Heads, I win; tails, I don’t lose much!

October 9, 2022

Value investor Mohnish Pabrai wrote The Dhandho Investor: The Low-Risk Value Method to High Returns (Wiley, 2007).  It’s an excellent book that captures the essence of value investing:

The lower the price you pay relative to the probable intrinsic value of the business, the higher your returns will likely be if you’re right and the lower your losses will likely be if you’re wrong.

If you have a good investment process as a value investor—whether it’s quantitative and statistical, or it involves stock-picking—then typically you’ll be right on about 60 percent of the positions.  Because losses are minimized on the other 40 percent, the portfolio is likely to do well over time.

Mohnish sums up the Dhandho approach as:

Heads, I win;  tails, I don’t lose much!

There is one very important additional idea that Mohnish focused on in his recent (October 2016) lecture at Peking University (Guanghua School of Management):

10-BAGGERS TO 100-BAGGERS

A 10-bagger is an investment that goes up 10x after you buy it.  A 100-bagger is an investment that goes up 100x after you buy it.  Mohnish gives many examples of stocks—a few of which he kept holding and many of which he sold—that later became 10-baggers, 20-baggers, up to a few 100-baggers.  If you own a stock that has already been a 2-bagger, 3-bagger, 5-bagger, etc., and you sell and the stock later turns out to be a 20-bagger, 50-bagger, or 100-bagger, often you have made a huge mistake by selling too soon.

Link to Mohnish’ lecture at Peking University:  https://www.youtube.com/watch?v=Jo1XgDJCkh4

Here’s the outline for this blog post:

    • Patel Motel Dhandho
    • Manilal Dhandho
    • Virgin Dhandho
    • Mittal Dhandho
    • The Dhandho Framework
    • Dhandho 101: Invest in Existing Businesses
    • Dhandho 102: Invest in Simple Businesses
    • Dhandho 201: Invest in Distressed Businesses in Distressed Industries
    • Dhandho 202: Invest in Businesses with Durable Moats
    • Dhandho 301: Few Bets, Big Bets, Infrequent Bets
    • Dhandho 302: Fixate on Arbitrage
    • Dhandho 401: Margin of Safety—Always!
    • Dhandho 402: Invest in Low-Risk, High-Uncertainty Businesses
    • Dhandho 403: Invest in the Copycats rather than the Innovators
    • A Short Checklist
    • Be Generous

 

PATEL MOTEL DHANDHO

(Mohnish published the book in 2007.  I will use the present tense in this blog post.)

Mohnish notes that Asian Indians make up about 1 percent of the population of the United States.  Of these three million, a small subsection hails from the Indian state of Gujarat—the birthplace of Mahatma Gandhi.  The Patels are from a tiny area in Southern Gujarat.  Mohnish:

Less than one in five hundred Americans is a Patel.  It is thus amazing that over half of all the motels in the entire country are owned and operated by Patels… What is even more stunning is that there were virtually no Patels in the United States just 35 years ago.  They started arriving as refugees in the early 1970s without much in the way of capital or education.  Their heavily accented, broken-English speaking skills didn’t improve their prospects either.  From that severely handicapped beginning, with all the odds stacked against them, the Patels triumphed.  Patels, as a group, today own over $40 billion in motel assets in the United States, pay over $725 million a year in taxes, and employ nearly a million people.  How did this small, impoverished ethnic group come out of nowhere and end up controlling such vast resources?  There is a one word explanation:  Dhandho.

Dhandho means a low-risk, high-return approach to business.  It means the upside is much larger than the downside, which is the essence of value investing.

Dhandho is all about the minimization of risk while maximizing the reward… Dhandho is thus best described as endeavors that create wealth while taking virtually no risk.

Mohnish gives a brief history of the Patels.  Some Patels had gone to Uganda and were doing well there as entrepreneurs.  But when General Idi Amin came to power as a dictator in 1972, things changed.  The Ugandan state seized all of the businesses held by Patels and other non-natives.  These businesses were nationalized, and the previous owners were paid nothing.

Because India was already dealing with a severe refugee crisis in 1972-1973, the Indian-origin population that had been tossed out of Uganda was not allowed back into India.  Many Patels settled in England and Canada, and a few thousand were accepted in the United States.

In 1973, many nondescript motels were being foreclosed and then sold at distressed prices.  “Papa Patel” realized that a motivated seller or bank might finance 90% of the purchase.  If Papa Patel could put $5,000 down, he could get a motel on the cheap.  The Patel family would run things and also live there.  So they had no salaries to pay, and no rent to pay.  With rock-bottom expenses, they could then offer the lowest nightly rates.  This would lead to higher occupancy and high profits over time, given the very low cost structure.

As long as the motel didn’t fail, it would likely be a highly profitable venture relative to the initial $5,000 investment.  If the motel did fail, Papa Patel reasoned that he and his wife could bag groceries and save close to $5,000 in a couple of years.  Then Papa Patel could find another cheap motel and make the same bet.  If the probability of failure is 10%, then the odds of two failures in a row would be 1%, while nearly every other scenario would involve a high return on investment.  Once the first motel was solidly profitable, Papa Patel could let his oldest son take over and look for the next one to buy.

The Patels kept repeating this basic approach until they owned over half the motels in the United States.

 

MANILAL DHANDHO

The Patel formula is repeatable.  It’s not just a one-time opportunity based on unique circumstances.  Consider Manilal Chaudhari, also from Gujarat, says Mohnish.

Manilal had worked hard as an accountant in India.  In 1991, with sponsorship from his brother, he migrated to the United States.  His English was not good, and he couldn’t find a job in accounting.

His first job was working 112 hours a week at a gas station at minimum wage.  Later, he got a job at a power supply manufacturing company, Cherokee International, owned by a Patel.  Manilal worked full-time at Cherokee, and kept working at the gas station as much as possible.  The Persian owner of the gas station, recognizing Manilal’s hard work, gave him a 10 percent stake in the business.

In 1998, Manilal decided he wanted to buy a business.  One of the employees at Cherokee (a Patel) told Manilal that he wanted to invest with him in whatever business he found.  In 2001, the travel industry went into a slump and motel occupancy and prices plummeted.  Manilal found a Best Western motel on sale at a terrific location.  Since everyone in the extended family had been working non-stop and saving, Manilal – along with a few Patels from Cherokee – were able to buy the Best Western.

Four years later, the Best Western had doubled in value to $9 million.  The $1.4 million invested by Manilal and a few Patels was now worth $6.7 million, an annualized return of 48 percent.  This doesn’t include annual free cash flow.  Mohnish concludes:

Now, that’s what I’d call Manilal Dhandho.  He worked hard, saved all he could, and then bet it all on a single no-brainer bet.  Reeling from the severe impact of 9/11 on travel, the motel industry was on its knees.  As prices and occupancy collapsed, Manilal stepped in and made his play.  He was on the hunt for three years.  He patiently waited for the right deal to materialize.  Classically, his story is all about Few Bets, Big Bets, Infrequent Bets.  And it’s all about only participating in coin tosses where:

Heads, I win;  tails, I don’t lose much!

 

VIRGIN DHANDHO

The year was 1984 and Richard Branson knew nothing about the airline business.  He started his entrepreneurial journey at 15 and was very successful in building an amazing music recording and distribution business.

Somebody sent Branson a business plan about starting an all business class airline flying between London and New York.  Branson noted that when an executive in the music business received a business plan to start an airline involving a 747 jumbo jet, he knew that the business plan had been turned down in at least three thousand other places before landing on his desk…

Branson decided to offer a unique dual-class service.  But when he presented the idea to his partners and senior executives at the music business, they told him he was crazy.  Branson persisted and discovered that he could lease a 747 jumbo jet from Boeing.  Branson calculated that Virgin Atlantic Airlines, if it failed, would cost $2 million.  His record company was going to earn $12 million that year and about $20 million the following year.

Branson also realized that tickets get paid about 20 days before the plane takes off.  But fuel is paid 30 days after the plane lands.  Staff wages are paid 15 to 20 days after the plane lands.  So the working capital needs of the business would be fairly low.

Branson had found a service gap and Virgin Atlantic ended up doing well.  Branson would repeat this formula in many other business opportunities:

Heads, I win;  tails, I don’t lose much!

 

MITTAL DHANDHO

Mohnish says Rajasthan is the most colorful state of India.  Marwar is a small district in the state, and the Marwaris are seen as excellent businesspeople.  Lakshmi Mittal, a Marwari entrepreneur, went from zero to a $20 billion net worth in about 30 years.  And he did it in an industry with terrible economics:  steel mills.

Take the example of the deal he created to take over the gigantic Karmet Steel Works in Kazakhstan.  The company had stopped paying its workforce because it was bleeding red ink and had no cash.  The plant was on the verge of closure with its Soviet-era managers forced to barter for steel food for its workers.  The Kazakh government was glad to hand Mr. Mittal the keys to the plant for nothing.  Not only did Mr. Mittal retain the entire workforce and run the plant, he paid all the outstanding wages and within five years had turned it into a thriving business that was gushing cash.  The workers and townsfolk literally worship Mittal as the person who saved their town from collapse.

…The same story was repeated with the Sidek Steel plant in Romania, and the Mexican government handed him the keys to the Sibalsa Mill for $220 million in 1992.  It had cost the Mexicans over $2 billion to build the plant.  Getting dollar bills at 10 cents—or less—is Dhandho on steroids.  Mittal’s approach has always been to get a dollar’s worth of assets for far less than a dollar.  And then he has applied his secret sauce of getting these monolith mills to run extremely efficiently.

Mohnish recounts a dinner he had with a Marwari friend.  Mohnish asked how Marwari businesspeople think about business.  The friend replied that they expect their entire investment to be returned as dividends within three years, with the principal still being worth at least the initial amount invested.

