(Image: Zen Buddha Silence by Marilyn Barbone.)
April 23, 2017
Michael Shearn is the author of The Investment Checklist (Wiley, 2012), a very good book about how to research stocks.
For investors who have a long-term investment time horizon, micro-cap value stocks should be a major focus. I launched the Boole Microcap Fund to create a very low-cost way for investors to invest in undervalued micro-cap stocks. Boole currently uses a fully quantitative investment strategy. (Ultimately Boole will use an early form of artificial intelligence, which is a natural extension of a fully quantitative strategy.)
For investors who use a fully quantitative strategy, it’s worthwhile to review good investment checklists like Shearn’s. Although in practice, a quantitative micro-cap strategy can rely primarily on a few simple metrics – for example, a high EBIT/EV and a high Piotroski F-Score – one must regularly look for ways to improve the formula.
Shearn writes that he came up with his checklist by studying his own mistakes, and also by studying mistakes other investors and executives had made. Shearn says the checklist helps an investor to focus on what’s important. Shearn argues that a checklist also helps one to fight against the strong human tendency to seek confirming evidence while ignoring disconfirming evidence.
Shearn explains how the book is organized:
The three most common investing mistakes relate to the price you pay, the management team you essentially join when you invest in a company, and your failure to understand the future economics of the business you’re considering investing in. (page xv)
There are many ways to find investment ideas. One of the best ways to find the most potential investment ideas is to look at micro-cap stocks trading at high EBIT/EV (or, equivalently, low EV/EBIT) and with a high Piotroski F-Score.
Micro-cap stocks perform best over time. See: http://boolefund.com/best-performers-microcap-stocks/
Low EV/EBIT – equivalently, high EBIT/EV – does better than the other standard measures of cheapness such as low P/E, low P/S, and low P/B. See:
- Quantitative Value (Wiley, 2013), by Wesley Gray and Tobias Carlisle
- Deep Value (Wiley, 2014), Tobias Carlisle
A high Piotroski F-Score is most effective when applied to cheap micro-cap stocks. See: http://boolefund.com/joseph-piotroski-value-investing/
In sum, if you focus on micro-cap stocks trading at a high EBIT/EV and with a high Piotroski F-Score, you should regularly find many potentially good investment ideas. This is essentially the process used by the Boole Microcap Fund.
There are, of course, many other good ways to find ideas. Shearn mentions forced selling, such as when a stock is dropped from an index. Also, spin-offs typically involve some forced selling. Moreover, the 52-week low list and other new-low lists often present interesting ideas.
Looking for the areas of greatest distress can lead to good investment opportunities. For instance, some offshore oil drillers appear to be quite cheap from a three- to five-year point of view assuming oil returns to a market clearing price of $60-70.
CONCENTRATED VS. QUANTITATIVE
A fully quantitative approach can work quite well. Ben Graham, the father of value investing, often used a fully quantitative approach. Graham constructed a portfolio of the statistically cheapest stocks, according to various metrics like low P/E or low P/B.
I’ve already noted that the Boole Microcap Fund uses a fully quantitative approach: micro-cap stocks with a high EBIT/EV and a high Piotroski F-Score. This particular quantitative strategy has the potential to beat both the Russell Microcap Index and the S&P 500 Index by solid margins over time.
But there are a few ways that you can possibly do better than the fully quantitative micro-cap approach I’ve outlined. One way is using the same quantitative approach as a screen, doing in-depth research on several hundred candidates, and then building a very concentrated portfolio of the best 5 to 8 ideas.
In practice, it is extremely difficult to make the concentrated approach work. The vast majority of investors are better off using a fully quantitative approach (which selects the best 20 to 30 ideas, instead of the best 5 to 8 ideas).
The key ingredient to make the concentrated strategy work is passion. Some investors truly love learning everything possible about hundreds of companies. If you develop such a passion, and then apply it for many years, it’s possible to do better than a purely quantitative approach, especially if you’re focusing on micro-cap stocks. Micro-cap stocks are the most inefficiently priced part of the market because most professional investors never look there. Moreover, many micro-cap companies are relatively simple businesses that are easier for the investor to understand.
