Boole Microcap Fund

September 24, 2023

Warren Buffett, the world’s greatest investor, earned the highest returns of his career from microcap cigar butts.  Buffett wrote in the 2014 Berkshire Letter:

My cigar-butt strategy worked very well while I was managing small sums.  Indeed, the many dozens of free puffs I obtained in the 1950’s made the decade by far the best of my life for both relative and absolute performance.

Even then, however, I made a few exceptions to cigar butts, the most important being GEICO.  Thanks to a 1951 conversation I had with Lorimer Davidson, a wonderful man who later became CEO of the company, I learned that GEICO was a terrific business and promptly put 65% of my $9,800 net worth into its shares.  Most of my gains in those early years, though, came from investments in mediocre companies that traded at bargain prices.  Ben Graham had taught me that technique, and it worked.

But a major weakness in this approach gradually became apparent:  Cigar-butt investing was scalable only to a point.  With large sums, it would never work well…

Before Buffett led Berkshire Hathaway, he managed an investment partnership from 1957 to 1970 called Buffett Partnership Ltd. (BPL).  While running BPL, Buffett wrote letters to limited partners filled with insights (and humor) about investing and business.  Jeremy C. Miller has written a great book— Warren Buffett’s Ground Rules (Harper, 2016)—summarizing the lessons from Buffett’s partnership letters.

This blog post considers a few topics related to microcap cigar butts:

• Net Nets
• Dempster: The Asset Conversion Play
• Liquidation Value or Earnings Power?
• Mean Reversion for Cigar Butts
• Focused vs. Statistical
• The Rewards of Psychological Discomfort
• Conclusion

 

NET NETS

Here Miller quotes the November 1966 letter, in which Buffett writes about valuing the partnership’s controlling ownership position in a cigar-butt stock:

…Wide changes in the market valuations accorded stocks at some point obviously find reflection in the valuation of businesses, although this factor is of much less importance when asset factors (particularly when current assets are significant) overshadow earnings power considerations in the valuation process…

Ben Graham’s primary cigar-butt method was net nets.  Take net current asset value minus ALL liabilities, and then only buy the stock at 2/3 (or less) of that level.  If you buy a basket (at least 20-30) of such stocks, then given enough time (at least a few years), you’re virtually certain to get good investment results, predominantly far in excess of the broad market.

A typical net-net stock might have $30 million in cash, with no debt, but have a market capitalization of $20 million.  Assume there are 10 million shares outstanding.  That means the company has $3/share in net cash, with no debt.  But you can buy part ownership of this business by paying only $2/share.  That’s ridiculously cheap.  If the price remained near those levels, you could effectively buy $1 million in cash for $667,000—and repeat the exercise many times.

Of course, a company that cheap almost certainly has problems and may be losing money.  But every business on the planet, at any given time, is in either one of two states:  it is having problems, or it will be having problems.  When problems come—whether company-specific, industry-driven, or macro-related—that often causes a stock to get very cheap.

The key question is whether the problems are temporary or permanent.  Statistically speaking, many of the problems are temporary when viewed over the subsequent 3 to 5 years.  The typical net-net stock is so extremely cheap relative to net tangible assets that usually something changes for the better—whether it’s a change by management, or a change from the outside (or both).  Most net nets are not liquidated, and even those that are still bring a profit in many cases.

The net-net approach is one of the highest-returning investment strategies ever devised.  That’s not a surprise because net nets, by definition, are absurdly cheap on the whole, often trading below net cash—cash in the bank minus ALL liabilities.

Buffett called Graham’s net-net method the cigar-butt approach:

…I call it the cigar-butt approach to investing.  You walk down the street and you look around for a cigar butt someplace.  Finally you see one and it is soggy and kind of repulsive, but there is one puff left in it.  So you pick it up and the puff is free – it is a cigar butt stock.  You get one free puff on it and then you throw it away and try another one.  It is not elegant.  But it works.  Those are low return businesses.

Link: http://intelligentinvestorclub.com/downloads/Warren-Buffett-Florida-Speech.pdf

(Photo by Sky Sirasitwattana)

When running BPL, Buffett would go through thousands of pages of Moody’s Manuals (and other such sources) to locate just one or a handful of microcap stocks trading at less than liquidation value.  Other leading value investors have also used this technique.  This includes Charlie Munger (early in his career), Walter Schloss, John Neff, Peter Cundill, and Marty Whitman, to name a few.

The cigar-butt approach is also called deep value investing.  This normally means finding a stock that is available below liquidation value, or at least below net tangible book value.

When applying the cigar-butt method, you can either do it as a statistical group approach, or you can do it in a focused manner.  Walter Schloss achieved one of the best long-term track records of all time—near 21% annually (gross) for 47 years—using a statistical group approach to cigar butts.  Schloss typically had a hundred stocks in his portfolio, most of which were trading below tangible book value.

At the other extreme, Warren Buffett—when running BPL—used a focused approach to cigar butts.  Dempster is a good example, which Miller explores in detail in his book.

 

DEMPSTER: THE ASSET CONVERSION PLAY

Dempster was a tiny micro cap, a family-owned company in Beatrice, Nebraska, that manufactured windmills and farm equipment.  Buffett slowly bought shares in the company over the course of five years.

(Photo by Digikhmer)

Dempster had a market cap of $1.6 million, about $13.3 million in today’s dollars, says Miller.

• Note:  A market cap of $13.3 million is in the $10 to $25 million range—among the tiniest micro caps—which is avoided by nearly all investors, including professional microcap investors.

Buffett’s average price paid for Dempster was $28/share.  Buffett’s estimate of liquidation value early on was near $35/share, which is intentionally conservative.  Miller quotes one of Buffett’s letters:

The estimated value should not be what we hope it would be worth, or what it might be worth to an eager buyer, etc., but what I would estimate our interest would bring if sold under current conditions in a reasonably short period of time.

To estimate liquidation value, Buffett followed Graham’s method, as Miller explains:

• cash, being liquid, doesn’t need a haircut
• accounts receivable are valued at 85 cents on the dollar
• inventory, carried on the books at cost, is marked down to 65 cents on the dollar
• prepaid expenses and “other” are valued at 25 cents on the dollar
• long-term assets, generally less liquid, are valued using estimated auction values

Buffett’s conservative estimate of liquidation value for Dempster was $35/share, or $2.2 million for the whole company.  Recall that Buffett paid an average price of $28/share—quite a cheap price.

Even though the assets were clearly there, Dempster had problems.  Stocks generally don’t get that cheap unless there are major problems.  In Dempster’s case, inventories were far too high and rising fast.  Buffett tried to get existing management to make needed improvements.  But eventually Buffett had to throw them out.  Then the company’s bank was threatening to seize the collateral on the loan.  Fortunately, Charlie Munger—who later became Buffett’s business partner—recommended a turnaround specialist, Harry Bottle.  Miller:

Harry did such an outstanding job whipping the company into shape that Buffett, in the next year’s letter, named him “man of the year.”  Not only did he reduce inventories from $4 million to $1 million, alleviating the concerns of the bank (whose loan was quickly repaid), he also cut administrative and selling expenses in half and closed five unprofitable branches.  With the help of Buffett and Munger, Dempster also raised prices on their used equipment up to 500% with little impact to sales volume or resistance from customers, all of which worked in combination to restore a healthy economic return in the business.

Miller explains that Buffett rationally focused on maximizing the return on capital:

Buffett was wired differently, and he achieves better results in part because he invests using an absolute scale.  With Dempster he wasn’t at all bogged down with all the emotional baggage of being a veteran of the windmill business.  He was in it to produce the highest rate of return on the capital he had tied up in the assets of the business.  This absolute scale allowed him to see that the fix for Dempster would come by not reinvesting back into windmills.  He immediately stopped the company from putting more capital in and started taking the capital out.

With profits and proceeds raised from converting inventory and other assets to cash, Buffett started buying stocks he liked.  In essence, he was converting capital that was previously utilized in a bad (low-return) business, windmills, to capital that could be utilized in a good (high-return) business, securities.

Bottle, Buffett, and Munger maximized the value of Dempster’s assets.  Buffett took the further step of not reinvesting cash in a low-return business, but instead investing in high-return stocks.  In the end, on its investment of $28/share, BPL realized a net gain of $45 per share.  This is a gain of a bit more than 160% on what was a very large position for BPL—one-fifth of the portfolio.  Had the company been shut down by the bank, or simply burned through its assets, the return after paying $28/share could have been nothing or even negative.

Miller nicely summarizes the lessons of Buffett’s asset conversion play:

Buffett teaches investors to think of stocks as a conduit through which they can own their share of the assets that make up a business.  The value of that business will be determined by one of two methods: (1) what the assets are worth if sold, or (2) the level of profits in relation to the value of assets required in producing them.  This is true for each and every business and they are interrelated…

Operationally, a business can be improved in only three ways: (1) increase the level of sales; (2) reduce costs as a percent of sales; (3) reduce assets as a percentage of sales.  The other factors, (4) increase leverage or (5) lower the tax rate, are the financial drivers of business value.  These are the only ways a business can make itself more valuable.

Buffett “pulled all the levers” at Dempster…

 

LIQUIDATION VALUE OR EARNINGS POWER?

For most of the cigar butts that Buffett bought for BPL, he used Graham’s net-net method of buying at a discount to liquidation value, conservatively estimated.  However, you can find deep value stocks—cigar butts—on the basis of other low “price-to-a-fundamental” ratio’s, such as low P/E or low EV/EBITDA.  Even Buffett, when he was managing BPL, used a low P/E in some cases to identify cigar butts.  (See an example below: Western Insurance Securities.)

Tobias Carlisle and Wes Gray tested various measures of cheapness from 1964 to 2011.  Quantitative Value (Wiley, 2012)—an excellent book—summarizes their results.  James P. O’Shaughnessy has conducted one of the broadest arrays of statistical backtests.  See his results in What Works on Wall Street (McGraw-Hill, 4^th edition, 2012), a terrific book.

(Illustration by Maxim Popov)

• Carlisle and Gray found that low EV/EBIT was the best-performing measure of cheapness from 1964 to 2011.  It even outperformed composite measures.
• O’Shaughnessy learned that low EV/EBITDA was the best-performing individual measure of cheapness from 1964 to 2009.
• But O’Shaughnessy also discovered that a composite measure—combining low P/B, P/E, P/S, P/CF, and EV/EBITDA—outperformed low EV/EBITDA.

Assuming relatively similar levels of performance, a composite measure is arguably better because it tends to be more consistent over time.  There are periods when a given individual metric might not work well.  The composite measure will tend to smooth over such periods.  Besides, O’Shaughnessy found that a composite measure led to the best performance from 1964 to 2009.

Carlisle and Gray, as well as O’Shaughnessy, didn’t include Graham’s net-net method in their reported results.  Carlisle wrote another book, Deep Value (Wiley, 2014)—which is fascinating—in which he summarizes several tests of net nets:

• Henry Oppenheimer found that net nets returned 29.4% per year versus 11.5% per year for the market from 1970 to 1983.
• Carlisle—with Jeffrey Oxman and Sunil Mohanty—tested net nets from 1983 to 2008.  They discovered that the annual returns for net nets averaged 35.3% versus 12.9% for the market and 18.4% for a Small Firm Index.
• A study of the Japanese market from 1975 to 1988 uncovered that net nets outperformed the market by about 13% per year.
• An examination of the London Stock Exchange from 1981 to 2005 established that net nets outperformed the market by 19.7% per year.
• Finally, James Montier analyzed all developed markets globally from 1985 to 2007.  He learned that net nets averaged 35% per year versus 17% for the developed markets on the whole.

Given these outstanding returns, why didn’t Carlisle and Gray, as well as O’Shaughnessy, consider net nets?  Primarily because many net nets are especially tiny microcap stocks.  For example, in his study, Montier found that the median market capitalization for net nets was $21 million.  Even the majority of professionally managed microcap funds do not consider stocks this tiny.

• Recall that Dempster had a market cap of $1.6 million, or about $13.3 million in today’s dollars.
• Unlike the majority of microcap funds, the Boole Microcap Fund does consider microcap stocks in the $10 to $25 million market cap range.

In 1999, Buffett commented that he could get 50% per year by investing in microcap cigar butts.  He was later asked about this comment in 2005, and he replied:

Yes, I would still say the same thing today.  In fact, we are still earning those types of returns on some of our smaller investments.  The best decade was the 1950s;  I was earning 50% plus returns with small amounts of capital.  I would do the same thing today with smaller amounts.  It would perhaps even be easier to make that much money in today’s environment because information is easier to access.  You have to turn over a lot of rocks to find those little anomalies.  You have to find the companies that are off the map—way off the map.  You may find local companies that have nothing wrong with them at all.  A company that I found, Western Insurance Securities, was trading for $3/share when it was earning $20/share!!  I tried to buy up as much of it as possible.  No one will tell you about these businesses.  You have to find them.

Although the majority of microcap cigar butts Buffett invested in were cheap relative to liquidation value—cheap on the basis of net tangible assets—Buffett clearly found some cigar butts on the basis of a low P/E.  Western Insurance Securities is a good example.  It had a P/E of 0.15.

 

MEAN REVERSION FOR CIGAR BUTTS

Warren Buffett commented on high quality companies versus statistically cheap companies in his October 1967 letter to partners:

The evaluation of securities and businesses for investment purposes has always involved a mixture of qualitative and quantitative factors.  At the one extreme, the analyst exclusively oriented to qualitative factors would say, “Buy the right company (with the right prospects, inherent industry conditions, management, etc.) and the price will take care of itself.”  On the other hand, the quantitative spokesman would say, “Buy at the right price and the company (and stock) will take care of itself.”  As is so often the pleasant result in the securities world, money can be made with either approach.  And, of course, any analyst combines the two to some extent—his classification in either school would depend on the relative weight he assigns to the various factors and not to his consideration of one group of factors to the exclusion of the other group.

Interestingly enough, although I consider myself to be primarily in the quantitative school… the really sensational ideas I have had over the years have been heavily weighted toward the qualitative side where I have had a “high-probability insight”.  This is what causes the cash register to really sing.  However, it is an infrequent occurrence, as insights usually are, and, of course, no insight is required on the quantitative side—the figures should hit you over the head with a baseball bat.  So the really big money tends to be made by investors who are right on qualitative decisions but, at least in my opinion, the more sure money tends to be made on the obvious quantitative decisions.

Buffett and Munger acquired See’s Candies for Berkshire Hathaway in 1972.  See’s Candies is the quintessential high quality company because of its sustainably high ROIC (return on invested capital) of over 100%.

Truly high quality companies—like See’s—are very rare and difficult to find.  Cigar butts are much easier to find by comparison.

Furthermore, it’s important to understand that Buffett got around 50% annual returns from cigar butts because he took a focused approach, like BPL’s 20% position in Dempster.

The vast majority of investors, if using a cigar-butt approach like net nets, should implement a group—or statistical—approach, and regularly buy and hold a basket of cigar butts (at least 20-30).  This typically won’t produce 50% annual returns.  But net nets, as a group, clearly have produced very high returns, often 30%+ annually.  To do this today, you’d have to look globally.

As an alternative to net nets, you could implement a group approach using one of O’Shaughnessy’s composite measures—such as low P/B, P/E, P/S, P/CF, EV/EBITDA.  Applying this to micro caps can produce 15-20% annual returns.  Still excellent results.  And much easier to apply consistently.

You may think that you can find some high quality companies.  But that’s not enough.  You have to find a high quality company that can maintain its competitive position and high ROIC.  And it has to be available at a reasonable price.

Most high quality companies are trading at very high prices, to the extent that you can’t do better than the market by investing in them.  In fact, often the prices are so high that you’ll probably do worse than the market.