 

THE DHANDHO FRAMEWORK

Mohnish lays out the Dhando framework, including:

  • Invest in existing businesses.
  • Invest in simple businesses.
  • Invested in distressed businesses in distressed industries.
  • Invest in businesses with durable moats.
  • Few bets, big bets, and infrequent bets.
  • Fixate on arbitrage.
  • Margin of safety—always.
  • Invest in low-risk, high-uncertainty businesses.
  • Invest in the Copycats rather than the Innovators.

Let’s look at each point.

 

DHANDHO 101: INVEST IN EXISTING BUSINESSES

Over a long period of time, owning parts of good businesses via the stock market has been shown to be one of the best ways to preserve and grow wealth.  Mohnish writes that there are six big advantages to investing in stocks:

  • When you buy stock, you become a part owner of an existing business. You don’t have to do anything to create the business or to make the business run.
  • You can get part ownership of a compounding machine. It is simple to buy your stake, and the business is already fully staffed and running.
  • When people buy or sell entire businesses, both buyer and seller typically have a good idea of what the business is worth. It’s hard to find a bargain unless the industry is highly distressed.  In the public stock market, however, there are thousands and thousands of businesses.  Many stock prices change by 50% or more in any given year, but the intrinsic value of most businesses does not change by 50% in a given year.  So a patient investor can often find opportunities.
  • Buying an entire business usually takes serious capital. But buying part ownership via stock costs very little by comparison.  In stocks, you can get started with a tiny pool of capital.
  • There are likely over 100,000 different businesses in the world with public stock available.
  • For a long-term value investor, the transaction costs are very low (especially at a discount broker) over time.

 

DHANDHO 102: INVEST IN SIMPLE BUSINESSES

As Warren Buffett has noted, you generally do not get paid extra for degree of difficulty in investing.  There is no reason, especially for smaller investors, not to focus on simple businesses.  By patiently looking at hundreds and hundreds of microcap stocks, eventually you can find a 10-bagger, 20-bagger, or even a 100-bagger.  And the small business in question is likely to be quite simple.  With such a large potential upside, there is no reason, if you’re a small investor, to look at larger or more complicated businesses.  (The Boole Microcap Fund that I manage focuses exclusively on micro caps.)

It’s much easier to value a simple business because it usually is easier to estimate the future free cash flows.  The intrinsic value of any business—what the business is worth—is the sum of all future free cash flows discounted back to the present.  This is called the discounted cash flow (DCF) approach.  (Intrinsic value could also mean liquidation value in some cases.)

You may need to have several scenarios in your DCF analysis—a low case, a mid case, and a high case.  (What you’re really looking for is a high case that involves a 10-bagger, 20-bagger, or 100-bagger.)  But you’re still nearly always better off limiting your investments to simple businesses.

Only invest in businesses that are simple—ones where conservative assumptions about future cash flows are easy to figure out.

 

DHANDHO 201: INVEST IN DISTRESSED BUSINESSES IN DISTRESSED INDUSTRIES

The stock market is usually efficient, meaning that stock prices are usually accurate representations of what businesses are worth.  It is very difficult for an investor to do better than the overall stock market, as represented by the S&P 500 Index or another similar index.

Stock prices, in most instances, do reflect the underlying fundamentals.  Trying to figure out the variance between prices and underlying intrinsic value, for most businesses, is usually a waste of time.  The market is mostly efficient.  However, there is a huge difference between mostly and fully efficient.

Because the market is not always efficient, value investors who patiently examine hundreds of different stocks eventually will find a few that are undervalued.  Because public stock markets are highly liquid, if an owner of shares becomes fearful, he or she can quickly sell those shares.  For a privately held business, however, it usually takes months for an owner to sell the position.  Thus, a fearful owner of public stock is often more likely to sell at an irrationally low price because the sale can be completed right away.

Where can you find distressed businesses or industries?  Mohnish offers some suggestions:

  • Business headlines often include articles about distressed businesses or industries.
  • You can look at prices that have dropped the most in the past 52 weeks. You can also look at stocks trading at low price-to-earnings ratios (P/Es), low price-to-book ratios (P/Bs), high dividend yields, and so on.  Not every quantitatively cheap stock is undervalued, but some are.  There are various services that offer screening such as Value Line.
  • You can follow top value investors by reading 13-F Forms or through different services. I would only note that the vast majority of top value investors are not looking at microcap stocks.  If you’re a small investor, your best opportunities are very likely to be found among micro caps.  Very few professional investors ever look there, causing microcap stocks to be much more inefficiently priced than larger stocks.  Also, micro caps tend to be relatively simple, and they often have far more room to grow.  Most 100-baggers start out as micro caps.
  • Value Investors Club (valueinvestorsclub.com) is a club for top value investors. You can get free guest access to all ideas that are 45 days old or older.  Many cheap stocks stay cheap for a long time.  Often good ideas are still available after 45 days have elapsed.

 

DHANDHO 202: INVEST IN BUSINESSES WITH DURABLE MOATS

A moat is a sustainable competitive advantage.  Moats are often associated with capital-light businesses.  Such businesses (if successful) tend to have sustainably high ROIC (return on invested capital)—the key attribute of a sustainable competitive advantage.  Yet sometimes moats exist elsewhere and sometimes they are hidden.

Sometimes the moat is hidden.  Take a look at Tesoro Corporation.  It is in the oil refining business—which is a commodity.  Tesoro has no control over the price of its principle raw material, crude oil.  It has no control [of the price] over its principal finished good, gasoline.  Nonetheless, it has a fine moat.  Tesoro’s refineries are primarily on the West Coast and Hawaii.  Refining on the West Coast is a great business with a good moat.  There hasn’t been a refinery built in the United States for the past 20 years.  Over that period, the number of refineries has gone down from 220 to 150, while oil demand has gone up about 2 percent a year.  The average U.S. refinery is operating at well over 90 percent of capacity.  Anytime you have a surge in demand, refining margins escalate because there is just not enough capacity.

…How do we know when a business has a hidden moat and what that moat is?  The answer is usually visible from looking at its financial statements.  Good businesses with good moats… generate high returns on capital deployed in the business.  (my emphasis)

But the nature of capitalism is that any company that is earning a high return on invested capital will come under attack by other businesses that want to earn a high return on invested capital.

It is virtually a law of nature that no matter how well fortified and defended a castle is, no matter how wide or deep its moat is, no matter how many sharks or piranhas are in that moat, eventually it is going to fall to the marauding invaders.

Mohnish quotes Charlie Munger:

Of the fifty most important stocks on the NYSE in 1911, today only one, General Electric, remains in business… That’s how powerful the forces of competitive destruction are.  Over the very long term, history shows that the chances of any business surviving in a manner agreeable to a company’s owners are slim at best.

Mohnish adds:

There is no such thing as a permanent moat.  Even such invincible businesses today like eBay, Google, Microsoft, Toyota, and American Express will all eventually decline and disappear.

…It takes about 25 to 30 years from formation for a highly successful company to earn a spot on the Fortune 500… it typically takes many blue chips less than 20 years after they get on the list to cease to exist.  The average Fortune 500 business is already past its prime by the time it gets on the list.

If you’re a small investor, searching for potential 10-baggers or 100-baggers among microcap stocks makes excellent sense.  You want to find tiny companies that much later reach the Fortune 500.  You don’t want to look at companies that are already on the Fortune 500 because the potential returns are far more likely to be mediocre going forward.

 

DHANDHO 301: FEW BETS, BIG BETS, INFREQUENT BETS

Claude Shannon was a fascinating character—he often rode a unicycle while juggling, and his house was filled with gadgets.  Shannon’s master’s thesis was arguably the most important and famous master’s thesis of the twentieth century.  In it, he proposed binary digit or bit, as the basic unit of information.  A bit could have only two values—0 or 1, which could mean true or false, yes or no, or on or off.  This allowed Boolean algebra to represent any logical relationship.  This meant that the electrical switch could perform logic functions, which was the practical foundation for all digital circuits and computers.

The mathematician Ed Thorp, a colleague of Shannon’s at MIT, had discovered a way to beat the casinos at blackjack.  But Thorp was trying to figure out how to size his blackjack bets as a function of how favorable the odds were.  Someone suggested to Thorp that he talk to Shannon about it.  Shannon recalled a paper written by a Bell Labs colleague of his, John Kelly, that dealt with this question.

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.

Thorp proceeded to use the Kelly criterion to win quite a bit of money at blackjack, at least until the casinos began taking countermeasures such as cheating dealers, frequent reshuffling, and outright banning.  But Thorp realized that the stock market was also partly inefficient, and it was a far larger game.

Thorp launched a hedge fund that searched for little arbitrage situations (pricing discrepancies) involving warrants, options, and convertible bonds.  In order to size his positions, Thorp used the Kelly criterion.  Thorp evolved his approach over the years as previously profitable strategies were copied.  His multi-decade track record was terrific.

Ed Thorp examined Buffett’s career and concluded that Buffett has used the essential logic of the Kelly criterion by concentrating his capital into his best ideas.  Buffett’s concentrated value approach has produced an outstanding, unparalleled 65-year track record.

Thorp has made several important points about the Kelly criterion as it applies to long-term value investing.  The Kelly criterion was invented to apply to a very long series of bets.  Value investing differs because even a concentrated value investing approach will usually have at least 5-8 positions in the portfolio at the same time.  Thorp argues that, in this situation, the investor must compare all the current and prospective investments simultaneously on the basis of the Kelly criterion.

Mohnish gives an example showing how you can use the Kelly criterion on your top 8 ideas, and then normalize the position sizes.