I’m quite passionate about value investing, including micro-cap value investing. But I’m also passionate about fully automated investing, whether via index funds or quantitative value funds. I know that low-cost broad market index funds are the best long-term investment for most investors. Low-cost quantitative value funds – especially if focused on micro caps – can do much better than low-cost broad market index funds.
I am more passionate about perfecting a fully quantitative investment strategy – ultimately by using an early form of artificial intelligence – than I am about studying hundreds of micro-cap companies in great detail. I know that a fully quantitative approach that picks the best 20 to 30 micro-cap ideas is very likely to perform better than my best 5 to 8 micro-cap ideas over time
Also, once value investing can be done well by artificial intelligence, it won’t be long before the best AI value investor will be better than the best human value investor. Very few people thought that a computer could beat Garry Kasparov at chess, but IBM’s Deep Blue achieved this feat in 1997. Similarly, few people thought that a computer could beat human Jeopardy! champions. But IBM’s Watson trounced Ken Jennings and Brad Rutter at Jeopardy! in 2011.
Although investing is far more complex than chess or Jeopardy!, there is no reason to think that a form of artificial intelligence will not someday be better than the best human investors. This might not happen for many decades. But that it eventually will happen is virtually inevitable. Scientists will figure out, in ever more detail, exactly how the human brain functions. And scientists will eventually design a digital brain that can do everything the best human brain can do.
The digital brain will get more and more powerful, and faster and faster. And at some point, the digital brain is likely to gain the ability to accelerate its own evolution (perhaps by re-writing its source code). Some have referred to such an event – a literal explosion in the capabilities of digital superintelligence, leading to an explosion in technological progress – as the singularity.
UNDERSTANDING THE BUSINESS
If you’re going to try to pick stocks, then, notes Shearn, a good question to ask is: How would you evaluate this business if you were to become its CEO?
If you were to become CEO of a given business, then you’d want to learn everything you could about the industry and about the company. To really understand a business can easily take 6-12 months or even longer, depending on your prior experience and prior knowledge, and also depending upon the size and complexity of the business. (Micro-cap companies tend to be much easier to understand.)
You should read at least ten years’ worth of annual reports (if available). If you’re having difficulty understanding the business, Shearn recommends asking yourself what the customer’s world would look like if the business (or industry) did not exist.
You should understand exactly how the business makes money. You’d also want to understand how the business has evolved over time. (Many businesses include their corporate history on their website.)
UNDERSTANDING THE BUSINESS – FROM THE CUSTOMER PERSPECTIVE
The more you can understand a business from the customer’s perspective, the better position you will be in to value that business, because satisfied customers are the best predictor of future earnings for a business. As Dave and Sherry Gold, co-founders of dollar store retailer 99 Cent Only Stores, often say, ‘The customer is CEO.’ (page 39)
To gain an understanding of the customers, Shearn recommends that you interview some customers. Most investors never interview customers. So if you’re willing to spend the time interviewing customers, you can often gain good insight into the business that many other investors won’t have.
Shearn says it’s important to identify the core customers, since often a relatively small percentage of customers will represent a large chunk of the company’s revenues. Core customers may also reveal how the business caters to them specifically. Shearn gives an example:
Paccar is a manufacturer of heavy trucks that is a great example of a company that has built its product around its core customer, the owner operator. Owner operators buy the truck they drive and spend most of their time in it. They work for themselves, either contracting directly with shippers or subcontracting with big truck companies. Owner operators care about quality first, and want amenities, such as noise-proofed sleeper cabins with luxury-grade bedding and interiors. They also want the truck to look sharp, and Paccar makes its Peterbilt and Kenworth brand trucks with exterior features to please this customer. Paccar also backs up the driver with service features, such as roadside assistance and a quick spare parts network. Because owner operators want this level of quality and service, they are less price sensitive, and they will pay 10 percent more for these brands. (page 42)
Shearn writes that you want to find out how easy or difficult it is to convince customers to buy the products or services. Obviously a business with a product or service that customers love is preferable as an investment, other things being equal.
A related question is: what is the customer retention rate? The longer the business retains a customer, the more profitable the business is. Also, loyal customers make future revenues more predictable, which in itself can lead to higher profits. Businesses that carefully build long-term relationships with their customers are more likely to do well. Are sales people rewarded just for bringing in a customer, or are they also rewarded for retaining a customer?
