How Great Leaders Build Sustainable Businesses

(Image:  Zen Buddha Silence by Marilyn Barbone.)

January 16, 2022

Ian Cassell and Sean Iddings are successful microcap investors who co-authored the book, Intelligent Fanatics Project: How Great Leaders Build Sustainable Businesses (Iddings Cassel Publishing, 2016).  Ian Cassell is the founder of www.MicroCapClub.com.

If a microcap company is led by an intelligent fanatic, then it has a good chance of becoming a much larger company over time.  So, for a long-term investor, it makes sense to look for an intelligent fanatic who is currently leading a microcap company.  Cassel:

I want to find Reed Hastings in 2002, when Netflix (NFLX) was a $150 million market cap microcap (now worth $38 billion).  I want to find Bruce Cozadd in 2009, when Jazz Pharmaceuticals (JAZZ) was a $50 million market cap microcap (now worth $9 billion).

All great companies started as small companies, and intelligent fanatics founded most great companies.  So how do we find these rare intelligent fanatics early?  We find them by studying known intelligent fanatics and their businesses.  We look for common elements and themes, to help us in our search for the next intelligent fanatic-led business.

The term https://ramapoforchildren.org/youth/genre-analysis-essay/47/ cialis and 5 hour energy source site go site tadacip versus cialis essay writing my home Refissa Tretinoin Cream 0.05 Reviews mitos sobre el sildenafil can you exercise after taking cialis go site did tom kaulitz overdose viagra enter il cialis funziona contro l'ansia da prestazione https://businesswomanguide.org/capstone/thesis-communication-studies/22/ thesis 123 nursing home abuse essays gh esteroide efeitos colaterais do viagra https://mdp.berkeley.edu/wp-content/uploads/?online=argumentationen-beispiel-essay dystopian society essay https://shilohchristian.org/buy/cheap-custom-essay-ghostwriting-service-au/54/ buah semangka untuk viagra https://www.nationalautismcenter.org/letter/essay-editor-online/26/ get link essay videodrome paryavaran essay in hindi pdf get link alprazolam versus lexapro how to write a psychology case study report literary research paper edgar allan poe the thesis centre opening hours annee prochaine essay topics https://www.arvadachamber.org/verified/geography-coursework-evaluation/49/ intelligent fanatic is originally from Charlie Munger.  Cassel defines the term:

CEO or management team with large ideas and fanatical drive to build their moat.  Willing and able to think and act unconventionally.  A learning machine that adapts to constant change.  Focused on acquiring the best talent.  Able to create a sustainable corporate culture and incentivize their operations for continual progress.  Their time horizon is in five- or ten-year increments, not quarterly, and they invest in their business accordingly.  Regardless of the industry, they are able to create a moat [– i.e., a sustainable competitive advantage].

Cassel and Iddings give eight examples of intelligent fanatics:

  • Father of Sales and Innovation: John H. Patterson—National Cash Register
  • Retail Maverick: Simon Marks—Marks & Spencer
  • Original Warehouse Pioneer: Sol Price—Fedmart and Price Club
  • King of Clever Systems: Les Schwab—Les Schwab Tire Centers
  • Low-Cost Airline Wizard: Herb Kelleher—Southwest Airlines
  • Cult of Convenience: Chester Cadieux—QuikTrip
  • Leader of Steel: Kenneth Iverson—Nucor
  • Human Capital Allocators: 3G Partners—Garantia…

Cassel and Iddings conclude by summarizing the intelligent fanatic model.

 

FATHER OF SALES AND INNOVATION:  JOHN H. PATTERSON

Patterson purchased control of National Manufacturing Company, the originator of the cash register, in 1885, five years after the company had been formed.  Prospects did not appear good at all:

Everything was against a business selling cash registers at that time.  There was virtually no demand for cash registers.  Store owners could not justify the cost of the machine, which in today’s dollars would be roughly $1,000.  Patterson’s peers mocked his purchase of such a poor business, yet Patterson had a bold vision of what the cash register market could be, and he knew it would make a significant impact.

Patterson had had a great experience with the cash register.  His store in Coalton, Ohio, had immediately turned losses into profits simply by buying and installing a cash register.  It is hard to imagine now but employee theft at retail operations was common, given the primitive form of record keeping in those days.  Patterson knew the power of the cash register and needed to help merchants understand its value, too.

Patterson believed in staying ahead of what the current market was demanding:

We have made a policy to be just a short distance ahead, for the cash register has always had to make its market.  We had to educate our first customers;  we have to educate our present-day customer;  and our thought has always been to keep just so far ahead that education of the buyer will always be necessary.  Thus the market will be peculiarly our own—our customers will feel that we are their natural teachers and leaders.

…We are always working far ahead.  If the suggestions at the tryout demonstrate that the model will be much more valuable with changes or improvements, then send them out again to be tried.  And we keep up this process until every mechanical defect has been overcome and the model includes every feasible suggestion.

Few people at the time believed that the cash register would be widely adopted.  But Patterson predicted at least one cash register for every four hundred citizens in a town.  He was basically right.

Patterson started out working at the store on the family farm.  He was frustrated by the poor recordkeeping.  The employee books never reconciled.

Patterson then got a job as a toll collector at the Dayton office on the Miami and Erie Canal.  There were always arguments, with the bargemen complaining about higher tolls at certain locations.  Patterson solved the issue by developing a system of receipts, all of which would be sent to toll headquarters.

Patterson had extra time as a toll collector, so he started selling coal and wood out of his office.  He learned that he could differentiate himself by selling quality coal delivered on time and in the right quantity.  He also used the best horses, the best scales, and the best carts.  He made sure everything was quality and high-class.  His main challenge was that he never seemed to have enough cash since he was always reinvesting in the business, including advertising.

Eventually Patterson and his brother owned three coal mines, a store, and a chain of retail coal yards.  He had trouble with his mine store in Coalton, Ohio.  Revenues were high, but there were no profits and debt was growing.  He discovered that some clerks were only charging for half the coal.  Patterson bought two cash registers and hired new clerks.  Six months later, the debt was almost zero and there were profits.

Patterson then entered a venture to take one-third of the profits for operating the Southern Coal and Iron Company.  Unfortunately, this proved to be a disaster.  Patterson lost three years of his life and half his investment.

Meanwhile, Patterson had purchased stock in the cash register manufacturer National Manufacturing Company.  Patterson was also on the board of the company.  Patterson came up with a plan to increase sales, but the controlling shareholder and CEO, George Phillips, did not agree.  Patterson sold most of his stock.

But Patterson still believed in the idea of the cash register.  He was able to buy shares in National Manufacturing Company from George Phillips.  Patterson became the butt of Dayton jokes for buying such a bad business.  Patterson even tried to give his shares back to Phillips, but Phillips wouldn’t take them even as a gift.  So Patterson formed the National Cash Register Company.

Patterson started advertising directly to prospects through the mail.  He then sent highly qualified salesmen to those same prospects.  Patterson decided to pay his salesmen solely on commission and with no cap on how much they could make.  This was unconventional at the time, but it created effective incentives.  Patterson also bought expensive clothes for his salesmen, and at least one fine gown for the salesman’s wife.  As a result, the salesmen became high-quality and they also wanted a better standard of living.

Moreover, Patterson systematized the sales pitches of his salesmen.  This meant even salesmen with average ability could and did evolve into great salesmen.  Patterson also designated specific territories for the salesmen so that the salesmen wouldn’t be competing against one another.

Patterson made sure that salesmen and also manufacturing workers were treated well.  When he built new factories, he put in wall-to-wall glass windows, good ventilation systems, and dining rooms where employees could get decent meals at or below cost.  Patterson also made sure his workers had the best tools.  These were unusual innovations at the time.

Patterson also instituted a profit-sharing plan for all employees.

National Cash Register now had every worker aligned with common goals:  to increase efficiency, cut costs, and improve profitability.

Patterson was always deeply involved in the research and development of the cash register.  He often made sketches of new ideas in a memo book.  He got a few of these ideas patented.

NCR’s corporate culture and strategies were so powerful that John H. Patterson produced more successful businessmen than the best university business departments of the day.  More than a dozen NCR alumni went on to head large corporations, and many more went on to hold high corporate positions.

Cassel and Iddings sum it up:

Patterson was a perpetual beginner.  He bought NCR without knowing much of anything about manufacturing – except that he wanted to improve every business owner’s operations.  From his experiences, he took what he knew to be right and paid no attention to convention.  John Patterson not only experimented with improving the cash register machine but also believed in treating employees extremely well.  Many corporations see their employees as an expense line item;  intelligent fanatics see employees as a valuable asset.

When things failed or facts changed, Patterson showed an ability to pivot…

…He was able to get every one of his workers to think like owners, through his profit-sharing plan.  Patterson was always looking to improve production, so he made sure that every employee had a voice in improving the manufacturing operations.

 

RETAIL MAVERICK:  SIMON MARKS

Marks & Spencer was started by Michael Marks as a small outdoor stall in Leeds.  By 1923, when Michael’s son Simon was in charge, the company had grown significantly.  But Simon Marks was worried that efficient American competitors were going to wage price wars and win.

So Marks went to the U.S. to study his competitors.  (Walmart founder Sam Walton would do this four decades later.)  When Marks returned to Britain, he delivered a comprehensive report to his board:

I learned the value of more commodious and imposing premises.  I learned the value of checking lists to control stocks and sales.  I learned that new accounting machines could help to reduce the time formidably, to give the necessary information in hours instead of weeks.  I learned the value of counter footage and how in the chain store operation each foot of counter space had to pay wages, rent, overhead expenses, and profit.  There could be no blind spots insofar as goods are concerned.  This meant a much more exhaustive study of the goods we were selling and the needs of the public.  It meant that the staff who were operating with me had to be reeducated and retrained.

Cassel and Iddings:

…Simon Marks had been left a company with a deteriorating moat and a growing list of competitors.  He had the prescience and boldness to take a comfortable situation, a profitable, growing Marks & Spencer, and to take risks to build a long-term competitive edge.  From that point on, it could have been observed that Simon Marks had only one task – to widen Marks & Spencer’s moat every day for the rest of his life and to provide investors with uncommon profits.

Simon Marks convinced manufacturers that the retailer and manufacturer, by working together without the wholesale middleman, could sell at lower prices.  Marks made sure to maintain the highest quality at the lowest prices, making up for low profit margins with high volume.

Simon Marks was rare.  He was able to combine an appreciation for science and technology with an industry that had never cared to utilize it, all the while maintaining ‘a continuing regard for the individual, either as a customer or employee, and with a deep responsibility for his welfare and well-being.’  Marks & Spencer’s tradition of treating employees well stretched all the way back to Michael Marks’s Penny Bazaars in the covered stalls of Northern England… To Simon Marks, a happy and contented staff was the most valuable asset of any business.

Simon Marks established many policies to better Marks & Spencer’s labor relations, leading to increased employee efficiency and productivity…

Marks introduced dining rooms to provide free or low-cost meals to employees of stores.  Marks even put hair salons in stores so the female workforce could get their hair done during lunch.  He also provided free or reduced-cost health insurance.  Finally, he set up the Marks & Spencer Benevolent Trust to provide for the retirement of employees.  These moves were ahead of their time and led to low employee turnover and high employee satisfaction.

 

ORIGINAL WAREHOUSE PIONEER:  SOL PRICE

Sol Price founded Price Club in 1976.  The company lost $750,000 during its first year.  But by 1979, revenues reached $63 million, with $1.1 million in after-tax profits.

The strategy was to sell a limited number of items – 1,500 to 5,000 items versus 20,000+ offered by discounters – at a small markup from wholesale, to a small group of members (government workers and credit union customers).

Before founding Price Club, Sol Price founded and built FedMart from one location in 1954 into a company with $361 million in revenue by 1975.

…Thus, when Sol Price founded Price Club, other savvy retailers, familiar with this track record, were quick to pay close attention.  These retailers made it their obligation to meet Price, to learn as much as possible, and to clone Price’s concept.  They knew that the market opportunity was large and that Sol Price was an intelligent fanatic with a great idea.  An astute investor could have done the same and partnered with Price early in 1980 by buying Price Club stock.

One savvy retailer who found Sol Price early in the development of Price Club was Bernard Marcus, cofounder of Home Depot.  After getting fired from the home improvement company Handy Dan, Marcus met with Price, in the late 1970s.  Marcus was looking for some advice from Price about a potential legal battle with his former employer.  Sol Price had a similar situation at FedMart.  He told Marcus to forget about a protracted legal battle and to start his own business.