Say you look at your top 8 investment ideas.  You use the Kelly criterion on each idea separately to figure out how large the position should be, and this is what you conclude about the ideal bet sizes:

  • Bet 1 – 80%
  • Bet 2 – 70%
  • Bet 3 – 60%
  • Bet 4 – 55%
  • Bet 5 – 45%
  • Bet 6 – 35%
  • Bet 7 – 30%
  • Bet 8 – 25%

Of course, that adds up to 400%.  Yet for a value investor, especially running a concentrated portfolio of 5-8 positions, it virtually never makes sense to buy stocks on margin.  Leverage cannot make a bad investment into a good investment, but it can turn a good investment into a bad investment.  So you don’t need any leverage.  It’s better to compound at a slightly lower rate than to risk turning a good investment into a bad investment because you lack staying power.

So the next step is simply to normalize the position sizes so that they add up to 100%.  Since the original portfolio adds up to 400%, you just divide each position by 4:

  • Bet 1 – 20%
  • Bet 2 – 17%
  • Bet 3 – 15%
  • Bet 4 – 14%
  • Bet 5 – 11%
  • Bet 6 – 9%
  • Bet 7 – 8%
  • Bet 8 – 6%

(These percentages are rounded for simplicity.)

As mentioned earlier, if you truly know the odds of each bet in a long series of bets, the Kelly criterion tells you exactly how much to bet on each bet in order to maximize your long-term compounded rate of return.  Betting any other amount will lead to lower compound returns.  In particular, if you repeatedly bet more than what the Kelly criterion indicates, you eventually will destroy your capital.

It’s nearly always true when investing in a stock that you won’t know the true odds or the true future scenarios.  You usually have to make an estimate.  Because you never want to bet more than what the Kelly criterion says, it is wise to bet one half or one quarter of what the Kelly criterion says.  This is called half-Kelly or quarter-Kelly betting.  What is nice about half-Kelly betting is that you will earn three-quarters of the long-term returns of what full Kelly betting would deliver, but with only half the volatility.

So in practice, if there is any uncertainty in your estimates, you want to bet half-Kelly or quarter-Kelly.  In the case of a concentrated portfolio of 5-8 stocks, you will frequently end up betting half-Kelly or quarter-Kelly because you are making 5-8 bets at the same time.  In Mohnish’s example, you end up betting quarter-Kelly in each position once you’ve normalized the portfolio.

Mohnish quotes Charlie Munger again:

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.

When running the Buffett Partnership, Warren Buffett invested 40% of the partnership in American Express after the stock had been cut in half following the salad oil scandal.  American Express had to announce a $60 million loss, a huge hit given its total market capitalization of roughly $150 million at the time.  But Buffett determined that the essential business of American Express—travelers’ checks and charge cards—had not been permanently damaged.  American Express still had a very valuable moat.

Buffett explained his reasoning in several letters to limited partners, as quoted by Mohnish here:

We might invest up to 40% of our net worth in a single security under conditions coupling an extremely high probability that our facts and reasoning are correct with a very low probability that anything could change the underlying value of the investment.

We are obviously only going to go to 40% in very rare situations—this rarity, of course, is what makes it necessary that we concentrate so heavily, when we see such an opportunity.  We probably have had only five or six situations in the nine-year history of the partnerships where we have exceeded 25%.  Any such situations are going to have to promise very significant superior performance… They are also going to have to possess such superior qualitative and/or quantitative factors that the chance of serious permanent loss is minimal…

There’s virtually no such thing as a sure bet in the stock market.  But there are situations where the odds of winning are very high or where the potential upside is substantial.

One final note:  In constructing a concentrated portfolio of 5-8 stocks, if at least some of the positions are non-correlated or even negatively correlated, then the volatility of the overall portfolio can be reduced.  Some top investors prefer to have about 15 positions with low correlations.

Once you get to at least 25 positions, specific correlations typically tend not to be an issue, although some investors may end up concentrating on specific industries.  In fact, it often may make sense to concentrate on industries that are deeply out-of-favor.

Mohnish concludes:

…It’s all about the odds.  Looking out for mispriced betting opportunities and betting heavily when the odds are overwhelmingly in your favor is the ticket to wealth.  It’s all about letting the Kelly Formula dictate the upper bounds of these large bets.  Further, because of multiple favorable betting opportunities available in equity markets, the volatility surrounding the Kelly Formula can be naturally tamed while still running a very concentrated portfolio.

In sum, top value investors like Warren Buffett, Charlie Munger, and Mohnish Pabrai—to name just a few out of many—naturally concentrate on their best 5-8 ideas, at least when they’re managing a small enough amount of money.  (These days, Berkshire’s portfolio is massive, which makes it much more difficult to concentrate, let alone to find hidden gems among micro caps.)

You have to take a humble look at your strategy and your ability before deciding on your level of concentration.  The Boole Microcap Fund that I manage is designed to focus on the top 15-25 ideas.  This is concentrated enough so that the best performers—whichever stocks they turn out to be—can make a difference to the portfolio.  But it is not so concentrated that it misses the best performers.  In practice, the best performers very often turn out to be idea #9 or idea #17, rather than idea #1 or idea #2.  Many top value investors—including Peter Cundill, Joel Greenblatt, and Mohnish Pabrai—have found this to be true.

 

DHANDHO 302: FIXATE ON ARBITRAGE

The example often given for traditional commodity arbitrage is that gold is selling for $1,500 in London and $1,490 in New York.  By buying gold in New York and selling it in London, the arbitrageur can make an almost risk-free profit.

In merger arbitrage, Company A offers to buy Company B at, say, $20 per share.  The stock of Company B may move from $15 to $19.  Now the arbitrageur can buy the stock in Company B at $19 in order to capture the eventual move to $20.  By doing several such deals, the arbitrageur can probably make a nice profit, although there is a risk for each individual deal.

In what Mohnish calls Dhandho arbitrage, the entrepreneur risks a relatively small amount of capital relative to the potential upside.  Just look at the earlier examples, including Patel Motel Dhandho, Virgin Dhandho, and Mittal Dhandho.

Heads, I win;  tails, I don’t lose much!

 

DHANDHO 401: MARGIN OF SAFETY—ALWAYS!

Nearly every year, Buffett has hosted over 30 groups of business students from various universities.  The students get to ask questions for over an hour before going to have lunch with Buffett.  Mohnish notes that students nearly always ask for book or reading recommendations, and Buffett’s best recommendation is always Ben Graham’s The Intelligent Investor.  As Buffett told students from Columbia Business School on March 24, 2006:

The Intelligent Investor is still the best book on investing.  It has the only three ideas you really need:

  • Chapter 8—The Mr. Market analogy.  Make the stock market serve you.  The C section of the Wall Street Journal is my business broker—it quotes me prices every day that I can take or leave, and there are no called strikes.
  • Chapter 8—A stock is a piece of a business.  Never forget that you are buying a business which has an underlying value based on how much cash goes in and out.
  • Chapter 20—Margin of Safety.  Make sure that you are buying a business for way less than you think it is conservatively worth.

The heart of value investing is an idea that is directly contrary to economic and financial theory:

  • The bigger the discount to intrinsic value, the lower the risk.
  • The bigger the discount to intrinsic value, the higher the return.

Economic and financial theory teaches that higher returns always require higher risk.  But Ben Graham, the father of value investing, taught just the opposite:  The lower the price you pay below intrinsic value, the lower your risk and the higher your potential return.

Mohnish argues that the Dhandho framework embodies Graham’s margin of safety idea.  Papa Patel, Manilal, and Branson all have tried to minimize the downside while maximizing the upside.  Again, most business schools, relying on accepted theory, teach that low returns come from low risk, while high returns require high risk.

Mohnish quotes Buffett’s observations about Berkshire’s purchase of Washington Post stock in 1973:

We bought all of our [Washington Post (WPC)] holdings in mid-1973 at a price of not more than one-fourth of the then per-share business value of the enterprise.  Calculating the price/value ratio required no unusual insights.  Most security analysts, media brokers, and media executives would have estimated WPC’s intrinsic business value at $400 to $500 million just as we did.  And its $100 million stock market valuation was published daily for all to see.  Our advantage, rather, was attitude:  we had learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business value.

…Through 1973 and 1974, WPC continued to do fine as a business, and intrinsic value grew.  Nevertheless, by year-end 1974 our WPC holding showed a loss of about 25%, with a market value of $8 million against our cost of $10.6 million.  What we had bought ridiculously cheap a year earlier had become a good bit cheaper as the market, in its infinite wisdom, marked WPC stock down to well below 20 cents on the dollar of intrinsic value.

As of 2007 (when Mohnish wrote his book), Berkshire’s stake in the Washington post had grown over 33 years from the original $10.6 million to a market value of over $1.3 billion—more than 124 times the original investment.  Moreover, as of 2007, the Washington Post was paying a modest dividend (not included in the 124 times figure).  The dividend alone (in 2007) was higher than what Berkshire originally paid for its entire position.  Buffett:

Most institutional investors in the early 1970s, on the other hand, regarded business value as of only minor relevance when they were deciding the prices at which they would buy or sell.  This now seems hard to believe.  However, these institutions were then under the spell of academics at prestigious business schools who were preaching a newly-fashioned theory:  the stock market was totally efficient, and therefore calculations of business value—and even thought, itself—were of no importance in investment activities.  (We are enormously indebted to those academics:  what could be more advantageous in an intellectual contest—whether it be bridge, chess, or stock selection—than to have opponents who have been taught that thinking is a waste of energy?)

At any given time, a business is in either of two states:  it has problems or it will have problems.  Virtually every week there are companies or whole industries where stock prices collapse.  Many business problems are temporary and not permanent.  But stock investors on the whole tend to view business problems as permanent, and they mark down the stock prices accordingly.