You need to find out what pain the business alleviates for the customer, as well. Similarly, you want to find out how essential the product or service is. This will give you insight into how important the product or service is for the customers. Shearn suggests the question: If the business disappeared tomorrow, what impact would this have on the customer base?
EVALUATING THE STRENGTHS AND WEAKNESSES OF A BUSINESS AND INDUSTRY
Not only do you want to find out if the business has a sustainable competitive advantage. But you also want to learn if the industry is good, writes Shearn. And you want to find out about supplier relations.
Shearn lists common sources of sustainable competitive advantage:
- Network economics
- Brand loyalty
- Regulatory licenses
- Switching costs
- Cost advantages stemming from scale, location, or access to a unique asset
If a product or service becomes more valuable if more customers use it, then the business may have a sustainable competitive advantage from network economics. Facebook becomes more valuable to a wider range of people as more and more people use it.
If customers are loyal to a particular brand and if the business can charge a premium price, this creates a sustainable competitive advantage. Coca-Cola has a very strong brand. So does See’s Candies (owned by Berkshire Hathaway).
A patent legally protects a product or service over a 17- to 20-year period. If a patented product or service has commercial value, then the patent is a source of sustainable competitive advantage.
Regulatory licenses – by limiting competition – can be a source of sustainable competitive advantage.
Switching costs can create a sustainable competitive advantage. If it has taken time to learn new software, for example, that can create a high switching cost.
There are various cost advantages that can be sustainable. If there are high fixed-costs in a given industry, then as a business grows larger, it can benefit from lower per-unit costs. Sometimes a business has a cost advantage by its location or by access to a unique asset.
Sustainable Competitive Advantages Are Rare
Even if a business has had a sustainable competitive advantage for some time, that does not guarantee that it will continue to have one going forward. Any time a business is earning a high ROIC – more specifically, a return on invested capital that is higher than the cost of capital – competitors will try to take some of those excess returns. That is the essence of capitalism. High ROIC usually reverts to the mean (average ROIC) due to competition and/or due to changes in technology.
Most Investment Gains Are Made During the Development Phase
Shearn points out that most of the gains from a sustainable competitive advantage come when the business is still developing, rather than when the business is already established. The biggest gains on Wal-Mart’s stock occurred when the company was developing. Similarly for Microsoft, Amazon, or Apple.
Pricing power is usually a function of a sustainable competitive advantage. Businesses that have pricing power tend to have a few characteristics in common, writes Shearn:
- They usually have high customer-retention rates
- Their customers spend only a small percentage of their budget on the business’s product or service
- Their customers have profitable business models
- The quality of the product is more important than the price
Nature of Industry and Competitive Landscape
Some industries, like software, may be considered “good” in that the best companies have a sustainable competitive advantage as represented by a sustainably high ROIC.
But an industry with high ROIC’s, like software, is hyper-competitive. Competition and/or changes in technology can cause previously unassailable competitive advantages to disappear entirely.
It’s important to examine companies that failed in the past. Why did they fail?
IMPORTANT: Stock Price
As a value investor, depending upon the price, a low-quality asset can be a much better investment than a high-quality asset. This is a point Shearn doesn’t mention but should. As Howard Marks explains:
A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy. The tendency to mistake objective merit for investment opportunity, and the failure to distinguish between good assets and good buys, gets most investors into trouble.
Does the business have a good relationship with its suppliers? Does the business help suppliers to innovate? Is the business dependent on only a few suppliers?
MEASURING THE OPERATING AND FINANCIAL HEALTH OF THE BUSINESS
Shearn explains why the fundamentals – the things a business has to do in order to be successful – are important:
As an investor, identifying and tracking fundamentals puts you in a position to more quickly evaluate a business. If you already understand the most critical measures of a company’s operational health, you will be better equipped to evaluate unexpected changes in the business or outside environment. Such changes often present buying opportunities if they affect the price investors are willing to pay for a business without affecting the fundamentals of the business. (page 99)
Moreover, there are specific operating metrics for a given business or industry that are important to track. Monitoring the right metrics can give you insight into any changes that may be significant. Shearn lists the following industry primers:
- Reuters Operating Metrics
- Standard & Poor’s Industry Surveys
- Fisher Investment guides
Shearn also mentions internet search and books are sources for industry metrics. Furthermore, there are trade associations and trade journals.