Consider this observation by Charlie Munger:

The model I like to sort of simplify the notion of what goes o­n in a market for common stocks is the pari-mutuel system at the racetrack.  If you stop to think about it, a pari-mutuel system is a market.  Everybody goes there and bets and the odds change based o­n what’s bet.  That’s what happens in the stock market.

Any damn fool can see that a horse carrying a light weight with a wonderful win rate and a good post position etc., etc. is way more likely to win than a horse with a terrible record and extra weight and so o­n and so on.  But if you look at the odds, the bad horse pays 100 to 1, whereas the good horse pays 3 to 2.  Then it’s not clear which is statistically the best bet using the mathematics of Fermat and Pascal.  The prices have changed in such a way that it’s very hard to beat the system.

(Illustration by Nadoelopisat)

A horse with a great record (etc.) is much more likely to win than a horse with a terrible record.  But—whether betting on horses or betting on stocks—you don’t get paid for identifying winners.  You get paid for identifying mispricings.

The statistical evidence is overwhelming that if you systematically buy stocks at low multiples—P/B, P/E, P/S, P/CF, EV/EBITDA, etc.—you’ll almost certainly do better than the market over the long haul.

A deep value (cigar-butt) approach has always worked, given enough time.  Betting on “the losers” has always worked eventually, whereas betting on “the winners” hardly ever works.

Classic academic studies showing “the losers” doing far better than “the winners” over subsequent 3- to 5-year periods:

• Werner De Bondt and Richard Thaler (1985), “Does the Stock Market Overreact?”: https://onlinelibrary.wiley.com/doi/full/10.1111/j.1540-6261.1985.tb05004.x
• De Bondt and Thaler (1987), “Further Evidence on Investor Overreaction and Stock Market Seasonality”: https://www.jstor.org/stable/2328371?seq=1#page_scan_tab_contents
• Josef Lakonishok, Andrei Shleifer, and Robert Vishny (1994), “Contrarian Investment, Extrapolation, and Risk”: http://scholar.harvard.edu/files/shleifer/files/contrarianinvestment.pdf

That’s not to say deep value investing is easy.  When you put together a basket of statistically cheap companies, you’re buying stocks that are widely hated or neglected.  You have to endure loneliness and looking foolish.  Some people can do it, but it’s important to know yourself before using a deep value strategy.

In general, we extrapolate the poor performance of cheap stocks and the good performance of expensive stocks too far into the future.  This is the mistake of ignoring mean reversion.

When you find a group of companies that have been doing poorly for at least several years, those conditions typically do not persist.  Instead, there tends to be mean reversion, or a return to “more normal” levels of revenues, earnings, or cash flows.

Similarly for a group of companies that have been doing exceedingly well.  Those conditions also do not continue in general.  There tends to be mean reversion, but in this case the mean—the average or “normal” conditions—is below recent activity levels.

Here’s Ben Graham explaining mean reversion:

It is natural to assume that industries which have fared worse than the average are “unfavorably situated” and therefore to be avoided.  The converse would be assumed, of course, for those with superior records.  But this conclusion may often prove quite erroneous.  Abnormally good or abnormally bad conditions do not last forever.  This is true of general business but of particular industries as well.  Corrective forces are usually set in motion which tend to restore profits where they have disappeared or to reduce them where they are excessive in relation to capital.

With his taste for literature, Graham put the following quote from Horace’s Ars Poetica at the beginning of Security Analysis—the bible for value investors:

Many shall be restored that now are fallen and many shall fall than now are in honor.

Tobias Carlisle, while discussing mean reversion in Deep Value, smartly (and humorously) included this image of Albrecht Durer’s Wheel of Fortune:

(Albrecht Durer’s Wheel of Fortune from Sebastien Brant’s Ship of Fools (1494) via Wikimedia Commons)

 

FOCUSED vs. STATISTICAL

We’ve already seen that there are two basic ways to do cigar-butt investing: focused vs. statistical (group).

Ben Graham usually preferred the statistical (group) approach.  Near the beginning of the Great Depression, Graham’s managed accounts lost more than 80 percent.  Furthermore, the economy and the stock market took a long time to recover.  As a result, Graham had a strong tendency towards conservatism in investing.  This is likely part of why he preferred the statistical approach to net nets.  By buying a basket of net nets (at least 20-30), the investor is virtually certain to get the statistical results of the group over time, which are broadly excellent.

Graham also was a polymath of sorts.  He had wide-ranging intellectual interests.  Because he knew net nets as a group would do quite well over the long term, he wasn’t inclined to spend much time analyzing individual net nets.  Instead, he spent time on his other interests.

Warren Buffett was Graham’s best student.  Buffett was the only student ever to be awarded an A+ in Graham’s class at Columbia University.  Unlike Graham, Buffett has always had an extraordinary focus on business and investing.  After spending many years learning everything about virtually every public company, Buffett took a focused approach to net nets.  He found the ones that were the cheapest and that seemed the surest.

Buffett has asserted that returns can be improved—and risk lowered—if you focus your investments only on those companies that are within your circle of competence—those companies that you can truly understand.  Buffett also maintains, however, that the vast majority of investors should simply invest in index funds: https://boolefund.com/warren-buffett-jack-bogle/

Regarding individual net nets, Graham admitted a danger:

Corporate gold dollars are now available in quantity at 50 cents and less—but they do have strings attached.  Although they belong to the stockholder, he doesn’t control them.  He may have to sit back and watch them dwindle and disappear as operating losses take their toll.  For that reason the public refuses to accept even the cash holdings of corporations at their face value.

Graham explained that net nets are cheap because they “almost always have an unsatisfactory trend in earnings.”  Graham:

If the profits had been increasing steadily it is obvious that the shares would not sell at so low a price.  The objection to buying these issues lies in the probability, or at least the possibility, that earnings will decline or losses continue, and that the resources will be dissipated and the intrinsic value ultimately become less than the price paid.

(Image by Preecha Israphiwat)

Value investor Seth Klarman warns:

As long as working capital is not overstated and operations are not rapidly consuming cash, a company could liquidate its assets, extinguish all liabilities, and still distribute proceeds in excess of the market price to investors.  Ongoing business losses can, however, quickly erode net-net working capital.  Investors must therefore always consider the state of a company’s current operations before buying.

Even Buffett—nearly two decades after closing BPL—wrote the following in his 1989 letter to Berkshire shareholders:

If you buy a stock at a sufficiently low price, there will usually be some hiccup in the fortunes of the business that gives you a chance to unload at a decent profit, even though the long-term performance of the business may be terrible.  I call this the “cigar butt” approach to investing.  A cigar butt found on the street that has only one puff left in it may not offer much of a smoke, but the “bargain purchase” will make that puff all profit.

Unless you are a liquidator, that kind of approach to buying businesses is foolish.  First, the original “bargain” price probably will not turn out to be such a steal after all.  In a difficult business, no sooner is one problem solved than another surfaces—never is there just one cockroach in the kitchen.  Second, any initial advantage you secure will be quickly eroded by the low return that the business earns.  For example, if you buy a business for $8 million that can be sold or liquidated for $10 million and promptly take either course, you can realize a high return.  But the investment will disappoint if the business is sold for $10 million in ten years and in the interim has annually earned and distributed only a few percent on cost…

Based on these objections, you might think that Buffett’s focused approach is better than the statistical (group) method.  That way, the investor can figure out which net nets are more likely to recover instead of burn through their assets and leave the investor with a low or negative return.

However, Graham’s response was that the statistical or group approach to net nets is highly profitable over time.  There is a wide range of potential outcomes for net nets, and many of those scenarios are good for the investor.  Therefore, while there are always some individual net nets that don’t work out, a group or basket of net nets is nearly certain to work well eventually.

Indeed, Graham’s application of a statistical net-net approach produced 20% annual returns over many decades.  Most backtests of net nets have tended to show annual returns of close to 30%.  In practice, while around 5 percent of net nets may suffer a terminal decline in stock price, a statistical group of net nets has done far better than the market and has experienced fewer down years.  Moreover, as Carlisle notes in Deep Value, very few net nets are actually liquidated or merged.  In the vast majority of cases, there is a change by management, a change from the outside, or both, in order to restore earnings to a level more in line with net asset value.  Mean reversion.

 

THE REWARDS OF PSYCHOLOGICAL DISCOMFORT

We noted earlier that it’s far more difficult to find a company like See’s Candies, at a reasonable price, than it is to find statistically cheap stocks.  Moreover, if you buy a basket of statistically cheap stocks, you don’t have to possess an ability to analyze individual businesses in great depth.

That said, in order to use a deep value strategy, you do have to be able to handle the psychological discomfort of being lonely and looking foolish.

(Illustration by Sangoiri)

John Mihaljevic, author of The Manual of Ideas (Wiley, 2013), writes:

Comfort can be expensive in investing.  Put differently, acceptance of discomfort can be rewarding, as equities that cause their owners discomfort frequently trade at exceptionally low valuations….

…Misery loves company, so it makes sense that rewards may await those willing to be miserable in solitude…

Mihaljevic explains:

If we owned nothing but a portfolio of Ben Graham-style bargain equities, we may become quite uncomfortable at times, especially if the market value of the portfolio declined precipitously.  We might look at the portfolio and conclude that every investment could be worth zero.  After all, we could have a mediocre business run by mediocre management, with assets that could be squandered.  Investing in deep value equities therefore requires faith in the law of large numbers—that historical experience of market-beating returns in deep value stocks and the fact that we own a diversified portfolio will combine to yield a satisfactory result over time.  This conceptually sound view becomes seriously challenged in times of distress…

Playing into the psychological discomfort of Graham-style equities is the tendency of such investments to exhibit strong asset value but inferior earnings or cash flows.  In a stressed situation, investors may doubt their investment theses to such an extent that they disregard the objectively appraised asset values.  After all—the reasoning of a scared investor might go—what is an asset really worth if it produces no cash flow?

Deep value investors often find some of the best investments in cyclical areas.  A company at a cyclical low may have multi-bagger potential—the prospect of returning 300-500% (or more) to the investor.

Mihaljevic comments on a central challenge of deep value investing in cyclical companies:

The question of whether a company has entered permanent decline is anything but easy to answer, as virtually all companies appear to be in permanent decline when they hit a rock-bottom market quotation.  Even if a business has been cyclical in the past, analysts generally adopt a “this time is different” attitude.  As a pessimistic stock price inevitably influences the appraisal objectivity of most investors, it becomes exceedingly difficult to form a view strongly opposed to the prevailing consensus.

Consider the following industries that have been pronounced permanently impaired in the past, only to rebound strongly in subsequent years:  Following the financial crisis of 2008-2009, many analysts argued that the banking industry would be permanently negatively affected, as higher capital requirements and regulatory oversight would compress returns on equity.  The credit rating agencies were seen as impaired because the regulators would surely alter the business model of the industry for the worse following the failings of the rating agencies during the subprime mortgage bubble.  The homebuilding industry would fail to rebound as strongly as in the past, as overcapacity became chronic and home prices remained tethered to building costs.  The refining industry would suffer permanently lower margins, as those businesses were capital-intensive and driven by volatile commodity prices.

 

CONCLUSION

Buffett has made it clear, including in his 2014 letter to shareholders, that the best returns of his career came from investing in microcap cigar butts.  Most of these were mediocre businesses (or worse).  But they were ridiculously cheap.  And, in some cases like Dempster, Buffett was able to bring about needed improvements when required.

When Buffett wrote about buying wonderful businesses in his 1989 letter, that’s chiefly because investable assets at Berkshire Hathaway had grown far too large for microcap cigar butts.

Even in recent years, Buffett invested part of his personal portfolio in a group of cigar butts he found in South Korea.  So he’s never changed his view that an investor can get the highest returns from microcap cigar butts, either by using a statistical group approach or by using a more focused method.

 

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.

September 17, 2023

Hilary Kramer is the author of The Little Book of Big Profits from Small Stocks (2012, Wiley).  Kramer is a highly successful investor who has made most of her money by investing in single-digit priced stocks.  She reveals her methods in this book.

Important Note:  I am a value investor.  I am looking to buy stocks at 50% or less of intrinsic value.  Kramer’s approach is similar in many ways, but she is not a value investor per se.  Kramer is still trying to buy stocks for less than they are worth, either relative to future earnings or relative to book value.

Kramer writes:

So why aren’t more Main Street investors looking to low-priced stocks?  Well, one of the biggest beliefs on Wall Street is that stocks under $10 are too dangerous for most investors.  Many institutional investors, such as mutual funds and pensions, are actually prohibited from owning stocks that trade in the single digits.  Stock that have fallen below that magic $10 mark often lose the attention of the research departments, so no analysts follow them and they tend to be ignored.  Wall Street often treats the single-digit priced stock sector as a graveyard, best passed as quickly as possible while whistling on the way to other endeavors.

Kramer has identified three categories of low-priced stocks:

• • Fall angels: These are large company stocks that have stumbled and fallen out of favor for various reasons.  Some are cyclical stocks, while some were companies where management made mistakes and earnings fell short of Wall Street expectations.
  • Undiscovered growth companies: Many of these happen to be overlooked because they are in unattractive industries.
  • Bargain bin stocks: These are stocks trading below book value.

Kramer notes that it’s essential to read the company’s financial statements and investor presentations.  There’s no easy way to high stock market profits.

Here’s an outline:

• • The Classic Under $10 Stock
  • The Price Is Not Just Right, It’s Critical
  • Oh, How the Mighty Have Fallen
  • Growing Out of Sight
  • Shopping the Bargain Bin
  • Getting the World Healthy and Wealthy
  • Around the World Under $10
  • Forget Everything You Thought You Knew
  • Looking for the Right Stuff
  • Well Bought is Half Sold
  • Beware the Wolves of Wall Street
  • Low Prices and High Profits

 

THE CLASSIC UNDER $10 STOCK

Kramer mentions Darling International (DAR) as the classic $10 stock.  The company collects used cooking oil and grease from restaurants all over the United States.  Another division stops at slaughterhouses and butcher shops to collect hides, bone, and other animal by-products.  They turn all this unusable stuff into useable products.

Kramer noticed Darling stock when it fell from $16 to $4.  She found that Darling’s competitors were small, locally-owned companies that had a hard time competing with Darling’s economies of scale.  At the time, the company had 39 facilities around the United States and 970 trucks and tractor-trailers collecting raw materials from 115,000 locations.  Most of Darling’s customers were on long-term contracts.

Darling was growing rapidly both organically and by acquisition of smaller competitors.  Revenues had increased from $323 million in 2003 to $645 million in 2007.  Profits had almost doubled from $.29 a share to $.59 a share.  The company had also paid down it’s long-term debt.  Kramer:

Darling may be in a stinky business, but it is one profitable company.  In spite of this, by the end of 2008 the stock was solidly in the single digits, trading at $5 and change.  Recently, the company had moved into alternative energy where the collected grease could be used to create biofuel.

Darling stock hit $4, which is where Kramer bought.  A little less than three years later, the stock exceeded $16.  Kramer’s investment had produced a 300 percent gain.  Kramer writes:

In this book, my goal is to help you find your Darlings.  After two decades of investing, I can tell you that low-priced stocks are a great way to build, or rebuild, your wealth.  Many of my biggest winning stocks over the years started out as single-digit priced stocks.  They were stocks that were way off Wall Street’s radar screens for a variety of reasons, but once the Street and large institutional investors discovered them, they often soared in price.

Kramer says these breakout stocks share three characteristics:

1. 1. Low-priced (mainly under $10).
   2. Undervalued.
   3. Have specific catalysts in the near future that put them on the threshold of breaking out to much higher prices.

That said, some stocks under $10 are cheap because they deserve to be.  So it’s essential to have a good investment process, including reading the company’s financial statements and presentations.  Kramer adds that she wish she hadn’t sold Darling, as the stock was soon in the mid-20s.