Marcus borrowed many ideas from Price Club when he cofounded Home Depot.  Later, Sam Walton copied as much as he could from Price Club when he founded Walmart.  Walton:

I guess I’ve stolen – I actually prefer the word borrowed – as many ideas from Sol Price as from anyone else in the business.

Bernie Brotman tried to set up a deal to franchise Price Clubs in the Pacific Northwest.  But Sol Price and his son, Richard Price, were reluctant to franchise Price Club.  Brotman’s son, Jeff Brotman, convinced Jim Sinegal, a long-time Price Club employee, to join him and start Costco, in 1983.

Brotman and Sinegal cloned Price Club’s business model and, in running Costco, copied many of Sol Price’s strategies.  A decade later, Price Club merged with Costco, and many Price Club stores are still in operation today under the Costco name.

Back in 1936, Sol Price graduated with a bachelor’s degree in philosophy.  He got his law degree in 1938.  Sol Price worked for Weinberger and Miller, a local law firm in San Diego.  He represented many small business owners and learned a great deal about business.

Thirteen years later, Price founded FedMart after noticing a nonprofit company, Fedco, doing huge volumes.  Price set up FedMart as a nonprofit, but created a separate for-profit company, Loma Supply, to manage the stores.  Basically, everything was marked up 5% from cost, which was the profit Loma Supply got.

FedMart simply put items on the shelves and let the customers pick out what they wanted.  This was unusual at the time, but it helped FedMart minimize costs and thus offer cheaper prices for many items.

By 1959, FedMart had grown to five stores and had $46.3 million in revenue and nearly $500,000 in profits.  FedMart went public that year and raised nearly $2 million for expansion.

In 1962, Sam Walton had opened the first Walmart, John Geisse had opened the first Target, and Harry Cunningham had opened the first Kmart, all with slight variations on Sol Price’s FedMart business model.

By the early 1970s, Sol Price wasn’t enjoying managing FedMart as much.  He remarked that they were good at founding the business, but not running it.

While traveling in Europe with his wife, Sol Price was carefully observing the operations of different European retailers.  In particular, he noticed a hypermarket retailer in Germany named Wertkauf, run by Hugo Mann.  Price sought to do a deal with Hugo Mann as a qualified partner.  But Mann saw it as a way to buy FedMart.  After Mann owned 64% of FedMart, Sol Price was fired from the company he built.  But Price didn’t let that discourage him.

Like other intelligent fanatics, Sol Price did not sit around and mourn his defeat.  At the age of 60, he formed his next venture less than a month after getting fired from FedMart.  The Price Company was the name of this venture, and even though Sol Price had yet to figure out a business plan, he was ready for the next phase of his career.

…What the Prices [Sol and his son, Robert] ended up with was a business model similar to some of the concepts Sol had observed in Europe.  The new venture would become a wholesale business selling merchandise to other businesses, with a membership system similar to that of the original FedMart but closer to the ‘passport’ system used by Makro, in the Netherlands, in a warehouse setting.  The business would attract members with its extremely low prices.

During the first 45 days, the company lost $420,000.

Instead of doing nothing or admitting defeat, however, Sol Price figured out the problem and quickly pivoted.

Price Club had incorrectly assumed that variety and hardware stores would be large customers and that the location would be ideal for business customers.  A purchasing manager, however, raised the idea of allowing members of the San Diego City Credit Union to shop at Price Club.  After finding out that Price Club could operate as a retail shop, in addition to selling to businesses, the company allowed credit union members to shop at Price Club.  The nonbusiness customers did not pay the $25 annual business membership fee but got a paper membership pass and paid an additional 5% on all goods.  Business members paid the wholesale price.  The idea worked and sales turned around, from $47,000 per week at the end of August to $151,000 for the week of November 21.  The Price Club concept was now proven.

Sol Price’s idea was to have the smallest markup from cost possible and to make money on volume.  This was unconventional.

Price also sought to treat his employees well, giving them the best wages and providing the best working environment.  By treating employees well, he created happy employees who in turn treated customers well.

Instead of selling hundreds of thousands of different items, Sol Price thought that focusing on only a few thousand items would lead to greater efficiency and lower costs.  Also, Price was able to buy in larger quantities, which helped.  This approach gave customers the best deal.  Customers would typically buy a larger quantity of each good, but would generally save over time by paying a lower price per unit of volume.

Sol Price also saved money by not advertising.  Because his customers were happy, he relied on unsolicited testimonials for advertising.  (Costco, in turn, has not only benefitted from unsolicited testimonials, but also from unsolicited media coverage.)

Jim Sinegal commented:

The thing that was most remarkable about Sol was not just that he knew what was right.  Most people know the right thing to do.  But he was able to be creative and had the courage to do what was right in the face of a lot of opposition.  It’s not easy to stick to your guns when you have a lot of investors saying that you’re not charging customers enough and you’re paying employees too much.

Over a thirty-eight year period, including FedMart and then Price Club until the Costco merger in 1993, Sol Price generated roughly a 40% CAGR in shareholder value.

 

KING OF CLEVER SYSTEMS:  LES SCHWAB

Les Schwab knew how to motivate his people through clever systems and incentives.  Schwab realized that allowing his employees to become highly successful would help make Les Schwab Tire Centers successful.

Schwab split his profits with his first employees, fifty-fifty, which was unconventional in the 1950s.  Schwab would reinvest his portion back into the business.  Even early on, Schwab was already thinking about massive future growth.

As stores grew and turned into what Schwab called ‘supermarket’ tire centers, the number of employees needed to manage the operations increased, from a manager with a few helpers to six or seven individuals.  Schwab, understanding the power of incentives, asked managers to appoint their best worker as an assistant manager and give him 10% of the store’s profits.  Schwab and the manager each would give up 5%.

…Les Schwab was never satisfied with his systems, especially the employee incentives, and always strove to develop better programs.

…Early on, it was apparent that Les Schwab’s motivation was not to get rich but to provide opportunities for young people to become successful, as he had done in the beginning.  This remained his goal for decades.  Specifically, his goal was to share the wealth.  The company essentially has operated with no employees, only partners.  Even the hourly workers were treated like partners.

When Schwab was around fifteen years old, he lost his mother to pneumonia and then his father to alcohol.  Schwab started selling newspapers.  Later as a circulation manager, he devised a clever incentive scheme for the deliverers.  Schwab always wanted to help others succeed, which in turn would help the business succeed.

The desire to help others succeed can be a powerful force.  Les Schwab was a master at creating an atmosphere for others to succeed through clever programs.  Les always told his manager to make all their people successful, because he believed that the way a company treated employees would directly affect how employees would treat the customer.  Schwab also believed that the more he shared with employees, the more the business would succeed, and the more resources that would eventually be available to give others opportunities to become successful.  In effect, he was compounding his giving through expansion of the business, which was funded from half of his profits.

Once in these programs, it would be hard for employees and the company as a whole not to become successful, because the incentives were so powerful.  Schwab’s incentive system evolved as the business grew, and unlike most companies, those systems evolved for the better as he continued giving half his profits to employees.

Like other intelligent fanatics, Schwab believed in running a decentralized business.  This required good communication and ongoing education.

 

LOW-COST AIRLINE WIZARD:  HERB KELLEHER

The airline industry has been perhaps the worst industry ever.  Since deregulation in 1978, the U.S. airline industry alone has lost $60 billion.

Southwest Airlines is nearing its forty-third consecutive year of profitability.  That means it has made a profit nearly every year of its corporate life, minus the first fifteen months of start-up losses.  Given such an incredible track record in a horrible industry, luck cannot be the only factor.  There had to be at least one intelligent fanatic behind its success.

…In 1973, the upstart Texas airline, Southwest Airlines, with only three airplanes, turned the corner and reached profitability.  This was a significant achievement, considering that the company had to overcome three and a half years of legal hurdles by two entrenched and better-financed competitors:  Braniff International Airways had sixty-nine aircraft and $256 million in revenues, and Texas International had forty-five aircraft with $32 million in revenues by 1973.

As a young man, Herb ended up living with his mother after his older siblings moved out and his father passed away.  Kelleher says he learned about how to treat people from his mother:

She used to sit up talking to me till three, four in the morning.  She talked a lot about how you should treat people with respect.  She said that positions and titles signify absolutely nothing.  They’re just adornments;  they don’t represent the substance of anybody… She taught me that every person and every job is worth as much as any other person or any other job.

Kelleher ended up applying these lessons at Southwest Airlines.  The idea of treating employees well and customers well was central.

Kelleher did not graduate with a degree in business, but with a bachelor’s degree in English and philosophy.  He was thinking of becoming a journalist.  He ended up becoming a lawyer, which helped him get into business later.

When Southwest was ready to enter the market in Texas as a discount airline, its competitors were worried.

With their large resources, competitors did everything in their power to prevent Southwest from getting off the ground, and they were successful in temporarily delaying Southwest’s first flight.  The incumbents filed a temporary restraining order that prohibited the aeronautics commission from issuing Southwest a certificate to fly.  The case went to trial in the Austin state court, which did not support another carrier entering the market.

Southwest proceeded to appeal the lower court decision that the market could not support another carrier.  The intermediate appellate court sided with the lower court and upheld the ruling.  In the meantime, Southwest had yet to make a single dollar in revenues and had already spent a vast majority of the money it had raised.

The board was understandably frustrated.  At this point, Kelleher said he would represent the company one last time and pay every cent of legal fees out of his own pocket.  Kelleher convinced the supreme court to rule in Southwest’s favor.  Meanwhile, Southwest hired Lamar Muse as CEO, who was an experienced, iconoclastic entrepreneur with an extensive network of contacts.

Herb Kelleher was appointed CEO in 1982 and ran Southwest until 2001.  He led Southwest from $270 million to $5.7 billion in revenues, every year being profitable.  This is a significant feat, and no other airline has been able to match that kind of record in the United States.  No one could match the iron discipline that Herb Kelleher instilled in Southwest Airlines from the first day and maintained so steadfastly through the years.

Before deregulation, flying was expensive.  Herb Kelleher had the idea of offering lower fares.  To achieve this, Southwest did four things.

  • First, they operated out of less-costly and less-congested airports. Smaller airports are usually closer to downtown locations, which appealed to businesspeople.
  • Second, Southwest only operated the Boeing 737. This gave the company bargaining power in new airplane purchases and the ability to make suggestions in the manufacture of those plans to improve efficiency.  Also, operating costs were lower because everyone only had to learn to operate one type of plane.
  • Third, Southwest reduced the amount of time planes were on the ground to 10 minutes (from 45 minutes to an hour).
  • Fourth, Southwest treats employees well and is thus able to retain qualified, hardworking employees. This cuts down on turnover costs.

Kelleher built an egalitarian culture at Southwest where each person is treated like everyone else.  Also, Southwest was the first airline to share profits with employees.  This makes employees think and act like owners.  As well, employees are given autonomy to make their own decisions, as an owner would.  Not every decision will be perfect, but inevitable mistakes are used as learning experiences.

Kelleher focused the company on being entrepreneurial even as the company grew.  But simplifying did not include eliminating employees.

Southwest Airlines is the only airline – and one of the few corporations in any industry – that has been able to run for decades without ever imposing a furlough.  Cost reductions are found elsewhere, and that has promoted a healthy morale within the Southwest Airlines corporate culture.  Employees have job security.  A happy, well-trained labor force that only needs to be trained on one aircraft promotes more-efficient and safer flights.  Southwest is the only airline that has a nearly perfect safety record.

Kelleher once told the following story:

What I remember is a story about Thomas Watson.  This is what we have followed at Southwest Airlines.  A vice president of IBM came in and said, ‘Mr. Watson, I’ve got a tremendous idea…. And I want to set up this little division to work on it.  And I need ten million dollars to get it started.’  Well, it turned out to be a total failure.  And the guy came back to Mr. Watson and he said that this was the original proposal, it cost ten million, and that it was a failure.  ‘Here is my letter of resignation.’  Mr. Watson said, ‘Hell, no!  I just spent ten million on your education.  I ain’t gonna let you leave.’  That is what we do at Southwest Airlines.

One example is Matt Buckley, a manager of cargo in 1985.  He thought of a service to compete with Federal Express.  Southwest let him try it.  But it turned out to be a mistake.  Buckley:

Despite my overpromising and underproducing, people showed support and continued to reiterate, ‘It’s okay to make mistakes;  that’s how you learn.’  In most companies, I’d probably have been fired, written off, and sent out to pasture.

