A Few Lessons from Sherlock Holmes

September 24, 2023

Peter Bevelin is the author of the great book, Seeking Wisdom: From Darwin to Munger.  I wrote about this book here: https://boolefund.com/seeking-wisdom/

Bevelin also wrote a shorter book, A Few Lessons from Sherlock Holmes.  I’m a huge fan of Sherlock Holmes.  Robert Hagstrom has written an excellent book on Holmes called The Detective and the Investor.  Here’s my summary of Hagstrom’s book: https://boolefund.com/invest-like-sherlock-holmes/

I highly recommend Hagstrom’s book.  But if you’re pressed for time, Bevelin’s A Few Lessons from Sherlock Holmes is worth reading.

Belevin’s book is a collection of quotations.  Most of the quotes are from Holmes, but there are also quotes from others, including:

    • Joseph Bell, a Scottish professor of clinical surgery who was Arthur Conan Doyle’s inspiration for Sherlock Holmes
    • Dr. John Watson, Holmes’s assistant
    • Dr. John Evelyn Thorndike, a fictional detective and forensic scientist  in stories by R. Austin Freeman
    • Claude Bernard, a French physiologist
    • Charles Darwin, the English naturalist
    • Thomas McRae, an American professor of medicine and colleague of Sir William Osler
    • Michel de Montaigne, a French statesman and philosopher
    • William Osler, a Canadian physician
    • Oliver Wendell Holmes, Sr., an American physician and author

Sherlock Holmes:

Life is infinitely stranger than anything which the mind of man could invent.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Here’s an outline for this blog post:

    • Some Lessons
    • On Solving a Case—Observation and Inference
    • Observation—Start with collecting facts and follow them where they lead
    • Deduction—What inferences can we draw from our observations and facts?
    • Test Our Theory—If it disagrees with the facts it is wrong
    • Some Other Tools

 

SOME LESSONS

Bevelin quotes the science writer Martin Gardner on Sherlock Holmes:

Like the scientist trying to solve a mystery of nature, Holmes first gathered all the evidence he could that was relevant to his problem.  At times, he performed experiments to obtain fresh data.  He then surveyed the total evidence in the light of his vast knowledge of crime, and/or sciences relevant to crime, to arrive at the most probable hypothesis.  Deductions were made from the hypothesis; then the theory was further tested against new evidence, revised if need be, until finally the truth emerged with a probability approaching certainty.

Bevelin quotes Holmes on the qualities needed to be a good detective:

He has the power of observation and that of deduction.  He is only wanting in knowledge, and that may come in time.

It’s important to take a broad view.  Holmes:

One’s ideas must be as broad as Nature if they are to interpret Nature.

However, focus only on what is useful.  Bevelin quotes Dr. Joseph Bell:

He [Doyle] created a shrewd, quick-sighted, inquisitive man… with plenty of spare time, a retentive memory, and perhaps with the best gift of all—the power of unloading the mind of all burden of trying to remember unnecessary details.

Knowledge of human nature is obviously important.  Holmes:

Human nature is a strange mixture, Watson.  You see that even a villain and murderer can inspire such affection that his brother turns to suicide when he learns his neck is forfeited.

Holmes again:

Jealousy is a strange transformer of characters.

Bevelin writes that the most learned are not the wisest.  Knowledge doesn’t automatically make us wise.  Bevelin quotes Montaigne:

Judgment can do without knowledge but not knowledge without judgment.

Learning is lifelong.  Holmes:

Like all other arts, the Science of Deduction and Analysis is one which can only be acquired by long and patient study, nor is life long enough to allow any mortal to attain the highest possible perfection in it.

Interior view of the famous The Sherlock Holmes Museum on Nov. 14, 2015 in London

 

ON SOLVING A CASE—Observation and Inference

Bevelin quotes Dr. John Evelyn Thorndyke, a fictional detective in stories by R. Austin Freeman:

…I make it a rule, in all cases, to proceed on the strictly classical lines on inductive inquiry—collect facts, make hypotheses, test them and seek for verification.  And I always endeavour to keep a perfectly open mind.

Holmes:

We approached the case… with an absolutely blank mind, which is always an advantage.  We had formed no theories.  We were there simply to observe and to draw inferences from our observations.

Appearances can be deceiving.  If someone is likeable, that can cloud one’s judgment.  If someone is not likeable, that also can be misleading.  Holmes:

It is of the first importance… not to allow your judgment to be biased by personal qualities… The emotional qualities are antagonistic to clear reasoning.  I can assure you that the most winning woman I ever knew was hanged for poisoning three little children for their insurance-money, and the most repellant man of my acquaintence is a philanthropist who has spent nearly a quarter of a million on the London poor.

Holmes talking to Watson:

You remember that terrible murderer, Bert Stevens, who wanted us to get him off in ’87?  Was there ever a more mild-mannered, Sunday-school young man?

 

OBSERVATION—Start with collecting facts and follow them where they lead

Bevelin quotes Thomas McCrae, an American professor of medicine and colleague of Sir William Osler:

More is missed by not looking than not knowing.

That said, to conduct an investigation one must have a working hypothesis.  Bevelin quotes the French physiologist Claude Bernard:

A hypothesis is… the obligatory starting point of all experimental reasoning.  Without it no investigation would be possible, and one would learn nothing:  one could only pile up barren observations.  To experiment without a preconceived idea is to wander aimlessly.

(Charles Darwin, Photo by Maull and Polyblank (1855), via Wikimedia Commons)

Bevelin also quotes Charles Darwin:

About thirty years ago there was much talk that geologists ought only to observe and not theorise; and I well remember someone saying that at this rate a man might as well go into a gravel-pit and count the pebbles and describe the colors.  How odd it is that anyone should not see that all observation must be for or against some view if it is to be of any service!

Holmes:

Let us take that as  a working hypothesis and see what it leads us to.

It’s crucial to make sure one has the facts clearly in mind.  Bevelin quotes the French statesman and philosopher Montaigne:

I realize that if you ask people to account for “facts,” they usually spend more time finding reasons for them than finding out whether they are true…

Deception, writes Bevelin, has many faces.  Montaigne again:

If falsehood, like truth, had only one face, we would be in better shape.  For we would take as certain the opposite of what the liar said.  But the reverse of truth has a hundred thousand shapes and a limitless field.

Consider why someone might be lying.  Holmes:

Why are they lying, and what is the truth which they are trying so hard to conceal?  Let us try, Watson, you and I, if we can get behind the lie and reconstruct the truth.

It’s often not clear—especially near the beginning of an investigation—what’s relevant and what’s not.  Nonetheless, it’s vital to try to focus on what’s relevant because otherwise one can get bogged down by unnecessary detail.  Holmes:

The principal difficulty in your case… lay in the fact of their being too much evidence.  What was vital was overlaid and hidden by what was irrelevant.  Of all the facts which were presented to us we had to pick just those which we deemed to be essential, and then piece them together in order, so as to reconstruct this very remarkable chain of events.

Holmes again:

It is of the highest importance in the art of detection to be able to recognize out of a number of facts which are incidental and which are vital.  Otherwise your energy and attention must be dissipated instead of being concentrated.

Bevelin quotes the Canadian physician William Osler:

The value of experience is not in seeing much, but in seeing wisely.

Observation is a skill one must develop.  Most of us are not observant.  Holmes:

The world is full of obvious things which nobody by any chance ever observes.

(Illustration of Sherlock Holmes by Sidney Paget (1891), via Wikimedia Commons)

Holmes again:

I see no more than you, but I have trained myself to notice what I see.

Small things can have the greatest importance.  Several quotes from Holmes:

    • The smallest point may be the most essential.
    • It has long been an axiom of mine that the little things are infinitely the most important.
    • What seems strange to you is only so because you do not follow my train of thought or observe the small facts upon which large inferences may depend.
    • It is just these very simple things which are extremely liable to be overlooked.
    • Never trust general impressions, my boy, but concentrate yourself upon details.

Belevin also quotes Dr. Joseph Bell:

I always impressed over and over again upon all my scholars—Conan Doyle among them—the vast importance of little distinctions, the endless significance of trifles.

Belevin points out that it’s easy to overlook relevant facts.  It’s important always to ask if one has overlooked something.

 

DEDUCTION—What inferences can we draw from our observations and facts?

Most people reason forward, predicting what will happen next.  But few people reason backward, inferring the causes of the effects one has observed.  Holmes:

Most people, if you describe a chain of events to them, will tell you what the result would be.  They can put those events together in their minds, and argue from them that something will come to pass.  There are few people, however, who, if you told them a result, would be able to evolve from their own inner consciousness what the steps were which led up to that result.  This power is what I mean when I talk of reasoning backward, or analytically.