You may be wondering:  Due to capitalist competition, nearly all businesses eventually fail, so how can many business problems be temporary?  When we look at businesses experiencing problems right now, many of those problems will be solved over the next three to five years.  Thus, considering the next three to five years, many business problems are temporary.  But the fate of a given business over several decades is a different matter entirely.

 

DHANDHO 402: INVEST IN LOW-RISK, HIGH-UNCERTAINTY BUSINESSES

The future is always uncertain.  And that’s even more true for some businesses.  Yet if the stock price is low enough, high uncertainty can create a good opportunity.

Papa Patel, Manilal, Branson, and Mittal are all about investing in low-risk businesses.  Nonetheless, most of the businesses they invested in had a very wide range of possible outcomes.  The future performance of these businesses was very uncertain.  However, these savvy Dhandho entrepreneurs had thought through the range of possibilities and drew comfort from the fact that very little capital was invested and/or the odds of a permanent loss of capital were extremely low… Their businesses had a common unifying characteristic—they were all low-risk, high-uncertainty businesses.

In essence, says Mohnish, these were all simple bets:

Heads, I win;  tails, I don’t lose much!

Wall Street usually hates high uncertainty, and often does not distinguish between high uncertainty and high risk.  But there are several distinct situations, observes Mohnish, where Wall Street tends to cause the stock price to collapse:

  • High risk, low uncertainty
  • High risk, high uncertainty
  • Low risk, high uncertainty

Wall Street loves the combination of low risk and low uncertainty, but these stocks nearly always trade at high multiples.  On the other hand, Dhandho entrepreneurs and value investors are only interested in low risk and high uncertainty.

Mohnish discusses an example of a company he was looking at in the year 2000:  Stewart Enterprises (STEI), a funeral service business.  Leading companies such as Stewart Enterprises, Loewen, Service Corp. (SRV), and Carriage Services (CSV) had gone on buying sprees in the 1990s, acquiring mom-and-pop businesses in their industry.  These companies all ended up with high debt as a result of the acquisitions.  They made the mistake of buying for cash—using debt—rather than buying using stock.

Loewen ended up going bankrupt.  Stewart had $930 million of long-term debt with $500 million due in 2002.  Wall Street priced all the funeral service giants as if they were going bankrupt.  Stewart’s price went from $28 to $2 in two years.  Stewart kept coming up on the Value Line screen for lowest price-to-earnings (P/E) ratios.  Stewart had a P/E of less than three, a rarity.  Mohnish thought that funeral services must be a fairly simple business to understand, so he started doing research.

Mohnish recalled reading an article in the mid-1990s in the Chicago Tribune about the rate of business failure in various industries.  The lowest rate of failure for any type of business was funeral homes.  This made sense, thought Mohnish.  It’s not the type of business that aspiring entrepreneurs would dream about, and pre-need sales often make up about 25 percent of total revenue.  It’s a steady business that doesn’t change much over time.

Stewart had roughly $700 million in annual revenue and owned around 700 cemeteries and funeral homes.  Most of its business was in the United States.  Stewart’s tangible book value was $4 per share, and book value was probably understated because hard assets like land were carried at cost.  At less than $2 per share, Stewart was trading at less than half of stated tangible book value.  By the time the debt was due, the company would generate over $155 million in free cash flow, leaving a shortfall of under $350 million.

Mohnish thought through some scenarios and estimated the probability for each scenario:

  • 25% probability: The company could sell some funeral homes.  Selling 100 to 200 might take care of the debt.  Equity value > $4 per share.
  • 35% probability: Based on the company’s solid and predictable cash flow, Stewart’s lenders or bankers might decide to extend the maturities or refinance the debt—especially if the company offered to pay a higher interest rate.  Equity value > $4 per share.
  • 20% probability: Based on Stewart’s strong cash flows, the company might find another lender—especially if it offered to pay a higher interest rate.  Equity value > $4 per share.
  • 19% probability: Stewart enters bankruptcy.  Even assuming distressed asset sales, equity value > $2 per share.
  • 1% probability: A 50-mile meteor comes in or Yellowstone blows or some other extreme event takes place that destroys the company.  Equity value = $0.

The bottom line, as Mohnish saw it, was that the odds were less than 1% that he would end up losing money if he invested in Stewart at just under $2 per share.  Moreover, there was an 80% chance that the equity would be worth at least $4 per share.  So Mohnish invested 10 percent of Pabrai Funds in Stewart Enterprises at under $2 per share.

A few months later, Stewart announced that it had begun exploring sales of its international funeral homes.  Stewart expected to generate $300 to $500 million in cash from this move.  Mohnish:

The amazing thing was that management had come up with a better option than I had envisioned.  They were going to be able to eliminate the debt without any reduction in their cash flow.  The lesson here is that we always have a free upside option on most equity investments when competent management comes up with actions that make the bet all the more favorable.

Soon the stock hit $4 and Mohnish exited the position with more than 100% profit.

It’s worth repeating what investor Lee Ainslee has said:  Good management tends to surprise on the upside, while bad management tends to surprise on the downside.

Frontline

In 2001, Mohnish noticed two companies with a dividend yield of more than 15 percent.  Both were crude oil shippers:  Knightsbridge (VLCC) and Frontline (FRO).  Mohnish started reading about this industry.

Knightsbridge had been formed a few years earlier when it ordered several tankers from a Korean shipyard.  A very large crude carrier (VLCC) or Suezmax at the time cost $60 to $80 million and would take two to three years to be built and delivered.  Knightsbridge would then lease the ships to Shell Oil under long-term leases.  Shell would pay Knightsbridge a base lease rate (perhaps $10,000 a day per tanker) regardless of whether it used the ships or not.  On top of that, Shell paid Knightsbridge a percentage of the difference between a base rate and the spot market price for VLCC rentals, notes Mohnish.  So if the spot price for a VLCC was $30,000 per day, Knightsbridge might receive $20,000 a day.  If the spot was $50,000, it would get perhaps $35,000 a day.  Mohnish:

At the base rate, Knightbridge pretty much covered its principal and interest payments for the debt it took on to pay for the tankers.  As the rates went above $10,000, there was positive cash flow;  the company was set up to just dividend all the excess cash out to shareholders, which is marvelous…

Because of this unusual structure and contract, when tanker rates go up dramatically, this company’s dividends go through the roof.

Mohnish continues:

In investing, all knowledge is cumulative.  I didn’t invest in Knightsbridge, but I did get a decent handle on the crude oil shipping business.  In 2001, we had an interesting situation take place with one of these oil shipping companies called Frontline.  Frontline is the exact opposite business model of Knightsbridge.  It has the largest oil tanker fleet in the world, among all the public companies.  The entire fleet is on the spot market.  There are very few long-term leases.

Because it rides on the spot market on these tankers, there is no such thing as earnings forecasts or guidance.  The company’s CEO himself doesn’t know what the income will be quarter to quarter.  This is great, because whenever Wall Street gets confused, it means we likely can make some money.  This is a company that has widely gyrating earnings.

Oil tanker rates have ranged historically from $6,000 a day to $100,000 a day.  The company needs about $18,000 a day to breakeven… Once [rates] go above $30,000 to $35,000, it is making huge profits.  In the third quarter of 2002, oil tanker rates collapsed.  A recession in the United States and a few other factors caused a drop in crude oil shipping volume.  Rates went down to $6,000 a day.  At $6,000 a day Frontline was bleeding red ink, badly.  The stock went from $11 a share to around $3, in about three months.

Mohnish notes the net asset value of Frontline:

Frontline had about 70 VLCCs at the time.  While the daily rental rates collapsed, the price per ship hadn’t changed much, dropping about 10 percent or 15 percent.  There is a fairly active market in buying and selling oil tankers.  Frontline had a tangible book value of about $16.50 per share.  Even factoring in the distressed market for ships, you would still get a liquidation value north of $11 per share.  The stock price had gone from $15 to $3… Frontline was trading at less than one-third of liquidation value.

Keep in mind that Frontline could sell a ship for about $60 million, and the company had 70 ships.  Frontline’s annual interest payments were $150 million.  If it sold two to three ships a year, Frontline could sustain the business at the rate of $6,000 a day for several years.

Mohnish also discovered that Frontline’s entire fleet was double hull tankers.  All new tankers had to be double hull after 2006 due to regulations following the Exxon Valdez spill.  Usually single hull tankers were available at cheaper day rates than double hull tankers.  But this wasn’t true when rates dropped to $6,000 a day.  Both types of ship were available at the same rate.  In this situation, everyone would rent the double hull ships and no one rented the single hull ships.

Owners of the single hull ships were likely get jittery and to sell the ships as long as rates stayed at $6,000 a day.  If they waited until 2006, Mohnish explains, the ability to rent single hull ships would be much lower.  And by 2006, scrap rates might be quite low if a large number of single hull ships were scrapped at the same time.  The net result is that there is a big jump in scrapping for single hulled tankers whenever rates go down.  Mohnish:

It takes two to three years to get delivery of a new tanker.  When demand comes back up again, inventory is very tight because capacity has been taken out and it can’t be added back instantaneously.  There is a definitive cycle.  When rates go as low as $6,000 and stay there for a few weeks, they can rise to astronomically high levels, say $60,000 a day, very quickly.  With Frontline, for about seven or eight weeks, the rates stayed under $10,000 a day and then spiked to $80,000 a day in fourth quarter 2002.  The worldwide fleet of VLCCs in 2002 was about 400 ships.  Over the past several decades, worldwide oil consumption has increased by 2 percent to 4 percent on average annually.  This 2 percent to 4 percent is generally tied to GDP growth.  Usually there are 10 to 12 new ships added each year to absorb this added demand.  When scrapping increases beyond normal levels, the fleet is no longer increasing by 2 percent to 4 percent.  When the demand for oil rises, there just aren’t enough ships.  The only thing that’s adjustable is the price, which skyrockets.