Kelleher believed that any worthwhile endeavor entails some risk.  You have to experiment and then adjust quickly when you learn what works and what doesn’t.

Kelleher also created a culture of clear communication with employees, so that employees would understand in more depth how to minimize costs and why it was essential.

Communication with employees at Southwest is not much different from the clear communication Warren Buffett has had with shareholders and with his owned operations, through Berkshire Hathaway’s annual shareholder letters.  Intelligent fanatics are teachers to every stakeholder.

 

CULT OF CONVENIENCE:  CHESTER CADIEUX

Warren Buffett:

Back when I had 10,000 bucks, I put 2,000 of it into a Sinclair service station, which I lost, so my opportunity cost on it’s about 6 billion right now.  A fairly big mistake – it makes me feel good when Berkshire goes down, because the cost of my Sinclair station goes down too.

Chester Cadieux ran into an acquaintance from school, Burt B. Holmes, who was setting up a bantam store – an early version of a convenience store.  Cadieux invested $5,000 out of the total $15,000.

At the time, in 1958, there were three thousand bantam stores open.  They were open longer hours than supermarkets, which led customers to be willing to pay higher prices.

Cadieux’s competitive advantage over larger rivals was his focus on employees and innovation.  Both characteristics were rooted in Chester’s personal values and were apparent early in QuikTrip’s history.  He would spend a large part of his time – roughly two months out of the year – in direction communication with QuikTrip employees.  Chester said, ‘Without fail, each year we learned something important from a question or comment voiced by a single employee.’  Even today, QuikTrip’s current CEO and son of Chester Cadieux, Chet Cadieux, continues to spend four months of his year meeting with employees.

Cassel and Iddings:

Treat employees well and incentivize them properly, and employees will provide exceptional service to the customers.  Amazing customer service leads to customer loyalty, and this is hard to replicate, especially by competitors who don’t value their employees.  Exceptional employees and a quality corporate culture have allowed QuikTrip to stay ahead of competition from convenience stores, gas retailers, quick service restaurants, cafes, and hypermarkets.

Other smart convenience store operators have borrowed many ideas from Chester Cadieux.  Sheetz, Inc. and Wawa, Inc. – both convenience store chains headquartered in Pennsylvania – have followed many of Cadieux’s ideas.  Cadieux, in turn, has also picked up a few ideas from Sheetz and Wawa.

Sheetz, Wawa, and QuikTrip all have similar characteristics, which can be traced back to Chester Cadieux and his leadership values at QuikTrip.  When three stores in the same industry, separated only by geography, utilize the same strategies, have similar core values, and achieve similar success, then there must be something to their business models.  All could have been identified early, when their companies were much smaller, with qualitative due diligence.

One experience that shaped Chester Cadieux was when he was promoted to first lieutenant at age twenty-four.  He was the senior intercept controller at his radar site, and he had to lead a team of 180 personnel:

…he had to deal with older, battle-hardened sergeants who did not like getting suggestions from inexperienced lieutenants.  Chester said he learned ‘how to circumvent the people who liked to be difficult and, more importantly, that the number of stripes on someone’s sleeves was irrelevant.’  The whole air force experience taught him how to deal with people, as well as the importance of getting the right people on his team and keeping them.

When Cadieux partnered with Burt Holmes on their first QuikTrip convenience store, it seemed that everything went wrong.  They hadn’t researched what the most attractive location would be.  And Cadieux stocked the store like a supermarket.  Cadieux and Holmes were slow to realize that they should have gone to Dallas and learned all they could about 7-Eleven.

QuikTrip was on the edge of bankruptcy during the first two or three years.  Then the company had a lucky break when an experienced convenience store manager, Billy Neale, asked to work for QuikTrip.  Cadieux:

You don’t know what you don’t know.  And when you figure it out, you’d better sprint to fix it, because your competitors will make it as difficult as possible in more ways than you could ever have imagined.

Cadieux was smart enough to realize that QuikTrip survived partly by luck.  But he was a learning machine, always learning as much as possible.  One idea Cadieux picked up was to sell gasoline.  He waited nine years until QuikTrip had the financial resources to do it.  Cadieux demonstrated that he was truly thinking longer term.

QuikTrip has always adapted to the changing needs of its customers, demographics, and traffic patterns, and has constantly looked to stay ahead of competition.  This meant that QuikTrip has had to reinvest large sums of capital into store updates, store closures, and new construction.  From QuikTrip’s inception, in 1958, to 2008, the company closed 418 stores;  in 2008, QuikTrip had only five hundred stores in operation.

QuikTrip shows its long-term focus by its hiring process.  Cadieux:

Leaders are not necessarily born with the highest IQs, or the most drive to succeed, or the greatest people skills.  Instead, the best leaders are adaptive – they understand the necessity of pulling bright, energetic people into their world and tapping their determination and drive.  True leaders never feel comfortable staying in the same course for too long or following conventional wisdom – they inherently understand the importance of constantly breaking out of routines in order to recognize the changing needs of their customers and employees.

QuikTrip interviews about three out of every one hundred applicants and then chooses one from among those three.  Only 70% of new hires make it out of training, and only 50% of those remaining make it past the first 6 months on the job.  But QuikTrip’s turnover rate is roughly 13% compared to the industry average of 59%.  These new hires are paid $50,000 a year.  And QuikTrip offers a generous stock ownership plan.  Employees also get medical benefits and a large amount of time off.

Cadieux’s main goal was to make employees successful, thereby making customers and eventually shareholders happy.

 

LEADER OF STEEL:  F. KENNETH IVERSON

Ken Iverson blazed a new trail in steel production with the mini mill, thin-slab casting, and other innovations.  He also treated his employees like partners.  Both of these approaches were too unconventional and unusual for the old, slow-moving, integrated steel mills to compete with.  Ken Iverson harnessed the superpower of incentives and effective corporate culture.  He understood how to manage people and had a clear goal.

In its annual report in 1975, Nucor had all of its employees listed on the front cover, which showed who ran the company.  Every annual report since then has listed all employees on the cover.  Iverson:

I have no desire to be perfect.  In fact, none of the people I’ve seen do impressive things in life are perfect… They experiment.  And they often fail.  But they gain something significant from every failure.

Iverson studied aeronautical engineering at Cornell through the V-12 Navy College Training Program.  Iverson spent time in the Navy, and then earned a master’s degree in mechanical engineering from Purdue University.  Next he worked as an assistant to the chief research physicist at International Harvester.

Iverson’s supervisor told him you can achieve more at a small company.  So Iverson started working as the chief engineer at a small company called Illium Corp.  Taking chances was encouraged.  Iverson built a pipe machine for $5,000 and it worked, which saved the company $245,000.

Iverson had a few other jobs.  He helped Nuclear Corporation of America find a good acquisition – Vulcraft Corporation.  After the acquisition, Vulcraft made Iverson vice president.  The company tripled its sales and profits over the ensuing three years, while the rest of Nuclear was on the verge of bankruptcy.  When Nuclear’s president resigned, Iverson became president of Nuclear.

Nuclear Corporation changed its name to Nucor.  Iverson cut costs.  Although few could have predicted it, Nucor was about to take over the steel industry.  Iverson:

At minimum, pay systems should drive specific behaviors that make your business competitive.  So much of what other businesses admire in Nucor – our teamwork, extraordinary productivity, low costs, applied innovation, high morale, low turnover – is rooted in how we pay our people.  More than that, our pay and benefit programs tie each employee’s fate to the fate of our business.  What’s good for the company is good – in hard dollar terms – for the employee.

The basic incentive structure had already been in place at Vulcraft.  Iverson had the sense not to change it, but rather to improve it constantly.  Iverson:

As I remember it, the first time a production bonus was over one hundred percent, I thought that I had created a monster.  In a lot of companies, I imagine many of the managers would have said, ‘Whoops, we didn’t set that up right.  We’d better change it.’  Not us.  We’ve modified it some over the years.  But we’ve stayed with that basic concept ever since.

Nucor paid its employees much more than what competitors paid.  But Nucor’s employees produced much, much more.  As a result, net costs were lower for Nucor.  In 1996, Nucor’s total cost was less than $40 per ton of steel produced versus at least $80 per ton of steel produced for large integrated U.S. steel producers.

Nucor workers were paid a lower base salary – 65% to 70% of the average – but had opportunities to get large bonuses if they produced a great deal.

Officer bonuses (8% to 24%) were tied to the return on equity.

Nonproduction headquarter staff, engineers, secretaries, and so on, as well as department managers, could earn 25% to 82% of base pay based on their division’s return on assets employed.  So, if a division did not meet required returns, those employees received nothing, but they received a significant amount if they did.  There were a few years when all employees received no bonuses and a few years when employees maxed out their bonuses.

An egalitarian incentive structure leads all employees to feel equal, regardless of base pay grade or the layer of management an employee is part of.  Maintenance workers want producers to be successful and vice versa.

All production workers, including managers, wear hard hats of the same color.  Everyone is made to feel they are working for the common cause.  Nucor has only had one year of losses, in 2009, over a fifty-year period.  This is extraordinary for the highly cyclical steel industry.

Iverson, like Herb Kelleher, believed that experimentation – trial and error – was essential to continued innovation.  Iverson:

About fifty percent of the things we try really do not work out, but you can’t move ahead and develop new technology and develop a business unless you are willing to take risks and adopt technologies as they occur.

 

HUMAN CAPITAL ALLOCATORS:  3G PARTNERS

3G Partners refers to the team of Jorge Paulo Lemann, Carlos Alberto “Beto” Sicupira, and Marcel Hermann Telles.  They have developed the ability to buy underperforming companies and dramatically improve productivity.

When the 3G partners took control of Brahma, buying a 40% stake in 1989, it was the number two beer company in Brazil and was quickly losing ground to number one, Antarctica.  The previously complacent management and company culture generated low productivity – approximately 1,200 hectoliters of beverage produced per employee.  There was little emphasis on profitability or achieving more efficient operations.  During Marcel Telles’s tenure, productivity per employee multiplied seven times, to 8,700 hectoliters per employee.  Efficiency and profitability were top priorities of the 3G partners, and the business eventually held the title of the most efficient and profitable brewer in the world.  Through efficiency of operations and a focus on profitability, Brahma maintained a 20% return on capital, a 32% compound annual growth rate in pretax earnings, and a 17% CAGR in revenues over the decade from 1990 to 1999… Shareholder value creation stood at an astounding 42% CAGR over that period.

…Subsequent shareholder returns generated at what eventually became Anheuser-Busch InBev (AB InBev) have been spectacular, driven by operational excellence.

Jorge Paulo Lemann – who, like Sicupira and Telles, was born in Rio de Janeiro – started playing tennis when he was seven.  His goal was to become a great tennis player.  He was semi-pro for a year after college.  Lemann:

In tennis you win and lose.  I’ve learned that sometimes you lose.  And if you lose, you have to learn from the experience and ask yourself, ‘What did I do wrong?  What can I do better?  How am I going to win next time?’

Tennis was very important and gave me the discipline to train, practice, and analyze… In tennis you have to take advantage of opportunities.

So my attitude in business was always to make an effort, to train, to be present, to have focus.  Occasionally an opportunity passed and you have to grab those opportunities.

In 1967, Lemann started working for Libra, a brokerage.  Lemann owned 13% of the company and wanted to create a meritocratic culture.  But others disagreed with him.

In 1971, Lemann founded Garantia, a brokerage.  He aimed to create a meritocratic culture like the one at Goldman Sachs.  Lemann would seek out top talent and then base their compensation on performance.  Marcel Telles and Beto Sicupira joined in 1972 and 1973, respectively.

Neither Marcel Telles nor Beto Sicupira started off working in the financial markets or high up at Garantia.  Both men started at the absolute bottom of Garantia, just like any other employee…

Jorge Paulo Lemann initially had a 25% interest in Garantia, but over the first seven years increased it to 50%, slowly buying out the other initial investors.  However, Lemann also wanted to provide incentives to his best workers, so he began selling his stake to new partners.  By the time Garantia was sold, Lemann owned less than 30% of the company.

Garantia transformed itself into an investment bank.  It was producing a gusher of cash.  The partners decided to invest in underperforming companies and then introduce the successful, meritocratic culture at Garantia.  In 1982, they invested in Lojas Americanas.