Often the solution is simple.  Holmes:

The case has been an interesting one… because it serves to show very clearly how simple the explanation may be of an affair which at first sight seems to be almost inexplicable.

History frequently repeats.  Holmes:

They lay all the evidence before me, and I am generally able, by the help of my knowledge of the history of crime, to set them straight.  There is a strong family resemblance about misdeeds, and if you have all the details of a thousand at your finger ends, it is odd if you can’t unravel  the thousand and first.

Holmes:

There is nothing new under the sun.  It has all been done before.

That said, some cases are unique and different to an extent.  But bizarre cases tend to be easier to solve.  Holmes:

As a rule… the more bizarre a thing is the less mysterious it proves to be.  It is your commonplace, featureless crimes which are really puzzling, just as a commonplace face is the most difficult to identify.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

Holmes again:

It is a mistake to confound strangeness with mystery.  The most commonplace crime is often the most mysterious, because it presents no new or special features from which deductions may be drawn.

If something we expect to see doesn’t happen, that in itself can be a clue.  There was one case of a race horse stolen during the night.  When Holmes gathered evidence, he learned that the dog didn’t bark.  This means the midnight visitor must have been someone the dog knew well.

Moreover, many seemingly isolated facts could provide a solution if they are taken together.  Holmes:

You see all these isolated facts, together with many minor ones, all pointed in the same direction.

After enough facts have been gathered, then one can consider each possible hypothesis one at a time.  In practice, there are many iterations:  new facts are discovered along the way, and new hypotheses are constructed.  By carefully excluding each hypothesis that is not possible, eventually one can deduce the hypothesis that is true.  Holmes:

That process… starts upon the supposition that when you have eliminated all which is impossible, then whatever remains, however improbable, must be the truth.  It may well be that several explanations remain, in which case one tries test after test until one or other of them has a convincing amount of support.

 

TEST OUR THEORY—If it disagrees with the facts it is wrong

What seems obvious can be very misleading.  Holmes:

There is nothing more deceptive than an obvious fact.

“Truth is stranger than fiction,” said Mark Twain.  Holmes:

Life is infinitely stranger than anything which the mind of many could invent.

Holmes again:

One should always look for a possible alternative and provide against it.  It is the first rule of criminal investigation.

(Illustration of Sherlock Holmes by Sidney Paget, via Wikimedia Commons)

It’s vital to take time to think things through.  Watson:

Sherlock Holmes was a man… who, when he had an unsolved problem upon his mind, would go for days, and even for a week, without rest, turning it over, rearranging his facts, looking at it from every point of view until he had either fathomed it or convinced himself that his data were insufficient.

Sometimes doing nothing—or something else—is best when one is waiting for more evidence.  Holmes:

I gave my mind a thorough rest by plunging into a chemical analysis.  One of our greatest statesmen has said that a change of work is the best rest.  So it is.

 

SOME OTHER TOOLS

Bevelin observes the importance of putting oneself in another’s shoes.  Holmes:

You’ll get results, Inspector, by always putting yourself in the other fellow’s place, and thinking what you would do yourself.  It takes some imagination, but it pays.

Others may be of help.  Holmes:

If you will find the facts, perhaps others may find the explanation.

Watson was a great help to Holmes.  Watson:

I was a whetstone for his mind.  I stimulated him.  He liked to think aloud in my presence.  His remarks could hardly be said to be made to me—many of them would have been as appropriately addressed to his bedstead—but nonetheless, having formed the habit, it had become in some way helpful that I should register and interject.  If I irritated him by a certain methodical slowness in my mentality, that irritation served only to make his own flame-like intuitions and impressions flash up the more vividly and swiftly.  Such was my humble role in our alliance.

(Illustration of Sherlock Holmes and John Watson by Sidney Paget, via Wikimedia Commons)

Different lines of thought can approximate the truth.  Bevelin quotes Dr. Joseph Bell:

There were two of us in the hunt, and when two men set out to find a golf ball in the rough, they expect to come across it where the straight lines marked in their minds’ eye to it, from their original positions, crossed.  In the same way, when two men set out to investigate a crime mystery, it is where their researches intersect that we have a result.

Holmes makes the same point:

Now we will take another line of reasoning.  When you follow two separate chains of thought, Watson, you will find some point of intersection which should approximate to the truth.

It’s essential to be open to contradictory evidence.  Bevelin quotes Charles Darwin:

I have steadily endeavoured to keep my mind free so as to give up any hypothesis, however much beloved… as soon as facts are shown to be opposed to it.

Mistakes are inevitable.  Holmes:

Because I made a blunder, my dear Watson—which is, I am afraid, a more common occurrence than anyone would think who only knew me through your memoirs.

Holmes remarks that every mortal makes mistakes.  But the best are able to recognize their mistakes and take corrective action:

Should you care to add the case to your annals, my dear Watson… it can only be as an example of that temporary eclipse to which even the best-balanced mind may be exposed.  Such slips are common to all mortals, and the greatest is he who can recognize and repair them.

Bevelin quotes the physician Oliver Wendell Holmes, Sr.:

The best part of our knowledge is that which teaches us where knowledge leaves off and ignorance begins.

(Oliver Wendell Holmes, Sr., via Wikimedia Commons)

In the investment world, the great investors Warren Buffett and Charlie Munger use the term circle of competence.  Here’s Buffett:

What an investor needs is the ability to correctly evaluate selected businesses.  Note that word “selected”:  You don’t have to be an expert on every company, or even many.  You only have to be able to evaluate companies within your circle of competence.  The size of that circle is not very important; knowing its boundaries, however, is vital.

Buffett again:

What counts for most people in investing is not how much they know, but rather how realistically they define what they don’t know.

Munger:

Knowing what you don’t know is more useful than being brilliant.

Finally, here’s Tom Watson, Sr., the founder of IBM:

I’m no genius.  I’m smart in spots—but I stay around those spots.

 

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:  https://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.

The Superinvestors of Graham-and-Doddsville

September 17, 2023

According to the Efficient Market Hypothesis (EMH), stock prices reflect all available information and are thus fairly valued.  It’s impossible to get investment results better than the market except by luck.

However, Warren Buffett, arguably the greatest investor of all time and a value investor, has argued that he knows a group of value investors, all of whom have done better than the market over time.  Buffett argues that there’s no way every investor in this group could have gotten lucky at the same time.  Also, Buffett didn’t pick this group of investors after they already had produced superior performance.  Rather, he identified them ahead of time.  The only thing these investors had in common was that they believed in the value investing framework, according to which sometimes the price of a stock can be far below the intrinsic value of the business in question.

Buffett presented his argument in 1984.  But the logic still holds today.  The title of Buffett’s speech was The Superinvestors of Graham-and-Doddsville.  The speech is still available as an essay here: https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors

Despite the unassailable logic and evidence of Buffett’s argument, still today many academic economists and theorists continue to argue that the stock market is efficient and therefore impossible to beat except by luck.  These academics therefore argue that investors such as Warren Buffett just got lucky.

Let’s examine Buffett’s essay.

Buffett first says to imagine a national coin-flipping contest.  225 million Americans (the population in 1984) get up at sunrise and bet one dollar on the flip of a coin.  If they call correctly, they win a dollar from those who called incorrectly.  Each day the losers drop out.  And the winners bet again the following morning, putting cumulative winnings on the line.

After ten straight days, there will be approximately 220,000 Americans who correctly called ten coin tosses in a row.  Each of these participants will have a little more than $1,000.

Buffett writes hilariously:

Now this group will probably start getting a little puffed up about this, human nature being what it is.  They may try to be modest, but at cocktail parties they will occasionally admit to attractive members of the opposite sex what their technique is, and what marvelous insights they bring to the field of flipping.

After another ten days of this daily contest, there will be approximately 215 flippers left who correctly called twenty coin tosses in a row.  Each of these contestants will have turned a dollar into $1 million.

Buffett continues:

By then, this group will really lose their heads. They will probably write books on “How I turned a Dollar into a Million in Twenty Days Working Thirty Seconds a Morning.” Worse yet, they’ll probably start jetting around the country attending seminars on efficient coin-flipping and tackling skeptical professors with, “If it can’t be done, why are there 215 of us?”

By then some business school professor will probably be rude enough to bring up the fact that if 225 million orangutans had engaged in a similar exercise, the results would be much the same — 215 egotistical orangutans with 20 straight winning flips.

But then Buffett says:

I would argue, however, that there are some important differences in the examples I am going to present.  For one thing, if (a) you had taken 225 million orangutans distributed roughly as the U.S. population is; if (b) 215 winners were left after 20 days; and if (c) you found that 40 came from a particular zoo in Omaha, you would be pretty sure you were on to something.  So you would probably go out and ask the zookeeper about what he’s feeding them, whether they had special exercises, what books they read, and who knows what else.  That is, if you found any really extraordinary concentrations of success, you might want to see if you could identify concentrations of unusual characteristics that might be causal factors.