Kramer points out that there will always be recessions and economic slowdowns periodically.  It is wise to build a list of obsessive lifestyle stocks, because usually these stocks sell off just like other stocks during a recession but the businesses in question tend not to decline nearly as much.

 

THE PRICE IS NOT JUST RIGHT, IT’S CRITICAL

The major brokerage houses have gone to great lengths to discourage trading in low-priced stocks.  To be sure, there are many low-priced stocks belonging to bad businesses, bankrupt companies, and overhyped enterprises.  But there are many solid companies that just happen to have hit challenges, causing their stocks to drop.

Kramer gives another example of a stock that hit single digits where the business itself was solid: Dendreon (DNDN).

Dendreon was developing a new drug manufactured from the patient’s own immune cells.  This new drug represented a potentially groundbreaking step in the fight against prostate cancer.  FDA approval looked imminent.

However, in May of 2007, the FDA decided they needed more trials and more information before they could approve the drug for widespread usage.  The stock began dropping and by May of 2009, Dendreon stock hit $2.60.  The market cap of the company had gone from $3 billion to $400 million.

Kramer did her homework and found that Dendreon’s new drug was likely to be approved after the new trials.  It took some time for Kramer to buy a full position, but she ended up getting one at an average price of $5 per share.

In May 2009, the FDA approved Dendreon’s new drug.  In less than two weeks, the stock was back over $20 and worth $3 billion again.  The stock kept going up from there because it was clear the new drug would be a commercial success.  A year later, Kramer sold for more than $50, a 900 percent profit—a ten-bagger.  Kramer:

I am not going to tell you that every low-priced stock you buy in your lifetime will breakout and become a ten-bagger.  Most investors only have a few of those in a lifetime.  I am going to tell you that we can make Wall Street’s aversion to low-priced stocks work for you more often than not and produce consistent and exciting profits.  Any ten-baggers you run across long the way will just be icing on the cake!

 

OH, HOW THE MIGHTY HAVE FALLEN

Kramer writes:

These are companies that were once considered blue chip or growth darlings that have fallen monstrously out of favor with Wall Street and investors.  These are stocks that were once widely owned and if not loved, at least admired and respected.  Something went drastically wrong for these companies and the share price plummeted into single digits.  In most cases investors sold too late and much money was lost along the way, often creating a cloud of ill will and outright distrust for these companies in many cases…

Often in the stock market, though, aversion can signal opportunity.

Kramer explains:

When it comes to identifying true fallen angels, there are two key questions you need to ask.  The first question is what went wrong?  Did management overdiversify the basic business and expand into areas where they had no expertise or advantage?  Did the company borrow too much money and is now having a hard time generating sufficient cash flow to service their debt load?  Has a competitor surpassed them in the marketplace?  Has there been a change in consumers’ buying habits and preferences that have left the company behind?  Have there been accounting irregularities or regulatory issues that the company must put behind it in a satisfactory manner before the company can return to profitability?  Are there customer or supplier lawsuits weighing on the company and its stock price?  The list of problems, mistakes, and management stumbles that make a once great company into a fallen angel are legion.  Before you even consider investing in a fallen angel stock you need to know exactly what went wrong and who is responsible for the problems.

The next question then becomes can it be fixed?  Can the company shed itself of unprofitable divisions or subsidiaries that take away from the core business?  Can management regain focus and catch back up to its competitors?  Can the company generate sufficient cash flow to pay down its debt or can the balance sheet be restructured in a fashion that allows a return to profitability?  Can regulatory issues be solved without permanent harm to the company?  Can they maintain a reasonable relationship with key suppliers and customers until the current crisis has passed?  Are the accounting and regulatory issues mistakes or are they fraudulent or criminal activity?  Can their products and services regain acceptance from consumers?  Once we figure out what has gone wrong, we need to figure out if the problems can be fixed.  If so, we have a candidate for a fallen angel stock, and in my experience the companies that do achieve a turnaround can then see their stock price double or even triple before too much time passes.

Kramer is quick to note that many of these stocks are not good investments for a variety of reasons.  So the investor has to carefully examine many such companies in order to identify one or a tiny handful of fallen angels.

Kramer gives the example of Ford Motor Company (F).  For a long time, Ford was the bluest of blue chips.  The company was incorporated in 1903 and is credited with inventing the production line method of assembling vehicles.  In World War II, Ford creating a great number of vehicles to meet military demand.

Froom 2005 to 2010 however, the company stumbled.  Not only had they acquired many other car companies and divisions that were not profitable, but they had rising healthcare costs combined with slowing sales and declining margins.  Management then made a bet in 2006 that they might need cash.  So they raised $23.6 billion in debt.  The CEO said this would cushion the company if there were a recession.  Kramer:

In 2008 the bottom came out from under the U.S. car market.  The automakers were heavily exposed to the consumer lending market and as the credit crisis deepened default rates climbed and profits evaporated.  In 2008 For had the worst year in its history, losing over $414 billion as the recession deepened.  Auto industry executives ended up going hat in hand to Capitol Hill to plead for a federal bailout.

Here is where Ford’s gamble at the end of 2006 paid off.  Both Chrysler and General Motors (GM) ended up having to file bankruptcy and accept government bailouts and funding.  Ford had enough cash on hand from the cash-out refinancing that they did not have to go to those lengths to survive.  Because they had cash on hand they could run their day-to-day operations without government assistance.  They engineered an equity-for-debt sawp that reduced debt loads by more than $10 billion.  Management worked out a deal with the UAW to accept stock in lieu of cash for pension and healthcare expenses.  Ford’s stock fell under $2 in 2009 as things looked bleak for the entire industry, and it began to divest some of its noncore lines like Jaguar, Land Rover, and Volvo.

This was where Kramer got interested in Ford’s stock.  Ford had lowered its debt and also Kramer found, after doing some research, that Ford’s F150 line of trucks was still dominant and the company had a loyal customer base.  Two years later, Ford stock (F) had gone from $2 to $18.

Kramer next describes her greatest fallen angel investment ever, one where the stock increased dramatically over the 8+ years that Kramer held it: Priceline.com (PCLN).  Many internet stocks had crashed after the bubble in 1999-2000.  This included Priceline, which had hit $1 per share.

The company had made some misteps by trying to expand beyond travel services using a name-your-own-price model to sell gasoline, groceries, long distance telephone plans, and a host of other items.  They also tried to compete with eBay (EBAY) in the online auction business.  They even tried a name-your-own-price home mortgage program.  Nearly all these ventures failed.

The stock had fallen from $165 to $1.  But Kramer discovered that the company still had plenty of cash.  And Priceline was exiting all of their noncore operations and schemes and returning to their basic travel business.  Friends told Kramer they were still using the service and were still very satisfied.  Kramer bought the stock in February 2003.

The company did a one for six reverse stock split.  This made Kramer’s cost basis, adjusted for the reverse split, $7.63 per share.   By 2011, the stock had hit $543 and Kramer was continuing to hold it.  Kramer:

I have made over 70 times my money by finding this fallen angel and asking two crucial questions: What went wrong? and Can it be fixed?

What went wrong was obvious.  The stock got caught up in the collapse of the Internet boom and management tried to enter businesses where they had no competitive advantage.  And once they returned to their original core focus, I felt it could be fixed and that it was only a matter of time before business and the stock price began to grow again.

What’s the best way to find fallen angel candidates?  Kramer offers several methods.  Read the news, as the stocks of one-time leaders that have fallen are usually paid attention in the media.  Look at 52-week low lists.  Check all the stocks in the S&P 500 to see which ones are single-digit stocks.  Finally, one of the best tools is to use a web-based stock screener.

After you have a list of candidates, you have to go to work reading the financial statements and company presentations.  You have to ask the two questions: What went wrong? and Can it be fixed?

 

GROWING OUT OF SIGHT

You can make a lot of money if you own a growth stock, but the key is to buy at a low price.  Kramer explains that many growth stocks are already very popular, which means their stock prices are already quite high.  Kramer writes:

We are more interested in the type of stocks that legendary Peter Lynch described in his classic book One Up On Wall Street.  Mr. Lynch described the perfect stock as one that was in a boring niche business.  Preferably the company would be a business that was dull or downright disagreeable.  He jokingly said that he would also like it if there were rumors of toxic waste or Mafia involvement!  This type of stock would be way off the Wall Street radar screen, and few institutions would own it and analysts would not cover it or write reports for the sales force to pump the stock.

Kramer reminds the reader that she had already described just such a stock in the first chapter: Darling International.  Rendering and grease collection is a dull messy business, but a necessary one.  Kramer jokes that she has never been to a party and heard someone talking about the wonderful hide rendering company that was in their portfolio.  Kramer:

This is exactly what made Darling such an outstanding investment opportunity.  No one was paying any attention to the company as they grew into the largest company in the business and grew earnings rapidly.  Darling was not only a classic under $10 breakout stock, it was also an undiscovered growth stock.

Of course, not all growth stocks that are still cheap are unknown.  Sometimes investors simply give up on a company, which makes the stock low-priced.

Kramer suggests a class of companies she calls “obsessive product companies.”

These companies make products that people simply do not want to live without regardless of what is going on in the economy or the world.  There are some hobbies or products that become lifestyles.  Many of these are not recognized on Wall Street for the simple reason that they do not share the same interests or recognize that in many cases the company in question makes a product that is not going to go away regardless of the economy.  If business does slow down a bit, it is simply going to create pent-up demand.  Purchases may be delayed but they will not be denied!

Krames gives the example of Cabela’s (CAB), the outdoor superstore company.  In late 2008, like other retailers, Cabela’s saw slowing sales and the stock fell to $5.  Kramer explains what Wall Street missed: Cabela’s sells hunting and fishing products, and the buyers of these products are very serious about their chosen hobby.  Also, while Cabela’s had over $300 million in debt, the company had close to $400 million in cash.  Moreover, their credit card operation never really experienced big losses, again because their customers were very serious about their hobby and didn’t want to let their Cabela’s account become delinquent.

Furthermore, the company was asset rich.  It owned 24 of their 29 locations, and the book value of the stock was over $12.

In 2008, Kramer began buying the stock under $5.  By the end of 2009, Cabela’s had over $500 million in cash and they had reduced their debt.  Kramer sold at $14.92, for a return of almost 200 percent in less than a year.

Kramer notes that there will always be recessions and slowdowns periodically.  It is wise to build a list of obsessive lifestyle stocks.  When recession hits, these stocks tend to decline just like other stocks even though the obsessive lifestyle businesses tend not to decline nearly as much as other businesses.

Furthermore, Kramer suggests looking for companies that can experience earnings growth without necessarily being exciting.  She gives the example of Dole Foods (DOLE).  The company was founded in 1891.  In 2003, businessman David Murdoch bought the company from Castle and Cook.  The company expanded into other lines of fruits and vegetables.  In 2009, the company went public at $12.50 a share.

Nobody paid any attention.  Kramer:

Dole had grown into the largest producer and distributor of fruits and vegetables in the world but to investors these were not exciting products.  The stock price languished and early in 2010 it fell below the $10 mark where I began to take notice of the company.

Kramer believed that the demand for healthy foods was only going to grow in the years ahead.  This was true not only in the United States, but also in many emerging markets globally.  The stock soon increased 50 percent.  Kramer writes:

The mantra of most growth stock investors is bigger, better, faster.  They are looking for the newest fads and the most exciting products.  The truth is that the best growth stories are often found in our cupboards and refrigerators.  The regular seemingly boring products we use every day can create growth stories and when those companies see their stock price fall into the single digits, they become tremendous profit opportunities.

Kramer also recommends running a web-based stock screen.  Search for companies that have been growing steadily for at least five years.  Most of these stocks will already be high-priced, but occasionally you may find a low-priced one.  Kramer:

…just finding one of these before Wall Street does can make a huge difference in your net worth over time.

Kramer:

To run this search, set the screener to look for stocks that have grown earnings and revenues by at least 15 percent a year for the past five years.  We also want companies that do not owe a lot of money and have decent balance sheets.  Legendary investor Benjamin Graham once set that threshold as owning twice what you owe, so I think that’s a reasonable threshold.  Set the debt to equity ratio at a maximum of .3.  This will give us a company with at least 70 percent equity and 30 percent debt as part of the total capital structure.

Of course, you also include on the screen the requirement that the stock price be below $10.  Kramer:

Your list of stocks is going to be short and the companies will be small.  In fact if you ran it right now for U.S. stocks the resulting list would be just 51 names out of all the stocks listed on major exchanges and markets here in the United States.  The largest company on this list is going to be just $750 million in market capitalization and the smallest is just under $30 million in total market cap.  There are some pretty interesting companies and it will be worth your time to search this list and dig a little deeper to find the real winners out of this list.  You want to look for companies with products that have exposure to huge potential markets like alternative energy, smartphones, and other communication devices, social networking, or any other product or service that can see continued steady growth for years to come… Decent levels of insider ownership are also preferable in these small, steady growers.  If the founders and managers of these little growth gems still own a good share of the company, say 10 percent or more, they have a vested interest in seeing the stock price go higher over time.

Kramer next mentions a screen for explosive growers.  These are low-priced breakout stocks that have seen a surge of earnings and revenues in the past year.  Kramer:

We usually find two types of companies on this list.  One is a company that stumbled or is caught by the economic cycle and has had depressed earnings and sales.  Now the cycle has swung back in their direction and they are set to surge.  The other is a company that has a breakthrough with some product or service that suddenly takes the world by storm and is set to explode upward.

We want explosive growth here so we will initially set the bar high.  Set your screener to look for companies with earnings growth of at least 100 percent annually.  Often profit margins are also exploding so revenue growth is not as critical with this screen.  Again, we do not want too much debt, but we can give these exploders a little more room, so set the debt to equity ratio ceiling at 50 percent.

Once again, a recession or a bear market can create many low-priced stocks among the explosive growers.  Kramer says the investor will learn to love recessions and bear markets for this very reason.

 

SHOPPING THE BARGAIN BIN

This is the method of finding stocks that are trading below tangible book value.  (Intangible assets are not included.)  Kramer:

Bargain bin stocks sell below book value for many reasons.  The company could be experiencing a slowdown in its business and Wall Street has abandoned the stock.  The whole industry may be unloved, as was once the case with electric utility stocks back in the 1980s.  Cost overruns on nuclear power plants and a hostile regulatory environment had all of these stocks selling for less than their book value.  In the aftermath of the Savings and Loan crisis in the early 1990s, almost all small bank and thrift stocks sold well below the value of their assets.  Sometimes it is just a stock that is too small for analysts to follow and the stock price has languished as the assets have grown.  Our job is to figure out if those assets can be converted to either a higher stock price or be turned into cash via a takeover or restructuring in the near future.

Kramer gives the example of Tesoro (TSO), a major North American refiner of petroleum products.  In 2008, its stock fell well below its book value.  When the economy slows down, business is awful for refiners.  However, the company had many tangible assets and we knew the recession would eventually end.  Tesoro owned seven refineries and 879 retail gas stations.  Tesoro also owned 900 miles of oil pipelines around the country.  The most important point, writes Kramer, is that there are not many refineries in the United States.  There hasn’t been a new refinery built in the United States since 1977.  Therefore, these are irreplaceable assets.  Kramer:

The assets already appeared pretty valuable to me.  Although the business was terrible the asset pile was worth a lot of money.  With the stock trading around $8 or so the tangible book value of Tesoro was about $23 a share.  The assets were being discounted in the marketplace by more than 65 percent.  That was just the discount from the accounting value of the assets.  Because refineries are irreplaceable assets the discount was even greater when you considered the real value of Tesoro’s asset collection.

Kramer bought Tesoro around $8.  Once the economy recovered, so did Tesoro’s profits and the stock soon tripled.