Buying control of outside businesses gave Lemann the ability to promote his best talent into those businesses.  Beto Sicupira was appointed CEO and went about turning the company around.  The first and most interesting tactic Beto utilized was to reach out to the best retailers in the United States, sending them all letters and asking to meet them and learn about their companies;  neither Beto nor his partners had any retailing experience.  Most retailers did not respond to this query, but one person did:  Sam Walton of Walmart.

The 3G partners met in person with the intelligent fanatic Sam Walton and learned about his business.  Beto was utilizing one of the most important aspects of the 3G management system:  benchmarking from the best in the industry.  The 3G partners soaked up everything from Walton, and because the young Brazilians were a lot like him, Sam Walton became a mentor and friend to all of them.

In 1989, Lemann noticed an interesting pattern:

I was looking at Latin America and thinking, Who was the richest guy in Venezuela?  A brewer (the Mendoza family that owns Polar).  The richest guy in Colombia?  A brewer (the Santo Domingo Group, the owner of Bavaria).  The richest in Argentina?  A brewer (the Bembergs, owners of Quilmes).  These guys can’t all be geniuses… It’s the business that must be good.

3G always set high goals.  When they achieved one ambitious goal, then they would set the next one.  They were never satisfied.  When 3G took over Brahma, the first goal was to be the best brewer in Brazil.  The next goal was to be the best brewer in the world.

3G has always had a truly long-term vision:

Marcel Telles spent considerable time building Brahma, with a longer-term vision.  The company spent a decade improving the efficiency of its operations and infusing it with the Garantia culture.  When the culture was in place, a large talent pipeline was developed, so that the company could acquire its largest rival, Antarctica.  By taking their time in building the culture of the company, management was ensuring that the culture could sustain itself well beyond the 3G partners’ tenure.  This long-term vision remains intact and can be observed in a statement from AB InBev’s 2014 annual report:  ‘We are driven by our passion to create a company that can stand the test of time and create value for our shareholders, not only for the next ten or twenty years but for the next one hundred years.  Our mind-set is truly long term.’

3G’s philosophy of innovation was similar to a venture capitalist approach.  Ten people would be given a small amount of capital to try different things.  A few months later, two out of ten would have good ideas and so they would get more funding.

Here are the first five commandments (out of eighteen) that Lemann created at Garantia:

  • A big and challenging dream makes everyone row in the same direction.
  • A company’s biggest asset is good people working as a team, growing in proportion to their talent, and being recognized for that. Employee compensation has to be aligned with shareholders’ interests.
  • Profits are what attract investors, people, and opportunities, and keep the wheels spinning.
  • Focus is of the essence. It’s impossible to be excellent at everything, so concentrate on the few things that really matter.
  • Everything has to have an owner with authority and accountability. Debate is good, but in the end, someone has to decide.

Garantia had an incentive system similar to that created by other intelligent fanatics.  Base salary was below market average.  But high goals were set for productivity and costs.  And if those goals are achieved, bonuses can amount to many times the base salaries.

The main metric that employees are tested against is economic value added – employee performance in relation to the cost of capital.  The company’s goal is to achieve 15% economic value added, so the better the company performs as a whole, the larger is the bonus pool to be divided among employees.  And, in a meritocratic culture, the employees with the best results are awarded the highest bonuses.

Top performers also are given a chance to purchase stock in the company at a 10% discount.

The 3G partners believe that a competitive atmosphere in a business attracts high-caliber people who thrive on challenging one another.  Carlos Brito said, ‘That’s why it’s important to hire people better than you.  They push you to be better.’

 

THE INTELLIGENT FANATICS MODEL

Cassel and Iddings quote Warren Buffett’s 2010 Berkshire Hathaway shareholder letter:

Our final advantage is the hard-to-duplicate culture that permeates Berkshire.  And in businesses, culture counts.

One study found the following common elements among outperformers:

What elements of those cultures enabled the top companies to adapt and to sustain performance?  The common answers were the quality of the leadership, the maintenance of an entrepreneurial environment, prudent risk taking, innovation, flexibility, and open communication throughout the company hierarchy.  The top-performing companies maintained a small-company feel and had a long-term horizon.  On the other hand, the lower-performing companies were slower to adapt to change.  Interviewees described these companies as bureaucratic, with very short-term horizons.

Cassel and Iddings discuss common leadership attributes of intelligent fanatics:

Leading by Example

Intelligent fanatics create a higher cause that all employees have the chance to become invested in, and they provide an environment in which it is natural for employees to become heavily invested in the company’s mission.

…At Southwest, for example, the company created an employee-first and family-like culture where fun, love, humor, and creativity were, and continue to be, core values.  Herb Kelleher was the perfect role model for those values.  He expressed sincere appreciation for employees and remembered their names, and he showed his humor by dressing up for corporate gatherings and even by settling a dispute with another company through an arm wrestling contest.

Unblemished by Industry Dogma

Industries are full of unwritten truths and established ways of thinking.  Industry veterans often get accustomed to a certain way of doing or thinking about things and have trouble approaching problems from a different perspective.  This is the consistency and commitment bias Charlie Munger has talked about in his speech ‘The Psychology of Human Misjudgment.’  Succumbing to the old guard prevents growth and innovation.

…All of our intelligent fanatic CEOs were either absolute beginners, with no industry experience, or had minimal experience.  Their inexperience allowed them to be open to trying something new, to challenge the old guard.  The CEOs developed new ways of operating that established companies could not compete with.  Our intelligent fanatics show us that having industry experience can be a detriment.

Teaching by Example

Jim Sinegal learned from Sol Price that ‘if you’re not spending ninety percent of your time teaching, you’re not doing your job.’

Founder Ownership Creates Long-Term Focus

The only way to succeed in dominating a market for decades is to have a long-term focus.  Intelligent fanatics have what investor Tom Russo calls the capacity to suffer short-term pain for long-term gain…. As Jeff Bezos put it, ‘If we have a good quarter, it’s because of work we did three, four, five years ago.  It’s not because we did a good job this quarter.’  They build the infrastructure to support a larger business, which normally takes significant up-front investment that will lower profitability in the short term.

Keep It Simple

Jorge Paulo Lemann:

All the successful people I ever met were fanatics about focus.  Sam Walton, who built Walmart, thought only about stores day and night.  He visited store after store.  Even Warren Buffett, who today is my partner, is a man super focused on his formula.  He acquires different businesses but always within the same formula, and that’s what works.  Today our formula is to buy companies with a good name and to come up with our management system.  But we can only do this when we have people available to go to the company.  We cannot do what the American private equity firms do.  They buy any company, send someone there, and constitute a team.  We only know how to do this with our team, people within our culture.  Then, focus is also essential.

Superpower of Incentives

Intelligent fanatics are able to create systems of financial incentive that attract high-quality talent, and they provide a culture and higher cause that immerses employees in their work.  They are able to easily communicate the why and the purpose of the company so that employees themselves can own the vision.

…All of this book’s intelligent fanatic CEOs unleashed their employees’ fullest potential by getting them to think and act as owners.  They did this two ways:  they provided a financial incentive, aligning employees with the actual owners, and they gave employees intrinsic motivation to think like owners.  In every case, CEOs communicated the importance of each and every employee to the organization and provided incentives that were simple to understand.

Experimentation

Intelligent fanatics and their employees are unstoppable in their pursuit of staying ahead of the curve.  They test out many ideas, like a scientist experimenting to find the next breakthrough.  In the words of the head of Amazon Web Services (AWS), Andy Jassy, ‘We think of (these investments) as planting seeds for very large trees that will be fruitful over time.’

Not every idea will work out as planned.  Jeff Bezos, the founder and CEO of Amazon, said, ‘A few big successes compensate for dozens and dozens of things that did not work.’  Bezos has been experimenting for years and often has been unsuccessful…

Productive Paranoia

Jim Collins describes successful leaders as being ‘paranoid, neurotic freaks.’  Although paranoia can be debilitating for most people, intelligent fanatics use their paranoia to prepare for financial or competitive disruptions.  They also are able to promote this productive paranoia within their company culture, so the company can maintain itself by innovating and preparing for the worst.

Decentralized Organizations

Intelligent fanatics focus a lot of their mental energy on defeating bureaucracies before they form.

…Intelligent fanatics win against internal bureaucracies by maintaining the leanness that helped their companies succeed in the first place… Southwest was able to operate with 20% fewer employees per aircraft and still be faster than its competitors.  It took Nucor significantly few workers to produce a ton of steel, allowing them to significantly undercut their competitors’ prices.

Dominated a Small Market Before Expanding

Intelligent fanatics pull back on the reins in the beginning so they can learn their lessons while they are small.  Intelligent fanatic CEOs create a well-oiled machine before pushing the accelerator to the floor.

Courage and Perseverance in the Face of Adversity

Almost all successful people went through incredible hardship, obstacles, and challenges.  The power to endure is the winner’s quality.  The difference between intelligent fanatics and others is perseverance…

Take, for instance, John Patterson losing more than half his money in the Southern Coal and Iron Company, or Sol Price getting kicked out of FedMart by Hugo Mann.  Herb Kelleher had to fight four years of legal battles to get Southwest Airlines’ first plane off the ground.  Another intelligent fanatic, Sam Walton, got kicked out of his first highly successful Ben Franklin store due to a small clause in his building’s lease and had to start over.  Most people would give up, but intelligent fanatics are different.  They have the uncanny ability to quickly pick themselves up from a large mistake and move on.  They possess the courage to fight harder than ever before…

 

CULTURE:  THE ONLY TRUE SUSTAINABLE COMPETITIVE ADVANTAGE

Intelligent fanatics demonstrate the qualities all employees should emulate, both within the organization and outside, with customers.  This allows employees to do their jobs effectively, by giving them autonomy.  All employees have to do is adjust their internal compass to the company’s true north to solve a problem.  Customers are happier, employees are happier, and if you make those two groups happy, then shareholders are happier.

…Over time, the best employees rise to the top and can quickly fill the holes left as other employees retire or move on.  Employees are made to feel like partners, so the success of the organization is very important to them.  Partners are more open to sharing new ideas or to offering criticism, because their net worth is tied to the long-term success of the company.

Companies with a culture of highly talented, driven people continually challenge themselves to offer best-in-class service and products.  Great companies are shape-shifters and can maneuver quickly as they grow and as the markets in which they compete change.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Verde AgriTech (AMHPF)

(Image: Zen Buddha Silence, by Marilyn Barbone)

January 2, 2022

Verde AgriTech (AMHPF) is an agri-tech company founded in 2005 by Cristiano Veloso.  Veloso comes from a family of farmers.  He is highly educated and intellectually curious.

Verde owns the first Brazilian potash mine in 33 years.  Brazil imports 94% of its potash.  Verde is the lowest cost potash producer—its cost is $170 per ton of potash—for two mains reasons:

    • Because Verde produces its potash in Brazil, that makes it lower cost than most potash producers who exist outside of Brazil and have to pay additional shipping costs;
    • Verde’s production process does not use any water or chemicals, and no tailings dams or waste generation is needed.  The company’s deposit is at the surface, while most potash mines are deep.

Because Verde is the lowest cost producer, it has a sustainable competitive advantage that should allow it to earn high margins—and high return on invested capital—for many years.

Furthermore, traditional potash has high salinity and is therefore bad for the biodiversity of the soil.  The world uses 61.5 million tons of potassium chloride each year, which is equivalent to 460 billion liters of bleach.

Verde’s product—K Forte—is a salinity and chloride free potassium specialty fertilizer.  Verde produces K Forte by using the naturally occurring glauconite in the Alto Paranaiba region in the state of Minas Gerais in Brazil.  Whereas traditional potash contains potassium and chlorine, K Forte contains potassium, silicon, magnesium, and manganese. As a result, K Forte is better for the soil and leads to healthier plants and ultimately healthier food.  K Forte also improves the carbon capture capacity of the soil.  The company’s mission: “Our purpose is to improve the health of people and the planet.”

Verde currently has only Plant 1 running.  It is maxed out at 400,000 tons per year (tpy).  The company has already maxed out Plant 1’s production.  Plant 2 is expected to start producing in Q3 2022 and it will be able to produce 800,000 tpy.  Plant 3 will be even larger.