Pabrai Funds bought Frontline stock in the fall of 2002 at $5.90 a share, about half of liquidation value of $11 to $12.  When the stock moved up to $9 to $10, Mohnish sold the shares.  Because he bought the stock at roughly half liquidation value, this was a near risk-free bet:  Heads, I win a lot;  tails, I win a little!

Mohnish gives a final piece of advice:

Read voraciously and wait patiently, and from time to time amazing bets will present themselves.

Important Note:  Had Mohnish kept the shares of Frontline, they would have increased dramatically.  The shares approached $120 within a few years, so Mohnish would have made 20x his initial investment at $5.90 per share had he simply held on for a few years.

As noted earlier, Mohnish recently gave a lecture at Peking University (Guanghua School of Management) about 10-baggers to 100-baggers, giving many examples of stocks like Frontline that he had actually owned but sold way too soon.  Link:  https://www.youtube.com/watch?v=Jo1XgDJCkh4

 

DHANDHO 403: INVEST IN THE COPYCATS RATHER THAN THE INNOVATORS

What Mohnish calls copycats are businesses that simply copy proven innovations.  The first few Patels figured out the economics of motel ownership.  The vast majority of Patels who came later simply copied what the first Patels had already done successfully.

Mohnish writes:

Most entrepreneurs lift their business ideas from other existing businesses or from their last employer.  Ray Kroc loved the business model of the McDonald brothers’ hamburger restaurant in San Bernardino, California.  In 1954, he bought the rights to the name and know-how, and he scaled it, with minimal change.  Many of the subsequent changes or innovations did not come from within the company with its formidable resources—they came from street-smart franchisees and competitors.  The company was smart enough to adopt them, just as they adopted the entire concept at the outset.

 

A SHORT CHECKLIST

Mohnish gives a list of good questions to ask before buying a stock:

  • Is it a business I understand very well—squarely within my circle of competence?
  • Do I know the intrinsic value of the business today and, with a high degree of confidence, how it is likely to change over the next few years?
  • Is the business priced at a large discount to its intrinsic value today and in two to three years?  Over 50 percent?
  • Would I be willing to invest a large part of my net worth into this business?
  • Is the downside minimal?
  • Does the business have a moat?
  • Is it run by able and honest managers?

If the answers to these questions are yes, buy the stock.  Furthermore, writes Mohnish, hold the stock for at least two to three years before you think about selling.  This gives enough time for conditions to normalize and thus for the stock to approach intrinsic value.  One exception:  If the stock increases materially in less than two years, you can sell, but only after you have updated your estimate of intrinsic value.

In any scenario, you should always update your estimate of intrinsic value.  If intrinsic value is much higher than the current price, then continuing to hold is almost always the best decision.  One huge mistake to avoid is selling a stock that later becomes a 10-bagger, 20-bagger, or 100-bagger.  That’s why you must always update your estimate of intrinsic value.  And don’t get jittery just because a stock is hitting new highs.

A few more points:

  • If you have a good investment process, then about 2/3 of the time the stock will approach intrinsic value over two to three years.  1/3 of the time, the investment won’t work as planned—whether due to error, bad luck, or unforeseeable events—but losses should be limited due to a large margin of safety having been present at the time of purchase.
  • In the case of distressed equities, there may be much greater potential upside as well as much greater potential downside.  A few value investors can use this approach, but it’s quite difficult and typically requires greater diversification.
  • For most value investors, it’s best to stick with companies with low or no debt.  You may grow wealth a bit more slowly this way, but as Buffett and Munger always ask, what’s the rush?  Buffett and Munger had a friend Rick Guerin who owned a huge number of Berkshire Hathaway shares, but many of the shares were on margin.  When Berkshire stock got cut in half—which will happen occasionally to almost any stock, no matter how good the company—Guerin was forced to sell much of his position.  Had Guerin not been on margin, his non-margined shares in Berkshire would later have been worth a fortune (approaching $1 billion).
  • Your own mistakes are your best teachers, explains Mohnish.  You’ll get better over time by studying your own mistakes:

While it is always best to learn vicariously form the mistakes of others, the lessons that really stick are ones we’ve stumbled through ourselves.

 

BE GENEROUS

Warren Buffett and Bill Gates are giving away most of their fortune to help many people who are less fortunate.  Bill and Melinda Gates devote much of their time and energy (via the Gates Foundation) to saving or improving as many human lives as possible.

Mohnish Pabrai and his wife started the Dakshana Foundation in 2005.  Mohnish:

I do urge you to leverage Dhandho techniques fully to maximize your wealth.  But I also hope that… you’ll use some time and some of that Dhandho money to leave this world a little better place than you found it.  We cannot change the world, but we can improve this world for one person, ten people, a hundred people, and maybe even a few thousand people.

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

There’s Always Something to Do

October 2, 2022

There’s Always Something to Do:  The Peter Cundill Investment Approach, by Christopher Risso-Gill (2011), is an excellent book.  Cundill was a highly successful deep value investor whose chosen method was to buy stocks below their liquidation value.

Here is an outline for this blog post:

  • Peter Cundill
  • Getting to First Base
  • Launching a Value Fund
  • Value Investment in Action
  • Going Global
  • A Decade of Success
  • Investments and Stratagems
  • Learning From Mistakes
  • Entering the Big League
  • There’s Always Something Left to Learn
  • Pan Ocean
  • Fragile X
  • What Makes a Great Investor?
  • Glossary of Terms with Cundill’s Comments

 

PETER CUNDILL

It was December in 1973 when Peter Cundill first discovered value investing.  He was 35 years old at the time.  Up until then, despite a great deal of knowledge and experience, Cundill hadn’t yet discovered an investment strategy.  He happened to be reading George Goodman’s Super Money on a plane when he came across chapter 3 on Benjamin Graham and Warren Buffett.  Cundill wrote about his epiphany that night in his journal:

…there before me in plain terms was the method, the solid theoretical back-up to selecting investments based on the principle of realizable underlying value.  My years of apprenticeship were over:  ‘THIS IS WHAT I WANT TO DO FOR THE REST OF MY LIFE!’

What particularly caught Cundill’s attention was Graham’s notion that a stock is cheap if it sells below liquidation value.  The farther below liquidation value the stock is, the higher the margin of safety and the higher the potential returns.  This idea is at odds with modern finance theory, according to which getting higher returns always requires taking more risk.

Peter Cundill became one of the best value investors in the world.  He followed a deep value strategy based entirely on buying companies below their liquidation values.

We do liquidation analysis and liquidation analysis only.

 

GETTING TO FIRST BASE

One of Cundill’s first successful investments was in Bethlehem Copper.  Cundill built up a position at $4.50, roughly equal to cash on the balance sheet and far below liquidation value:

Both Bethlehem and mining stocks in general were totally out of favour with the investing public at the time.  However in Peter’s developing judgment this was not just an irrelevance but a positive bonus.  He had inadvertently stumbled upon a classic net-net:  a company whose share price was trading below its working capital, net of all its liabilities.  It was the first such discovery of his career and had the additional merit of proving the efficacy of value theory almost immediately, had he been able to recognize it as such.  Within four months Bethlehem had doubled and in six months he was able to start selling some of the position at $13.00.  The overall impact on portfolio performance had been dramatic.

Riso-Gill describes Cundill as having boundless curiosity.  Cundill would not only visit the worst performing stock market in the world near the end of each year in search of bargains.  But he also made a point of total immersion with respect to the local culture and politics of any country in which he might someday invest.

 

LAUNCHING A VALUE FUND

Early on, Cundill had not yet developed the deep value approach based strictly on buying below liquidation value.  He had, however, concluded that most models used in investment research were useless and that attempting to predict the general stock market was not doable with any sort of reliability.  Eventually Cundill immersed himself in Graham and Dodd’s Security Analysis, especially chapter 41, “The Asset-Value Factor in Common-Stock Valuation,” which he re-read and annotated many times.

When Cundill was about to take over an investment fund, he wrote to the shareholders about his proposed deep value investment strategy:

The essential concept is to buy under-valued, unrecognized, neglected, out of fashion, or misunderstood situations where inherent value, a margin of safety, and the possibility of sharply changing conditions created new and favourable investment opportunities.  Although a large number of holdings might be held, performance was invariably established by concentrating in a few holdings.  In essence, the fund invested in companies that, as a result of detailed fundamental analysis, were trading below their ‘intrinsic value.’  The intrinsic value was defined as the price that a private investor would be prepared to pay for the security if it were not listed on a public stock exchange.  The analysis was based as much on the balance sheet as it was on the statement of profit and loss.

Cundill went on to say that he would only buy companies trading below book value, preferably below net working capital less long term debt (Graham’s net-net method).  Cundill also required that the company be profitable—ideally having increased its earnings for the past five years—and dividend-paying—ideally with a regularly increasing dividend.  The price had to be less than half its former high and preferably near its all time low.  And the P/E had to be less than 10.

Cundill also studied past and future profitability, the ability of management, and factors governing sales volume and costs.  But Cundill made it clear that the criteria were not always to be followed precisely, leaving room for investment judgment, which he eventually described as an art form.

Cundill told shareholders about his own experience with the value approach thus far.  He had started with $600,000, and the portfolio increased 35.2%.  During the same period, the All Canadian Venture Fund was down 49%, the TSE industrials down 20%, and the Dow down 26%.  Cundill also notes that 50% of the portfolio had been invested in two stocks (Bethlehem Copper and Credit Foncier).

About this time, Irving Kahn became a sort of mentor to Cundill.  Kahn had been Graham’s teaching assistant at Columbia University.