Scientific inquiry naturally follows such a pattern.  If you were trying to analyze possible causes of a rare type of cancer — with, say, 1,500 cases a year in the United States — and you found that 400 of them occurred in some little mining town in Montana, you would get very interested in the water there, or the occupation of those afflicted, or other variables.  You know it’s not random chance that 400 come from a small area.  You would not necessarily know the causal factors, but you would know where to search.

Buffett adds:

I submit to you that there are ways of defining an origin other than geography.  In addition to geographical origins, there can be what I call an intellectual origin.  I think you will find that a disproportionate number of successful coin-flippers in the investment world came from a very small intellectual village that could be called Graham-and-Doddsville.  A concentration of winners that simply cannot be explained by chance can be traced to this particular intellectual village.

Buffett then argues:

In this group of successful investors that I want to consider, there has been a common intellectual patriarch, Ben Graham.  But the children who left the house of this intellectual patriarch have called their “flips” in very different ways.  They have gone to different places and bought and sold different stocks and companies, yet they have had a combined record that simply cannot be explained by random chance…

The common intellectual theme of the investors from Graham-and-Doddsville is this: they search for discrepancies between the value of a business and the price of small pieces of that business in the market… Our Graham & Dodd investors, needless to say, do not discuss beta, the capital asset pricing model, or covariance in returns among securities.  These are not subjects of any interest to them.  In fact, most of them would have difficulty defining those terms. The investors simply focus on two variables: price and value.

As Ben Graham said:

Price is what you pay.  Value is what you get.

The Efficient Market Hypothesis argues that the current value of any stock is already reflected in the price.  Value investors, however, don’t believe that.  Value investors believe that stock prices are usually correct – the market is usually efficient – but not always.

Buffett speculates on why there have been so many academic studies of stock prices:

I always find it extraordinary that so many studies are made of price and volume behavior, the stuff of chartists.  Can you imagine buying an entire business simply because the price of the business had been marked up substantially last week and the week before?  Of course, the reason a lot of studies are made of these price and volume variables is that now, in the age of computers, there are almost endless data available about them.  It isn’t necessarily because such studies have any utility; it’s simply that the data are there and academicians have worked hard to learn the mathematical skills needed to manipulate them.  Once these skills are acquired, it seems sinful not to use them, even if the usage has no utility or negative utility.  As a friend said, to a man with a hammer, everything looks like a nail.

Buffett then proceeds to discuss the group of value investors that he had selected decades before 1984.  Why is it that the value investors whom Buffett had identified decades ago before ended up far outperforming the market?  The one thing they had in common was that they distinguished between price and value, and they only bought when price was far below value.  Other than that, these investors had very little in common.  They bought very different stocks from one another and they also had different methods of portfolio construction, with some like Charlie Munger having very concentrated portfolios and others like Walter Schloss having very diversified portfolios.

Buffett shows the records for Walter Schloss, Tom Knapp, Warren Buffett (himself), Bill Ruane, Charlie Munger, Rick Guerin, Stan Perlmeter, and two others.  For details on the track records of the value investors Buffett had previously identified, see here: https://www8.gsb.columbia.edu/articles/columbia-business/superinvestors

While discussing Rick Guerin, Buffett offered the following interesting comments:

One sidelight here: it is extraordinary to me that the idea of buying dollar bills for 40 cents takes immediately to people or it doesn’t take at all.  It’s like an inoculation.  If it doesn’t grab a person right away, I find that you can talk to him for years and show him records, and it doesn’t make any difference.  They just don’t seem able to grasp the concept, simple as it is.  A fellow like Rick Guerin, who had no formal education in business, understands immediately the value approach to investing and he’s applying it five minutes later.  I’ve never seen anyone who became a gradual convert over a ten-year period to this approach.  It doesn’t seem to be a matter of IQ or academic training.  It’s instant recognition, or it is nothing.

And when discussing Stan Perlmeter, Buffett says:

Perlmeter does not own what Walter Schloss owns.  He does not own what Bill Ruane owns.  These are records made independently.  But every time Perlmeter buys a stock it’s because he’s getting more for his money than he’s paying.  That’s the only thing he’s thinking about.  He’s not looking at quarterly earnings projections, he’s not looking at next year’s earnings, he’s not thinking about what day of the week it is, he doesn’t care what investment research from any place says, he’s not interested in price momentum, volume, or anything.  He’s simply asking: What is the business worth?

Buffett then comments on the nine track records he mentioned:

So these are nine records of “coin-flippers” from Graham-and-Doddsville.  I haven’t selected them with hindsight from among thousands.  It’s not like I am reciting to you the names of a bunch of lottery winners — people I had never heard of before they won the lottery.  I selected these men years ago based upon their framework for investment decision-making.  I knew what they had been taught and additionally I had some personal knowledge of their intellect, character, and temperament.  It’s very important to understand that this group has assumed far less risk than average; note their record in years when the general market was weak.  While they differ greatly in style, these investors are, mentally, always buying the business, not buying the stock.  A few of them sometimes buy whole businesses far more often they simply buy small pieces of businesses.  Their attitude, whether buying all or a tiny piece of a business, is the same.  Some of them hold portfolios with dozens of stocks; others concentrate on a handful.  But all exploit the difference between the market price of a business and its intrinsic value.

I’m convinced that there is much inefficiency in the market.  These Graham-and-Doddsville investors have successfully exploited gaps between price and value.  When the price of a stock can be influenced by a “herd” on Wall Street with prices set at the margin by the most emotional person, or the greediest person, or the most depressed person, it is hard to argue that the market always prices rationally.  In fact, market prices are frequently nonsensical.

Buffett then discusses risk versus reward.  When you are practicing value investing, the lower the price is relative to probable intrinsic value, the less risk there is but simultaneously the greater upside there is.  As Buffett puts it, if you buy a dollar bill for 60 cents, it’s riskier than if you buy a dollar bill for 40 cents, but the expected reward is greater in the latter case.

Speaking of risk versus reward, Buffett gives an example:

The Washington Post Company in 1973 was selling for $80 million in the market.  At the time, that day, you could have sold the assets to any one of ten buyers for not less than $400 million, probably appreciably more.  The company owned the PostNewsweek, plus several television stations in major markets.  Those same properties are worth $2 billion now, so the person who would have paid $400 million would not have been crazy.

Now, if the stock had declined even further to a price that made the valuation $40 million instead of $80 million, its beta would have been greater.  And to people that think beta measures risk, the cheaper price would have made it look riskier.  This is truly Alice in Wonderland. I have never been able to figure out why it’s riskier to buy $400 million worth of properties for $40 million than $80 million.

Buffett adds that you also want to be sure that the managers of the business are reasonably competent.  But this is a very doable task.

Buffett concludes his essay by saying that people may wonder why he is writing it in the first place, given that it may create more competitors using value investing.  Buffett observes that the secret has been out since 1934, when Ben Graham and David Dodd published Security Analysis, and yet there has been no trend towards value investing.

 

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:  https://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.

The Growth Trap

September 10, 2023

Jeremy Siegel is the author of The Future for Investors (Crown Business, 2005).  Warren Buffett commented:  “Jeremy Siegel’s new facts and ideas should be studied by investors.”  (Although the book was published in 2005, most of the facts and ideas still hold.)

 

INTRODUCTION

Siegel summarizes the main lesson from his previous book, Stocks for the Long Run:

My research showed that over extended periods of time, stock returns not only dominate the returns on fixed-income assets, but they do so with lower risk when inflation is taken into account.  These findings established that stocks should be the cornerstone of all long-term investors’ portfolios.

As you extend forward in time, especially to three or four decades, the real return from stocks is roughly 6.5 to 7 percent, which will nearly always be better than any other investment, such as fixed-income or gold.  Siegel has given many talks on Stocks for the Long Run, and he reports that two questions always come up:

  • Which stocks should I hold for the long run?
  • What will happen to my portfolio when the baby boomers retire and begin liquidating their portfolios?

Siegel says he wrote The Future for Investors in order to answer these questions.  He studied all 500 firms that constituted the S&P 500 Index when it was first formulated in 1957.  His conclusions – that the original firms in the index outperformed the newcomers (those added later to the index) – were surprising:

These results confirmed my feeling that investors overprice new stocks, many of which are in high technology industries, and ignore firms in less exciting industries that often provide investors superior returns.  I coined the term the growth trap to describe the incorrect belief that the companies that lead in technological innovation and spearhead economic growth bring investors superior returns.