Potash prices could remain high for much of 2022.  See: https://www.dtnpf.com/agriculture/web/ag/crops/article/2021/12/17/sanctions-affect-world-potash-supply

More importantly, potash prices could be high for much of the next decade if it turns out to be a commodities bull market.  See: https://www.bridgewater.com/its-mostly-a-demand-shock-not-a-supply-shock-and-its-everywhere

The current market cap of AMHPF is $110.57 million, while the stock price is $2.20.  The enterprise value (EV) is $114.47 million.  Assuming that production is maxed out for Plants 1 and 2, that would be 1,200,000 tpy.  Assuming a potash price of $400, that would be $66.67 per ton ($400 for 6 tons of K Forte).  Revenue would be $80.00 million.

Operating cost per ton is $28.33 ($170 for 6 tons of K Forte).  So operating costs would be $34.00 million.  That means operating profit would be $46.00 million.  Net profit would be $41.00 million.  EBITDA would be $47.00 million.  (That puts the EBITDA margin at 58.8%.  If potash prices are higher, the EBITDA margin can reach 70-80%.)   Operating cash flow can be estimated at $47.00 million.

Using these figures, we get the following multiples:

    • EV/EBITDA = 2.44
    • P/E = 2.70
    • P/B = 1.76
    • P/CF = 2.35
    • P/S = 1.38

Also note that the NAV of the company—based on its glauconite resources and on the fact that the total Brazilian market for potash is 20 million tpy—is $49.77 per share in Canadian dollars or $38.82 per share in U.S. dollars.

The CEO Cristiana Veloso owns 20% of the shares.  Also, he has been adamant about not using shares to fund growth.  For the construction of its Plant 2, the company is using $3.75 million in debt and $1.41 million in internally generated cash flows.

On the most recent quarterly call, Veloso commented on the triple digit growth: “Blitzscaling is never an easy endeavour, but I’m confident we have built the right team to continue succeeding at this challenge.  It is still day 1 at Verde.”

The company board includes people like Alysson Paolinelli, a professor, former minister of agriculture, and a World Food Prize winner.

Verde AgriTech has a Piotroski F_Score of 7, which is good.

Net debt is low:  Cash is $2.4 million.  Debt is $2.8 million.  TL/TA is 30%, which is good.

Intrinsic value scenarios:

    • Low case: Assume $400 per ton for potash prices—the current price is over $700—and that plant 2 is delayed.  In this scenario, revenue could be $27 million and net profit $5 million.  With a P/E of 15, the stock would trade at $1.49, which is 32% below today’s $2.20.
    • Mid case: Assume $400 per ton for potash prices—the current price is over $700.  With plant 1 and plant 2 producing, production would be 1,200,000 tpy.  That translates into $80 million in revenue and $41 million in net profit.  The company should have at least a P/E of 15.  That would put the intrinsic value of the stock at $12.24, which is over 450% higher than today’s $2.20.
    • High case: Assume $400 per ton for potash prices—the current price is over $700.  With plant 1 and plant 2 producing, production would be 1,200,000 tpy.  That translates into $80 million in revenue and $41 million in net profit.  The company should have at least a P/E of 25 because of its significant growth potential.  That would put the intrinsic value of the stock at $20.39, which is over 825% higher than today’s $2.20.
    • Very high case:  NAV per share—based on the company’s glauconite resources and on the size of the Brazilian market—is $38.82.  That is over 1,660% higher than today’s $2.20.  In other words, a 16-bagger.  (Note that the company has 777.28 million tons of glauconite reserves, enough to supply most of the Brazilian market for decades.)

Risks

The biggest risks are market adoption risk, currency risk, political risk, and commodity price risk.

So far, farmers are adopting Verde’s products, as evidenced by the sold out production.

The Brazilian real seems to be fairly stable at $0.18 per U.S. dollar.  But if there is a flight to safety during a bear market or recession, the Brazilian real would decline versus the U.S. dollar.

One political risk is that their application for the license needed to start Plant 2 in Q3 2022 won’t be approved in time.  Another political risk is government corruption and the lack of growth-oriented reforms.

There is a risk that the price of potash could fall significantly.  This seems unlikely, given double digit inflation in many parts of the world.  It seems to be a commodity bull market.  It’s even possible that potash prices will remain at $600-800 per ton, which would mean huge profits for Verde Agritech as long as it can fully increase its production as planned.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Research Solutions (RSSS)

(Image: Zen Buddha Silence, by Marilyn Barbone)

January 2, 2022

Research Solutions has a program called Article Galaxy which gives researchers in the scientific, technical, and medical field unlimited access to articles for the price of $10,649 a year.  It’s an outstanding value for many researchers, who otherwise have to pay $4,000 to $6,000 for each article.  Article Galaxy users are growing rapidly at 30% to 40% a year.

Research Solutions aims to be “The Bloomberg for Scientific, Technical, and Medical Research.”  RSSS has a strong competitive position because it offers such a great value proposition to those who sign up for Article Galaxy.  Article Galaxy also integrates with other software and automatically gathers new content of interest.

The company provides excellent customer service.  They listen carefully to their customers—both criticism and applause—and often they implement requested features.

A great value proposition plus excellent customer service means there is low churn plus an ability to upsell often.

In brief, Research Solutions has a strong competitive position that should allow it to continue growing rapidly and to earn a high ROIC (return on invested capital) for decades.

Because customers pay upfront, while the company pays its expenses throughout the year, Research Solutions has a negative cash conversion cycle.  Free cash flow grows as new customers sign up, while capital does not need to be kept or raised in order to fund growth.  (As far as fixed assets, it’s just a leased office space plus computers.)

Article Galaxy generates gross margins over 80%.  Gross profit from new sales translates almost entirely to free cash flow because the marginal cost of new users is much less than their lifetime value.

Management believes the total addressable market (TAM) for Article Galaxy is 700,000 users.  Management ultimately aims to capture 4% of the TAM, which is 28,000 users.

RSSS currently has 590 users of Article Galaxy.  Assume that the number of users grows 35% a year for the next six years.  Then there would be over 3,500 users in six years (still only 0.5% of the TAM).

Assume the price for Article Galaxy in six years is $12,500 (representing CAGR—compound annual growth rate—of 3.3%).  Assume gross margins stay at 80%+ and gross profits from legacy transactions are $6 million.  The tax rate is 28%.

Then we get the following figures in six years:  Revenue will be $43.75 million, EBITDA will be $25.25 million, net income will be $18.18 million, and operating cash flow will be $25.25 million.

The current market cap is $65.78 million, while enterprise value (EV) is $55.63 million.

This gives us the following multiples in six years:

    • EV/EBITDA = 2.20
    • P/E = 3.62
    • P/B = 3.29
    • P/CF = 2.61
    • P/S = 1.50

The current Piotroski F_Score is 7, which is good.

The founder of Research Solutions and executive chairman of the board is Peter Derycz.  Derycz owns 15.1% of the stock.  Management, directors, and employees own 7.9%.  So total insider ownership is 23%, which is excellent.

Cash is $10.9 million, while debt is zero.  TL/TA is 67.7%, which is fine because there is high cash and no debt.

Intrinsic value scenarios

    • Low case: Although users of Article Galaxy have been growing at 30% to 40% a year, growth may slow to 10% a year.  In this case, the stock would be worth $1.33, which is 46% lower than today’s $2.46.  (There also could be a bear market during which most stocks decline 40% to 50%.  But in this case, stocks would bounce back eventually.)
    • Mid case: Users of Article Galaxy will probably grow at 35% a year for the next six years.  That would put the number of users of Article Galaxy at 3,500+.  (That is still only 0.5% of the TAM of 700,000.)  In this scenario, for a very high-quality growing business, I assume the P/E should be at least 22.  That puts the intrinsic value of the stock at $12.49 six years from now.  That is over 400% higher than today’s $2.46.  The CAGR—compound annual growth rate—of the stock over six years would be 31.1%.
    • High case: Assume that users of Article Galaxy grow at 30% a year for the next ten years.  That would put the number of users of Article Galaxy at close to 8,000, but let’s say 7,000, which is still only 1% of the TAM of 700,000.  In this scenario, the intrinsic value of the stock would be $27.21 ten years from now.  That is over 1,000% higher than today’s $2.46.  In other words, a 10-bagger.  The CAGR of the stock over ten years would be 27.2%.
    • Very high case: Assume that the users of Article Galaxy grow at close to 30% a year for the next fifteen years.  That would put the total number of users of Article Galaxy at 28,000+.  This is 4% of the TAM of 700,000, which Research Solutions has as a target in its most recent investor presentation (November, 2021).  In this scenario, the intrinsic value of the stock would be $130.60 fifteen years from now.  That is over 5,200% higher than today’s $2.46.  In other words, a 50-bagger.  The CAGR of the stock over fifteen years would be 30.3%.

Risks

One risk is sites that offer free access to scientific articles illegally.  But this hasn’t been a problem so far for Research Solutions.  Many outstanding organizations are already clients of Research Solutions and customer feedback is quite positive.  (When the feedback is negative, RSSS listens carefully and tries to improve accordingly.)  People in the scientific, technical, and medical community are less piracy-prone than most.

Another risk would be open-source journals that make content freely available.  This hasn’t been a problem yet for Research Solutions.  But it’s important to keep an eye on this.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

Ten Attributes of Great Investors

(Image:  Zen Buddha Silence by Marilyn Barbone.)

December 26, 2021

Michael Mauboussin is the author of several excellent books, including More Than You Know and Think Twice.  I wrote about these books here:

He has also written numerous papers, including Thirty Years: Reflections on the Ten Attributes of Great Investorshttps://bit.ly/2zlaljc

When it comes to value investing, Mauboussin is one of the best writers in the world.  Mauboussin highlights market efficiency, competitive strategy analysis, valuation, and decision making as chief areas of focus for him the past couple of decades.  Mauboussin:

What we know about each of these areas today is substantially greater than what we did in 1986, and yet we have an enormous amount to learn.  As I like to tell my students, this is an exciting time to be an investor because much of what we teach in business schools is a work-in-progress.

(Image by magele-picture)

Here are the Ten Attributes of Great Investors:

  • Be numerate (and understand accounting).
  • Understand value (the present value of free cash flow).
  • Properly assess strategy (or how a business makes money).
  • Compare effectively (expectations versus fundamentals).
  • Think probabilistically (there are few sure things).
  • Update your views effectively (beliefs are hypotheses to be tested, not treasures to be protected).
  • Beware of behavioral biases (minimizing constraints to good thinking).
  • Know the difference between information and influence.
  • Position sizing (maximizing the payoff from edge).
  • Read (and keep an open mind).

 

BE NUMERATE (AND UNDERSTAND ACCOUNTING)

Mauboussin notes that there are two goals when analyzing a company’s financial statements:

  • Translate the financial statements into free cash flow.
  • Determine how the competitive strategy of the company creates value.

The value of any business is the future free cash flow it will produce discounted back to the present.

(Photo by designer491)

Free cash flow is cash earnings minus investments that must be made to grow future earnings.  Free cash flow represents what owners of the business receive.  Warren Buffett refers to free cash flow as owner earnings.

Earnings alone cannot give you the value of a company.  You can grow earnings without growing value.  Whether earnings growth creates value depends on how much money the company invests to generate that growth.  If the ROIC (return on invested capital) of the company’s investment is below the cost of capital, then the resulting earnings growth destroys value rather than creates it.

After calculating free cash flow, the next goal in financial statement analysis is to figure out how the company’s strategy creates value.  For the company to create value, the ROIC must exceed the cost of capital.  Analyzing the company’s strategy means determining precisely how the company can get ROIC above the cost of capital.

Mauboussin writes that one way to analyze strategy is to compare two companies in the same business.  If you look at how the companies spend money, you can start to understand competitive positions.

Another way to grasp competitive position is by analyzing ROIC.

Photo by stanciuc

You can break ROIC into two parts:

  • profitability (net operating profit after tax / sales)
  • capital velocity (sales / invested capital)

Companies with high profitability but low capital velocity are using a differentiation strategy.  Their product is positioned in such a way that the business can earn high profit margins.  (For instance, a luxury jeweler.)

Companies with high capital velocity but low profitability have adopted a cost leadership strategy.  These businesses may have very thin profit margins, but they still generate high ROIC because their capital velocity is so high.  (Wal-Mart is a good example.)

Understanding how the company makes money can lead to insight about how long the company can maintain a high ROIC (if ROIC is high) or what the company must do to improve (if ROIC is low).

 

UNDERSTAND VALUE (THE PRESENT VALUE OF FREE CASH FLOW)

Mauboussin:

Great fundamental investors focus on understanding the magnitude and sustainability of free cash flow.  Factors that an investor must consider include where the industry is in its life cycle, a company’s competitive position within its industry, barriers to entry, the economics of the business, and management’s skill at allocating capital.

