yourself about your own potential for failure, you’re going to have a problem—and you’re going to lose money, maybe a lot of money.”

“Because quitting is very important when you re buying and selling stocks”

Ever so often, I get into an investment decision which upon closer scrutiny, turned out to not hold up as well as I initially thought. In particular, consumer discretionary and retail stocks come to mind. In most cases, I overstayed in the positions even after realising there were flaws in my original investment thesis that warranted quick remedial actions.

The most memorable was the case of, lets call it “Duke” Distillers, a manufacturer and marketeer of baijiu in China. At first sight, it looked like an extremely undervalued growth opportunity back in mid-to-late 2013. This was especially given its fast growing revenues (32% year-on-year growth in FY2013 vs FY2012), profit, operating and free cash flows. At that point in September 2013, the stock was trading at $5.00 (split adjusted) or a market cap of about $400 million. With its net cash position of close to $140 million and being valued on a free cash flow / enterprise value basis of about 15%, it was a screaming buy and boy did I buy. The prevailing sentiment for the depressed price at that point was China’s crackdown on conspicuous consumption by public officials (expensive watches, liquor, food, etc). As such, there were plenty of uncertainties surrounding luxury product stocks with exposure to China. I was well aware of that and since Duke supplied mid-range baijiu, my variant perception was that it would not be as affected as its extremely well-known peers such as Kweichow Moutai and Wuliangye. Duke’s financials on the surface compared favourably against its peers and I was elated.

I was also aware of the concerns over frauds when it came to Chinese companies, especially since there were a number of famous blowups in prior to then. I did some checks with a friend who frequented China for business and gathered that the liquor was indeed being peddled in China. Since the valuation was compelling, I jumped in with both feet. Thereafter, the stock price promptly fell and I while I normally would not be fazed, I did get a little jittery, given that it is after all a China-based company which I had no means of truly and personally doing channel checks and scuttlebutts.

I decided to re-run the figures, this time, diving much deeper into its operational metrics to test the reasonableness against its peers. In particular, its revenue generated per dollar of gross and net PPE was extremely elevated at double and triple digit percentage terms above the most renowned of its peers. That raised alarm bells immediately since I found it hard to fathom how Duke, a less established company, was able to produce so much more volume of products per asset employed. Given that the vats and techniques used for liquor production isn’t exactly rocket science and even if I accounted for improved technology, the difference should not have been way off the charts, much less for a small producer. Like a deer in front of headlights, I did what a normal deer would do – freeze up. At that point, I could have got out of the position at a relatively small loss of about 5%. I hoped against hope, that Duke was indeed much superior and that my calculations were wrong. In other words, I was delusional, stayed wrong and that was definitely not okay.

The stock price continued falling and I got out it progressively. By the time I sold the last of my position, that last share was unwound at a 20% loss. The episode was a valuable lesson on doing a more thorough analysis, especially when things seem too good to be true and when it is an unknown name. On hindsight, it seems elementary that I should have investigated deeper. And I really should have, but I was blinded by the compelling valuation. Most importantly, the moment that I knew that I was wrong, I should not have stayed wrong. I continue to learn every day and hope that I do not make the same silly mistakes again.

As a side note, not that I continued to track the financial performance of the company thereafter, but at this moment, the stock price is trading at $0.80, a whopping 84% below when I first initiated the position in 2013. I can count my lucky stars I had self-doubts on myself and the business, and that I got out before losing substantially all my capital tied up in Duke.

 

Other great quotes in the book worth reflecting on

“Success is a lousy teacher. It seduces smart people into thinking they can’t lose.” – Bill Gates

“I sent a gofer who was working for me at the time to twenty drugstores around my office. I had him put a small nick on the packaging of the first five Chemtrak tests on the shelf at every location. He went back every other week for several months. At the end of this process, those first five tests in all the stores still had nicks on them. Not a single one had sold. That was all the proof I needed. I shorted Chemtrak’s stock.”

“They had come up with all sorts of impressive numbers and projections showing that their product would fill a profitable niche. But, as with Chemtrak’s management team, they hadn’t analyzed the thing that would make them money: the way people in the real world actually behave.”