As far as screening for companies trading below tangible book, Kramer also recommends that the companies be profitable so that they are not burning through their assets.  Kramer then recommends including on the screen that the debt to equity be a maximum of .30.  And of course, the screen includes stocks that are below $10.  Kramer concludes the chapter:

When we look over the list of stocks priced cheap compared to their assets, we want to consider what the actual assets are.  The key question is: Can they be turned into profits at some point?  If the assets are cash or commodity inventories, the answer is probably yes.  They can be sold, returned to shareholders, or perhaps a competitor or private equity investor will recognize the value and buy the company at a premium.  Are the assets real estate, such as commercial properties, hotels, or apartments?  If so they can also probably be sold at a profit at a point in the future.

 

GETTING THE WORLD HEALTHY AND WEALTHY

The opportunities in low-priced stocks, whether fallen angels, undiscovered growth gems, or bargain stocks, occur in a variety of sectors.  That said, some sectors may be particularly interesting, depending upon the investor and his or her expertise.  Kramer mentions the biotech and pharmaceutical sector:

This particular sector is absolutely overflowing with low-priced investment opportunities—a trend I expect to continue in the near future.

There are a few key reasons for the sector’s hot hand.  The most obvious reason is the advancements in technology.  It seems like there is a new breakthrough drug, medical treatment, or device almost every week.  We have seen advances not just in biotechnology, but in robotic surgery, titanium hips, cancer protocols, and life extension programs.  Increasingly we are seeing the breakthroughs come from smaller companies wth smaller stock prices.

Kramer adds that there is a real need for these products.  For example, in 2010, nearly 1.6 million Americans were diagnosed with cancer, and 570,000 died from the disease, according to the American Cancer Society.  Furthermore, according to the University of Texas M.D. Anderson Cancer Center, the number of new cancer cases diagnosed annually in the United States is expected to increase by 45 percent to 2.3 million in 2030.  There are also increasingly more cancer cases globally.

In the United States, according to the National Cancer Institute, part of the National Institute of Health (NIH), total expenditures on cancer treatment will grow at least 27 percent from 2010 to 2020, advancing from $127.6 billion to $158 billion.  Kramer notes that the good news is that these treatment dollars are being funneled into innovative companies fighting this disease.

Here’s where the importance of smaller, lower-priced companies in this sector comes into play.  The giant drug companies are looking to partner with these smaller companies to develop new products as an addition to their own research and development efforts.

Sometimes big pharmaceuticals, if they don’t partner with a smaller company, will acquire the company instead.

Kramer mentions that she bought Ariad Pharmaceuticals at $8 a share in 2011.  Ariad is an emerging biopharmaceutical company that at the time had three potentially game-changing cancer treatments.  Kramer explains that for one of these treatments, Merck partnered with Ariad.  Kramer comments:

The partnership approach to developing drugs is going to be the model of groundbreaking research in the future.  By setting up news searches and tracking the news of the largest pharmaceutical companies, you can keep on top of the exciting smaller companies that are working on potential blockbuster drugs.

Successful partnerships with larger drug companies have turned some single-digit stocks into huge winners.  Regeneron (RGEN) has seen its stock price go from under $6 a share to well over $60 in just over five years as its partnership with pharmaceutical giant Sanofi-aventis has allowed it to develop promising cancer and autoimmune system drugs.  Incyte’s partnership with Novartis helped drive the strock price from $2 to over $20 in three years.

Smaller biotechnology companies can push the curve in new research in ways that larger more established companies simply cannot.  Rather than invest in unproven drugs and technologies, the larger companies prefer to provide cash and assistance to the up-and-coming companies.  In return they can access potential breakthrough drugs with less overhead.  It is a win for the company, for investors in the smaller company, and often for patients.  As researchers and biotech companies continue to search for the answers for mankind’s medical issues these opportunities for low-priced breakout stocks will be increasingly available to attentive investors.

Kramer also mentions breakthroughs in medical devices and surgical techniques.  This includes new cardiac stents being developed, new robotic surgical devices, new bone and joint replacement products, and many other devices and products to improve health and combat age-old problems.

Kramer points out that it takes some specialized effort to effectively search the universe of healthcare, drug, and biotechnology companies.  Sometimes growth screens will produce ideas, but often more digging is required.  Kramer concludes:

You can find news on such developments at www.fda.gov.  The site has a wealth of information of new drugs being approved and which companies are developing them.  It also tracks which drugs are in short supply and could lead to production ramp-up or higher margins for their manufacturers.  The site also has information and reports that will help you understand the approval process for new drugs which will prove useful over the long run as you search for cheap stocks in the medical and drug fields.

This is an area where you probably need to learn to steal ideas as well… It took me many years to develop the expertise and contacts needed to continually uncover the potential big winners, particularly in biotech stocks.  You can get ideas from top managers in the field by searching through the portfolios of top mutual fund managers specializing in the medical and biootech fields.  They have to disclose their portfolio to the SEC and are widely available on various research and financial sites on the Internet.

One new drug or technology can take a company from obscurity to superstardom and the stock price will go higher than you could have ever though possible.  Staying on top of which smaller single-digit stocks have promising research and strong partnerships with large drug companies can be a tremendous source of single-digit stock winners over your investing career.

 

AROUND THE WORLD UNDER $10

Emerging markets have evolved and become more like U.S. markets.  There are the same cycles of fear and greed that create fallen angel stocks.  Kramer:

Companies will be created that have exciting new products with the potential for strong long-term growth and yet stay under the radar screen for an extended period of time.  We can find low-priced potential breakout stocks located all around the world in today’s dynamic, connected stock markets.

Kramer comments:

In a lot of ways emerging economies look a lot like the United States did back around the turn of the century.  Back then people moved from the rural towns into the cities as jobs in new industries became available.  Automobiles began to replace the horse and buggy.  Radios and telephones became items that were desired by every household.  Investing in companies that built infrastructure, like the steel and railroad companies, was hugely successful.  So was putting your money into electric utilities and energy companies that served the growing demand for power.  Early investors in companies that sprang up to serve these new consumers, like Sears, Roebuck and Company, also did very well.

Today we are seeing similar trends developing, as smartphones and portable commmunications and entertainment devices are adopted throughout the world and are in high demand in emerging economies like China, Brazil, and India.  Further, the robust demographic growth in emerging economies is creating the need for bigger, better, and more efficient infrastructure to maintain such growth.

Kramer gives the example of Cemex (CX).  When she was in Mexico in 2001, Kramer noticed the country was experiencing a building boom.  She got curious about all the cement trucks and construction vehicles, not to mention cranes.  CX not only sold cement in Mexico, but also in the United States, Europe, the Philippines, and the Middle East.  Kramer bought the stock around $8 in early 2003, and over the next three years, the stock went over $30, allowing her so sell at around $29.  Kramer continues:

Interestingly, the stock collapsed again in the global recession of 2008.  As global building began to collapse as credit tightened and the economy slowed, the shares fell all the way back into the single digits.  In fact, Cemex stock fell below $4.  Once again, as the global economy began to dig itself out, the stock slowly reversed and reached a high of $14 a share a little more than a year later.

Building materials stocks like Cemex are going to get hit hard during a time of a global slowdown, but will be among the first and fastest to recover at the first sign of an improvement in economic conditions.  Emerging markets may have frequent stumbles along the way to progress but once the trend towards a more industrialized consumer society begins, history tells us it rarely reverses itself.  Following building supply- and infrastructure-related stocks and buying when they are low priced and unpopular can be a path to large long-term profits.

Moreover, as an emerging economy creates a new middle class, there will be demand for goods and services that make life more interesting.

 

FORGET EVERYTHING YOU THOUGHT YOU KNEW

First, the efficient market hypothesis, which says all available information is already reflected in all stocks and therefore it’s impossible to beat the market except by luck, is simply not true.  Most of the examples Kramer has given illustrate this.  Also, various value investors have beaten the market over time for nearly a century.

Second, a low P/E ratio is not typically how to find a low-priced breakout stock because often a low-priced breakout stock has very little earnings, which makes the P/E ratio very high.

My note here:  My fund, the Boole Microcap Fund, uses five metrics for cheapness:

• • low price-to-earnings (low P/E)
  • low price-to-cash flow (low P/CF)
  • low price-to-sales (low P/S)
  • low price-to-book (low P/B)
  • low enterprise value-to-EBITDA (low EV/EBITDA)

In the terrific book, What Works on Wall Street (4th edition), James P. O’Shaughnessy demonstrates that using all five of these metrics of cheapness simultaneously has produced the highest returns historically.

My fund also uses other quantitative information like a high Piotroski F-Score, low debt, high insider ownership, insider buying, high ROE, and positive 6-month and 1-year momentum.

So while I do agree with Kramer’s explanation of fallen angels, undiscovered growth stocks, and bargain bin favorites, I don’t entirely agree on low P/E.  It’s OK for the P/E to be high (or even negative!) as long as most of the other metrics of cheapness are low.  However, I do estimate normalized sales, earnings, and cash flows, and if most of the metrics for cheapness are quite low relative to normalized estimates, then these can be particularly interesting stocks.

Moreover, if a company has been profitable for years, and then suddenly has its profits disappear for temporary reasons like a recession, that can be the makings of an excellent investment when the stock price has collapsed.

Kramer says a high P/E is OK if earnings have temporarily collapsed, but she does write the following:

As a rule we want our companies to be profitable.  As we discussed, many of them stumbled and that’s why they are a low-priced stock in the first place.  The fact that they are still profitable in the worst of times gives us an indication management knows what they are doing and can return to higher profitability levels in short order.  If they are not profitable there needs to be some reason or catalyst that we can see that will restore the bottom line to black ink in a relatively short period of time.

Kramer continues by explaining that an improvement or deterioration in various metrics can be more important than the absolute level:

Let’s consider return on equity for a second.  This is a widely used measure in financial research that evaluates how much a company is earning relative to the amount of equity invested in the company.  It is a pretty good measure of how profitably management is using the money entrusted to it by shareholders.  However just the number by itself is not enough to evaluate a stock for breakout potential.

Kramer gives the example of Toll Brothers (TOL).  The company has a decent year in 2006 and had a return on equity (ROE) of 20 percent.  That seems good, however year over year the ROE had declined from 53 percent to 20 percent.  This was, for Kramer, a huge red flag.  The trend continued and TOL had a small ROE in 2007 and negative ROE in 2008.  This example illustrates why the direction of many metrics can be more important than the absolute level.

 

LOOKING FOR THE RIGHT STUFF

Kramer holds that the company should have a relatively strong balance sheet, and own at least as much as they owe.  In other words, the debt to total capitalization should be below 0.50.  If it’s higher than that, there is an increased risk of bankruptcy during a recession or business slowdown.

Kramer writes:

It is also very important to read the footnotes and fine print in a filing of a prospective stock.  I want to see if the auditors signed off and issued an unqualified opinion of the company’s financials.  If they issued a qualified opinion that’s a huge red flag that something may be wrong with the data I am using to evaluate the company.  Has the company recently changed auditors?  That can be a flag as well, and indicates the previous firm had some questions that company didn’t want to answer or did not like the conclusions the auditor drew out of the financial data.  Is there a concern about the company’s ability to continue as a going concern?  Are there a lot of complex off-balance-sheet arrangements?  These could have a substantial negative influence on the company’s leverage and operating ratios that are not included in the basic balance sheet and income statement presentation.

Kramer highly recommends going to the investor relations part of a company’s website.  She gives Wendy’s/Arby’s Group (WEN).  (Keep in mind Kramer was writing this book in 2011.  Today Wendy’s and Arby’s are separate entities.)

When I go to the investor relations section of their website I find links to all their SEC filings, historical information about their finances, and stock price.  The last few years of press releases, including quarterly earnings reports, are readily available.  The really interesting section to me is webcasts and presentations.  Here I find links to recent presentations at various conferences and investor meetings, including videos and PowerPoint presentations.

…

I see from the presentation that the company is introducing a new line of burger products in the second half of 2011 that look pretty enticing.  They have a strong balance sheet and are buying back stock.  I see in the presentation that they have recently increased the dividend.  Managing is continuing with their efforts to sell the Arby’s business and refocus on the core Wendy’s brand.  The presentation contains information about international expansion plans, menu changes, as well as a discussion of finances.  This is all valuable information and reinforced my conviction about owning the company.

Kramer adds that not all companies have in-depth investor presentations, but many do.  Note: Many microcap companies—the focus of my fund, the Boole Microcap Fund—do not have these presentations, but some do.

Kramer continues:

The next thing I like to do is look at the stock price chart.  I am not a chartist by any means, but the price chart can provide valuable information, especially in timing my purchase of a low-priced breakout stock.  Is the stock moving higher on increased buying activity in the stock?  This could be a sign that the larger investors, such as hedge funds, are starting to notice the company and I want to get in as soon as possible.  Is the stock breaking out to new highs?  Has it bounced off a level of support, such as a double price bottom that might indicate institutional buying is putting a bottom in the stock and the time to buy has been reached?  I never make a decision because of the chart itself but if the stock has passed the research process, charts can provide valuable information about what other investors think of the company.

Kramer adds:

Another important piece of information I like to check when evaluating a stock is who is buying and selling the shares.  Are insiders buying or selling the stock?  If they are selling is it just one officer or director or several of them?  One seller could be someone in need of cash for some personal reason but many sellers over a period of time is a huge red flag.  If the folks running the company are selling, I am not so sure I should be buying the stock.  I need to check my conclusion.  Insiders may sell for several reasons, but they only buy for one: They like the potential of the company and think the stock is underpriced relative to the potential for gains in the future.  Insider buying increases my conviction about a company that has passed all my other tests.

Kramer also recommends calling experts, which is easier if you happen to know some, but can still be done even if you don’t.

Moreover, Kramer mentions some great research resources, including Value Line, which not only has momentum-based rankings, but also has a decade’s worth of historical financial data plus analyst commentary.  Standard and Poor’s also publishes valuable stock research.  Furthermore, some of Morningstar’s equity research is available for free.  Yahoo! finance has free information on companies.

Note: There are other resouces, too, including Seeking Alpha, for which you have to pay roughly $33 a month.  And, for microocap investors, there is the Micro Cap Club (https://microcapclub.com/), which you can join for $500 a year (or for free if you write up an investment idea and it is accepted) and also Small Cap Discoveries (https://smallcapdiscoveries.com/), which costs $1,000 a year.

 

WELL BOUGHT IS HALF SOLD

First, every investor will make plenty of mistakes.  Many top investors are only right 49% of the time or up to 60% of the time.  How you deal with mistakes is important.  I wrote last week about this: https://boolefund.com/the-art-of-execution/

Sometimes, if the stock falls, it makes sense to buy more.  Other times, it’s best to sell.  The most important question to ask yourself is: Knowing what I know now, would I buy the stock at its current price?  If yes, then buying more after the decline is the right move.  If no, then immediately selling is the right move.  Remember the quote attributed to John Maynard Keynes:

When the facts change, I change my mind; what do you do?

Kramer writes:

You want to read any filings or news releases since you bought the stock.  Has the company taken on more debt?  Did they miss a key product launch date?  Is the company spending its cash at an alarming rate?  Are inventories growing as customers delay or cancel orders?  Have regulatory or legal issues emerged that change the outlook for the company?  Have the macroeconomic issues that face the company changed since you bought the stock?  You are looking for material negative changes in the company or its outlook since you originally bought the stock.  If there are any, then you want to sell the stock.  The old adage that the first loss is the best one holds true.  If the situation worsens, do not wait for a bounce or to get back to even—sell the stock and move on.

Kramer next handles the topic of when to sell winners.  If the stock price has gone up, you want to review the situation.  Are revenues and profits still growing or rebounding?  Is the company paying down debt or otherwise fixing any balance sheet issues?  Are the company’s products being well-received?