 

VALUE INVESTMENT IN ACTION

Having a clearly defined set of criteria helped Cundill to develop a manageable list of investment candidates in the decade of 1974 to 1984 (which tended to be a good time for value investors).  The criteria also helped him identify a number of highly successful investments.

For example, the American Investment Company (AIC), one of the largest personal loan companies in the United States, saw its stock fall from over $30.00 to $3.00, despite having a tangible book value per share of $12.00.  As often happens with good contrarian value candidates, the fears of the market about AIC were overblown.  Eventually the retail loan market recovered, but not before Cundill was able to buy 200,000 shares at $3.00.  Two years later, AIC was taken over at $13.00 per share by Leucadia.  Cundill wrote:

As I proceed with this specialization into buying cheap securities I have reached two conclusions.  Firstly, very few people really do their homework properly, so now I always check for myself.  Secondly, if you have confidence in your own work, you have to take the initiative without waiting around for someone else to take the first plunge.

…I think that the financial community devotes far too much time and mental resource to its constant efforts to predict the economic future and consequent stock market beaviour using a disparate, and almost certainly incomplete, set of statistical variables.  It makes me wonder what might be accomplished if all this time, energy, and money were to be applied to endeavours with a better chance of proving reliable and practically useful.

Meanwhile, Cundill had served on the board of AIC, which brought some valuable experience and associations.

Cundill found another highly discounted company in Tiffany’s.  The company owned extremely valuable real estate in Manhattan that was carried on its books at a cost much lower than the current market value.  Effectively, the brand was being valued at zero.  Cundill accumulated a block of stock at $8.00 per share.  Within a year, Cundill was able to sell it at $19.00.  This seemed like an excellent result, except that six months later, Avon Products offered to buy Tiffany’s at $50.00.  Cundill would comment:

The ultimate skill in this business is in knowing when to make the judgment call to let profits run.

Sam Belzberg—who asked Cundill to join him as his partner at First City Financial—described Cundill as follows:

He has one of the most important attributes of the master investor because he is supremely capable of running counter to the herd.  He seems to possess the ability to consider a situation in isolation, cutting himself off from the mill of general opinion.  And he has the emotional confidence to remain calm when events appear to be indicating that he’s wrong.

 

GOING GLOBAL

Partly because of his location in Canada, Cundill early on believed in global value investing.  He discovered that just as individual stocks can be neglected and misunderstood, so many overseas markets can be neglected and misunderstood.  Cundill enjoyed traveling to these various markets and learning the legal accounting practices.  In many cases, the difficulty of mastering the local accounting was, in Cundill’s view, a ‘barrier to entry’ to other potential investors.

Cundill also worked hard to develop networks of locally based professionals who understood value investing principles.  Eventually, Cundill developed the policy of exhaustively searching the globe for value, never favoring domestic North American markets.

 

A DECADE OF SUCCESS

Cundill summarized the lessons of the first 10 years, during which the fund grew at an annual compound rate of 26%.  He included the following:

  • The value method of investing will tend at least to give compound rates of return in the high teens over longer periods of time.
  • There will be losing years; but if the art of making money is not to lose it, then there should not be substantial losses.
  • The fund will tend to do better in slightly down to indifferent markets and not to do as well as our growth-oriented colleagues in good markets.
  • It is ever more challenging to perform well with a larger fund…
  • We have developed a network of contacts around the world who are like-minded in value orientation.
  • We have gradually modified our approach from a straight valuation basis to one where we try to buy securities selling below liquidation value, taking into consideration off-balance sheet items.
  • THE MOST IMPORTANT ATTRIBUTE FOR SUCCESS IN VALUE INVESTING IS PATIENCE, PATIENCE, AND MORE PATIENCE.  THE MAJORITY OF INVESTORS DO NOT POSSESS THIS CHARACTERISTIC.

 

INVESTMENTS AND STRATAGEMS

Buying at a discount to liquidation value is simple in concept.  But in practice, it is not at all easy to do consistently well over time.  Peter Cundill explained:

None of the great investments come easily.  There is almost always a major blip for whatever reason and we have learnt to expect it and not to panic.

Although Cundill focused exclusively on discount to liquidation value when analyzing equities, he did develop a few additional areas of expertise, such as distressed debt.  Cundill discovered that, contrary to his expectation of fire-sale prices, an investor in distressed securities could often achieve large profits during the actual process of liquidation.  Success in distressed debt required detailed analysis.

 

LEARNING FROM MISTAKES

1989 marked the fifteenth year in a row of positive returns for Cundill’s Value Fund.  The compound growth rate was 22%.  But the fund was only up 10% in 1989, which led Cundill to perform his customary analysis of errors:

…How does one reduce the margin of error while recognizing that investments do, of course, go down as well as up?  The answers are not absolutely clear cut but they certainly include refusing to compromise by subtly changing a question so that it shapes the answer one is looking for, and continually reappraising the research approach, constantly revisiting and rechecking the detail.

What were last year’s winners?  Why?—I usually had the file myself, I started with a small position and stayed that way until I was completely satisfied with every detail.

For most value investors, the investment thesis depends on a few key variables, which should be written down in a short paragraph.  It’s important to recheck each variable periodically.  If any part of the thesis has been invalidated, you must reassess.  Usually the stock is no longer a bargain.

It’s important not to invent new reasons for owning the stock if one of the original reasons has been falsified.  Developing new reasons for holding a stock is usually misguided.  However, you need to remain flexible.  Occasionally the stock in question is still a bargain.

 

ENTERING THE BIG LEAGUE

In the mid 1990’s, Cundill made a large strategic shift out of Europe and into Japan.  Typical for a value investor, he was out of Europe too early and into Japan too early.  Cundill commented:

We dined out in Europe, we had the biggest positions in Deutsche Bank and Paribas, which both had big investment portfolios, so you got the bank itself for nothing.  You had a huge margin of safety—it was easy money.  We had doubles and triples in those markets and we thought we were pretty smart, so in 1996 and 1997 we took our profits and took flight to Japan, which was just so beaten up and full of values.  But in doing so we missed out on some five baggers, which is when the initial investment has multiplied five times, and we had to wait at least two years before Japan started to come good for us.

This is a recurring problem for most value investors—that tendency to buy and to sell too early.  The virtues of patience are severely tested and you get to thinking it’s never going to work and then finally your ship comes home and you’re so relieved that you sell before it’s time.  What we ought to do is go off to Bali or some such place and sit in the sun to avoid the temptation to sell too early.

As for Japan, Cundill had long ago learned the lesson that cheap stocks can stay cheap for “frustratingly long” periods of time.  Nonetheless, Cundill kept loading up on cheap Japanese stocks in a wide range of sectors.  In 1999, his Value Fund rose 16%, followed by 20% in 2000.

 

THERE’S ALWAYS SOMETHING LEFT TO LEARN

Although Cundill had easily avoided Nortel, his worst investment was nevertheless in telecommunications: Cable & Wireless (C&W).  In the late 1990’s, the company had to give up many of its networks in newly independent former British colonies.  The shares dropped from 15 pounds per share to 6 pounds.

A new CEO, Graham Wallace, was brought in.  He quickly and skillfully negotiated a series of asset sales, which dramatically transformed the balance sheet from net debt of 4 billion pounds to net cash of 2.6 billion pounds.  Given the apparently healthy margin of safety, Cundill began buying shares in March 2000 at just over 4 pounds per share.  (Net asset value was 4.92 pounds per share.)  Moreover:

[Wallace was] generally regarded as a relatively safe pair of hands unlikely to be tempted into the kind of acquisition spree overseen by his predecessor.

Unfortunately, a stream of investment bankers, management consultants, and brokers made a simple but convincing pitch to Wallace:

the market for internet-based services was growing at three times the rate for fixed line telephone communications and the only quick way to dominate that market was by acquisition.

Wallace proceeded to make a series of expensive acquisitions of loss-making companies.  This destroyed C&W’s balance sheet and also led to large operating losses.  Cundill now realized that the stock could go to zero, and he got out, just barely.  As Cundill wrote later:

… So we said, look they’ve got cash, they’ve got a valuable, viable business and let’s assume the fibre optic business is worth zero—it wasn’t, it was worth less than zero, much, much less!

Cundill had invested nearly $100 million in C&W, and they lost nearly $59 million.  This loss was largely responsible for the fund being down 11% in 2002.  Cundill realized that his investment team needed someone to be a sceptic for each potential investment.

 

PAN OCEAN

In late 2002, oil prices began to rise sharply based on global growth.  Cundill couldn’t find any net-net’s among oil companies, so he avoided these stocks.  Some members of his investment team argued that there were some oil companies that were very undervalued.  Finally, Cundill announced that if anyone could find an oil company trading below net cash, he would buy it.

Cundill’s cousin, Geoffrey Scott, came across a neglected company:  Pan Ocean Energy Corporation Ltd.  The company was run by David Lyons, whose father, Vern Lyons, had founded Ocelot Energy.  Lyons concluded that there was too much competition for a small to medium sized oil company operating in the U.S. and Canada.  The risk/reward was not attractive.

What he did was to merge his own small Pan Ocean Energy with Ocelot and then sell off Ocelot’s entire North American and other peripheral parts of the portfolio, clean up the balance sheet, and bank the cash.  He then looked overseas and determined that he would concentrate on deals in Sub-Saharan Africa, where licenses could be secured for a fraction of the price tag that would apply in his domestic market.

Lyons was very thorough and extremely focused… He narrowed his field down to Gabon and Tanzania and did a development deal with some current onshore oil production in Gabon and a similar offshore gas deal in Tanzania.  Neither was expensive.