The more I investigated returns, the more I determined that the growth trap affected not just individual stocks, but also entire sectors of the market and even countries.  The fastest-growing new firms, industries, and even foreign countries often suffered the worst return.  I formulated the basic principle of investor return, which specifies that growth alone does not yield good returns, but only growth in excess of the often overly optimistic estimates that investors have built into the price of stock.  It was clear that the growth trap was one of the most important barriers between investors and investment success.

As regards the aging of the baby-boom generation, Siegel argues that growth in developing countries (like China and India) will keep the global economy moving forward.  Also, as citizens in developing countries become wealthier, they will buy assets that baby-boomers are selling.  Siegel also holds that information technology will be central to global economic growth.

I am not going to discuss baby-boomer retirement any further in this blog post.  I would only note that there is a good chance that economically significant innovation could surprise on the upside in the next few decades.  See, for instance, The Second Machine Age, by Erik Brynjolfsson and Andrew McAfee (W. W. Norton, 2016).  As Warren Buffett has frequently observed, the luckiest people in history are those being born now.  Life in the future for most people is going to be far better than at any previous time in history.

 

THE GROWTH TRAP

Siegel opens the first chapter by noting the potential impact of improving technology:

The future for investors is bright.  Our world today stands at the brink of the greatest burst of invention, discovery, and economic growth ever known.

Yet investors must be careful to avoid the growth trap:

The growth trap seduces investors into overpaying for the very firms and industries that drive innovation and spearhead economic expansion.  This relentless pursuit of growth – through buying hot stocks, seeking exciting new technologies, or investing in the fastest-growing countries – dooms investors to poor returns.  In fact, history shows that many of the best-performing investments are instead found in shrinking industries and in slower-growing countries.

Although technology has created amazing wealth and well-being, investing in new technologies is generally a poor investment strategy.  Siegel explains:

How can this happen?  How can these enormous economic gains made possible through the proper application of new technology translate into substantial investment losses?  There’s one simple reason:  in their enthusiasm to embrace the new, investors invariably pay too high a price for a piece of the action.  The concept of growth is so avidly sought after that it lures investors into overpriced stocks in fast-changing and overly competitive industries, where the few big winners cannot begin to compensate for the myriad of losers.

To illustrate his point, Siegel compares Standard Oil of New Jersey (now ExxonMobil) with the new-economy juggernaut, IBM.  Consider the growth rates of these companies from 1950 to 2003:

Growth Measures IBM Standard Oil Advantage
Revenue/Share 12.19% 8.04% IBM
Dividends/Share 9.19% 7.11% IBM
Earnings/Share 10.94% 7.47% IBM
Sector Growth 14.65% -14.22% IBM

IBM performed much better fundamentally than Standard Oil of New Jersey.  Moreover, from 1950 to 2003, the technology sector rose from 3 percent of the market to almost 18 percent, while oil stocks shrank from 20 percent of the market to 5 percent.  Therefore, it seems clear that an investor who had to choose between IBM and Standard Oil in 1950 should have chosen IBM.  But this would have been the wrong decision.

Over the entire period, Standard Oil of New Jersey had an average P/E of 12.97, while IBM had an average P/E of 26.76.  Also, Standard Oil had an average dividend yield of 5.19%, while IBM had an average dividend yield of 2.18%.  As a result, the total returns for the two stocks were as follows:

Return  Measures IBM Standard Oil Advantage
Price Appreciation 11.41% 8.77% IBM
Dividend Return 2.18% 5.19% Standard Oil
Total Return 13.83% 14.42% Standard Oil

Siegel explains:

IBM did very well, but investors expected it to do well, and its stock price was consistently high.  Investors in Standard Oil had very modest expectations for earnings growth and kept the price of its shares low, allowing investors to accumulate more shares through the reinvestment of dividends.  The extra shares proved to be Standard Oil’s margin of victory.

Here are Siegel’s broad conclusions on the S&P 500 Index:

  • The more than 900 new firms that have been added to the index since it was formulated in 1957 have, on average, underperformed the original 500 firms in the index.
  • Long-term investors would have been better off had they bought the original S&P 500 firms in 1957 and never bought any new firms added to the index. By following this buy-and-never-sell approach, investors would have outperformed almost all mutual funds and money managers over the last half century.
  • Dividends matter a lot. Reinvesting dividends is the critical factor giving the edge to most winning stocks in the long run… Portfolios invested in the highest-yielding stocks returned 3 percent per year more than the S&P 500 Index, while those in the lowest-yielding stocks lagged the market by almost 2 percent per year.
  • The return on stocks depends not on earnings growth but solely on whether this earnings growth exceeds what investors expected, and those growth expectations are embodied in the price-to-earnings, or P/E ratio. Portfolios invested in the lowest-P/E stocks in the S&P 500 Index returned almost 3 percent per year more than the S&P 500 Index, while those invested in the high-P/E stocks fell 2 percent per year behind the index.
  • The growth trap holds for industry sectors as well as individual firms. The fastest-growing sector, the financials, has underperformed the benchmark S&P 500 Index, while the energy sector, which has shrunk almost 80 percent since 1957, beat this benchmark index.  The lowly railroads, despite shrinking from 21 percent to less than 5 percent of the industrial sector, outperformed the S&P 500 Index over the last half century.
  • The growth trap holds for countries as well. The fastest-growing country over the last decade has rewarded investors with the worst returns.  China, the economic powerhouse of the 1990s, has painfully disappointed investors with its overpriced shares and falling stock prices.

 

THE TRIED AND TRUE

But how, you will ask, does one decide what [stocks are] ‘attractive’?  Most analysts feel they must choose between two approaches customarily thought to be in opposition: ‘value’ and ‘growth.’… We view that as fuzzy thinking… Growth is always a component of value [and] the very term ‘value investing’ is redundant.

– Warren Buffett, Berkshire Hathaway annual report, 1992

What was the best-performing stock from 1957 to 2003?  Siegel answers that it was Philip Morris.  Siegel observes:

The superb returns in Philip Morris illustrate an extremely important principle of investing:  what counts is not just the growth rate of earnings but the growth of earnings relative to the market’s expectation.  One reason investors had low expectations for Philip Morris’s growth was because of its potential liabilities.  But its growth has continued apace.  The low expectations combined with high growth and a high dividend yield provide the perfect environment for superb investor returns.

What were the top-performing S&P 500 Survivors from 1957 to 2003?

Rank 2003 Name Accumulation of $1,000 Annual Return
1 Philip Morris $4,626,402 19.75%
2 Abbott Labs $1,281,335 16.51%
3 Bristol-Myers Squibb $1,209,445 16.36%
4 Tootsie Roll Industries $1,090,955 16.11%
5 Pfizer $1,054,823 16.03%
6 Coca-Cola $1,051,646 16.02%
7 Merck $1,003,410 15.90%
8 PepsiCo $866,068 15.54%
9 Colgate-Palmolive $761,163 15.22%
10 Crane $736,796 15.14%
11 H. J. Heinz $635,988 14.78%
12 Wrigley $603,877 14.65%
13 Fortune Brands $580,025 14.55%
14 Kroger $546,793 14.41%
15 Schering-Plough $537,050 14.36%
16 Proctor & Gamble $513,752 14.26%
17 Hershey Foods $507,001 14.22%
18 Wyeth $461,186 13.99%
19 Royal Dutch Petroleum $398,837 13.64%
20 General Mills $388,425 13.58%
S&P 500 $124,486 10.85%

Siegel points out that most of the top twenty performers have strong brands, but are not technology companies per se.  Siegel discusses some of these great companies:

Number four on this list is a most unlikely winner – a small manufacturer originally named the Sweets Company of America.  This company has outperformed the market by 5 percent a year since the index was formulated.  The founder of this firm, an Austrian immigrant, named its product after his five-year-old daughter’s nickname, Tootsie….

The surviving company with the sixth highest return produces a product today with the exact same formula as it did over 100 years ago, much like Tootsie Roll…. Although the company keeps the formula for its drinks secret, it is no secret that Coca-Cola has been one of the best companies you could have owned over the last half century.

…Pepsi also delivered superb returns to its shareholders, coming in at number eight and beating the market by over 4 percent per year.

Two others of the twenty best-performing stocks also manufacture products virtually unchanged over the past 100 years:  the William Wrigley Jr. Company and Hershey Foods.  Wrigley came in at number twelve, beating the market by almost 4 percent per year, whereas Hershey came in at seventeen, beating the market by 3 percent a year.

Wrigley is the largest gum manufacturer in the world, commanding an almost 50 percent share in the global market and selling in approximately 100 countries.  Hershey is currently the number-one U.S.-based publicly traded candy maker (Mars, a private firm, is number one, followed by Swiss-based Nestle).