It’s worth repeating: The value of any business (or any financial asset) is the future free cash flow it will produce discounted back to the present.  Successful investors understand the variables that impact free cash flow.

Illustration by OpturaDesign

 

PROPERLY ASSESS STRATEGY (OR HOW A COMPANY MAKES MONEY)

Mauboussin says this attribute has two elements:

  • How does the company make money?
  • Does the company have a sustainable competitive advantage, and if so, how durable is it?

To see how a business makes money, you have to figure out the basic unit of analysis.  Mauboussin points out that the basic unit of analysis for a retailer is store economics:  How much does it cost to build a store?  What revenues will it generate?  What are the profit margins?

Regarding sustainable competitive advantage, Warren Buffett famously said:

The key to investing is not assessing how much an industry is going to affect society, or how much it will grow, but rather determining the competitive advantage of any given company and, above all, the durability of that advantage.

If a company has a sustainable competitive advantage, then ROIC (return on invested capital) is above the cost of capital.  To assess the durability of that advantage, you have to analyze the industry and how the company fits in.  Looking at the five forces that determine industry attractiveness is a common step.  You should also examine potential threats from disruptive innovation.

Mauboussin:

Great investors can appreciate what differentiates a company that allows it to build an economic moat around its franchise that protects the business from competitors.  The size and longevity of the moat are significant inputs into any thoughtful valuation.

Bodiam Castle, Photo by valeryegorov

Buffett popularized the term economic moat to refer to a sustainable competitive advantage.  Here’s what Buffett said at the Berkshire annual meeting in 2000:

So we think in terms of that moat and the ability to keep its width and its impossibility of being crossed as the primary criterion of a great business.  And we tell our managers we want the moat widened every year.  That doesn’t necessarily mean the profit will be more this year than it was last year because it won’t be sometimes.  However, if the moat is widened every year, the business will do very well.

 

COMPARE EFFECTIVELY (EXPECTATIONS VERSUS FUNDAMENTALS)

Mauboussin:

Perhaps the most important comparison an investor must make, and one that distinguishes average from great investors, is between fundamentals and expectations.  Fundamentals capture a sense of a company’s future financial performance.  Value drivers including sales growth, operating profit margins, investment needs, and return on investment shape fundamentals.  Expectations reflect the financial performance implied by the stock price.

Mauboussin mentions pari-mutuel betting, specifically horse racing.

(Photo by Elshaneo)

Fundamentals are how fast the horse will run, while expectations are the odds.

  • If a company has good fundamentals, but the stock price already reflects that, then you can’t expect to beat the market by investing in the stock.
  • If a company has bad fundamentals, but the stock price is overly pessimistic, then you can expect to beat the market by investing in the stock.

The best business in the world will not bring excess returns if the stock price already fully reflects the high quality of the business.  Similarly, a terrible business can produce excess returns if the stock price indicates that investors have overreacted.

To make money by investing in a stock, you have to have what great investor Michael Steinhardt calls a variant perception—a view at odds with the consensus view (as reflected in the stock price).  And you have to be right.

Mauboussin observes that humans are quick to compare but aren’t good at it.  This includes reasoning by analogy, e.g., asking whether a particular turnaround is similar to some other turnaround.  However, it’s usually better to figure out the base rate:  What percentage of all turnarounds succeed?  (Not a very high number, which is why Buffett quipped, “Turnarounds seldom turn.”)

Another limitation of humans making comparisons is that people tend to see similarities when they’re looking for similarities, but they tend to see differences when they’re looking for differences.  For instance, Amos Tversky did an experiment in which the subjects were asked which countries are more similar, West Germany and East Germany, or Nepal and Ceylon?  Two-thirds answered West Germany and East Germany.  But then the subjects were asked which countries seemed more different.  Logic says that they would answer Nepal and Ceylon, but instead subjects again answered West Germany and East Germany.

 

THINK PROBABILISTICALLY (THERE ARE FEW SURE THINGS)

Great investors are always seeking an edge, where the price of an asset misrepresents the probabilities or the outcomes.  By similar logic, great investors evaluate each investment decision based on the process used rather than based on the outcome.

  • A good investment decision is one that if repeatedly made would be profitable over time.
  • A bad investment decision is one that if repeatedly made would lead to losses over time.

However, a good decision will sometimes lead to a bad outcome, while a bad decision will sometimes lead to a good outcome.  Investing is similar to other forms of betting in that way.

Photo by annebel146

Furthermore, what matters is not how often an investor is right, but rather how much the investor makes when he is right versus how much he loses when he is wrong.  In other words, what matters is not batting average but slugging percentage.  This is hard to put into practice due to loss aversion—the fact that as humans we feel a loss at least twice as much as an equivalent gain.

There are three ways of determining probabilities.  Subjective probability is a number that corresponds with your state of knowledge or belief.  Mauboussin gives an example:  You might come up with a probability that two countries will go to war.  Propensity is usually based on the physical properties of the system.  If a six-sided die is a perfect cube, then you know that the odds of a particular side coming up must be one out of six.  Frequency is the third approach.  Frequency—also called the base rate—is measured by looking at the outcomes of a proper reference class.  How often will a fair coin land on heads?  If you gather all the records you can of a fair coin being tossed, you’ll find that it lands on heads 50 percent of the time.  (You could run your own trials, too, by tossing a fair coin thousands or millions of times.)

Often subjective probabilities are useful as long as you remain open to new information and properly adjust your probabilities based on that information.  (The proper way to update such beliefs is using Bayes’s theorem.)  Subjective probabilities are useful when there’s no clear reference class—no relevant base rate.

When you’re looking at corporate performance—like sales or profit growth—it’s usually best to look at frequencies, i.e., base rates.

An investment decision doesn’t have to be complicated.  In fact, most good investment decisions are simple.  Mauboussin quotes Warren Buffett:

Take the probability of loss times the amount of possible loss from the probability of gain times the amount of possible gain.  That is what we’re trying to do.  It’s imperfect, but that’s what it’s all about.

Buffett again:

Investing is simple, but not easy.

 

UPDATE YOUR VIEWS EFFECTIVELY (BELIEFS ARE HYPOTHESES TO BE TESTED, NOT TREASURES TO BE PROTECTED)

We have a strong preference for consistency when it comes to our own beliefs.  And we expect others to be consistent.  The problem is compounded by confirmation bias, the tendency to look for and see only information that confirms our beliefs, and the tendency to interpret ambiguous information in a way that supports our beliefs.  As long as we feel like our beliefs are both consistent and correct—and, as a default psychological setting, most of us feel this way most of the time—we’ll feel comfortable and we won’t challenge our beliefs.

Illustration by intheskies

Great investors seek data and arguments that challenge their views.  Great investors also update their beliefs when they come across evidence that suggests they should.  The proper way to update beliefs is using Bayes’s theorem.  To see Bayes’s theorem and also a clear explanation and example, see: http://boolefund.com/the-signal-and-the-noise/

Mauboussin:

The best investors among us recognize that the world changes constantly and that all of the views that we hold are tenuous.  They actively seek varied points of view and update their beliefs as new information dictates.  The consequence of updated views can be action: changing a portfolio stance or weightings within a portfolio.  Others, including your clients, may view this mental flexibility as unsettling.  But good thinking requires maintaining as accurate a view of the world as possible.

 

BEWARE OF BEHAVIORAL BIASES (MINIMIZING CONSTRAINTS TO GOOD THINKING)

Mauboussin:

Keith Stanovich, a professor of psychology, likes to distinguish between intelligence quotient (IQ), which measures mental skills that are real and helpful in cognitive tasks, and rationality quotient (RQ), the ability to make good decisions.  His claim is that the overlap between these abilities is much lower than most people think.  Importantly, you can cultivate your RQ.

Rationality is only partly genetic.  You can train yourself to be more rational.

Great investors relentlessly train themselves to be as rational as possible.  Typically they keep an investment journal in which they write down the reasoning for every investment decision.  Later they look back on their decisions to analyze what they got right and where they went wrong.

Great investors also undertake a comprehensive study of cognitive biases.  For a list of cognitive biases, see these two blog posts:

It’s rarely enough just to know about cognitive biases.  Great investors take steps—like using a checklist—designed to mitigate the impact that innate cognitive biases have on investment decision-making.

Photo by Kenishirotie

 

KNOW THE DIFFERENCE BETWEEN INFORMATION AND INFLUENCE

A stock price generally represents the collective wisdom of investors about how a given company will perform in the future.  Most of the time, the crowd is more accurate than virtually any individual investor.

(Illustration by Marrishuanna)

However, periodically a stock price can get irrational.  (If this weren’t the case, great value investors could not exist.)  People regularly get carried away with some idea.  For instance, as Mauboussin notes, many investors got rich on paper by investing in dot-com stocks in the late 1990’s.  Investors who didn’t own dot-com stocks felt compelled to jump on board when they saw their neighbor getting rich (on paper).

Mauboussin mentions the threshold model from Mark Granovetter, a professor of sociology at Stanford University.  Mauboussin:

Imagine 100 potential rioters milling around in a public square.  Each individual has a “riot threshold,” the number of rioters that person would have to see in order to join the riot.  Say one person has a threshold of 0 (the instigator), one has a threshold of 1, one has a threshold of 2, and so on up to 99.  This uniform distribution of thresholds creates a domino effect and ensures that a riot will happen.  The instigator breaks a window with a rock, person one joins in, and then each individual piles on once the size of the riot reaches his or her threshold.  Substitute “buy dotcom stocks” for “join the riot” and you get the idea.

The point is that very few of the individuals, save the instigator, think that rioting is a good idea.  Most would probably shun rioting.  But once the number of others rioting reaches a threshold, they will jump in.  This is how the informational value of stocks is set aside and the influential component takes over.

Great investors are not influenced much at all by the behavior of other investors.  Great investors know that the collective wisdom reflected in a stock price is usually right, but sometimes wrong.  These investors can identify the occasional mispricing and then make an investment while ignoring the crowd.

 

POSITION SIZING (MAXIMIZING THE PAYOFF FROM EDGE)

Great investors patiently wait for situations where they have an edge, i.e., where the odds are in their favor.  Many investors understand the need for an edge.  However, fewer investors pay much attention to position sizing.

If you know the odds, there’s a formula—the Kelly criterion—that tells you exactly how much to bet in order to maximize your long-term returns.  The Kelly criterion can be written as follows:

  • F = p – [q/o]

where

  • F = Kelly criterion fraction of current capital to bet
  • o = Net odds, or dollars won per $1 bet if the bet wins (e.g., the bet may pay 5 to 1, meaning you win $5 per each $1 bet if the bet wins)
  • p = probability of winning
  • q = probability of losing = 1 – p

The Kelly criterion has a unique mathematical property: if you know the probability of winning and the net odds (payoff), then betting exactly the percentage determined by the Kelly criterion leads to the maximum long-term compounding of capital.  (This assumes that you’re going to make a long series of bets.)  Betting any percentage that is not equal to that given by the Kelly criterion will inevitably lead to lower compound growth over a long period of time.

Mauboussin adds:

Proper portfolio construction requires specifying a goal (maximize sum for one period or parlayed bets), identifying an opportunity set (lots of small edge or lumpy but large edge), and considering constraints (liquidity, drawdowns, leverage).   Answers to these questions suggest an appropriate policy regarding position sizing and portfolio construction.

In brief, most investors are ineffective at position sizing, but great investors are good at it.

 

READ (AND KEEP AN OPEN MIND)

Great investors generally read a ton.  They also read widely across many disciplines.  Moreover, as noted earlier, great investors seek to learn about the arguments of people who disagree with them.  Mauboussin:

Berkshire Hathaway’s Charlie Munger said that he really liked Albert Einstein’s point that “success comes from curiosity, concentration, perseverance and self-criticism. And by self-criticism, he meant the ability to change his mind so that he destroyed his own best-loved ideas.”  Reading is an activity that tends to foster all of those qualities.

(Photo by Lapandr)

Mauboussin continues:

Munger has also said, “In my whole life, I have known no wise people (over a broad subject matter area) who didn’t read all the time—none, zero.”  This may be hyperbolic, but seems to be true in the investment world as well.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Journey Energy (JRNGF)

(Image: Zen Buddha Silence, by Marilyn Barbone)

December 12, 2021

It’s usually not possible to predict oil prices.  But oil prices have been relatively low on average since early 2015.