Geoffrey Scott examined Pan Ocean, and found that its share price was almost equal to net cash and the company had no debt.  He immediately let Cundill know about it.  Cundill met with David Lyons and was impressed:

This was a cautious and disciplined entrepreneur, who was dealing with a pool of cash that in large measure was his own.

Lyons invited Cundill to see the Gabon project for himself.  Eventually, Cundill saw both the Gabon project and the Tanzania project.  He liked what he saw.  Cundill’s fund bought 6% of Pan Ocean.  They made six times their money in two and a half years.

 

FRAGILE X

As early as 1998, Cundill had noticed a slight tremor in his right arm.  The condition worsened and affected his balance.  Cundill continued to lead a very active life, still reading and traveling all the time, and still a fitness nut.  He was as sharp as ever in 2005.  Risso-Gill writes:

Ironically, just as Peter’s health began to decline an increasing number of industry awards for his achievements started to come his way.

For instance, he received the Analyst’s Choice award as “The Greatest Mutual Fund Manager of All Time.”

In 2009, Cundill decided that it was time to step down, as his condition had progressively worsened.  He continued to be a voracious reader.

 

WHAT MAKES A GREAT INVESTOR?

Risso-Gill tries to distill from Cundill’s voluminous journal writings what Cundill himself believed it took to be a great value investor.

INSATIABLE CURIOSITY

Curiosity is the engine of civilization.  If I were to elaborate it would be to say read, read, read, and don’t forget to talk to people, really talk, listening with attention and having conversations, on whatever topic, that are an exchange of thoughts.  Keep the reading broad, beyond just the professional.  This helps to develop one’s sense of perspective in all matters.

PATIENCE

Patience, patience, and more patience…

CONCENTRATION

You must have the ability to focus and to block out distractions.  I am talking about not getting carried away by events or outside influences—you can take them into account, but you must stick to your framework.

ATTENTION TO DETAIL

Never make the mistake of not reading the small print, no matter how rushed you are.  Always read the notes to a set of accounts very carefully—they are your barometer… They will give you the ability to spot patterns without a calculator or spreadsheet.  Seeing the patterns will develop your investment insights, your instincts—your sense of smell.  Eventually it will give you the agility to stay ahead of the game, making quick, reasoned decisions, especially in a crisis.

CALCULATED RISK

… Either [value or growth investing] could be regarded as gambling, or calculated risk.  Which side of that scale they fall on is a function of whether the homework has been good enough and has not neglected the fieldwork.

INDEPENDENCE OF MIND

I think it is very useful to develop a contrarian cast of mind combined with a keen sense of what I would call ‘the natural order of things.’  If you can cultivate these two attributes you are unlikely to become infected by dogma and you will begin to have a predisposition toward lateral thinking—making important connections intuitively.

HUMILITY

I have no doubt that a strong sense of self belief is important—even a sense of mission—and this is fine as long as it is tempered by a sense of humour, especially an ability to laugh at oneself.  One of the greatest dangers that confront those who have been through a period of successful investment is hubris—the conviction that one can never be wrong again.  An ability to see the funny side of oneself as it is seen by others is a strong antidote to hubris.

ROUTINES

Routines and discipline go hand in hand.  They are the roadmap that guides the pursuit of excellence for its own sake.  They support proper professional ambition and the commercial integrity that goes with it.

SCEPTICISM

Scepticism is good, but be a sceptic, not an iconoclast.  Have rigour and flexibility, which might be considered an oxymoron but is exactly what I meant when I quoted Peter Robertson’s dictum ‘always change a winning game.’  An investment framework ought to include a liberal dose of scepticism both in terms of markets and of company accounts.

PERSONAL RESPONSIBILITY

The ability to shoulder personal responsibility for one’s investment results is pretty fundamental… Coming to terms with this reality sets you free to learn from your mistakes.

 

GLOSSARY OF TERMS WITH CUNDILL’S COMMENTS

Here are some of the terms.

ANALYSIS

There’s almost too much information now.  It boggles most shareholders and a lot of analysts.  All I really need is a company’s published reports and records, that plus a sharp pencil, a pocket calculator, and patience.

Doing the analysis yourself gives you confidence buying securities when a lot of the external factors are negative.  It gives you something to hang your hat on.

ANALYSTS

I’d prefer not to know what the analysts think or to hear any inside information.  It clouds one’s judgment—I’d rather be dispassionate.

BROKERS

I go cold when someone tips me on a company.  I like to start with a clean sheet: no one’s word.  No givens.  I’m more comfortable when there are no brokers looking over my shoulder.

They really can’t afford to be contrarians.  A major investment house can’t afford to do research for five customers who won’t generate a lot of commissions.

EXTRA ASSETS

This started for me when Mutual Shares chieftain Mike Price, who used to be a pure net-net investor, began talking about something called the ‘extra asset syndrome’ or at least that is what I call it.  It’s taking, you might say, net-net one step farther, to look at all of a company’s assets, figure the true value.

FORECASTING

We don’t do a lot of forecasting per se about where markets are going.  I have been burned often enough trying.

INDEPENDENCE

Peter Cundill has never been afraid to make his own decisions and by setting up his own fund management company he has been relatively free from external control and constraint.  He doesn’t follow investment trends or listen to the popular press about what is happening on ‘the street.’  He has travelled a lonely but profitable road.

Being willing to be the only one in the parade that’s out of step.  It’s awfully hard to do, but Peter is disciplined.  You have to be willing to wear bellbottoms when everyone else is wearing stovepipes.’ – Ross Southam

INVESTMENT FORMULA

Mostly Graham, a little Buffett, and a bit of Cundill.

I like to think that if I stick to my formula, my shareholders and I can make a lot of money without much risk.

When I stray out of my comfort zone I usually get my head handed to me on a platter.

I suspect that my thinking is an eclectic mix, not pure net-net because I couldn’t do it anyway so you have to have a new something to hang your hat on.  But the framework stays the same.

INVESTMENT STRATEGY

I used to try and pick the best stocks in the fund portfolios, but I always picked the wrong ones.  Now I take my own money and invest it with that odd guy Peter Cundill.  I can be more detached when I treat myself as a normal client.

If it is cheap enough, we don’t care what it is.

Why will someone sell you a dollar for 50 cents?  Because in the short run, people are irrational on both the optimistic and pessimistic side.

MANTRAS

All we try to do is buy a dollar for 40 cents.

In our style of doing things, patience is patience is patience.

One of the dangers about net-net investing is that if you buy a net-net that begins to lose money your net-net goes down and your capacity to be able to make a profit becomes less secure.  So the trick is not necessarily to predict what the earnings are going to be but to have a clear conviction that the company isn’t going bust and that your margin of safety will remain intact over time.

MARGIN OF SAFETY

The difference between the price we pay for a stock and its liquidation value gives us a margin of safety.  This kind of investing is one of the most effective ways of achieving good long-term results.

MARKETS

If there’s a bad stock market, I’ll inevitably go back in too early.  Good times last longer than we think but so do bad times.

Markets can be overvalued and keep getting expensive, or undervalued and keep getting cheap.  That’s why investing is an art form, not a science.

I’m agnostic on where the markets will go.  I don’t have a view.  Our task is to find undervalued global securities that are trading well below their intrinsic value.  In other words, we follow the strict Benjamin Graham approach to investing.

NEW LOWS

Search out the new lows, not the new highs.  Read the Outstanding Investor Digest to find out what Mason Hawkins or Mike Price is doing.  You know good poets borrow and great poets steal.  So see what you can find.  General reading—keep looking at the news to see what’s troubled.  Experience and curiosity is a really winning combination.

What differentiates us from other money managers with a similar style is that we’re comfortable with new lows.

NOBODY LISTENING

Many people consider value investing dull and as boring as watching paint dry.  As a consequence value investors are not always listened to, especially in a stock market bubble.  Investors are often in too much of a hurry to latch on to growth stocks to stop and listen because they’re afraid of being left out…

OSMOSIS

I don’t just calculate value using net-net.  Actually there are many different ways but you have to use what I call osmosis—you have got to feel your way.  That is the art form, because you are never going to be right completely; there is no formula that will ever get you there on its own.  Osmosis is about intuition and about discipline and about all the other things that are not quantifiable.  So can you learn it?  Yes, you can learn it, but it’s not a science, it’s an art form.  The portfolio is a canvas to be painted and filled in.

PATIENCE

When times aren’t good I’m still there.  You find bargains among the unpopular things, the things that everybody hates.  The key is that you must have patience.

RISK

We try not to lose.  But we don’t want to try too hard.  The losses, of course, work against you in establishing decent compound rates of return.  And I hope we won’t have them.  But I don’t want to be so risk-averse that we are always trying too hard not to lose.

STEADY RETURNS

All I know is that if you can end up with a 20% track record over a longer period of time, the compound rates of return are such that the amounts are staggering.  But a lot of investors want excitement, not steady returns.  Most people don’t see making money as grinding it out, doing it as efficiently as possible.  If we have a strong market over the next six months and the fund begins to drop behind and there isn’t enough to do, people will say Cundill’s lost his touch, he’s boring.

TIMING: “THERE’S ALWAYS SOMETHING TO DO”

…Irving Kahn gave me some advice many years ago when I was bemoaning the fact that according to my criteria there was nothing to do.  He said, ‘there is always something to do.  You just need to look harder, be creative and a little flexible.’

VALUE INVESTING

I don’t think I want to become too fashionable.  In some ways, value investing is boring and most investors don’t want a boring life—they want some action: win, lose, or draw.

I think the best decisions are made on the basis of what your tummy tells you.  The Jesuits argue reason before passion.  I argue reason and passion.  Intellect and intuition.  It’s a balance.

We do liquidation analysis and liquidation analysis only.