…Heinz is another strong brand name, one that is virtually synonymous with ketchup.  Each year, Heinz sells 650 million bottles of ketchup and makes 11 billion packets of ketchup and salad dressings – almost two packets for every person on earth.  But Heinz is just not a ketchup producer, and it does not restrict its focus to the United States.  It has the number-one or –two branded business in fifty different countries, with products such as Indonesia’s ABC soy sauce (the second-largest-selling soy sauce in the world) and Honig dry soup, the best-selling soup brand in the Netherlands.

Colgate-Palmolive also makes the list, coming in at number nine.  Colgate’s products include Colgate toothpastes, Speed Stick deoderant, Irish Spring soaps, antibacterial Softsoap, and household cleaning products such as Palmolive and Ajax.

No surprise that Colgate’s rival, Procter & Gamble, makes this list as well, at number sixteen.  Procter & Gamble began as a small, family-operated soap and candle company in Cincinnati, Ohio, in 1837.  Today, P&G sells three hundred products, including Crest, Mr. Clean, Tide, and Tampax, to more than five billion consumers in 140 countries.

…Number twenty on the list is General Mills, another company with strong brands, which include Betty Crocker, introduced in 1921, Wheaties (the ‘Breakfast of Champions’), Cheerios, Lucky Charms, Cinnamon Toast Crunch, Hamburger Helper, and Yoplait yogurt.

What is true about all these firms is that their success came through developing strong brands not only in the United States but all over the world.  A well-respected brand name gives the firm the ability to price its product above the competition and deliver more profits to investors.

…Besides the strong consumer brand firms, the pharmaceuticals had a prominent place on the list of best-performing companies.  It is noteworthy that there were only six health care companies in the original S&P 500 that survive to today in their original corporate form, and all six made it onto the list of best performers.  All of these firms not only sold prescription drugs but also were very successful in marketing brand-name over-the-counter treatments to consumers, very much like the brand-name consumer staples stocks that we have reviewed.

…When these six pharmaceuticals are added to the eleven name-brand consumer firms, seventeen, or 85 percent, of the twenty top-performing firms from the original S&P 500 Index, feature well-known consumer brand names.

 

INVESTOR EXPECTATIONS

What really matters for investors is the price paid today compared to all future free cash flows.  But investors very regularly overvalue high-growth companies and undervalue low-growth or no-growth companies.  This is the key reason value investing works.  As Siegel writes:

Expectations are so important that without even knowing how fast a firm’s earnings actually grow, the data confirm that investors are too optimistic about fast-growing companies and too pessimistic about slow-growing companies.  This is just one more confirmation of the growth trap.

Thus, if you want to do well as an investor, it is best to stick with companies trading at low multiples (low P/E, low P/B, low P/S, etc.).  All of the studies have confirmed this.  See:  https://boolefund.com/the-ugliest-stocks-are-the-best-stocks/

Siegel did his own study, dividing S&P 500 Index companies into P/E quintiles.  From 1957 to 2003, the lowest P/E quintile – bought at the beginning of each year – produced an average annual return of 14.07% (with a risk of 15.92%), while the highest P/E quintile produced an average annual return of 9.17% (with a risk of 19.39%).  The S&P 500 Index averaged 11.18% (with a risk of 17.02%)

If you’re doing buy-and-hold value investing – as Warren Buffett does today – then you can pay a higher price as long as it is still reasonable and as long as the brand is strong enough to persist over time.  Buffett has made it clear, however, that if he were managing a small amount of money, he would focus on microcap companies available at cheap prices.  That would generate the highest returns, with 50% per year being possible in micro caps for someone like Buffett.  See: https://boolefund.com/buffetts-best-microcap-cigar-butts/

Siegel discusses GARP, or growth at a reasonable price:

Advocates here compute a very similar statistic called the PEG ratio, or price-to-earnings ratio divided by the growth rate of earnings.  The PEG ratio is essentially the inverse of the ratio that Peter Lynch recommended in his book, assuming you add the dividend yield to the growth rate.  The lower the PEG ratio, the more attractively priced a firm is with respect to its projected earnings growth.  According to Lynch’s criteria, you would be looking for firms with lower PEG ratios, preferably 0.5 or less, but certainly less than 1.

It’s important to note that earnings growth is very mean-reverting.  In other words, most companies that have been growing fast do NOT continue to do so, but tend to slow down quite a bit.  That’s why deep value investing – simply buying the cheapest companies (based on low P/E or low EV/EBIT), which usually have low- or no-growth – tends to produce better returns over time than GARP investing does.  This is most true, on average, when you invest in cheap microcap companies.

Deep value microcap investing tends to work quite well, especially if you also use the Piotroski F-Score to screen for cheap microcap companies that also have improving fundamentals.  This is the approach used by the Boole Microcap Fund.  See: https://boolefund.com/cheap-solid-microcaps-far-outperform-sp-500/

One other way to do very well investing in micro caps is to try to find the ones that will grow for a long time.  It’s much more difficult to use this approach successfully than it is to buy cheap microcap companies with improving fundamentals.  But it is doable with enough patience and discipline.  See MicroCapClub.com if you want to learn about some microcap investors who use this approach.

 

GROWTH IS NOT RETURN

Most investors seem to believe that the fastest-growing industries will yield the best returns.  But this is simply not true.  Siegel compares financials to energy companies:

Of the ten major industries, the financial sector has gained the largest share of market value since the S&P 500 Index was founded in 1957.  Financial firms went from less than 1 percent of the index to over 20 percent in 2003, while the energy sector has shrunk from over 21 percent to less than 6 percent over the same period.  Had you been looking for the fastest-growing sector, you would have sunk your money in financial stocks and sold your oil stocks.

But if you did so, you would have fallen into the growth trap.  Since 1957, the returns on financial stocks have actually fallen behind the S&P 500 Index, while energy stocks have outperformed over the same period.  For the long-term investor, the strategy of seeking out the fastest-growing sector is misguided.

Siegel continues by noting that the GICS (Global Industrial Classification Standard) breaks the U.S. and world economy down into ten sectors:  materials, industrials, energy, utilities, telecommunication services, consumer discretionary, consumer staples, health care, financial, and information technology.  (Recently real estate has been added as an eleventh sector.)

Just as the fastest-growing companies, as a group, underperform the slower growers in terms of investment returns, so new companies underperform the tried and true.  Siegel explains what his data show:

These data confirm my basic thesis:  the underperformance of new firms is not confined to one industry, such as technology, but extends to the entire market.  New firms are overvalued by investors in virtually every sector of the market.

Siegel also answers the question of why energy did so well, despite shrinking from over 21 percent to less than 6 percent of the market:

Why did the energy sector perform so well?  The oil firms concentrated on what they did best:  extracting oil at the cheapest possible price and returning the profits to the shareholders in the form of dividends.  Furthermore investors had low expectations for the growth of energy firms, so these stocks were priced modestly.  The low valuations combined with the high dividends contributed to superior investor returns.

Technology firms have experienced high earnings growth.  Yet investors have tended to expect even higher growth going forward than what subsequently occurs.  Thus we see again that investors systematically overvalue high-growth companies, which leads to returns that trail the S&P 500 Index.  Technology may be the best example of this phenomenon.  Technology companies have grown very fast, but investors have generally expected too much going forward.

The financial sector is another case of high growth but disappointing (or average) returns.  Much of the growth in financials has come from new companies joining the sector and being added to the index.  Siegel:

The tremendous growth in financial products has spurred the growth of many new firms.  This has caused a steady increase in the market share of the financial sector, but competition has kept the returns on financial stocks close to average over the whole period.

To conclude his discussion of the various sectors, Siegel writes:

The data show that three sectors emerge as long-term winners.  They are health care, consumer staples, and energy.  Health care and consumer staples comprise 90 percent of the twenty best-performing surviving firms of the S&P 500 Index.  These two sectors have the highest proportion of firms where management is focused on bringing quality products to the market and expanding brand-name recognition on a global basis.

The energy sector has delivered above-average returns despite experiencing a significant contraction of its market share.  The excellent returns in this sector are a result of two factors:  the relatively low growth expectations of investors (excepting the oil and gas extractors during the late 1970s) and the high level of dividends.

 

TECHNOLOGY: PRODUCTIVITY CREATOR AND VALUE DESTROYER

Siegel opens the chapter by remarking:

Economic growth is not the same as profit growth.  In fact, productivity growth can destroy profits and with it stock values.

Siegel continues:

Any individual or firm through its own effort can rise above the average, but every individual and firm, by definition, cannot.  Similarly, if a single firm implements a productivity-improving strategy that is unavailable to its competition, its profits will rise.  But if all firms have access to the same technology and implement it, then costs and prices will fall and the gains of productivity will go to the consumer.