Kramer then adds:

On the technical side of things, is daily trading volume increasing or at least staying steady?  This can be a sign that the big institutions that sold the stock when it was falling are now buying back in and this is going to push the stock price still higher.  Is the stock making new 52-week highs?  Are you seeing a steady pattern of higher highs and, more importantly, higher short-term lows in the stock?  Stocks are always going to move in ebbs and flows.  When you chart a low point of a pullback above the low point of the prior round of profit taking, this is a very bullish sign for the stock.  Buyers are moving in and the stock is probably heading higher, so ride the wave and let your profits grow.

As long as things are improving you want to own the stock.  I have stocks today like Priceline that I have simply never sold even though they have risen by hundreds of percent.

Kramer then writes:

As a stock move higher there are some indications that indicate it is time to part ways with the stock.  If business starts to slow and is no longer improving it is time to sell.  If revenues and earnings have been rising and then the company announces a down quarter, it is time to ring the register and take your profits.  If you have a stock that has moved higher and the company announces a large debt or equity offering, you want to consider selling the shares…. The need to raise moeny is a sign that the company is not generating enough cash to meet its goal and it’s a reason to consider taking profits.

Sometimes it also makes sense to sell part of the position as the stock movies higher.  This, too, is covered in last week’s blog post about The Art of Execution: https://boolefund.com/the-art-of-execution/

Kramer makes another important point:  If it seems like now everyone loves the stock, whereas previously (when the stock price was low) they hated or ignored the stock—which is what created the opportunity for you to buy at a low price—then it’s time to consider selling.  The question becomes: if everyone loves it, who is left to buy?

Finally, sometimes the stock you own will get acquired, in which case you have to sell but can usually do so at a higher price than you paid.  It also makes sense, argues Kramer, to be aware of when larger companies may want to buy smaller competitors.  Often such inorganic growth (via acquistions) is less expensive than organic growth (opening new locations, developing new products, etc.).  As discussed earlier, this can frequently be the case for large drug companies: In order to expand their product lines, they will look to acquire smaller companies.

 

BEWARE THE WOLVES OF WALL STREET

Low-priced stocks are viewed as riskier than higher-priced stocks, but usually that’s not case.  Kramer writes:

All things being equal, the answers to the risk versus reward equation are found in the financial statements, not the stock price.  This is a classic case of broad-based statements, such as ‘all low-priced stocks are risky,’ just being wrong.

That said, as an investor you do have to be careful of “pump and dump” schemes, which historically have often happened with very low-priced stocks.  Kramer:

Unscrupulous operators accumulate or create a large block of stock at a very low price.  They then hype the stock as the next big thing to unsuspecting investors.  They talk about getting in on the ground floor, revolutionary breakthroughs, and other buzzwords designed to get the blood pumping and the greed flowing.  When investors get excited about this wonderful company, the operators simply dump their stock at much higher prices and walk away with investors’ hard-earned money.

Most of the time these companies have no real business or assets.  They are just shell companies set up for the specific purpose of fleecing investors.  Some of them may be little mining stocks or small tech companies that are badly underfunded and will be broke and bankrupt very shortly.

Kramer adds:

The SEC has done a great job of cleaning up the penny stock brokerage firms and they are not as prevalent as they once were.  However there are still a few out there and as long as greed and dishonesty exist there always will be.

Krames then writes:

I do not want to imply that all Internet-based research on low-priced stocks or advisory services devoted to low-priced stocks are bad.  I run such a service myself and I know several other reputable conscientious folks who do the same.  The best defense against being taken advantage of in the stock market is to do the homework yourself and check the facts before you buy the story!  You will quickly be able to see who is trying to make you money and who is trying to rip you off.

Furthermore, you must be aware that there are many low-priced stocks that deserve to be low-priced.  Also, nearly every company that goes bankrupt sees its stock go to a low price before bankruptcy.  That’s why it’s important, again, to do your homework.  You have to be sure the company doesn’t have too much debt.  Also, is the company making money or losing money?  If the company is losing money, do they have a credible turnaround plan in place?  Kramer:

If you see allegations of accounting or securities fraud in a company’s reports, it is best just to take a pass on that issue even if you think there is potential.  Unless you are a very experienced forensic accountant or securities attorney, it becomes very difficult to decipher exactly how these cases will end.  Lots of people thought companies like Enron and WorldCom would be able to survive after the initial fraud allegations were revealed.  They were not and a lot of people lost a lot of money.

Kramer concludes the chapter:

The key to avoiding risks in the stock market, especially in low-priced stocks, is to use common sense.  No one is going to send you an email to tell you all about a stock that is going to make you rich beyond your wildest dreams.  As I have said earlier in this book, finding these gems takes work and effort on your part and no one is going to give you the keys to the kingdom with no effort or cost on your part.  Keep in mind, if your Uncle Fred were really a great stock picker he would not borrow $100 every time you see him.  Read the 10Q and 10K, go through the financials, and read management’s discussion of the business.  Check the footnotes for warning signs and red flags.

Most of the time the alleged risks of low-priced stocks are just that—alleged.  If you find a stock with the right financial and business characteristics the risks are actually nonexistent.  It is the perception of greatly increased risks with low-priced stocks that is creating the opportunities for us to earn breakout profits.

 

LOW PRICES AND HIGH PROFITS

In this chapter, Kramer wraps up the book.  She writes:

Hopefully I have given you the tools and information you need to begin investing in the exciting world of low-priced breakout stocks.  Over my years in and around the financial markets I have found this to be the single best area for investors to earn explosive gains in stocks.

Kramer again:

By getting ahead of Wall Street in lower-priced stocks we benefit from the institutional pack-mentality that dominates many traditional investment managers.  When they are selling and pushing stocks to low prices, we are buying.  Then, when their excitement for these stocks return, we are selling to them.  We are finding solid growth stocks before Wall Street notices and will see our stocks soar when they show up on the Street’s radar screen.  There simply is no better way for individual investors to outperform the market in my opinion.

Kramer argues that it pays to be optimistic about the long term:

If you focus on the fear you miss opportunities.  If you focused on all that was wrong with the auto industry in 2008, you would have totally missed the fact that Ford was in fine shape and stood to benefit fomr the problems of its competitors.  If you gave up when Dendreon got the first delay from the FDA, you would have missed some spectacular gains by never investigating further to discover that it was just a delay and approval for their cancer drugs was probably forthcoming.

The same applies to the stock market itself.  Markets are going to have declines.  There will be recessions and bear markets throughout your career.  The right way to look at these occasions is as inventory creation events, not catastrophes.

I would add that often microcap stocks have a low correlation with the broader market.  Warren Buffett, arguably the greatest investor of all time, said in 1999 during the internet bubble:

If I was running $1 million today, or $10 million for that matter, I’d be fully invested.  Anyone who says that size does not hurt investment performance is selling.  The highest rates of return I’ve ever achieved were in the 1950s.  I killed the Dow.  You ought to see the numbers.  But I was investing peanuts then.  It’s a huge structural advantage not to have a lot of money.  I think I could make you 50% a year on $1 million.  No, I know I could.  I guarantee that.

Kramer writes:

There is another advantage to owning low-priced stocks when the market corrects.  Many of these stocks are fallen angels or growth companies that stumbled briefly, driving the stock below $10.  Wall Street and the big institutions already sold their shares and your stocks will not experience the type of selling pressure higher-priced issues are experiencing.  When the large leveraged investors, like hedge funds, need to sell stocks they sell the higher priced more liquid issues to meet margin calls, not lower-priced smaller companies.  So not only does the selling not hit your stocks as hard as the big names, they often push the big companies down to where they become inventory for you!

Kramer continues:

The best investors fit into the category that I like to call optimistic cynics.  They are well aware that every bear market has ended and every economic recession has been followed by an economic recovery.  They also know that the world is fully of entrepreneurs and innovators who will discover new solutions to old problems and the world gets better over time throughout history.  They know that companies that are out of favor today are often tomorrow’s darlings.  In the stock market, optimism pays off over time.  It always has and always will.

The cynical part comes from not taking anyone’s word for anything.  Trust but verify is the order of the day.  Great investors do not act on tips, rumors, and sales pitches.  By doing their research and homework they avoid many of the mistakes investors can make that will damage their net worth.  They dig into the financial filings and company presentations to determine what is really going on with the company and the likelihood they can recover or continue to grow.  When markets are soaring and everyone is piling into stocks, great investors ask the most critical question of all: Is it really different this time?  When markets are collapsing they ask themselves if the world is really ending.  The answers to those questions help to temper your enthusiasm at market tops and turn your fear into action at market bottoms.

Kramer advises reading as much as possible, which she says is “some of the best advice I can give you about successful investing.”  Not just people who agree with your views of the world, the market, and stocks, but also people who disagree with your views.  Sometimes you will find holes in your thought process and other times you will gain more confidence in your previous conclusions.  Either way, it can make you a better investor.

Kramer reminds us that we have to pay close attention to the footnotes to search for any red flags or time bombs.  Also, the company presentation, often available on their website, usually contains valuable information about new products, services, or markets, as well as management’s plans.

It’s also a good idea to see if insiders are buying.  If they are, that’s always a bullish signal because it means the people running the company believe the stock is undervalued.  On the other hand, if groups of insiders are selling, especially at a low price, that’s a huge red flag.  Moreover, if excellent professional investors are buying or selling, it’s a good idea to pay attention to that.

Kramer ends with the following:

Investing in low-priced potential breakout stocks is work.  However it can increase your net worth quicker than almost any other effort applied to investing I am aware of.  One investment like Priceline can make it easier to put the kids through college or retire a few years earlier.  An investment in an undiscovered growth gem like Darling can pay for a dream vacation or even a dream home.  If you are willing to work at it, investing in single-digit stocks should add many digits to your account values over time.

 

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.

September 10, 2023

Investor Lee Freeman-Shor hired 45 of the world’s top investors and gave each between $20 million and $150 million to invest.  He instructed each one to invest only in their ten best ideas.  Freeman-Shor then examined the 1,866 investments made by this elite group over the course of June 2006 to October 2013.  The result is the book, The Art of Execution: How the world’s best investors get it wrong and still make millions (2015).

Freeman-Shor explains that the best ideas of the best investors could reasonably be expected to generate excellent long-term results.  Freeman-Shor:

These were ideas that they had significant confidence in, and were often the result of hundreds of hours of research by some of the smartest people on the planet.

Given all this, I was sure that I would make a lot of money.

It might surprise you, then, to be told that most of their investments lost money.

Out of 1,866 investments, a total of 920—about 49% of the total—made money.

However, almost all of these investors made money.  How was this possible?  Freeman-Shor studied every single trade in order to analyze what had happened.

Freeman-Shor quotes Leo Melamed, a successful futures trader:

I could be wrong 60% of the time and come out a big winner.  The key is money management.

Paul Tudor Jones:

The reason for all the Wall Street success stories he knew was down to: money management, money management, money management.

George Soros:

It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.

Here’s the outline for the book:

PART I. I’M LOSING (WHAT SHOULD I DO?)

• • The Rabbits: Caught in the Capital Impairment
  • The Assassins: The Art of Killing Losses
  • The Hunters: Pursuing Losing Shares

PART II. I’M WINNING (WHAT SHOULD I DO?)

• • The Raiders: Snatching at Treasure
  • The Connoisseurs: Enjoying Every Last Drop

CONCLUSION: THE HABITS OF SUCCESS

THE WINNER’S CHECKLIST

1. 1. Best ideas only
   2. Position size matters
   3. Be greedy when winning
   4. Materially adapt when you are losing
   5. Only invest in liquid stocks

THE LOSER’S CHECKLIST

1. 1. Invest in lots of ideas
   2. Invest a small amount in each idea
   3. Take small profits
   4. Stay in an investment idea and refuse to adapt when losing
   5. Do not consider liquidity

 

PART I. I’M LOSING—WHAT SHOULD I DO?

The Rabbits: Caught in the Capital Impairment

Freeman-Shor remarks that the Rabbits ended up being the least successful investors working for him, despite the fact that these were all prestigious investors.

Freeman-Shor gives a case study: Vyke Communications, a UK-based company that specialized in software that allowed users to make phone calls and send text messages.  The investor bought shares on October 31, 2007 at £2.10.  When the price fell, the investor bought more.  This was the right move if the investor still believed in the idea.  However, the stock kept falling and the investor decided to stay invested.  Two and a half years later on July 2, 2010, the investor sold the entire position at £0.02, for a 99% loss.

Another case study: Vostok Nafta, an investment company listed on the Swedish stock exchange that invests in assets in the Commonwealth of Independent States, a loose associtaion of some of the countries that used to make up the USSR.  This investor bought shares April 11, 2008, at £9.14.  Five months later, he sold at £3.95, for a loss of 57%.  Freeman-Shor notes that the only reason the investor sold was because Free-Shor was pressuring him to either buy more or sell.

Yet another case study: Raymarine, a company that specializes in marine electronics.  An investor bought shares on May 31, 2007, at £4.27.  23 months later the price had collapsed, but the investor still believed in the idea.  Eventually, partly due to pressure, the investor sold his entire position on April 15, 2009, at £0.17.  This was a loss of 96%.

Where did the Rabbits go wrong?  Freeman-Shor states ten reasons for why the Rabbits failed:

(1) The narrative fallacy framing bias

Framing bias, discovered by Amos Tversky and Daniel Kahneman, means that people tend to reach a conclusion based on the way a problem is presented.  In the case of the Rabbits, they allowed their favorite types of investment to influence how they viewed the stock in question.  The Rabbits still believed in the investment thesis for a stock that had fallen a great deal and so they still believed they would make money going forward.  Freeman-Shor:

The Rabbits are a great example of how professional investors often react to a black-swan event—an event they did not anticipate and which has negatively impacted their investment story.  They tend to dismiss it.

(2) Primacy error

Primacy error means that first impressions have a lasting and disproportional effect on a person.  Because the Rabbits had a very positive first impression, they failed to update their investment thesis to incorporate new information.

(3) Anchoring

Related to primacy error is anchoring.  Rabbits tended to anchor to initial information, being very slow to change their minds.  Freeman-Shor:

It took one Rabbit two and a half years to change his mind on Vyke, and another Rabbit almost two years to react to Raymarine’s decline.  The other never changed his mind on Vostok.  Similar stubbornness occurred on many other investments.

(4) Endowment bias

As humans, we tend to overvalue our own possessions, which includes the investments we’ve made.

When there are large losses that happen quickly, they are almost impossible to accept.  It’s easier to hold on to a losing position.  Rabbits did not want to admit the loss by selling because they were too fixated on what they had paid for the stock.

(5) The pull of the crowd

There were many other investors who got burned on the same investments that the Rabbits got burned on.  This could have contributed further to the Rabbits being unable to admit their error and sell.   Freeman-Shor quotes John Maynard Keynes:

It is the long-term investor… who will in practice come in for most criticism… if in the short run he is unsuccessful, which is very likely, he will not receive much mercy.  Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.

(6) Ego

Freeman-Shor says that the Rabbits were more interested in being right than in making money.  Many professional investors are this way.

The Rabbits simply could not admit that they were wrong.  Freeman-Shor observes:

The fact is, the greatest minds on the planet can be wrong.  My findings suggest you should expect to be wrong at least half of the time.  The very best investment minds are!

(7) Self-attribution bias

Self-attribution bias means that we blame others or external factors for our misfortunes but take full credit when things go well.  This is why we tend not to learn from past mistakes, but to keep repeating them.

The Rabbits, writes Freeman-Shor, tended to blame Mr. Market (“The market is being stupid”) or Mr. Unlucky (“It wasn’t muy fault, I was unlucky because of XYZ that no one could have foreseen”).