If oil prices remain high, then Journey Energy (JRNGF) will probably be a wonderful investment.

 

OIL PRICES

It appears probable that oil prices will be higher in the coming years, perhaps $65 to $75 a barrel (WTI) or more.  (If there is a recession, oil prices will likely drop temporarily before snapping back.)

Here is the best article I’ve seen on oil prices: https://seekingalpha.com/article/4474152-the-historic-oil-bull-market-will-reward-buyers-of-energy-equities

If the demand for jet fuel normalizes over the next 12 to 18 months, that will add approximately 1.5 million bpd (barrels per day) to oil demand.  Also, continued recovery in transportation is likely to add 500,000 bpd to oil demand.

Since 2012, global oil supply has increased by 10 million bpd.  6 million bpd has come from U.S. shale oil while 4 million bpd has come from OPEC.

Currently, U.S. shale oil production is at 7.5 million bpd, about 1.5 million bpd below its peak of 9 million barrels per day.  Because investors are demanding that U.S. shale oil production return more cash to shareholders—which it hasn’t done for most of the last 8+ year—U.S. shale oil production is likely to increase only 750,000 bpd in 2022.  Thus far, capex has been much lower than cash flow from operations.  And only the Permian basin has enough frac fleets to grow production.

Recently, OPEC+ agreed to increase production by 400,000 bpd each month starting in July 2021 and going through September 2022.  But so far, instead of adding the scheduled 1.6 million bpd, OPEC+ instead has only added 900,000 bpd.  With oil prices being high, OPEC+ members have every incentive to maximize their production.  They are not doing so because they cannot.  (For example, Angola is underproducing its quota by 250,o00 bpd, while Nigeria is underproducing its quota by 390,000 bpd.)

Meanwhile, the major producers in OPEC+ are not overproducing in order to make up for the deficit.  (Russia is overproducing its quota by 100,000 bpd, but other major producers in OPEC+ are not overproducing their quotas.)  Thus, the collective supply deficit from OPEC+ will keep growing.  It may turn out that OPEC+ is not able to achieve pre-pandemic production levels.

This situation has caused oil inventories to be 200 million barrels lower than pre-COVID levels.  The lower inventories fall, the more upward pressure on oil prices there is.  If oil inventories keep falling, then eventually the oil price will hit $100 per barrel (WTI).

Since it takes five years to develop a major oil project, there won’t be any material addition to oil supply from new projects for at least five years.

Of course, if there is a recession, oil prices will fall temporarily but then snap back.

As for long-term demand for oil, it’s likely to grow at least at 1% a year on average.  It may grow more than that as a result of all the fiscal and monetary stimuli in response to the COVID pandemic.  See this recent note from Bridgewater Associates, “It’s Mostly a Demand Shock, Not a Supply Shock, and It’s Everywhere”: https://www.bridgewater.com/its-mostly-a-demand-shock-not-a-supply-shock-and-its-everywhere

Also, longer term, the per capita oil consumption in China, India, Africa, and other countries nearby is a tiny fraction of the per capita oil consumption in the United States.  The transition away from fossil fuels is likely to take decades, and oil demand is likely to increase for at least 10 to 20 years.  If per capita oil consumption increases in China, India, Africa, and other countries nearby, that may make oil demand keep increasing even as western countries are working to reduce their oil demand.

Even if car manufacturers started making only all-electric vehicles today, oil demand would keep rising for many years, as Daniel Yergin points out in The New Map.

I am, of course, in favor of the transition to a post-fossil fuel economy.  But the global economy needs a lot of oil in order to make that transition over the next several decades.

The oil and gas industry will exist in close to its current form 10 or 20 years from now, as Jeremy Grantham has noted.  (As well, most oil companies do not have more than 15-20 years of reserves.)  The fact that some investors are no longer investing in oil and gas companies means that oil and gas stocks now have even higher expected returns.

 

JOURNEY ENERGY

Journey Energy (JRNGF) appears very cheap because of the recent increases in oil prices.

Normalized EBITDA is at least $60 million.  Normalized net income per share is at least $0.80.  Operating cash flow per share is least $1.10.  And normalized revenue is at least $132 million.  Whether the normalized figures are higher or lower depends mostly on oil prices.

The current market cap is $85.7 million, while the current enterprise value (EV) is $134.2 million.  The stock price is $1.73.

Using the normalized figures, here are the multiples:

    • EV/EBITDA = 2.23
    • P/E = 2.16
    • P/NAV = 0.69
    • P/CF = 1.57
    • P/S = 0.64

(We use P/NAV instead of P/B.  The NAV assumes $70 WTI.)

The Piotroski F_Score is 7, which is good.

In order to pay down debt, Journey Energy spent very little on capex in 2020 and 2021.  The company has $7.6 million in cash and $67.9 million in debt.  (Debt a year ago was $124.6 million.)  JRNGF plans to end 2021 with debt at $53 to $54 million.

In 2022, the company plans to spend $36 million on capex and $20 million on debt reduction, leading to a debt level of about $34 million at the end of 2022.

Currently, TL/TA is 76.0%.  This is high, but Journey Energy continues to rapidly pay down debt.

Insider ownership is 10%.  That is worth $8.5 million.  Insiders will make a good deal of money if the company does well.

For the intrinsic value scenarios, we calculate NAV based on 2P reserves (proved plus probable).

    • Low case: If the oil price averages $50 (WTI), then the stock may be worth half the current NAV ($2.50), which is $1.25.  That is 28% lower than today’s $1.73.
    • Mid case: If the oil price averages $70 (WTI), then NAV per share is $3.75.  That is over 210% higher than today’s $1.73.
    • High case: If the oil price averages $90 (WTI), then NAV per share is $6.25.  That is over 360% higher than today’s $1.73.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Superior Gold (SUPGF)

(Image: Zen Buddha Silence, by Marilyn Barbone)

December 5, 2021

A MISTAKE: HUMMINGBIRD RESOURCES (HUMRF)

I should briefly mention a mistake that I made: Hummingbird Resources (HUMRF).  The Boole Microcap Fund established a position in October and November of 2020.  There is no question that the stock was quantitatively very cheap.  You can see my investment thesis at the time here: http://boolefund.com/hummingbird-resources-plc-humrf/

HUMRF was in the top 50 stocks on our screen, meaning the top 2% out of more than two thousand companies that we ranked.

However, management has consistently over-promised and under-delivered.  Costs have been much higher than management forecasted and, even worse, they continue to escalate.  Production has usually been lower than forecasted.  The start of production at their main project, the Kouroussa gold mine, has repeatedly been pushed back.  Cash flows and earnings are deteriorating.  Debt is too high.  Debt is not going to come down much if costs continue to escalate.  Finally, their main producing mine is located in Mali, where there is significant political risk.

Looking back, there were four red flags that I missed:

    • Costs had been coming in much higher than management forecasted, and they generally kept increasing;
    • Production was usually lower than forecasted, while new projects kept being delayed;
    • Insider ownership was (and is) only 3%, which means management doesn’t really believe in the company’s potential.
    • The company’s main producing mine is in Mali, which is politically risky.

Of course, if gold prices rise, HUMRF may do very well.  But other gold miners may also do very well if gold prices rise.  If gold prices fall, HUMRF won’t do well at all, whereas some other gold miners will be relatively safe.

 

SUPERIOR GOLD (SUPGF)

Superior Gold  is a Canadian gold producer that owns and operates 100% of the Plutonic Gold operations located in the world-class goldfields of Western Australia.

Superior Gold (SUPGF) has a market cap of $67 million.  With $20.5 million in cash and $11.5 million in debt, the enterprise value (EV), which is market cap plus debt minus cash, is $58 million.

SUPGF appears cheap:

    • EV/EBITDA = 2.80
    • P/E = 6.87
    • P/NAV = 0.42
    • P/CF = 2.91
    • P/S = 0.52

(I use P/NAV instead of P/B because P/NAV is more relevant.)

TL/TA is 60%.  But more than half of the liabilities are for mine rehabilitation, which will happen years in the future.  The lease obligation is $11.3 million.  The long-term debt is zero, while the cash balance is $20.5 million.  Thus, the company’s net debt is low.

The current Piotroski F-Score of Superior Gold is 7, which is good.

Including options, insider ownership is close to 4.5%.  That is worth over $3.5 million.  If the company executes on its plan, insiders could make $5 million to $15 million or more (depending upon gold prices).

The company keeps improving its reserves each quarter.

Moreover, Superior Gold is producing 75,000 ounces of gold a year and it is on its way to producing 100,000 ounces of gold a year.  By expanding to a second mill (which is low cost), SUPGF can produce at least 150,000 ounces of gold a year (and possibly much more if the grade is high enough).

Ultimately, Superior Gold aims to return to mid-tier producer status by producing 200,000+ ounces of gold a year.  Increasing from 150,000 ounces to 200,000+ ounces will likely require smart exploration.

Superior Gold’s main challenge has been high costs.  But the new CEO Chris Jordaan is doing an outstanding job implementing a solid plan to reduce costs.

Intrinsic value scenarios:

    • Low case:  The gold price may decline.  NAV per share is $1.31.  The company may be worth half that, which is $0.65.  That is 20% higher than today’s $0.54.
    • Mid case:  If the gold price stays above $1,500, then the company is probably worth NAV, which is $1.31 per share.  That is over 140% higher than today’s $0.54.
    • High case:  If the gold price exceeds $2,000, then Superior Gold could be worth $3.00 a share or more.  That is over 450% higher than today’s $0.54.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Macro Enterprises (MCESF)

(Image: Zen Buddha Silence, by Marilyn Barbone)

November 28, 2021

I first wrote up Macro Enterprises (MCESF) in January 2020, when the stock price was $2.79.  At the time, here were the five metrics of cheapness:

    • EV/EBITDA = 1.37
    • P/E = 3.72
    • P/B = 1.08
    • P/CF = 3.51
    • P/S = 0.26

Today the stock price is at $2.15.  Normalized earnings are $20 million.  And here are the five metrics of cheapness:

    • EV/EBITDA = 1.41
    • P/E = 3.35
    • P/B = 0.75
    • P/CF = 2.16
    • P/S = 0.30

The current figures are very similar to the previous figures, except that P/B and P/CF are both much lower.  Therefore, overall, Macro Enterprises is cheaper now than it was before.  Much of this is because the stock price has dropped from $2.79 to $2.15.

Next we calculate the Piotroski F-Score, which is a measure of the fundamental strength of the company.  For more on the Piostroski F-Score, see my blog post here: http://boolefund.com/piotroski-f-score/

Macro Enterprises has a Piotroski F-Score of 7.  (The best score possible is 9, while the worst score is 0.)  This is a very good score.

Then we rank the company based on low debt and high insider ownership.

We measure debt levels by looking at total liabilities (TL) to total assets (TA).  Macro Enterprises has TL/TA of 38%, which is fairly low.

Insider ownership is important because that means that the people running the company have interests that are aligned with the interests of other shareholders.  Macro’s founder and CEO, Frank Miles, owns approximately 30%+ of the shares outstanding.  This is excellent.

Intrinsic Value

Macro Enterprises has been in operation for over 25 years.  Over that time, it has earned a reputation for safety and reliability while becoming one of the largest pipeline construction companies in western Canada.

Intrinsic value scenarios:

    • Low case: Macro is probably not worth less than half of book value, which is $2.83 per share.  That’s 34% lower than today’s share price of $2.15.
    • Mid case: The company is probably worth at least EV/EBITDA of 5.0.  That translates into a share price of $6.57, which is over 200% higher than today’s $2.15.
    • High case: Macro may easily be worth at least EV/EBITDA of 8.0.  That translates into a share price of $10.29, which is over 375% higher than today’s $2.15.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Delta Apparel (DLA)

(Image: Zen Buddha Silence, by Marilyn Barbone)

November 21, 2021

From the company’s website:

“Delta Apparel, Inc., along with its operating subsidiaries, DTG2Go, LLC, Salt Life, LLC, and M.J. Soffe, LLC, is a vertically-integrated, international apparel company that designs, manufactures, sources, and markets a diverse portfolio of core activewear and lifestyle apparel products under the primary brands of Salt Life®, Soffe®, and Delta… The Company specializes in selling casual and athletic products through a variety of distribution channels and tiers, including outdoor and sporting goods retailers, independent and specialty stores, better department stores and mid-tier retailers, mass merchants and e-retailers, the U.S. military, and through its business-to-business e-commerce sites.  The Company’s products are also made available direct-to-consumer on its websites… as well as through its branded retail stores.”