Siegel notes that Buffett had to deal with this type of issue when he was managing Berkshire Hathaway, a textile manufacturer.  Buffett discussed plans presented to him that would improve workers’ productivity and lower costs:

Each proposal to do so looked like an immediate winner.  Measured by standard return-on-investment tests, in fact, these proposals usually promised greater economic benefits than would have resulted from comparable investments in our highly profitable candy and newspaper businesses.

Yet Buffett realized that the proposed improvements were available to all textile companies.  Buffett commented in his 1985 annual report:

[T]he promised benefits from these textile investments were illusory.  Many of our competitors, both domestic and foreign, were stepping up to the same kind of expenditures and, once enough companies did so, their reduced costs became the baseline for reduced prices industrywide.  Viewed individually, each company’s investment decision appeared cost-effective and rational; viewed collectively, the decisions neutralized each other and were irrational (just as happens when each person watching a parade decides he can see a little better if he stands on tiptoes).  After each round of investment, all the players had more money in the game and returns remained anemic.

Eventually, after a decade, Buffett realized he had to close the company.  (He had kept it open for a decade out of concern for the employees, and because management was doing an excellent job with the hand it was dealt.)  Siegel comments:

Buffett contrasts his decision to close up shop with that of another textile company that opted to take a different path, Burlington Industries.  Burlington Industries spent approximately $3 billion on capital expenditures to modernize its plants and equipment and improve its productivity in the twenty years following Buffett’s purchase of Berkshire.  Nevertheless, Burlington’s stock returns badly trailed the market.  As Buffett states, ‘This devastating outcome for the shareholders indicates what can happen when much brain power and energy are applied to a faulty premise.’

Siegel then draws a broader conclusion about technology:

Historical economic data indicate that the fruits of technological change, no matter how great, have ultimately benefited consumers, not the owners of firms.  Productivity lowers the price of goods and raises the real wages of workers.  That is, productivity allows us to buy more with less.

Certainly, technological change has transitory effects on profits.  There is usually a ‘first mover’ advantage.  When one firm incorporates a new technology that has not yet been implemented by others, profits will increase.  But as others avail themselves of this technology, competition ensures that prices will fall and profits will revert to normal.

 

WINNING MANAGEMENTS IN LOSING INDUSTRIES

Siegel quotes Peter Lynch:

As a place to invest, I’ll take a lousy industry over a great industry anytime.  In a lousy industry, one that’s growing slowly if at all, the weak drop out and the survivors get a bigger share of the market.  A company that can capture an ever-increasing share of a stagnant market is a lot better off than one that has to struggle to protect a dwindling share of an exciting market.

Many investors try to look for an industry with a bright future, and then select a company that will benefit from this growth.  As we’ve already seen, this doesn’t work in general because investors systematically overvalue high-growth companies.

A deep value investment strategy looks for companies at low multiples, with terrible performance.  These companies, as a group, have done much better than the market over time.

Although a deep value approach works well even if it is entirely quantitative – which is what Ben Graham, the father of value investing, often did – it can work even better if you can identify a winning management.  Siegel explains:

… some of the most successful investments of the last thirty years have come from industries whose performances have been utterly horrendous.

These companies have bucked the trend.  They all rose above their competitors by following a simple approach:  maximize productivity and keep costs as low as possible.

Siegel gives Southwest Airlines as an example.  Investors have lost more money in the airline industry than in any other.  But Southwest Airlines established itself as ‘the low-fare airline.’  It accomplished this by being the low-cost airline.  It offered only single-class service, with no assigned seats and no meals.  It only operated city-to-city where demand was high enough.  And it only used Boeing 737’s.  As a result of being the low-cost and low-fare airline, the business performed well and the stock followed.

Siegel also mentions the example of Nucor, which pioneered the use of ‘minimill’ technology and the recycling of scrap steel.  While the steel industry as a whole underperformed the market by close to 4 percent a year for thirty years, Nucor outperformed the market by over 5 percent a year over the same time period.  According to Jim Collins and others, at least 80 percent of Nucor’s success had to do with the leadership and culture of the company.  At Nucor, executives actually received fewer benefits than regular workers:

  • All workers were eligible to receive $2,000 per year for each child for up to four years of postsecondary education, while the executives received no such benefit.
  • Nucor lists all of its employees – more than 9,800 – in its annual report, sorted alphabetically with no distinctions for officer titles.
  • There are no assigned parking spots and no company cars, boats, or planes.
  • All employees of the company receive the same insurance coverage and amount of vacation time.
  • Everybody wears the same green spark-proof jackets and hard hats on the floor (in most integrated mills, different colors designate authority).

Siegel quotes Buffett:

It is the classic example of an incentive program that works.  If I were a blue-collar worker, I would like to work for Nucor.

In stark contrast, Bethlehem Steel had executives using the corporate fleet for personal reasons, like taking children to college or weekend vacations.  Bethlehem also renovated a country club with corporate funds, at which shower priority was determined by executive rank, notes Siegel.

Siegel concludes his discussion of Southwest Airlines and Nucor (and Wal-Mart):

The success of these firms must make investors stop and think.  The best-performing stocks are not in industries that are at the cutting edge of the technological revolution; rather, they are often in industries that are stagnant or in decline.  These firms are headed by managements that find and pursue efficiencies and develop competitive niches that enable them to reach commanding positions no matter what industry they are in.  Firms with these characteristics, which are often undervalued by the market, are the ones that investors should want to buy.

Another great example of a company implementing a low-cost business strategy is 3G Capital, a Brazilian investment firm.  (3G was founded in 2004 by Jorge Paulo Lemann, Carlos Alberto Sicupira, and Marcel Herrmann Telles.)  3G is best known for partnering with Buffett’s Berkshire Hathaway for its acquisitions, including Burger King, Tim Hortons, and Kraft Foods.  When 3G acquires a company, they typically implement deep cost cuts.

 

REINVESTED DIVIDENDS:  THE BEAR MARKET PROTECTOR AND RETURN ACCELERATOR

Siegel explains what can happen to a dividend-paying stock during a bear market:  If the stock price falls more than the dividend, then the higher dividend yield can then be used to reinvest, leading to a higher share count than otherwise.  The Great Depression led to a 25-year period – October 1929 to November 1954 – during which stocks plunged and then took a long time to recover.  Most investors did not do well, often because they could not or did not hold on to their shares.  But investors with dividend-paying stocks who reinvested those dividends did quite well, as Siegel notes:

Instead of just getting back to even in November 1954, stockholders who reinvested their dividends (indicated as ‘total return’) realized an annual rate of return of 6 percent per year, far outstripping those who invested in either long- or short-term government bonds.  In fact, $1,000 invested in stocks at the market peak turned into $4,440 when the Dow finally recovered to its old high on that November day a quarter century later.  Although the price appreciation was zero, the $4,400 that resulted solely from reinvesting dividends was almost twice the accumulation in bonds and four times the accumulation in short-term treasury bills.

Siegel concludes:

There is an important lesson to be taken from this analysis.  Market cycles, although difficult on investors’ psyches, generate wealth for long-term stockholders.  These gains come not through timing the market but through the reinvestment of dividends.

Bear markets are not only painful episodes that investors must endure; they are also an integral reason why investors who reinvest dividends experience sharply higher returns.  Stock returns are generated not by earnings and dividends alone but by the prices that investors pay for these cash flows.  When pessimism grips shareholders, those who stay with dividend-paying stocks are the big winners.

The same logic applies to individual stocks.  If a company is a long-term survivor (or leader), then short-term bad news causing the stock to drop will enhance your long-term returns if you’re reinvesting dividends.  This is also true if you’re dollar-cost averaging.

In theory, share repurchases when the stock is low can work even better than dividends because share repurchases create tax-deferred gains.  In practice, Siegel observes, management is often not as committed to a policy of share repurchases as it is to paying dividends.  Once a dividend is being paid, the market usually views a reduced dividend unfavorably.  Also, shareholders can track dividends more easily than share repurchases.  In sum, when a stock is low, it is usually better for shareholders if they can reinvest dividends instead of relying on management to repurchase shares.

 

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:  https://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.

How Great Leaders Build Sustainable Businesses

September 3, 2023

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 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:  https://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 UPDATE: Atlas Engineered Products (APEUF)

August 27, 2023

I first wrote about Atlas Engineered Products (APEUF) on December 11, 2022, here: https://boolefund.com/case-study-atlas-engineered-products-apeuf/

Since then, the stock has increased 63%, from $0.54 to $0.88.  However, the stock is still undervalued and it seems to have a sustainably high ROE (return on equity) of between 26% and 40%, which should allow the business and the stock to compound over time.

Atlas Engineered Products is a leading Canadian manufacturer of engineered wood products, including roof systems and roof trusses, floor systems and floor trusses, and wall panels.