Shearn suggests monitoring the appropriate metrics, and writing down any changes that occur over three- to five-year periods. (Typically a change over just one year is not enough to draw a conclusion.)
Companies list their key risks in the 10-K in the section Risk Factors. It is obviously important to identify what can go wrong. Shearn:
…it is important for you to spend some time in this section and investigate whether the business has encountered the risks listed in the past and what the consequences were. This will help you understand how much impact each risk may have. (page 106)
You would like to identify how each risk could impact the value of the business. You may want to use scenario analysis of the value of the business in order to capture specific downside risks.
Shearn advises thinking like an insurance underwriter about the risks for a given business. What is the frequency of a given risk – in other words, how often has it happened in the past? And what is the severity of a given risk – if the downside scenario materializes, what impact will that have on the value of the business? It is important to study what has happened in the past to similar businesses and/or to businesses that were in similar situations. This allows you to develop a better idea of the frequency – i.e., the base rate – of specific risks.
Is the Balance Sheet Strong or Weak?
A strong balance sheet allows the business not only to survive, but in some cases, to thrive by being able to take advantage of opportunities. A weak balance sheet, on the other hand, can mean the difference between temporary difficulties and insolvency.
You need to figure out if future cash flows will be enough to make future debt payments.
For value investors in general, the advice given by Graham, Buffett, and Munger is best: Avoid companies with high debt. The vast majority of the very best value investments ever made involved companies with low debt or no debt. Therefore, it is far simpler just to avoid companies with high debt.
Occasionally there may be equity stub situations where the potential upside is so great that a few value investors may want to carefully consider it. Then you would have to determine what the liquidity needs of the business are, what the debt-maturity schedule is, whether the interest rates are fixed or variable, what the loan covenants indicate, and whether specific debts are resource or non-recourse.
Return on Reinvestment or RONIC
It’s not high historical ROIC that counts:
What counts is the ability of a business to reinvest its excess earnings at a high ROIC, which is what creates future value. (page 129)
You need to determine the RONIC – return on new invested capital. How much of the excess earnings can the company reinvest and at what rate of return?
How to Improve ROIC
Shearn gives two ways a business can improve its ROIC:
- Using capital more efficiently, such as managing inventory better or managing receivables better, or
- Increasing profit margins, instead of through one-time, non-operating boosts to cash earnings.
A supermarket chain has low net profit margins, so it must have very high inventory turnover to be able to generate high ROIC. On the other hand, a steel manufacturer has low asset turnover, therefore it must achieve a high profit margin in order to generate high ROIC.
EVALUATING THE DISTRIBUTION OF EARNINGS (CASH FLOWS)
Scenario analysis is useful when there is a wide range of future earnings. As mentioned earlier, some offshore oil drillers appear very cheap right now on the assumption that oil returns to a market clearing price of $60-70 a barrel within the next few years. If it takes five years for oil to return to $60-70, then many offshore oil drillers will have lower intrinsic value (a few may not survive). If it takes three years (or less) for oil to return to $60-70, then some offshore drillers are likely very cheap compared to their normalized earnings.
Compare Cash Flow from Operations to Net Income
As Shearn remarks, management has much less flexibility in manipulating cash flow from operations than it does net income because the latter includes many subjective estimates. Over the past one to five years, cash flow from operations should closely approximate net income, otherwise there may be earnings manipulation.
If the accounting is conservative and straightforward, that should give you more confidence in management than if the accounting is liberal and hard to understand. Shearn lists some ways management can manipulate earnings:
- Improperly inflating sales
- Under- or over-stating expenses
- Manipulating discretionary costs
- Changing accounting methods
- Using restructuring charges to increase future earnings
- Creating reserves by manipulating estimates
Management can book a sale before the revenue is actually earned in order to inflate revenues.
Management can capitalize an expense over several time periods, which shifts some current expenses to later periods thereby boosting short-term earnings. Expenses commonly capitalized include start-up costs, R&D expenses, software development, maintenance costs, marketing, and customer-acquisition costs. Shearn says you can find out whether a business routinely capitalizes its costs by reading the footnotes to the financial statements.