(8) The wrong information

Freeman-Shor:

Because many of the Rabbits had been professionally investing for a couple of decades, controlling a significant amount of assets, they had Rolodexes to die for.  When they found the ‘story’ behind an investment being challenged, they liked nothing better than picking up the phone and dialling the CEO on his or her personal number to get to the bottom of things.  Despite being reassured by the CEO that the setback was merely a bump in the road and the media was making a mountain out of a mole hill, the Rabbits would do nothing.  They neither bought more shares nor sold their holdings.

A hugely appealing temptation for more information comes from the need to abrogate responsibility in times of crisis.  It is very common when a difficult decision has to be made to see the decision-maker involving more people.  The more people involved, the more they can relax because if it goes wrong it was not their fault.

(9) Too big to fail

Like many investors, Rabbits found it far more difficult to walk away from a large losing investment than a small losing investment.

(10) The gambler’s fallacy

The gambler’s fallacy is the mistaken belief that after a period of poor performance, a given stock was due to perform well.

Each coin toss in a series has a 50/50 chance of coming up heads and each toss is independent of prior tosses.  The gambler’s fallacy ignores this and instead involves the belief that, after a series of tails, the next toss was likely to be heads.  But there’s only a 50/50 chance of this because each toss is independent.

What could the Rabbits have done differently?

Freeman-Shor writes:

The bad news is, everyone can be a Rabbit.  The good news is, no one needs to be.  There are a few simple things they could have done to overcome their problems.

(1) Always have a plan.

Freeman-Shor:

Investing is all about probabilities.  Whether you invest should depend on the odds and the edge you think you have.  Given the odds and your edge you should know exactly what you are going to do if the stock you are investing in falls or rises by 20%, 50% and so on.

When faced with a painful loss-making position, most people do nothing.  They turn into a Rabbit and procrastinate, letting all their biases play havoc with their decision-making, hoping time will resolve their issues so they don’t have to.

It’s essential to have a plan.

(2) Sell or buy more

Freeman-Shor:

The only solution to a losing situation is to sell out or significantly increase your stake.

Freeman-Shor says the investor needs to ask himself or herself a key question:

If I had a blank piece of paper and were looking to invest today, would I buy into that stock given what I now know?

If the answer is “no,” then the investor must sell.  If the answer is “yes,” then the investor should significantly add to the position.

Freeman-Shor notes that legendary investor Peter Lynch would (i) sell if the fundamentals were worse but the price had increased or (ii) buy if the fundamentals were better but the price had decreased.  This is logical.

The real mistake the Rabbits made was doing nothing when their investment had declined in price.  The logical thing is either to admit a mistake and sell, or buy more at the lower price.  Freeman-Shor:

I have learnt that I cannot trust great investors to do the right thing when they are losing—like top athletes, they require coaching and management.

(3) Don’t go all in

As an investor, you should always be able to add to an investment if the price falls, assuming you have taken a fresh look at the investment and decided it’s a good one at the new price.  This means you don’t want one position to become too large.  Freeman-Shor quotes Mohnish Pabrai:

In my own portfolios at Pabrai Funds, I adjust for this [getting the odds wrong] by simply placing bets at 10% of assets for each bet.  It is suboptimal, but it takes care of the Bet 6 being superior to Bet 2 problem.  Many times the bottom three to four bets outperform the ones I felt the best about.

(4) Don’t be hasty to jump in, do be hasty to jump out

Cutting your losses early makes excellent sense, although it is difficult.  Freeman-Shor writes the following, ending with a quote from Ned Davis:

Not least because selling out of a stock helps clear your head and enables you to assess a situation more objectively.  It’s like taking a decongestion pill when suffering from a cold.

And buying slowly over time (known as dollar or pound-cost averaging), with a reduced position size at the outset, ensures you have plenty of ammunition left to load up when a share finally capitulates (assuming it does).

“[W]hat separates the winners from the losers?  The answer is simple—the winners makes small mistakes while the losers make big mistakes.”

(5) Remember there is a difference between ‘being right’ and ‘making money’

Freeman-Shor:

In investing, a lot of success can be attributed to being in the right place at the right time—otherwise known as luck.

(6) Seek out opposition

When people lose money they don’t want to be told they are wrong…

What you should really do is to speak to someone with an opposing view.

Ideally you should also sell out of the stock while you do that, so that you have removed the emotional attachment of a vested interest.  This mitigates endowment bias and you can always buy the stock back later.

If you would not put money to work in a particular share today, knowing what you now know, then you have to concede that the investment is dead—and if you haven’t already sold, you absolutely should now.

(7) Be humble

Freeman-Shor notes that the Rabbits, on the whole, were incredibly smart and never said, “I don’t know.”

But this is a very dangerous mindset to have.  First, it assumes the market is made up of buyers and sellers that are not equally expert, when in fact many will be.  Second, ‘knowing more’ often leads to a person not seeing the wood for the trees.

Throughout history there have been many examples that demonstrate this.  My favourites are Harry Warner, of Warner Bros., who in 1927 said, “Who the hell wants to hear actors talk?”, and Thomas Watson, chairman of IBM, who in 1943 said, “I think there is a world market for maybe five computers.”

Experts are surprisingly bad at forecasting.  Falling for your own hype can also often lead to mistakes that the least intelligent person in the world would not be capable of.  Warren Buffett, when talking about the collapse of Long-Term Capital Management, marvelled at “10 or 15 guys with an average IQ of maybe 170 getting themselves into a position where they can lose all their money.”

And crowds are often surprisingly wise—the market can be right even when everyone who makes it up is individually wrong.

Freeman-Shor mentions the jelly beans in a jar experiment.  If you take a jar full of jelly beans and ask everyone in a room of 50 or 60 to guess at how many jelly beans are in the jar, typically the average guess is very close to the truth.  Moreover, the best individual guess is often not even as good as the average guess, and of course there are many individual guesses that are wildly wrong.  This experiment is analogous to the stock market.

Again, only 49% of the best ideas from some of the best investors—those Freeman-Shor hired—ended up being right.

(8) Keep quiet and carry on

Some investors make the mistake of talking publicly about their investments and their anticipated returns.  This makes it much more difficult to change their minds if new facts warrant it.

(9) Don’t underestimate the downside—adapt to it

Many Rabbits like stocks that could shoot for the moon.  However, often such stocks can get wiped out if they don’t work.  Freeman-Shor suggests treating such stocks as options: Size the position as if it were an option—almost like a venture capital investment—so that, if it works, you can do well, whereas if it doesn’t work, the loss will be contained.

(10) Be open to different kinds of story

Deep value investing can produce the highest long-term returns.  Freeman-Shor:

Many studies have shown that stocks with the worst stories tend to produce the highest returns.

Stated differently, value investing—investing in cheap stocks that no one likes because they have terrible stories that led to their stock price falling—produce the highest returns over time.

(11) Get sick of sick notes

Freeman-Shor suggests getting familiar with the typical excuses investors like to offer:

• • The ‘If only’ defence.
  • The ‘I would have been right but for’ defence.
  • The ‘It just hasn’t happened yet” defence.
  • The ‘Who could have foreseen at the time I invested that XYZ would happen…’ defence.
  • If it’s gone down this much already, it can’t go much lower.
  • You can always tell when a stock hits rock bottom.
  • Eventually they always come back.
  • When it rebounds slightly, I’ll sell.

(12) Be suspicious of status.

Freeman-Shor writes:

Lastly, whether you work in the investment industry or are thinking about trusting your money to someone who does, there is a bonus moral in the story of the Rabbits: it is dangerous to assume that just because an investment professional is highly educated and has years of experience, he or she will be good at making money and getting the big calls right.

IT’S ALL ABOUT CAPITAL IMPAIRMENT

Freeman-Shor says:

One of the reasons that the Rabbits held on to losing investments was fear of the unnkown: if they sold out, the shares might rally, and they would miss out.  It was better to stick with a current loss than worry about that double-whammy.

This is known as ambiguity aversion, and describes why people prefer to stick with intolerable situations merely because a hypothetical alternative might be worse.  Better the devil you know.

Freeman-Shor again:

I believe that even the best investors often overlook the fact that a stock’s price would need a practically supernatural rise of 900% to break even if they have foolishly ridden it down 90% and done nothing.

THE LESSONS OF POKER

Freeman-Shor observes:

Stories are the biggest factor in determining what decisions we make.  For the Rabbits, the stories in their heads led them to invest many millions in companies that ultimatley lost them and me vast amounts of money.  Their actions post-investment were clouded by the story that led them to invest on day one.

The moral here is to try to avoid being blinded by your story.  Above all, have a plan of action as to what you will do if you find yourself in a losing position, even if you still think you are right.

The key difference between the Rabbits and successful investors in this book is that when the Rabbits were losing they did nothing.  As we will see with the Assassins and Hunters, they acted decisively to bail themselves out of the holes they found themselves in.

Freeman-Shor quotes Darwin:

It is not the strongest of the species that survive, nor the most intelligent, but the one most responsive to change.

Freeman-Shor then writes:

If only the Rabbits had played poker.  Any poker player knows that it is not how many hands you win that matters, it’s how much you win when you win, and how much you lose when you lose.

Each hand in poker represents a story and the goal for a poker player is to try to make money with whatever story they have been given—good or bad.  If the story is poor then you don’t stick with it and throw money at the problem; the odds are stacked against you.   You fold your hand, cut your losses and live to fight another day.

Likewise, if you are dealt a good hand but then see the flop and realise the hand is now nowhere near as strong as you thought, you fold.

 

The Assassins: The Art of Killing Losses

Freeman-Shor quotes the legendary investor Warren Buffett’s rules for investing success:

Rule No. 1—Never lose money.

Rule No. 2—Never forget rule No.1.

Freeman-Shor then explains:

The Assassins are the investors who really lived and breathed this principle while working for me.  When it came to selling losing positions so as to preserve their capital they were ruthless, like cold-hearted hitmen, pulling the trigger without emotion.  Then they carried on with their lives like nothing had happened.

Hedge fund titan Stanley Druckenmiller had this to say about fellow hedge fund titan George Soros.

[He is] the best loss taker I have seen.  He doesn’t care whether he wins or loses on a trade.  If a trade doesn’t work, he’s confident enough about his ability to win on other trades that he can easily walk away from the position.

Freeman-Shor explains that successful investing is all about asymmetric returns:

…winning is about ensuring the upside return potential is significantly greater than the downside potential loss.

Despite that you might imagine, in reality we can all be as cold and ruthless as the Assassins.

Freeman-Shor adds:

What I liked about the Assassins was that they lived by a pair of sacred rules.

The rules were derived from their own experience and beliefs, and the key to their success was that when they were losing they would always let the rules, not their emotions or feelings, drive their decision.

They knew that when faced with the uncertainty that naturally follows when the market has turned against them, they could not rely on themselves to do the right thing.

They therefore committed to becoming slaves to the rules.  When a loss occurred they would follow their commandments to the letter.

Importantly, these two rules had been well thought through when the Assassins were in an emotionally ‘cold state’.  They planned well in advance; before they invested, they knew what they would do afterwards.  They did this because they knew that when push came to shove they were likely to make poor decisions in a ‘hot’ (or emotionally charged) state of mind.

THE CODE OF THE ASSASSINS

(1) Kill all losers at 20-33%.

The Assassins know that it’s very tempting, when it comes time to kill a losing trade, to wait.  That’s why they used a device: the stop-loss.  Freeman-Shor:

The Assassins’ rules required them to put a stop-loss in place at the same time they they bought any share.  If the stop-loss was triggered by a share price going down a certain amount, it automatically sold their entire stake.

Freeman-Shor comments that some investors use a “review” instead of a stop-loss, but that a stop-loss is often better.  Freeman-Shor continues:

Legendary investor and art collector Roy Neuberger, whose investment firm Neuberger Berman bears his name, credits the 10% rule as part of the reason for his success.  He always cuts his losses when they hit 10%—no matter what.  Recognise your mistakes early and take immediate action was his mantra.

The Assassins’ rule was the same, but they despatched their losers at slightly different predetermined points depending on their own experience and preferences: almost always somewhere between 20% and 33% (it depended on the Assassin).  Despite Neuberger’s rule, my findings support the Assassins’ approach.  This range of stop-loss levels avoids you getting whipsawed while giving a realistic chance of being able to recover from the loss incurred.

Freeman-Shor offers a case study: Genmab, a Danish biotechnology company that specializes in creating human antibody treatments for people suffering from cancer.  Two weeks after investing, the Assassin was down 30%.  His stop-loss activated at -32% and he sold on Nvember 16, 2009, with the shares trading at £12.43, having originally bought the company on October 29, 2009, at £18.34.  This was a good decision because the shares then fell another 49%.  While it was tough to take a 30% loss so quickly, that was much better than a 65% loss.

Freeman-Shor gives another case study: Dods, a media company that provides information, organizes events, and does publishing.  Dods had become the most trusted source for political data.  An Assassin bought shares on December 29, 2006, at £0.51.  Ten months later, his stop-loss at 39% sold out on October 31, 2007 at £0.31.  After that, the stock fell another 63%.  So the Assassin was clearly right to sell when his stop-loss had been triggered.

Freeman-Shor comments:

In the world of investments there is no such thing as a safe bet.  If you invest in a company and think that it is bulletproof, I urge you to have an action plan to decide what to do when things go wrong—things often do.

The next case study: Royal Bank of Scotland.  It is one of three banks in the UK that is permitted to issue UK banknotes.  An Assassin bought shares on May 30, 2008, at £22.29.  When the credit crisis started, this Assassin actually moved faster than his stop-loss, selling out at £18.62.  This was a loss of 16%.  The stock then lost a further 82%.  Good decision by this assassin.

(2) Kill losers after a fixed amount of time.

Freeman-Shor explains the logic of this rule: Time is money.

Being in a losing position too long—even if the size of that loss hasn’t hit 20% or more—can have a devastating effect on your wealth.  This was something the Assassins were acutely aware of.

DON’T SELL TOO SOON

While having a strict discipline for dealing with losing stocks is important, you don’t want to be overly strict or too quick.

Freeman-Shor gives the example of Compass Group, the world’s largest food service company.  It serves billions of meals a year.  One of the investors that Freeman-Shor manages bought on November 20, 2007 at £3.19.  He then stold the entire stake twelve months later at £3.04, for a loss of only 5%.  At the time Freeman-Shor was writing the book, the stock had already increased 143% since it was sold, which was more than the overall market increased.

Freeman-Shor offers the example of BMW.  One of his investors bought BMW on April 11, 2008 at £34.95.  He sold two months later on June 23, 2008, at a price of £32.35 for a loss of 7%.  The stock then went up 95%.

Another example: Perelli, the Italian tyre manufacturer.  One of Freeman-Shor’s investors bought on January 22, 2010 at £4.61.  He sold one month later at £4.26, a loss of 8%.  Perilli subsequently increased 103% as of the time Freeman-Shor was writing the book.

And: Rightmove, where people in the UK look for a property to rent or buy.  One of Freeman-Shor’s investors bought shares at £5.51 on November 13, 2009.  A month later, on December 30, 2009, he sold at a price of £4.91, a loss of 11%.  The shares then shot up 202%.

BE CAREFUL ON YOUR NEXT INVESTMENT

When a person sells a losing investment, they often become risk-seeking, which is called the break-even effect.  This is not a good idea.

AN ELUSIVE CADRE

Freeman-Shor writes:

The Assassins were some of the most disciplined investors I have met, and a significant factor in their ability to make money was that they cut their losses consistently.  A study by Professor Frazzini supports the Assassins’ approach too: it shows that the highest investment returns were achieved by those investors that had the highest rate of selling out of losing positions.  Those that realised the least amount of losing positions experienced the lowest returns.