Atlas’s specialist design team uses cutting edge design and engineering technology to ensure that their clients get consistent, accurate, top-quality products.

Atlas has acquired and improved 8 companies since going public in late 2017.

The market for roof systems and trusses, floor systems and trusses, and wall panels, is local because it is too expensive to transport such large items over a long distance.  As a result, this market is extremely fragmented.  There are hundreds of small regional operators with sales in the range of $3 to $15 million.  Many of these operators need succession planning.  Atlas thus has an opportunity to continue making acquisitions.

Atlas is providing an opportunity for many of these small operators for succession planning purposes.

At the same time, Atlas can profit from operational efficiences, technological advances, advantages of scale in procurement, and expanded product distribution.  (Most small regional operators are unable or unwilling to invest in technology and automation.)

Atlas focuses on the higher added value and most scalable products.  It quickly winds down or sells lower margin businesses.

The company aims to sell all of its products at all of its locations.  In addition to the core product offering, Atlas is focused on complementary product lines chiefly related to engineered wood.  The company also has an ongoing program of equipment upgrade and automation at all of its locations.  Moreover, Atlas continues to expand its sales team.

Here is the company’s most recent investor presentation: https://www.atlasengineeredproducts.com/dist/assets/presentation/Investor-Deck-May-2023-Rev-2.3.8-compressed.pdf

Clients choose Atlas Engineered Products:

    • To save money: Atlas is cost effective and efficient, with national buying power and best-in-class design, production, and automation technology.
    • To save time: Offsite customized manufactured roof and floor trusses, and wall panels, can be installed onsite up to 5x’s faster than traditional stick frame construction.
    • For expanded product offerings: Roof, wall, and floor systems, and engineered wood products, offers customers a one-stop product delivery.
    • Atlas is environmentally friendly: it uses less energy to manufacture, and has fewer emissions and waste.

Here are the current multiples:

    • EV/EBITDA = 3.49
    • P/E = 9.16
    • P/B = 2.33
    • P/CF = 3.99
    • P/S = 1.24

Insider ownership is 18.7%, which is very good.  TL/TA (total liabilities/total assets) is 41.5%, which is decent.

ROE is 26%, which is quite good.  Normalized ROE is likely higher, although ROE would temporarily dip during a recession or slowdown (but Atlas would probably then have more good acquisition opportunities).

Over the longer term, demographics are a tailwind, as the Canadian government plans to admit 500,000 immigrants per year by 2025.

The Piotroski F_score is 7, which is good.

Intrinsic value scenarios:

    • Low case: During a recession and/or a bear market, the stock could fall 50% from $0.88 to $0.44.
    • Mid case: The current EV/EBITDA is 3.49, but in a normal environment it should be at least 6.0.  That would mean the stock is worth $1.52, which is 72% above today’s $0.88.
    • High case: If the company can maintain its ROE of between 26% and 40%, while reinvesting most of its profits into both inorganic and organic growth, then Atlas’ profits and stock could continue to compound at a high rate over time.

Risks

The housing market is cyclical.  Economies are slowing down as interest rates rise.  There will likely be a recession (which would slow down organic growth but increase acquisitions) and/or a bear market.

 

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.

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 UPDATE: Delta Apparel (DLA)

August 20, 2023

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.”

I first wrote about Delta Apparel (DLA) here: https://boolefund.com/case-study-delta-apparel-dla/

At the time, the stock was at $30.01.  We ended up selling most of our position at $28-29 (after having bought at $15.26).

Since then, the stock has declined over 75% to today’s $7.40.  The company is in the process of reducing its inventory to pay off debt.  This means the recent results have been poor and the next couple of quarters will also be rough.

Delta Apparel has two segments: Salt Life and the Delta Group.

Salt Life is a very popular brand in the Southeast U.S.  Many people who love the outdoors, including the ocean, love the Salt Life brand.  In 2022, Salt Life had sales of $60 million with operating income of $8.2 million.  Also, the brand grew its number of stores at a healthy clip.  There is much room for the Salt Life brand to grow.  According to a writeup on Value Investors Club, the Salt Life brand could reach $500 million in sales, like Tommy Bahama.

Here is the writeup on Value Investors Club: https://valueinvestorsclub.com/idea/Delta_Apparel_/1415242928

The Delta Group includes two different businesses: a commoditized active wear business and a specialized digital printing business, DTG2GO.  In a normal year, the active wear business generates $320 million in sales with an operating margin of 6-7%.

DTG2GO is a market leader in the direct-to-garment digital print and fulfillment industry, bringing technology 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.  DTG2GO has sales of $60 million with an operating margin of around 15%.  DTG2GO does digital printing for companies including Fanatics and Redbubble.  Fanatics, a $30 billion private company, stopped in-house printing and fulfillment, and has outsourced them to DTG2GO.

Important Note: Digital impressions are about 2% of total graphic impressions on clothing.  There is huge room for growth here.  Digital printing will allow almost any retailer to lower costs, reduce inventory, increase selection, and speed up delivery times.

Here are the normalized figures for Delta Apparel:  EBITDA is $60 million, net income is $30 million, cash flow is $95 million, and revenue is $440 million.

The market cap is $51.9 million, while the enterprise value (EV) is $273.7 million.

Here are the multiples for Delta Apparel:

    • EV/EBITDA = 4.56
    • P/E = 1.73
    • P/B = 0.31
    • P/CF = 0.55
    • P/S = 0.12

Delta Apparel has a Piotroski F-Score of 6, which is decent.  This will likely begin to improve some time next year, after the company has reduced its inventory and debt.

We measure debt levels by looking at total liabilities (TL) to total assets (TA).  DLA has TL/TA of 64.7%, which is OK.  The company is in the process of paying down its debt.

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.

Intrinsic value scenarios:
    • Low case: The stock could decline 50% during a bear market or recession.
    • Mid case:  The company should trade for a P/E of at least 10 based on normalized earnings of $30 million.  That would be a market cap of $300 million, or a stock price of $42.86.  That is 480% higher than today’s $7.40.
    • High case:  Normalized earnings could reach $40 million.  With a P/E of 12, that would be a market cap of $480 million, or a stock price of $68.57.  That is over 825% higher than today’s $7.40.

 

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:  https://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 UPDATE: Genco Shipping (GNK)

August 6, 2023

I first wrote up the idea of GNK in June 2020 here: https://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 $13.94, but the stock is still very cheap.

The market cap is $610.8 million.  Cash is $47.9 million, while debt is $153.5 million.

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 move higher.

The company’s strategy is to have net debt of zero, to pay regular dividends, and to make acquisitions at low prices using its stock.

The company continues to voluntarily pay down debt.  The company has reduced its debt by $295.7 million since the start of 2021, a 66% reduction in debt.

As a result, the company’s cash breakeven rate has been reduced from $13,050 to $9,715, the lowest in the drybulk industry.  This compares well to the $12,300 Q3 2023 TCE estimate to date based on fixtures for 61% of the quarter’s available days.

Meanwhile, the company has paid 16 consecutive quarterly dividends totaling $4.60 per share, which is 33% of its current stock price of $3.94.

Here are the current multiples:

    • EV/EBITDA = 3.78
    • P/E = 7.11
    • P/B = 0.62
    • P/CF = 4.73
    • P/S = 1.34

Insiders own 1.3% of the shares outstanding, which is worth about $7.9 million (at today’s stock price of $13.94).  Insiders will obviously do well if they successfully lead the company forward.

Genco Shipping has a Piotroski F_Score of 7, which is decent.

TL/TA is 15.6%, which is excellent.  This is a function of the company’s ongoing strategy to reach net debt of zero.

ROE is 8.9%, which is low.  This is because rates are fairly low.  When rates improve, ROE will improve.

Intrinsic value scenarios:

    • Low case: GNK could fall 50%, from today’s $13.94 to $6.97, if there’s a bear market and/or a recession.
    • Mid case: The company is worth an EV/EBITDA of at least 6.  That would put fair value for the stock at $26.79, which is over 90% higher than today’s $13.94.
    • High case: The company may be worth an EV/EBITDA of 8.  That would put fair value for the stock at $33.51, which is 140% higher than today’s $13.94.
    • Very high case:  If rates improve significantly, EBITDA could increase at least 50%.  If the company is worth an EV/EBITDA of at least 6, then the fair value for the stock would be $38.04, which is over 170% higher than today’s $13.94.

Risks

If there is a bear market and/or a recession, rates could collapse and the stock could drop 50% or more.

 

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:  https://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 UPDATE: Global Ship Lease (GSL)

July 30, 2023

Our investment in Global Ship Lease (GSL) has been one of our best ideas thus far.

Shipping is a terrible business.  It is asset-intensive, with low returns on capital.  There are short-lived booms and sustained busts.  Also, the booms are impossible to predict with any precision.