Manipulating discretionary costs is common, writes Shearn. Most companies try to meet their quarterly earnings goals. Most great owner operator businesses – like Warren Buffett’s Berkshire Hathaway or Henry Singleton’s Teledyne – spend absolutely no time worrying about short-term (including quarterly) earnings.
Managers often extend the useful life of particular assets, which reduces quarterly depreciation expenses.
A business reporting a large restructuring loss may add extra expenses in the restructuring charge in order to reduce future expenses (and boost future earnings).
Management can overstate certain reserve accounts in order to draw on those reserves during future bad times (in order to boost earnings during those bad times). Reserves can be booked for: bad debts, sales returns, inventory obsolescence, warranties, product liability, litigation, or environmental contingencies.
If a business has high operating leverage, then it is more difficult to forecast future earnings. Again, scenario analysis can help in this situation.
High operating leverage means that a relatively small change in revenues can have a large impact on earnings. A business with high fixed costs has high operating leverage, whereas a business with low fixed costs has low operating leverage.
For example, as Shearn records, in 2008, Boeing reported that revenues decreased 8.3 percent and operating income decreased 33.9 percent.
The amount of working capital a business needs depends on the capital intensity and the speed at which a business can turn its inventory into cash. The shorter the commitment or cycle, the less cash is tied up and the more a business can use the cash for other internal purposes. (page 163)
Boeing takes a long time to turn sheet metal and various electronics into an airplane. Restaurants, on the other hand, turn inventories into cash quite quickly.
The Cash Conversion Cycle (CCC) tells you how quickly a company can turn its inventory and receivables into cash and pay its short-term obligations.
CCC = Inventory conversion period (Days)
+ Receivables conversion period (Days)
– Payables conversion period (Days)
When a company has more current liabilities than current assets, that means it has negative working capital. In this situation, the customers and suppliers are financing the business, so growth is less expensive. Typically cash flow from operations will exceed net income for a business with negative working capital.
Negative working capital is only good as long as sales are growing, notes Shearn.
MANAGEMENT – BACKGROUND AND CLASSIFICATION
Sound management is usually essential for a business to do well, although ideally, as Buffett joked, you want a business so good that any idiot can run it, because eventually one will.
Shearn offers good advice on how to judge management:
It is best to evaluate a management team over time. By not rushing into investment decisions and by taking the time to understand a management team, you can reduce your risk of misjudging them. Most errors in assessing managers are made when you try to judge their character quickly or when you see only what you want to see and ignore flaws or warning signs. The more familiar you are with how managers act under different types of circumstances, the better you are able to predict their future actions. Ideally, you want to understand how managers have operated in both difficult and favorable circumstances. (pages 174-175)
Types of managers
- Long-tenured manager
- Hired hand
An owner-operator is a manager who has a genuine passion for the business and is typically the founder. Shearn gives examples:
- Sam Walton, founder of Wal-Mart
- Dave and Sherry Gold, co-founders of 99 Cent Only Stores
- Joe Mansueto, founder of Morningstar
- John Mackey, co-founder of Whole Foods Market
- Warren Buffett, CEO of Berkshire Hathaway
- Founders of most family-controlled businesses
These passionate leaders run the business for key stakeholders such as customers, employees, and shareholders alike… They typically are paid modestly and have high ownership interests in the business. (page 177)
(Shearn also defines a second and third type of owner-operator to the extent that the owner-operator runs the business for their own benefit.)
A long-tenured manager has worked at the business for at least three years. (A second type of long-tenured manager joined from outside the business, but worked in the same industry.)
A hired hand is a manager who has joined from outside the business, but who has worked in a related industry. (Shearn defines a second type of hired hand who has worked in a completely unrelated industry.)
The Importance of Tenure in Operating the Business
Out of the 500 businesses in the S&P 500, only 28 have CEOs who have held office for more than 15 years (this is as of the year 2012, when Shearn was writing). Of these 28 long-term CEOs, 25 of them had total shareholder returns during their tenures that beat the S&P 500 index (including dividends reinvested).