The losing trait of riding losing positions while taking profits on winning positions has been called the disposition effect by Frazzini.

 

The Hunters: Pursuing Losing Shares

Instead of using a stop-loss like the Assassins, the Hunters instead would—in certain situations—buy more of a stock that had decreased.  Quite often, the Hunters would end up making a profit.

It’s important to note that the Hunters committed to buying more at lower prices—if they became available—before they even bought their initial stake.  Freeman-Shor explains:

The key reason for the Hunters’ approach lay in their invariably contrarian style.  They were value investors.  They generally found themselves buying when everyone else was seling, and this was an extension of that philosophy, another way of exploiting Mr. Market when he was acting irrationally.

SUCCESS STARTS FROM FAILURE

Many successful Hunters had at least one terrible year near the beginning of their career.  The Hunters learned how to be contrarian but also to be right more often than not.  (Otherwise, there’s no benefit from being a contrarian.)  Just as important, the Hunters learned to admit when they had made a mistake.  Freeman-Shor:

They also grew unafraid to sell if it became clear they really had made a mistake.  Poor value investors I have come across refuse to adapt when they are losing and tend to support their lack of action by saying, “I got it wrong but the stock is simply too cheap to sell now.”  A bad contrarian investor can make for a very committed Rabbit.

But if a stock still passed the vital ‘Would I buy this knowing what I know now?’ test, the Hunters followed their plan, and started to put their money on the side to work as the share price dropped.

SNATCHING VICTORY

Many Hunters enjoyed the game of trying to pick a bottom in a given stock.  It’s often not possible to do this, but sometimes it is possible to come close.  As Freeman-Shor explains, successfully investing near the bottom can often create a nice profit.  The Hunters enjoyed snatching victory from the jaws of defeat.

Freeman-Shor:

Be under no illusions: being a Hunter requires patience and discipline.  You have to expect a share price to go against you in the near term and not panic when it does.  You have to be prepared to make money from stocks that may never recapture the original price you paid for your first lost of shares.  If you know your personality is one which demands instant gratification, this approach is not for you.

Freeman-Shor quote Peter Lynch:

I’m accustomed to hanging around with a stock when the price is going nowhere.  Most of the money I make is in the third or fourth year that I’ve owned something.

Freeman-Shor offers some case studies.

Aker Solutions is a Norwegian oil services company.  It provides products and services related to the construction, maintenance, and operation of oil and gas fields.  One of Freeman-Shor’s Hunters bought the stock on April 14, 2008, at £15.84 per share.  A year and a half later, the stock was much lower.  The Hunter bought significantly more on September 28, 2009, so that his average cost was only £7.61.  He sold at £9.58 because he realized his original thesis was no longer true.  Had he not done anything, he would have had a loss of 40%.  Instead, he made a 24% profit.

Experian is an Irish company that operates globally.  The company collects information on individuals and produces credit scores used by lenders.  A Hunter bought the stock on June 13, 2006, at an initial price of £9.02.  After the price declined, the Hunter bought more, reducing his average cost to £5.66.  When he sold at £7.06, he realized a profit of 19%.  Had he done nothing, he would have lost 22%.  Freeman-Shor notes that the Hunter, by his actions, had turned a losing position into a winning position.

Technip is a French company that does engineering and construction for the oil and gas industry.  It’s a leader in areas such as subsea drilling, laying specially built pipelines, producing floating offshore platforms, and planning the development of oil and gas fields.  A Hunter bought the stock on April 11, 2008, at a price of £55.42.  When the stock declined, the Hunter bought much more, reducing his average cost to £42.24.  He later sold at £52.13.  He realized a gain of 22%.  Once again, a Hunter had turned a loss into a gain by buying more shares on the decline.

Thomson Reuters is a global media company based on New York.  It provides the latest content and data to the finance industry.  It also produces material to help lawyers and accountants ensure they are up-to-date on the professional education.  Moreover, the company produces research for the pharmaceutical industry.  A Hunter bought stock on June 13, 2006, at £22.25.  The stock dropped and the Hunter bought materially more, reducing his average cost to £15.82.  He sold on September 10, 2009, at £18.92.  Instead of a loss of 15%, the Hunter made a profit of 17%.

HUNTING FOR THE COMPOUNDING EFFECT

Freeman-Shor mentions the Kelly criterion.  Freeman-Shor doesn’t mention the details, but they’re important, so here they are:

The Kelly criterion can be written as follows:

• • F = p – [q/o]

where

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

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

Both Warren Buffett and Charlie Munger are proponents of the essential logic of the Kelly criterion.  Here’s Charlie Munger:

The wise ones bet heavily when the world offers them that opportunity.  They bet big when they have the odds.  And the rest of the time, they don’t.  It’s just that simple.

As for Buffett, he famously invested 40% of his hedge fund into American Express in the late 1960s.  Buffett realized a large profit.  Later, Buffett invested 25% of Berkshire Hathaway’s portfolio in Coca-Cola.  Buffett again enjoyed a large profit of more than 10x (and counting).

Freeman-Shor notes the following:

If a stock you are invested in has fallen materially in price, but nothing else has changed—the investment thesis is still intact—your odds will have improved significantly and you should materially increase your stake in that company.

Freeman-Shor adds:

If you are a Hunter… you choose not to control risk by diversification but by thoroughly understanding the risk and returns of a particular stock or handful or stocks.  Your goal is to find companies that have an unbelievably attractive, asymmetric payoff profile.

The fact that you are only investing in a few companies means that you have the opportunity to invest big on day one, and then follow up with large top-up investments should the share price fall.

Warren Buffett wrote in his 1993 letter to the shareholders of Berkshire Hathaway:

If you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification make no sense for you.  It is apt to simply hurt your results and increase your risk.  I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices—the businesses he understands best and that present the least risk, along with the greatest profit potential.

Freeman-Shor concludes by pointing out that coaches would be quite helpful for investors:

I find it bizarre that top athletes and sportsmen and women have coaches but the majority of investment professionals do not.

How can they expect to improve their game if they do not have constructive feedback?

 

PART II. I’M WINNING—WHAT SHOULD I DO?

The Raiders: Snatching at Treasure

Freeman-Shor writes:

Raiders occupy a thin line between success and disaster.  These are investors who like nothing better than taking a profit as soon as practical.  They are the stock market equivalent of gold-age adventurers: having penetrated through the dense jungle, found the lost temple or buried treasure, they fill their pockts with all the ancient coins and gems they can—then turn tail and run.

Unlike gold-age adventurers, they are rarely chased by angry locals or rivals.  The only boulders rolling after them are in their imaginations.  They are terrified of getting caught and losing everything, and to ensure they at least come away with something end up leaving countless chests and swagbags of treasure behind completely unnecessarily.

Freeman-Shor continues:

I discovered the Raiders when I noticed the rather distressing fact that one of my investors had an incredible success rate—almost 70% of his ideas were correct, which is truly phenomenal—but he hadn’t made me any money.

I broke down the data for his investments and discovered that whenever he made a small gain, say 10%, he would immediately sell the stock and take the profit.

Interestingly, he was a hedge fund manager and in his own trading was an expert at shorting shares—and staying short.  But when it came to long-only investments, he and the other Raiders lacked a key habit that the successful investors I worked with possessed.  He did not embrace the right tail of the distribution curve.  In ordinary terms, the Raiders did not run their winners.

Freeman-Shor then gives some examples.

Chicago Bridge & Iron is a multinational company that does energy industry infrastructure projects.  One of the Raiders bought the stock on September 3, 2009, at £10.66.  A month later, on October 5, 2009, he sold at £12.29.  A few years later, the stock was at £30.38.  The stock had increased 147% since the Raider had so prematurely sold it.

British American Tobacco manufactures and sells tobacco products, including the brands Lucky Strike, Pall Mall, Vogue, John Player, Benson & Hedges, and Kent.  One of Freeman-Shor’s Raiders bought on July 3, 2009, at £19.96.  Two and a half months later, on September 21, 2009, he sold at £21.75, a profit of 9%.   A few years later, the stock was at £37.93, 74% higher than where the Raider had sold it.

Swedish Match is a world leader in chewable tobacco.  The Raider bought on October 10, 2008, when the shares were at €10.56.  This investor sold after two months on December 16, 2008, at €10.18, a 4% loss.  He decided to buy back in on June 24, 2009, at €11.23, before selling on April 22, 2010, at €17.54, for a profit of 56%.  A couple of years later, the stock was at €25.88, a further increase of 49%.

Novo Nordisk is a Danish pharmaceutical company and a world leader in diabetes medication (insulin) and care equipment (injection devices and needles).  The company is also a leader in hemophilia care and hormone-replacement therapy.  One of Freeman-Shor’s investors bought on April 22, 2009, at €35.71.  He later sold on December 4, 2009, at €45.32, a profit of 27%.  A couple of years later, the stock was at €124.92, a further increase of 175%.  This Raider had made a huge error, assuming the intrinsic value of the stock was near €124.92 or higher.

Freeman-Shor summarizes by saying that Raiders are right most of the time, but still lose money because their losses are bigger than their gains.  If they could learn to stick with winning ideas, they would be winning investors.  Freeman-Shor comments:

…the most successful investors I worked with, those that made the most money, all had one thing in common: the presence of a couple of big winners in their portfolios.  Any approach that does not embrace the possibility of winning big is doomed.

WHY DO INVESTORS SELL TOO SOON?

(1) It feels so good.  Selling for a profit feels nice.  We get a hit from testosterone and dopamine.

(2) I’m bored.  As Peter Lynch observed:

[I]t’s normally harder to stick with a winning stock… than it is to believe in it after the price goes down.

(3) Frustration.  It’s very difficult to patiently wait for years.  One factor is hyperbolic discounting, which makes people prefer $1 today versus $2 tomorrow.

(4) Fear.  Because of loss aversion, we tend to feel the pain of a loss at least twice as much as the pleasure of an equivalent gain.  When a Raider’s investment starts doing well, he often fears what might happen if he doesn’t sell.

(5) Short-termism.  There is recency bias.  Freeman-Shor:

My own fund—the Old Mutual European Best Ideas fund—is a good example of this.  If you took a three-year view from 2009 to 2011 you would have said I was a superstar.  If you viewed my performance during August 2011, or for the year 2011 alone, you would have said quite the reverse.

The flows my fund experienced showed just this.  Shortly after delivering those three-year performance figures I had over $200 million invested into my fund.  But during August 2011, clients withdrew tens of millions of dollars.

Since 2011 the performance of the fund has been strong and, surprise surprise, we have attacted inflows again.

Imposing different time frames on an investment can produce very different results—and Raiders invariably impose short-term ones.  This can be deadly for winning trades.

(6) Risk aversion.  People are risk-averse when winning—and tend to take profits—and they are risk-seeking when losing.  When winning, selling is appealing because the certainty of a small victory is better than the uncertainty of a loss or greater victory.  When losing, risk is appealing because anything is better than a certain loss.

WHY YOU SHOULDN’T SELL EARLY

(1) Rarity value.  Freeman-Shor:

All the successful investors I have managed made money because they won big in a few names, while ensuring the bad ideas did not materially hurt them.

… Stock market returns over time show kurtosis, which means fat tails are larger than would be expected from a normal distribution curve.  This means that a few big winners and losers distort the overall market return—and an investor’s return.  If you are not invested in those big winners your returns are drastically reduced.

(2) Beat your rivals.  Honing your ability to let winners run can give you a very significant advantage as an investor.

(3) You cannot trust your next investment.  The odds of picking a winning trade—based on the results of some of the best investors in the world working for Freeman-Shor—are roughly 49%.  This means the odds of picking five winning investments in a row are roughly 2.8%.  So if you have a winning investment, stick with it as long as possible.

(4) Winners can keep winning.  The research says that a momentum strategy can be a winning strategy.  A stock that has gone up over 6 months or a year often continues to go up.  Of course, no stock goes up forever, so even though you should let a winner run—as long as the investment thesis is intact and the intrinsic value is higher than the current stock price—you should eventually sell unless it’s a company with a sustainably high return on equity (ROE).

(5) You can never predict big winners when you first invest.  Freeman-Shor:

Many legendary investors did not predict their biggest winners—and have admitted it.  Some all-time greats even built their investment style around not knowing how big a winner might be: Jesse Livermore became of of the wealthiest men in America in the 20th century by adopting a simple trend-following approach.

In effect he bought stocks that were being bid up and rode them up, never knowing if it would turn out to be a big winner when he initiated the position.

TOO PROFESSIONAL

Some reasons why professional investors tend to sell too soon.

(1) Bonuses.  Many fund managers are paid an annual bonus.  (It would make much more sense to pay a bonus—and allow the bonus to be large—every five or ten years.)

(2) Expectations.  Some fund managers feel the outperformance cannot continue.  The error being made is that essentially no investor can predict their biggest winners ahead of time.  So it’s best to stick with a winner as long as the investment thesis is intact and the estimated intrinsic value is high enough (or the company has a sustainably high ROE).

(3) Forecasting.  Often when fund managers look one or two years ahead and use conservative assumptions, the estimated intrinsic value is not much higher than the current stock price.   This makes it difficult to stick with the big winners.

(4) Relativity.  Unfortunately, many fund managers are evaluated on a shorter-term basis.  This makes them obsess over shorter-term results.  However, the biggest winners often increase the most in year 3 or year 4 or later.  A fund manager worried about 6-month or 1-year performance will tend to miss the biggest winners.

Freeman-Shor writes:

So being assessed on a relative basis leads fund managers to pay a lot of attention to how they are performing relative to both the benchmark index and their peer group.  Worse still, some do this on a daily basis.  They know the value of their holdings almost to the hour.

And it leads to a lot of unnecessary early selling.  It helps professional investors think that stocks are riskier than they actually are.  By monitoring a stock they are invested in several times a day, they notice the share price moves up and down quite a bit.  The price seems volatile.

But what if you just reviewed an investment every ten years?  You would probably find that the stock has made you quite a lot of money.  Moreover, because you did not check the stock price during that ten-year period, you did not notice the price moving up and down every day.  You never experienced the pain of a 20% fall in one day—perhaps 50% in a year.  You were completely unaware of the volatility of the ride you were on.  You therefore come to the conclusion that investing in the stock market is not risky at all.

My note: Fidelity did a study of its accounts and it found that the best-performing accounts belonged to people who either forgot they had an account or to people who had died.

 

The Connoisseurs: Enjoying Every Last Drop

Freeman-Shor writes:

The Connoisseurs are the last and most successful investment tribe I discovered among the top investors who worked for me.  These are the investors whose performance lived up to the billing—or exceeded it.  They did not get paralysed by unexpected losses or carried away with victories.  They treated every investment like a vintage of wine: if it was off, they got rid of it immediately, but if it was good they knew it would only get better with age.  They usually drank the odd bottle now and then, to tide them over—but otherwise they sat back and waited.

It takes a long of nerve to do nothing or merely trim a position when winning.  Everything points to us being hard-wired to sell out of an investment when we have made a reasonable profit.

…

Taking small profits along the journey like a Connoisseur allows us to get instant gratification without ruining our long-term wealth aspirations.  This ‘trick’ is one that I have seen in action and which allowed my best investors to stay in absolutely phenomenal winners.

HOW TO RIDE WINNERS

Freeman-Shor:

In terms of hit rate, as a group [Connoissers] actually had a worse record than the average for my investors.  Six out of ten ideas the Connoisseurs invested in lost money.  The trick was that when they won, they won big.  They rode their winners far beyond most people’s comfort zone.

How to be like a Connoisseur:

(1) Find unsurprising companies.

The Connoisseurs’ approach was to identify companies with a view to holding them for ten or more years.  They would buy businesses that they viewed as low ‘negative surprise’ companies.  In other words, it was hard to envisage anything that could cause these companies to fail in generating profits over the years ahead.