However, if you can buy shipping stocks when they are significantly undervalued, you have good odds of earning high returns.

I first wrote up the idea of GSL in June 2020 here: https://boolefund.com/global-ship-lease-gsl/

At the time, the stock at $4.62 a share was extremely cheap based on our five measures of cheapness:

    • EV/EBITDA = 5.28
    • P/E = 1.93
    • P/NAV = 0.20
    • P/CF = 0.81
    • P/S = 0.29

These figures made Global Ship Lease one of the top ten cheapest companies out of over two thousand that we ranked.

We bought GSL stock in June 2020 at $4.57.  Today the stock is at $21.58.  The position is up over 370% so far, which makes it our best-performing idea.

But there still appears to be substantial upside for GSL.

Demand

70% of global containerized trade volume is in non-mainline routes—and these routes are growing faster than mainline routes.  These routes are served by mid-sized and smaller containerships.  This is where GSL focuses.

Supply

The supply of mid-sized and smaller container ships is constrained.  The orderbook-to-fleet ratio for these ships is at 14.5%.  It takes two to three years for shipyards to make a new ship.  If all 25+ year-old ships were scrapped, then the annual growth rate for mid-sized and smaller ships would be about 1.1%.

GSL today

As of the end of Q1 2023, the total charter backlog is $2.1 billion, which is 2.5 years of contract coverage.  GSL’s revenues, cash flows, and earnings are already set at high levels for the next 2.5 years.

Here are the current multiples for GSL:

    • EV/EBITDA = 3.23
    • P/E = 2.64
    • P/NAV = 0.35
    • P/CF = 1.88
    • P/S = 1.21

George Youroukos, Executive Chairman of the Board, recently acquired approximately $10 million of GSL’s stock.  Youroukos clearly believes GSL’s stock is cheap.   This brings Youroukos’ total position to 6.4% of GSL’s outstanding shares, worth over $50 million.

The Piotroski F_Score is 7, which is decent.

Cash is $162.2 million, while debt is $882.8 million.  The company continues to pay down its debt and expects to have $757 million in debt by the end of 2023 and $588 million in debt by the end of 2024.  Moreover, GSL has reduced its cost of debt from 7.56% in Q4 2018 to 4.53% in Q1 2023.

TL/TA (total liabilities/total assets) is 51.8%, which is pretty good.

ROE is 33.0%.  The high ROE is due in large part to leverage.  ROA is 13.7%, which is still decent.

The current dividend yield is 7.0%.  Also, the company has bought back $33.8 million shares and has $6.2 million left to spend on buybacks.  Because the stock is quite undervalued, the buybacks are very accretive for shareholders.

Here is GSL’s Q1 2023 earnings presentation: https://www.globalshiplease.com/static-files/a226750c-bb27-45e2-8017-a0183e07ad26

Intrinsic value scenarios:

    • Low case: If there is a bear market or recession, GSL could fall 50%, from today’s $21.58 to $10.79.  This would be a major buying opportunity.
    • Mid case: Global Ship Lease has a P/E of 2.64, but should have a P/E of at least 6.  That means the stock is worth approximately $49.05, which is about 127% higher than today’s $21.58.
    • High case: GSL should have a P/E of 8.  That means the stock is worth about $65.40, which is over 200% higher than today’s $21.58.

Bottom Line

GSL is one of our best-performing stocks, up over 370% since we bought it in June of 2020.  The Boole Microcap Fund continues to hold much of the position because GSL is still undervalued.   If GSL hits $49.05, it will be up over 970% since we bought it.  If GSL hits $65.40, it will be 1,330% since we bought it.

 

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:  https://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 UPDATE: Karora Resources (KRRGF)

July 23, 2023

Karora Resources (KRRGF) is a gold miner in Western Australia.  I wrote up the idea of Karora Resources on November 21, 2021: https://boolefund.com/case-study-karora-resources-krrgf/

Since then, the company has increased its gold production, having just achieved a record 40,823 ounces in Q2 2023.

The market cap is $645.5 million, while enterprise value (EV) is $632.0 million.

Some time between 2024 and 2025, Karora will produce over 200,000 ounces of gold on an annual basis.  Karora will also produce over 800 tons of nickel.

Revenue based on 200k ounces of gold and a gold price of $2,250 per ounce is $450 million.  All-in sustaining cost (AISC) can be assumed to be $1,200 per ounce.  So EBITDA for gold production would be approximately $210 million.

Revenue based on 800 tons of nickel production and a price per ton of nickel of $21,970 is $17.6 million.  EBITDA for nickel production would be about $7 million.

Total revenue would be approximately $467.6 million.  Total EBITDA would be $217 million.  (Cash flow would be close to EBITDA.)  And assuming the normalized profit margin is 17.4 percent, earnings would be about $81.4 million.

Here are the multiples based on these assumptions:

    • EV/EBITDA = 2.91
    • P/E = 7.93
    • P/NAV = 0.20
    • P/CF = 2.97
    • P/S = 1.38
  • Karora Resources is exceptionally well-managed, led by CEO Paul Andre Huet and managing director of Australia Leigh Junk.  The Karora team—despite numerous external headwinds—has met or exceeded every target it has set since its acquisition of HGO Mill in mid-2019.

Also, management owns 2% of the shares outstanding, which is worth about $13 million.  That $13 million could become $26 million (or more) if Karora keeps executing.

Karora Resources has a Piotroski F_Score of 7, which is good.

Net debt is low:  Cash is $68.9 million.  Debt is $51.2 million.  TL/TA is 37.2%, which is good.

Very importantly, Karora’s growth is internally funded by existing cash and cash flow.  Karora is not relying on debt for growth.

Furthermore, Karora has massive exploration potential.

Intrinsic value scenarios:

    • Low case: Gold prices could fall.  Also, there could be a market correction or a recession during which the stock could temporarily fall by 50% or more (from today’s $3.50 to $1.75).  This would be a major buying opportunity.
    • Mid case: The P/E = 7.9 relative to 2024 production, assuming the gold price is  around $2,250 per ounce.  But the P/E should be at least 16 for a mid-tier, multi-asset gold producer in a top tier jurisdiction (Western Australia).  This implies  over 100% upside from today’s $3.50, or an intrinsic value of $7.09 per share.  This does not factor in the company’s huge exploration potential.
    • High case: Gold prices could be much higher in an inflationary scenario.  If gold prices reach $2,750, then with a net profit margin of 25%, earnings would reach $141.9 million.  With a P/E of 16, KRRGF would be worth at least $12.98 per share.  That is over 270% higher than today’s $3.50.

Note that Karora’s operations are in Western Australia, so there is very little political risk.

 

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:  https://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 UPDATE: In-Play Oil (IPOOF)

July 16, 2023

I first wrote about In-Play Oil (IPOOF) on April 24, 2022 here: https://boolefund.com/case-study-inplay-oil-ipoof/

Since then, the stock has gone from $3.03 to $1.95, a decrease of 35%.  IPOOF is clearly cheaper now than it was then, and that’s reflected in the multiples (see below).

 

OIL PRICES

See here: https://boolefund.com/case-study-update-journey-energy-jrngf/

 

IN-PLAY OIL (IPOOF)

Here is the company’s most recent investor presentation: https://www.inplayoil.com/sites/2/files/documents/inplay_june_2023_presentation_website_final.pdf

In-Play Oil appears very cheap.  Here are the multiples:

    • EV/EBITDA = 1.50
    • P/E = 3.17
    • P/B = 0.81
    • P/CF = 1.40
    • P/S = 1.01

The Piotroski F_Score is 8, which is very good.

The market cap is $174 million.  The enterprise value (EV) is $199.1 million.

TL/TA is 38.6%, which is good.

Insider ownership is 6.1%.  That is worth a bit more than $10.6 million.  If the stock at least doubles, insiders can make at least $10.6 million.

ROE is 30.4%, which is very good.

In-Play Oil continues to buy back shares of its stock, which creates significant value because the stock is very undervalued.  Also, the current dividend yield is 6.9%, which the company says is sustainable even at an oil price of $55 WTI.

Intrinsic value scenarios:

    • Low case: If there is a bear market or recession, IPOOF could temporarily decline 50%.  This would be a major buying opportunity.
    • Mid case: The current P/CF (price-to-cash flow), based on normalized cash flow of $53.2 million, is 3.27.  But In-Play Oil should eventually be at least 8 x cash flow.  That would make the stock worth $4.77, which is 145% higher than today’s $1.95.
    • High case: If the oil price averages $90 WTI, then cash flow would increase at least 50%.  At 8 x cash flow, IPOOF would be worth $7.16, which is over 265% higher than today’s $1.95.

 

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:  https://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.