Management Style: Lions and Hyenas
Based on an interview with Seng Hock Tan, Shearn distinguishes between Lion Managers and Hyena Managers.
- Committed to ethical and moral values
- Thinking long term and maintains a long-term focus
- Does not take shortcuts
- Thirsty for knowledge and learning
- Supports partners and alliances
- Treats employees as partners
- Admires perseverance
- Has little interest in ethics and morals
- Thinks short term
- Just wants to win the game
- Has little interest in knowledge and learning
- A survivor and an opportunist
- Treats employees as expenses
- Admires tactics, resourcefulness, and guile
Shearn observes that it can be risky to have a top executive who does not have a background in the day-to-day operations of the business.
Low Salaries and High Stock Ownership
Ideally, managers will be incentivized based high stock ownership (and comparatively low salaries) as a function of building long-term business value. This aligns management incentives with shareholder interests.
You also want managers who are generous to all employees in terms of stock ownership. This means the managers and employees have similar incentives (which are aligned with shareholder interests).
Finally, you want managers who gradually increase their ownership interest in the business over time.
MANAGEMENT – COMPETENCE
Obviously you prefer a good manager, not only because the business will tend to do better over time, but also because you won’t have to spend time worrying.
Shearn on a CEO who manages the business for all stakeholders:
If you were to ask investors whether shareholder value is more important than customer service at a business, most would answer that it is. What they fail to consider is that shareholder value is a byproduct of a business that keeps its customers happy. In fact, many of the best-performing stocks over the long term are the ones that balance the interests of all stakeholder groups, including customers, employees, suppliers, and other business partners. These businesses are managed by CEOs who have a purpose greater than solely generating profits for their shareholders. (pages 210-211)
Shearn mentions John Mackey, co-founder and CEO of Whole Foods Market, who coined the term conscious capitalism to describe businesses designed to benefit all stakeholders. Shearn quotes Mackey:
Long-term profits come from having a deeper purpose, great products, satisfied customers, happy employees, great suppliers, and from taking a degree of responsibility for the community and environment we live in. The paradox of profits is that, like happiness, they are best achieved by not aiming directly for them.
Continuous Incremental Improvement
Contrary to popular belief, most successful businesses are built on hundreds of small decisions, instead of on one well-formulated strategic plan. For example, when most successful entrepreneurs start their business, they do not have a business plan stating what their business will look like in 2, 5, or 10 years. They instead build their business day by day, focusing on customer needs and letting these customer needs shape the direction of their business. It is this stream of everyday decisions over time that accounts for great outcomes, instead of big one-time decisions….
Another common theme among businesses that improve day by day is that they operate on the premise that it is best to repeatedly launch a product or service with a limited number of its customers so that it can use customer reactions and feedback to modify it. They operate on the premise that it is okay to learn from mistakes…
You need to determine if the management team you are investing in works on proving a concept before investing a lot of capital in it or whether it prefers to put a lot of money in all at once hoping for a big payoff. (page 215)
PIPER = persistent incremental progress eternally repeated
As CEO, Henry Singleton was one of the best capital allocators in American business history. Under Singleton, Teledyne stock compounded at 17.9 percent over 25 years (or a 53x return, vs. 6.7x for the S&P 500 Index).
Singleton believed that the best plan was no plan, as he once explained at an annual meeting:
…we’re subject to a tremendous number of outside influences, and the vast majority of them cannot be predicted. So my idea is to stay flexible. I like to steer the boat each day rather than plan ahead way into the future.
Shearn points out that one major problem with a strategic plan is the commitment and consistency principle (see Robert Cialdini’s Influence). When people make a public statement, they tend to have a very difficult time admitting they were wrong and changing course when the evidence calls for it. Similarly, notes Shearn, strategic plans can make people blind to other opportunities.
When managers give short-term guidance, it can have similar effects as a strategic plan. People may make decisions that harm long-term business value just in order to hit short-term (statistically meaningless) numbers. Also, managers may even start borrowing from the future in order to meet the numbers. Think of Enron, WorldCom, Tyco, Adelphia, and HealthSouth, says Shearn.
Does management value its employees?
…Try to understand if the management team values its employees because the only way it will obtain positive results is through these people.