Even if in the future they had terrible management at the helm, that management would have to be extraordinarily incompetent to destroy the profit-making ability of the enterprise.  The companies were effectively money-printing machines.

The future growth of earnings was seen as very predictable, and because the Connoisseurs believed earnings growth drove stock prices, the stock price should therefore drift higher over time.

The main risk of buying these stocks was if they were rated highly at the outset (i.e. with high price/earnings ratio).  This could mean that the company fundamentally performs as expected but the share price doesn’t follow earnings upwards due to it getting derated.

(2) Look for big upside potential.  Where many investors go wrong is in investing in a lot of ideas with limited upside potential.  Since your win rate may be between 40% and 49%, it’s essential to focus only on stocks with the biggest upside potential—or stocks trading at the greatest discount to intrinsic value.

(3) Invest big—and focused.  Connoisseurs could end up with 50% of their portfolio in just two stocks.  Freeman-Shor:

Having massive belief in a couple of names meant they were prepared to ride the stocks with big positions even when they were up 200% or more.  Their success was testament to Stanley Druckenmiller’s comment that “position size can be more important than entry price.”

This is one of the reasons that I allow each of my current investors to invest up to 25% of the money I give them in a single idea.

Freeman-Shor quotes New Market Wizards:

When you have tremendous conviction on a trade, you have to go for the jugular.  It takes courage to be a pig.  It takes courage to ride a profit with huge leverage.  As far as Soros is concerned, when you’re right on something, you can’t own enough.

Freeman-Shor comments:

It is no use having a small investment in a big winner; you have to have a large position size to generate big returns.

(4) Don’t be scared.  One key to sticking with a big winner and not being attracted by another great investment is to take small profits as the potential big winner is going up.  But the bulk of the potential big winner should be maintained and not sold.

(5) Make sure you have a pillow.  Freeman-Shor writes about having a high boredom threshold:

Meeting some of my Connoisseurs could be very, very boring because nothing ever changed.  They would talk about the same stocks they had been invested in for the past five years or longer…

The fact is, most of us will find it difficult to emulate the Connoisseurs because we feel the need to do something when we get to the office (or home trading desk) every day.  We look at stock price charts, listen to the latest market news on Bloomberg TV, and fool ourselves into believing we could add value from making a few small trades here and there.  It is very hard to do nothing but focus on the same handful of companies every year, only researching new ideas on the side.

Many of us, seeing we have made a profit of 40% in one of our stocks, start actively looking for another company to invest the money into—instead of leaving it invested.  This is precisely why lots of investors never become very successful.

Freeman-Shor next gives some real-life examples.

Shoprite Holdings is the largest food retailer in Africa.  It also operates furniture outlets, fast food outlets, and pharmacies.  It is the Wal-Mart of Africa.  One of the Connoisseurs invested in Shoprite on May 20, 2009, at £3.96 per share.  He sold the position three years later on August 9, 2012, at £13.10 per share.  This was a return of 231% in only three years.  This investor trimmed along the way and realized an overall profit of 104%.

Spirax-Sarco Engineering is a UK company that builds and maintains steam and industrial fluid plants.  The company’s products—which include boilder and pipeline control valves and clean steam generators—are being used more and more.  One of the Connoisseurs had known about this company for decades.  He bought a position on November 30, 2007, at £9.63.  He sold five years later on October 22, 2012, at £19.70.  The Connoisseur trimmed along the way and so realized a profit of 70% by selling at an average price of £16.40.

Rotork is a UK-based business and the world’s leading manufacturer of valve actuators, whether electric, pneumatic, or hydraulic.  The Connoisseur had known about the company for a long time.  He bought a position on November 30, 2007, at £9.84.  He sold five years later at £25.18.  Because the investor took profits along the way, he realized an average selling price of £17.26, banking a profit of 74%.

President Chain Stores is a Taiwanese company.  The company is an international food conglomerate operating in Taiwan and China.  It’s similar to Wal-Mart.  One of the Connoisseurs established a position on June 15, 2006, at £1.37 per share.  He sold five years later on August 23, 2011, with the shares at £3.73.  Because he trimmed along the way, the investor realized an average selling price of £3.17.  This was a profit of 132%.

Kasikornbank is a commercial bank in Thailand.  Through its wholly-owned subsidiaries, it does everything from investment banking to securities brokerage, fund management, hire purchase, and machinery/equipment leasing.  A Connoiser initiated a position on June 20, 2008, at £1.09.  He sold two years later on November 1, 2010, when the shares were at £2.65.  Because the investor sold along the way, his average selling price was £1.88.  Thus, he realized a profit of 79%.

Freeman-Shor  writes an important point:

Remember, despite their successful approach, only one-in-three of the Connoisseurs’ ideas made money.  In other words, every Connoisseur was also an Assassin or a Hunter when it came to losses.

CLUES FROM THE FORBES RICH LIST

Most people on the Forbes rich list not only have created a wonderful business, but also have never sold out.  Many of these folks received buyout offers along the way, but they decided not to sell.  Freeman-Shor:

Over the past decade or so, I would imagine Bezos has been approached by hundreds, possibly thousands of other companies wanting to buy Amazon from him.  Could you have resisted if someone offered  you $10m or $100m for your company?  Resisting temptation and staying invested in a great idea is critical.  Had Jeff sold out earlier when he was building Amazon, we may never have heard about him today.

Freeman-Shor adds:

When you are winning, dedication and discipline is what you require.  The Pareto principle, otherwise known as the 80/20 rule, states that 80% of the effects come from 20% of the causes.  It helps explain why great investors can be wrong most of the time and still make money.  A few big winners make a massive difference to the eventual outcome.

WHY MANY FUND MANAGERS ARE DOOMED TO FAIL

Freeman-Shor writes that many fund managers find it nearly impossible to be Connoisseurs.

Firstly, many professional investors over-diversify when they invest because they are managing career risk.  Most are judged by their bosses and employers based on how they perform against an index or peer group over a short period of time.  This militates against concentrating investments in potential long-term winners.

Secondly, regulators—based on investment theories from the 1970s—have put into place rules that prohibit professional fund managers from holding large positions in just a handful of their very best money-making ideas.

Why?

Because they believed diversified portfolios represent less risk than a concentrated portfolio of stocks.  The reality, however, is that all you are doing is swapping one type of risk for another.  You are exchanging company specific risk (idiosyncratic risk), which may be very low depending on the type of company you invest in, for market risk (systematic risk).

Risk hasn’t been reduced, it has been transferred.

The legendary investor Warren Buffett has written that if you know the companies you’re investing in very well and if you’ve focused only on your very best ideas, risk is actually lower than if you added more ideas about which you had both less conviction and less knowledge.

ACADEMIC SUPPORT FOR ‘BEST IDEAS’ INVESTING

There was a paper that looked at the performance of investment managers’ best ideas.  They found:

• • The single highest-conviction stock of every manager taken together outperformed the market, as well as the other stocks in those managers’ portfolios, by approximately 1-4% a quarter.  That is a staggering 4-16% a year.  Over a ten-year time frame, that means these stocks could have outperformed the market by a phenomenal 48-341%!
  • The managers’ top five stocks also outperformed the market, as well as the other stocks in those managers’ portfolios, significantly.
  • The managers’ worst ideas—those stocks with the lowest weighting—performed significantly worse than the managers’ best ideas.

The study also found that there was little overlap in terms of the specific best ideas of the investors they studied.  The bottom line: Success comes from investing in your best idea.

The authors of the paper conclude:

What if each mutual fund manager had only to pick a few stocks, their best ideas?  Could they outperform under those circumstances?  We document strong evidence that they could, as the best ideas of the active managers generate up to an order of magnitude more alpha than their portfolio as a whole.

The paper also notes:

The poor overall performance of mutual fund managers in the past is not due to a lack of stock-picking ability, but rather to institutional factors that encourage them to over diversify, i.e. pick more stocks than their best alpha-generating ideas.

Again:

…the organization of the money management industry appears to make it optimal for managers to introduce stocks into their portfolios that are not outperformers… [in other words] managers attempt to maximise profits by maximizing assets under management… while investors benefit from concentration… managers under most commonly-used fee structures are better off with a more diversified portfolio.

DANGERS OF BEING A CONNOISSEUR

Freeman-Shor notes that while being a Connoisseur generates the highest returns, it is not easy and there are dangers, three in particular:

(1) You can be too late.  After a stock has increased a greal deal, at some point it won’t and the investor may be too late.  I would add: As long as the intrinsic value is higher than the current stock price, or as long as the ROE is sustainably high (if you’re buying a higher quality business as your value investment strategy) and the stock price reasonable, then you should be OK.

(2) Momentum can be illusory—and end abruptly.  See the previous point.

One must also beware of bubbles.  Freeman-Shor mentions the book by Charles Mackay, Extraordinary Popular Delusions and the Madness of Crowds (1841).

His research showed how people lose the ability to think rationally under pressures of crowd behavior.  At the height of a bull market or in the depths of a bear market people become herd-minded.

…

This suggests that sipping some of those profits over time makes a lot of sense.  While you stay invested and therefore have the potential to win big, you are mitigating the potential damage should the shares disappoint.

(3) You can get stuck.  If panic takes over, it can be difficult to sell.

 

CONCLUSION: THE HABITS OF SUCCESS

Freeman-Shor writes:

Having had the privilege of investing over a billion dollars with the best investors in the world, and managing them on a daily basis for over eight years, my preconceptions about successful investors have been shattered.

I discovered that the success enjoyed by top investors is not due to possessing a special gift, nor from having a privileged upbringing (though some who worked for me did).  Nor is it down to being born geniuses, though many were very smart.  Instead, any success ultimately came down to just one thing: execution.

This was the common thread that connected all of them.  And the secrets of successful execution were really just a matter of habit.

…

Each had learned the unseen art of executing ideas in a way that meant that even if they were wrong most of the time, they would still make a lot of money.

These successful investors didn’t have any clairvoyant forecasting abilities, but they knew what to do when they were winning or losing.  Freeman-Shor:

If they were losing they knew they had to materially adapt, like a poker player being dealt a poor hand.  A losing position was feedback from the market showing them that they were wrong to invest when they did.  They knew that doing nothing, or a little, was futile.  They had each independently developed a habit of significantly reducing or materially buying more shares when they were losing.

When winning, to take an analogy from baseball, the successful investors knew they had to try to hit a home run, as opposed to stealing first base.  This meant that they had developed the hidden habit of being resolved to stay invested in a winning position even when inside they were burning to take the profits they had made, and their inner voice was screaming, ‘Take the profit before you lose it!’

Freeman-Shor adds the following:

Success in investing is open to anyone, whatever their level of education or background, whether old or young, experienced or inexperienced.  You simply need to materially adapt when losing and remain faithful when winning.

If you have the discipline to do that, you can succeed.

I have no doubt that many professional investors reading this will neither change the way they invest nor adopt the winning habits I have revealed.  They will consider them too simple or common.  Most think they are just too smart and that they know best.  They are overconfident in the same way all drivers think they are better than average.  It’s their loss.

Freeman-Shor makes an additional, important point:

Some people may worry that adopting the habits of the successful investing tribes means losing their identity—or looking to invest with ideas that aren’t really theirs.  The good news is that the investors within each group all had radically different opinions about almost everything.  Their habits of execution overlapped, but the ideas that got them into an investment in the first place could not have been more different.

 

THE WINNER’S CHECKLIST: THE FIVE WINNING HABITS OF INVESTMENT TITANS

(1) BEST IDEAS ONLY.  You should only invest in your very best ideas.  Period.  One or two big winners is essential for success.

(2) POSITION SIZE MATTERS.  Again, it’s essential not to over-diversify.  Invest only in your very best ideas.  But have a handful of these ideas, not just one, because sometimes there are unforseen events or bad luck.

(3) BE GREEDY WHEN WINNING.  You have to let your winners run.  Embrace the possibility of the big win.  Embrace the right tail, the statistical long shots, of the distribution curve.  Give your investments the possibility of growing into ‘ten baggers.’

(4) MATERIALLY ADAPT WHEN YOU ARE LOSING.  Either add significantly to a losing position or sell out.  If you add more, you can turn a loser into a winner.

(5) ONLY INVEST IN LIQUID STOCKS.  How liquid a stock is depends in part on how much you’re investing.  If you’re investing $10 million or less, then most of the best investments will be microcap stocks.

 

THE LOSER’S CHECKLIST: THE FIVE LOSING HABITS OF MOST INVESTORS

(1) INVEST IN LOTS OF IDEAS.  As noted earlier, Warren Buffett has pointed out that you should concentrate on your best ideas and that adding more ideas than that would only increase risk and decrease returns.  Or as Charlie Munger said:

Wide diversification, which necessarily includes investment in mediocre businesses, only guarantees ordinary results.

(2) INVEST A SMALL AMOUNT IN EACH IDEA.  This is related to the previous point.  If you do not invest big in your best ideas, you won’t be able to do very well because a few big winners are what make the difference between an extraordinary track record and a mediocre one.

(3) TAKE SMALL PROFITS.  If you sell too much of your best ideas before giving them a chance to really run, you are cutting off your best chance for excellent overall results.

(4) STAY IN AN INVESTMENT IDEA AND REFUSE TO ADAPT WHEN LOSING

(5) DO NOT CONSIDER LIQUIDITY

 

 

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.

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.

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.

• • 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.

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.

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.

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.

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.

July 9, 2023

I first wrote about Obsidian Energy on November 14, 2021 here: https://boolefund.com/case-study-obsidian-energy-obelf/

Since then, the stock has gone from $3.74 to $6.18, an increase of 65%.  But the company’s cash flows have increased even more, meaning the stock is more undervalued today than it was in November, 2021.

 

OIL PRICES

Here is a superb article on oil prices: https://seekingalpha.com/article/4615799-oil-is-asymmetrically-positioned-to-the-upside

OPEC+ has not only continued to cut production targets, but it has been under-producing its targets simply because it cannot produce more.  Meanwhile, oil demand is healthy and increasing about 1% a year.

No one can predict oil prices, especially over shorter periods of time.  But demand is likely to exceed supply going forward, and inventories are likely to decline.  This probably means higher oil prices in the range of at least $75-90 per barrel (WTI).

But even if oil prices were to stay closer to $65-70, Obsidian Energy would still be very profitable.

If there’s a recession, oil prices could decline temporarily, but would quickly snap back.

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

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

 

OBSIDIAN ENERGY (OBE)

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

• • EV/EBITDA = 1.15
  • P/E = 0.79
  • P/B = 0.39
  • P/CF = 1.14
  • P/S = 0.72

The Piotroski F_Score is 8, which is very good.

The market cap is $507.4 million.  The company has $67 million in cash and $264.8 million in debt.  The enterprise value (EV) is $705.5 million.

TL/TA is 28.8%, which is excellent.

Insider ownership is 7%.  That is worth a bit more than $35 million.  If the stock at least doubles, insiders can make at least $35 million.

ROE is 68.1%, which is outstanding.

Obsidian Energy continues to buy back shares of its stock, which creates significant value because the stock is very undervalued.  If the stock remains undervalued, the company plans to increase buybacks once it has lowered its net debt to $169 million.

We calculate NAV based on 2P reserves (proved plus probable).  Intrinsic value scenarios:

• • Low case: If there is a bear market or recession, the stock could temporarily decline 50%.  This would be a major buying opportunity.
  • Mid case: If the oil price averages $70 WTI, then NAV per share is $16.24, which is over 160% higher than today’s $6.18.
  • High case: If the oil price averages $80 WTI, then NAV per share is $20.61, which is over 230% higher than today’s $6.18.
  • Very high case: If the oil price averages $90 WTI, then NAV per share is $24.66, which is 300% higher than today’s $6.18

 

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.