“If the rate of change on the outside exceeds the rate of change on the inside, the end is near.” -Jack Welch

“He called this fixation on evaluating numbers instead of flesh-and-blood managers going “Excel crazy.” … He would constantly chide me for burying my head too deeply in financial disclosures and earnings reports. “Get up and go outside, Scott,” he’d tell me. “You’ll learn more in five minutes of talking to someone at a company than you will in a week crunching its numbers.”

“In thirty years of visiting corporate headquarters, i don’t think I’ve ever met a single dumb person who had risen to helm a publicly traded company. But very few leaders, despite their intelligence, are willing to face hard facts and revise their thinking. That’s one of the main reasons more businesses fail than succeed.”

Quality Investing: Owning the best companies for the long term – Lawrence A. Cunningham , Torkell T. Eide, Patrick Hargreaves

I recently read the absolutely wonderful book which is jam-packed with many insights and nuggets of wisdom on investing in quality companies. It definitely deserves a place on every serious investor’s bookshelf. It’s not that the concepts are groundbreaking but they are clearly articulated and weaved together in a manner that provides further food for thought. Reading the book provides a timely reminder of what it means to be picking exceptional companies.

However, I also recognise that buying great businesses that are clearly understood is insufficient. To make the big money, one has to find the businesses as they are building their moats rather than after, when their moats are fully established and mature. An example would be investing in Microsoft when Bill Gates was at the helm in the early years, rather than when the competitive strengths are well recognised after Steve Ballmer took over. It is of course easier said than done. That is precisely why I think the book is essential reading to help recognise the type of companies a portfolio should hold while the underlying businesses compound their way nirvana.

In this entry, I’ll highlight 7 key points in the book which I thought stood out the most for me.

On 3 key factors necessary for a business to generate great returns
“In our view, three characteristics indicate quality. These are strong, predictable cash generation; sustainably high returns on capital; and attractive growth opportunities. Each of these financial traits is attractive in its own right, but combined, they are particularly powerful, enabling a virtuous circle of cash generation, which can be reinvested at high rates of return, begetting more cash, which can be reinvested again.” (pg 2)

High ROCs by themselves will not generate great returns for long
“It is relatively easy to identify a company that generates high returns on capital or which has delivered strong historical growth — there are plenty of screening tools which make this possible. The more challenging analytical endeavor is assessing the characteristics that combine to enable and sustain these appealing financial outputs.” (pg 3)

Clues of competitive advantage from analysing gross margins
“Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it… Gross profit margin demonstrates competitive advantage: it is the purest expression of customer valuation of a product, clearly implying the premium buyers assign to a seller for having fashioned raw materials into a finished item and branding it.” (pg 21)

Presence of older players signs of a less competitive industry
“Observing many older players in the industry is also encouraging – it’s a sign that long-term survival is possible.” (pg 39)

Companies selling products that go into the mouth or skin may be potential gold mines
“Intangible benefits often matter more to customers the more intimate the products are. Products that go in the mouth or on the skin carry more intangible potential than those that sit on a table or go into a machine, explaining why most people give the cost of their preferred toothpaste less thought than the price and brand of dishwasher detergent. This is one of the reasons why certain consumer products companies, from edibles to cosmetics, have proven to be such strong businesses over time.” (pg 45)

Why businesses aiming to sell to customers’ capex requirements are more vulnerable
“A business that is solely linked to customers’ capital expenditure makes for a much more complicated investment than one linked to their operating costs. In most cyclical industries, capital equipment is purchased amid periods of capacity expansion… On the other hand, for a company whose profits tie to customers’ operating costs, cyclicality poses less risk of disruption and remains relatively predictable.” (pg 28)

Learning from our own and others’ mistakes
“If smart people learn from their own mistakes while wise people learn from the mistakes of others, the goal is to be both smart and wise. The best thing to do after making or observing a mistake is to acknowledge it and absorb the relevant lessons to avoid repeating it.” (pg 158)