When employees feel they are partners with their boss in a mutual effort, rather than merely employees of some business run by managers they never see, morale will increase. Furthermore, when a business has good employee relations, it typically has many other good attributes, such as good customer relations and the ability to adapt quickly to changing economic circumstances. (page 225)
Are the CEO and CFO disciplined in making capital allocation decisions?
As Shearn observes, operating a business and allocating capital involve two completely different skills sets. Many CEOs do not have skill in capital allocation. Capital allocation includes:
- Investing in new projects
- Holding cash on the balance sheet
- Paying dividends
- Buying back stock
- Making acquisitions
One of the best capital allocators in corporate history was Henry Singleton, longtime CEO of Teledyne, who cofounded the business in 1960 and served as CEO until 1986. In John Train’s book The Money Masters, Warren Buffett reported that he believes ‘Henry Singleton has the best operating and capital-deployment record in American business.’ When Teledyne’s stock was trading at extremely high prices in the 1960s, Singleton used the high-priced stock as currency to make acquisitions. Singleton made more than 130 acquisitions of small, high-margin manufacturing and technology businesses that operated in defensible niches managed by strong management. When the price-to-earnings ratio of Teledyne fell sharply starting in the 1970s, he repurchased stock. Between 1972 and 1984, he reduced the share count by more than 90 percent. He repurchased stock for as low as $6 per share in 1972, which by 1987 traded at more than $400 per share. (page 249)
MANAGEMENT – POSITIVE AND NEGATIVE TRAITS
Does the CEO love the money or the business?
This question comes from Warren Buffett. Buffett looks for CEOs who love the business. CEOs who are passionate about their business are more likely to persevere through many difficulties and over long periods of time. CEOs who are passionate about their business are more likely to excel over the long term. As Steve Jobs said in his commencement address to Stanford University students in 2005:
The only way to do great work is to love what you do. If you haven’t found it yet, keep looking. Don’t settle.
If someone has stayed in one industry for a long time, odds are they love their work. If a CEO is very focused on the business, and not worried about appearances or large social or charity events, that’s a good sign the CEO is passionate about the business. Does the CEO direct philanthropic resources to causes they truly care about, or are they involved in ‘social scene philanthropy’?
Are the Managers Lifelong Learners Who Focus on Continuous Improvement?
Lifelong learners are managers who are never satisfied and continually find ways to improve the way they run a business. This drive comes from their passion for the business. It is extremely important for management to constantly improve, especially if a business has been successful for a long period of time. Look for managers who regard success as a base from which they continue to grow, rather than as a final accomplishment. (page 263)
How Have They Behaved Under Adversity?
You never truly know someone’s character until you have seen it tested by stress, adversity, or a crisis, because a crisis produces extremes in behavior… (page 264)
You need to determine how a manager responds to a difficult situation and then evaluate the action they took. Were they calm and intentional in dealing with a negative situation, or were they reactive instead? (page 266)
The best managers are those who quickly and openly communicate how they are thinking about the problem and outline how they are going to solve it. (page 267)
Does Management Think Independently?
…The best managers always maintain a long-term focus, which means that they are often building for years before they see concrete results. For example, in 2009, Jeff Bezos, founder of online retailer Amazon.com, talked about the way that some investors congratulate Amazon.com on success in a single reporting period. ‘I always tell people, if we have a good quarter, it’s because of the work we did three, four, and five years ago. It’s not because we did a good job this quarter.’ (page 275)
The best CEOs think independently.
BOOLE MICROCAP FUND
An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time. See the historical chart here: http://boolefund.com/best-performers-microcap-stocks/
This outperformance increases significantly by focusing on cheap micro caps. Performance can be further boosted by isolating cheap microcap companies that show improving fundamentals. We rank microcap stocks based on these and similar criteria.
There are roughly 10-20 positions in the portfolio. The size of each position is determined by its rank. Typically the largest position is 15-20% (at cost), while the average position is 8-10% (at cost). Positions are held for 3 to 5 years unless a stock approaches intrinsic value sooner or an error has been discovered.
The mission of the Boole Fund is to outperform the S&P 500 Index by at least 5% per year (net of fees) over 5-year periods. We also aim to outpace the Russell Microcap Index by at least 2% per year (net). The Boole Fund has low fees.
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