IMPORTANT:  DTG2Go is most important part of the company.  It is a “market leader in the direct-to-garment digital print and fulfillment industry, bringing technology and innovation to the supply chain of its customers.”  DTG2Go uses proprietary software to deliver on-demand, digitally printed apparel direct to consumers on behalf of the customer.

We bought DLA in late 2020 at an average cost of $15.26.  Today the stock is at $30.01, up about 96%.  But the stock is still quite undervalued.

Here are the original multiples for Delta Apparel from September 2020:

    • EV/EBITDA = 4.41
    • P/E = 7.38
    • P/B = 0.76
    • P/CF = 1.85
    • P/S = 0.28

Since then, the company has grown its earnings and cash flows.  Here are the normalized figures:  EBITDA is $75.3 million, net income is $38.2 million, cash flow is $120.3 million, and revenue is $597.9 million.

The market cap is $193.3 million, while the enterprise value (EV) is $320.5 million.

Here are the updated multiples:

    • EV/EBITDA = 4.26
    • P/E = 5.06
    • P/B = 1.23
    • P/CF = 1.61
    • P/S = 0.32

Delta Apparel has a Piotroski F-Score of 8, which is excellent.

We measure debt levels by looking at total liabilities (TL) to total assets (TA).  DLA has TL/TA of 63.4%, which is decent.

Insider ownership is important because that means that the people running the company have interests that are aligned with the interests of other shareholders.  At DLA, insider ownership is approximately 16%.  This is good.

What is the intrinsic value?

See this very good writeup on Value Investors Club: https://valueinvestorsclub.com/idea/DELTA_APPAREL_INC/9696182477

(You may have to register at www.valueinvestorsclub.com, but it’s free.)

From the writeup:

DTG2Go’s proprietary software and logistics system enable it to seamlessly integrate with any of its customer’s websitesand for digitally printed apparel to be manufactured upon purchase, and shipped within 24-48 hours directly to the customer without them knowing DLA had anything todo with the process.  This model is simply a better mouse-trap for virtually any retailer, enabling them to lower costs, eliminate holding inventory, increase selection, and quicken delivery times.  Imagine how much more money a retailer would make if it could multiply the selection of printed apparel it offers on its website at no additional cost, and with no inventory?  Also imagine how much money a retailer could save by almost never having to write-down this type of inventory again?  DTG2Go’s platform allows them to do both – no-brainerThis platform can also give e-retailors future capabilities such as allowing consumers to customize their own clothing, which many say is a coming trend.  DTG2Go’s market opportunity is huge, and has barely entered its first inning of growth.  Digital impressions  only make up about 2% of total graphic impressions on clothing.  DLA believes the digital impression market could grow over 400% in the coming years, to 10% of graphic impressions on clothing.  Other commentators expect even greater penetration of digital printing.  Given the tremendous advantages of digital printing for many applications versus traditional screen printing, it seems highly likely that rapid growth of 30%+ will continue into the foreseeable future.  Many industry participants expect digital printing to eventually comprise 50%+ of the graphic impressions market due to its superior cost and selection characteristics. It is also important to note that digital printing is generally environmentally superior versus screen printing, because of the cleaner water based ink used in the digital process.
Intrinsic value scenarios:
    • Low case: If the company trades at a P/E of 10 based on trailing earnings, then the stock would be $29, which is 3% lower than today’s $30.01.
    • Mid case:  The company should trade for a P/E of at least 15 based on normalized earnings.  That would put the stock at $90 per share, which is 200% higher than today’s $30.01.
    • High case:  Normalized earnings could easily be closer to $52.3 million.  Given the huge growth opportunities for DTG2Go, the company should trade at a P/E at least 20.  That would be the stock at $150 per share, which is 400% higher than today’s $30.01.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

If you are interested in finding out more, please e-mail me or leave a comment.

My e-mail: jb@boolefund.com

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Obsidian Energy (OBELF)

(Image: Zen Buddha Silence, by Marilyn Barbone)

November 14, 2021

Many oil and gas companies appear remarkably cheap if oil prices stay at $70 to $80.  Not only is it likely that oil prices will stay at $70 to $80, but it’s quite possible that oil prices will approach $90 or $100 (or even more).

Even at $60 oil, Obsidian Energy is undervalued.  But if oil prices are much higher than that, then Obsidian Energy—like some other oil companies—will likely be a wonderful investment.

 

OIL PRICES

Over the past 6 to 7 years, oil producers and oil-producing countries have significantly cut their capital spending due to lower oil prices.  As a result, many oil producers do not have much capacity to produce more oil.  Similarly, even OPEC+ appears to have much less spare capacity than it did in the past.

Check out this piece by Josh Young of Bison Interests, “OPEC+ Spare Capacity is Insufficient Amid Global Energy Crisis.”  Link: https://bisoninterests.com/content/f/opec-spare-capacity-is-insufficient-amid-global-energy-crisis

In recent years, shale oil companies have been able to boost production relatively quickly.  However, under pressure from investors, shale oil companies are now much more focused on generating free cash flow.  So they have yet to invest much in order to increase their production.

Thus, oil supply constrained.

Even more importantly, oil demand is very strong.

This is because massive monetary and fiscal stimuli have caused households to be flush with cash.  This has greatly increased demand for most goods and commodities.

See this recent note from Bridgewater Associates, “It’s Mostly a Demand Shock, Not a Supply Shock, and It’s Everywhere”: https://www.bridgewater.com/its-mostly-a-demand-shock-not-a-supply-shock-and-its-everywhere

Bridgewater argues that the supply of everything is at all-time highs.  But demand across most areas is much stronger than supply.  Due to the large amount of money the Federal Reserve has been printing, coupled with large fiscal stimulus, a massive amount of cash has been transferred to households.  Consumer spending has created demand that cannot be met by the increased supply.

Bridgewater concludes that demand is outstripping supply by a wide enough margin that high inflation will probably be mostly sustained, especially because extremely easy government policy continues to encourage further demand rather than limiting it.

Finally, even if car manufacturers started making only all-electric vehicles today, oil demand would keep rising for many years, as Daniel Yergin points out in The New Map.

Oil demand is likely to increase for at least 10 to 20 years before a peak is reached.  The peak itself could last for another 10 to 20 years.

I am, of course, in favor of the transition to a post-fossil fuel economy.  But the global economy needs a lot of oil in order to make that transition over the next several decades.

The oil and gas industry will exist in close to its current form 10 or 20 years from now, as Jeremy Grantham has noted.  (As well, most oil companies do not have more than 15-20 years of reserves.)  The fact that some investors are no longer investing in oil and gas companies means that oil and gas stocks now have even higher expected returns.

In sum, oil supply is quite constrained, while oil demand is very strong.  This situation is likely to persist for some time, which means oil prices could easily be $70 to $80, or even higher.  Also, oil stocks historically have done very well in inflationary environments.  Due to massive monetary and fiscal stimuli, the gap between demand and supply is likely to persist in many areas, which means high inflation may last for some time.

 

OBSIDIAN ENERGY

Obsidian Energy (OBELF) appears very cheap because of the recent increases in oil prices.  Here are the multiples:

    • EV/EBITDA = 1.53
    • P/E = 1.04
    • P/NAV = 0.29
    • P/CF = 1.97
    • P/S = 0.98

(We use P/NAV instead of P/B.  The NAV assumes $70 WTI.)

The Piotroski F_Score is 6, which is OK.

The market cap is $289.5 million.  The company has $4 million in cash and $406.5 million in debt.  TL/TA is 48%, which is OK.  The company plans to continuing paying down its debt, which it can easily due if oil prices remain relatively high.

Insider ownership is 7%.  That is worth a bit more than $20 million.  Insiders can make $40 million or much more if oil prices are $70 or higher and if the company continues to execute.

We calculate NAV based on 2P reserves (proved plus probable).

    • Low case: If the oil price averages $50 WTI, then NAV per share is $4.55, which is 21% higher than today’s $3.74.
    • Mid case: If the oil price averages $70 WTI, then NAV per share is $12.71, which is 240% higher than today’s $3.74.
    • High case: If the oil price averages $90 WTI, then NAV per share is $20.87, which is over 455% higher than today’s $3.74.

In March 2019, the company appointed Michael Faust as CEO.  (The previous CEO had done a poor job on costs, on where to invest, and on others areas.)

Faust significantly cut costs and improved efficiency.  Faust also focused capex on the right wells.  Overall, he did a great job.  After making these operational improvements, Faust stepped down.  But he is still on the board of directors and is deeply involved.

The interim CEO is Steve Loukas, who works at a hedge fund with a large stake in Obsidian Energy.  Loukas is doing an excellent job so far.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.

CASE STUDY: Genco Shipping (GNK)

(Image: Zen Buddha Silence, by Marilyn Barbone)

November 7, 2021

Here is the performance of the Boole Microcap Fund this year and since inception (06/09/20).

  Boole Microcap Fund Russell Microcap Index S&P 500 Index
2021 net return (thru 11/09/21) 54.3% 31.5% 26.6%
2020 net return from inception (06/09/20) 21.1% 31.7% 16.3%
Compounded annual return (net) 36.7% 31.6% 21.3%
Overall gain (net) 86.9% 73.2% 47.2%

I first wrote up the idea of GNK in June 2020 here: http://boolefund.com/genco-shipping-gnk/

At the time, the stock at $6.94 a share was very cheap based on our five measures of cheapness:

    • EV/EBITDA = 4.60
    • P/E = 6.52
    • P/B = 0.34
    • P/CF = 2.07
    • P/S = 0.70

Now the stock is up to $15.81.  There has been a huge increase in dry bulk shipping rates.

Dry bulk shipping rates are highly volatile.  But the supply of dry bulk ships is at a historic low.  Very few new vessels will come into the market over the next couple of years.  If someone wanted to order a new dry bulk ship, they would have to wait until early 2024 to get it.  There are far fewer shipyards than has been the case historically, and most of those shipyards already have orders, much of which is for container ships rather than dry bulk vessels.

Global GDP is expected to be 4% to 5%, which when coupled with the historically low supply, will probably lead to higher dry bulk shipping rates going forward.

Also, the company has a barbell approach to fleet composition: The minor bulk fleet provides stable cash flows, while the Capesize vessels provide meaningful upside and operating leverage if rates continue to move higher.

The market cap is $662.8 million.  EV is $915.1 million.  Normalized estimates: Revenue $620 million, EBITDA is $320 million, net income is $250 million, and cash flow of $360 million.

Here are the multiples based on normalized estimates:

    • EV/EBITDA = 2.86
    • P/E = 2.65
    • P/B = 0.53
    • P/CF = 1.84
    • P/S = 1.07

(P/B is based on P/NAV.  Vessel values have increased due to the increase in shipping rates.)

Because of the large increase in rates and the expectation that rates will remain volatile but high, GNK looks cheaper now than it was in June 2020.

Insiders own about 7.4% of the shares outstanding, which is worth about $49 million (at today’s stock price of $15.81).  Insiders will obviously do well if they successfully lead the company forward.

Genco Shipping has a Piotroski F_Score of 6, which is OK.

Debt is fairly low at $296.8 million.  TL/TA is 29%, which is good.  Also, the company is targeting total debt of zero.

Intrinsic value scenarios:

    • Low case: GNK is probably worth at least 50% of NAV.  NAV/share is $29.72.  50% of that is $14.36, which is 9% lower than today’s $15.81.
    • Mid case: Dry bulk rates are likely to stay relatively high, due to limited supply.  Also, the company will soon have no debt and plans a substantial dividend.  In this context, GNK is probably worth at least 140% of NAV.  That works out to $41.61, which is over 160% higher than today’s $15.81.
    • High case: If dry bulk rates continue to move higher over the next few years, GNK could be worth a P/E = 10.  That works out to $59.62, which is over 275% higher than today’s $15.81.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.  See the historical chart here:  http://boolefund.com/best-performers-microcap-stocks/

This outperformance increases significantly by focusing on cheap micro caps.  Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals.  We rank microcap stocks based on these and similar criteria.

There are roughly 10-20 positions in the portfolio.  The size of each position is determined by its rank.  Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost).  Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.

The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods.  We also aim to outpace the Russell Microcap Index by at least 2% per year (net).  The Boole Fund has low fees.

 

 

 

Disclosures: Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Boole Capital, LLC.