Ninety to 95% of all my investing meets the Graham tests.  The times I strayed from a rigorous application of this philosophy I got myself into trouble.

But what do you do when none of these companies is available?  The trick is to wait through the crisis stage and into the boredom stage.  Things will have settled down by then and values will be very cheap again.

We customarily do three tests: one of them asset-based—the NAV, using the company’s balance sheet.  The second is the sum of the parts, which I think is probably the most important part that goes into the balance sheet I’m creating.  And then a future NAV, which is making a stab (which I am always suspicious about) at what you think the business might be doing in three years from now.

WORKING LIFE

I’ve been doing this for thirty years.  And I love it.  I’m lucky to have the kind of life where the differentiation between work and play is absolutely zilch.  I have no idea whether I’m working or whether I’m playing.

My wife says I’m a workaholic, but my colleagues say I haven’t worked for twenty years.  My work is my play.

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Buffett’s Best: Microcap Cigar Butts

September 18, 2022

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, 4th 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:

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: http://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:  http://boolefund.com/best-performers-microcap-stocks/

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Ten Attributes of Great Investors

September 11, 2022

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

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

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

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

(Image by magele-picture)

Here are the Ten Attributes of Great Investors:

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

 

BE NUMERATE (AND UNDERSTAND ACCOUNTING)

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

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

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

(Photo by designer491)

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

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

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

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

Another way to grasp competitive position is by analyzing ROIC.

Photo by stanciuc

You can break ROIC into two parts:

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

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

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

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

 

UNDERSTAND VALUE (THE PRESENT VALUE OF FREE CASH FLOW)

Mauboussin:

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

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

Illustration by OpturaDesign

 

PROPERLY ASSESS STRATEGY (OR HOW A COMPANY MAKES MONEY)

Mauboussin says this attribute has two elements:

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

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

Regarding sustainable competitive advantage, Warren Buffett famously said:

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

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

Mauboussin:

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

Bodiam Castle, Photo by valeryegorov

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

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

 

COMPARE EFFECTIVELY (EXPECTATIONS VERSUS FUNDAMENTALS)

Mauboussin:

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

Mauboussin mentions pari-mutuel betting, specifically horse racing.

(Photo by Elshaneo)

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

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

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

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

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

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

 

THINK PROBABILISTICALLY (THERE ARE FEW SURE THINGS)

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

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

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

Photo by annebel146

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

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

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

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

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

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

Buffett again:

Investing is simple, but not easy.

 

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

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

Illustration by intheskies

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

Mauboussin:

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

 

BEWARE OF BEHAVIORAL BIASES (MINIMIZING CONSTRAINTS TO GOOD THINKING)

Mauboussin:

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

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

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

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

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

Photo by Kenishirotie

 

KNOW THE DIFFERENCE BETWEEN INFORMATION AND INFLUENCE

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

(Illustration by Marrishuanna)

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

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

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

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

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

 

POSITION SIZING (MAXIMIZING THE PAYOFF FROM EDGE)

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

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

  • F = p – [q/o]

where

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

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

Mauboussin adds:

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

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

 

READ (AND KEEP AN OPEN MIND)

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

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

(Photo by Lapandr)

Mauboussin continues:

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

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

The Outsiders: Radically Rational CEOs

August 14, 2022

William Thorndike is the author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success (Harvard Business Review Press, 2012).  It’s an excellent book profiling eight CEOs who compounded shareholder value at extraordinary rates over decades.

Through this book, value investors can improve their understanding of how to identify CEOs who maximize long-term returns to shareholders.  Also, investors can become better businesspeople, while businesspeople can become better investors.

I am a better investor because I am a businessman and a better businessman because I am an investor. – Warren Buffett

Thorndike explains that you only need three things to evaluate CEO performance:

  • the compound annual return to shareholders during his or her tenure
  • the return over the same period for peer companies
  • the return over the same period for the broader market (usually measured by the S&P 500)

Thorndike notes that 20 percent returns is one thing during a huge bull market—like 1982 to 1999.  It’s quite another thing if it occurs during a period when the overall market is flat—like 1966 to 1982—and when there are several bear markets.

Moreover, many industries will go out of favor periodically.  That’s why it’s important to compare the company’s performance to peers.

Thorndike mentions Henry Singleton as the quintessential outsider CEO.  Long before it was popular to repurchase stock, Singleton repurchased over 90% of Teledyne’s stock.  Also, he emphasized cash flow over earnings.  He never split the stock.  He didn’t give quarterly guidance.  He almost never spoke with analysts or journalists.  And he ran a radically decentralized organization.  Thorndike:

If you had invested a dollar with Singleton in 1963, by 1990, when he retired as chairman in the teeth of a severe bear market, it would have been worth $180.  That same dollar invested in a broad group of conglomerates would have been worth only $27, and $15 if invested in the S&P 500.  Remarkably, Singleton outperformed the index by over twelve times.

Thorndike observes that rational capital allocation was the key to Singleton’s success.  Thorndike writes:

Basically, CEOs have five essential choices for deploying capital—investing in existing operations, acquiring other businesses, issuing dividends, paying down debt, or repurchasing stock—and three alternatives for raising it—tapping internal cash flow, issuing debt, or raising equity.  Think of these options collectively as a tool kit.  Over the long term, returns for shareholders will be determined largely by the decisions a CEO makes in choosing which tools to use (and which to avoid) among these various options.  Stated simply, two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders.

Warren Buffett has noted that most CEOs reach the top due to their skill in marketing, production, engineering, administration, or even institutional politics.  Thus most CEOs have not been prepared to allocate capital.

Thorndike also points out that the outsider CEOs were iconoclastic, independent thinkers.  But the outsider CEOs, while differing noticeably from industry norms, ended up being similar to one another.  Thorndike says that the outsider CEOs understood the following principles:

  • Capital allocation is a CEO’s most important job.
  • What counts in the long run is the increase in per share value, not overall growth or size.
  • Cash flow, not reported earnings, is what determines long-term value.
  • Decentralized organizations release entrepreneurial energy and keep both costs and ‘rancor’ down.
  • Independent thinking is essential to long-term success, and interactions with outside advisers (Wall Street, the press, etc.) can be distracting and time-consuming.
  • Sometimes the best investment opportunity is your own stock.
  • With acquisitions, patience is vital… as is occasional boldness.

(Illustration by yiorgosgr)

Here are the sections in the blog post:

  • Introduction
  • Tom Murphy and Capital Cities Broadcasting
  • Henry Singleton and Teledyne
  • Bill Anders and General Dynamics
  • John Malone and TCI
  • Katharine Graham and The Washington Post Company
  • Bill Stiritz and Ralston Purina
  • Dick Smith and General Cinema
  • Warren Buffett and Berkshire Hathaway
  • Radical Rationality

 

INTRODUCTION

Only two of the eight outsider CEOs had MBAs.  And, writes Thorndike, they did not attract or seek the spotlight:

As a group, they shared old-fashioned, premodern values including frugality, humility, independence, and an unusual combination of conservatism and boldness.  They typically worked out of bare-bones offices (of which they were inordinately proud), generally eschewed perks such as corporate plans, avoided the spotlight wherever possible, and rarely communicated with Wall Street or the business press.  They also actively avoided bankers and other advisers, preferring their own counsel and that of a select group around them.  Ben Franklin would have liked these guys.

Thorndike describes how the outsider CEOs were iconoclasts:

Like Singleton, these CEOs consistently made very different decisions than their peers did.  They were not, however, blindly contrarian.  Theirs was an intelligent iconoclasm informed by careful analysis and often expressed in unusual financial metrics that were distinctly different from industry or Wall Street conventions.

Thorndike compares the outsider CEOs to Billy Beane as described by Michael Lewis in Moneyball.  Beane’s team, despite having the second-lowest payroll in the league, made the playoffs in four of his first six years on the job.  Beane had discovered newand unorthodoxmetrics that were more correlated with team winning percentage.

Thorndike mentions a famous essay about Leo Tolstoy written by Isaiah Berlin.  Berlin distinguishes between a “fox” who knows many things and a “hedgehog” who knows one thing extremely well.  Thorndike continues:

Foxes… also have many attractive qualities, including an ability to make connections across fields and to innovate, and the CEOs in this book were definite foxes.  They had familiarity with other companies and industries and disciplines, and this ranginess translated into new perspectives, which in turn helped them to develop new approaches that eventually translated into exceptional results.

(Photo by mbridger68)

 

TOM MURPHY AND CAPITAL CITIES BROADCASTING

When Murphy became CEO of Capital Cities in 1966, CBS’ market capitalization was sixteen times than that of Capital Cities.  Thirty years later, Capital Cities was three times as valuable as CBS.  Warren Buffett has said that in 1966, it was like a rowboat (Capital Cities) against QE2 (CBS) in a trans-Atlantic race.  And the rowboat won decisively!

Bill Paley, who ran CBS, used the enormous cash flow from its network and broadcast operations and undertook an aggressive acquisition program of companies in entirely unrelated fields.  Paley simply tried to make CBS larger without paying attention to the return on invested capital (ROIC).

Without a sufficiently high ROIC, growth destroys shareholder value instead of creating it.  But, like Paley, many business leaders at the time sought growth for its own sake.  Even if growth destroys value (due to low ROIC), it does make the business larger, bringing greater benefits to the executives.

Murphy’s goal, on the other hand, was to make his company as valuable as possible.  This meant maximizing profitability and ROIC:

…Murphy’s goal was to make his company more valuable… Under Murphy and his lieutenant, Dan Burke, Capital Cities rejected diversification and instead created an unusually streamlined conglomerate that focused laser-like on the media businesses it knew well.  Murphy acquired more radio and TV stations, operated them superbly well, regularly repurchased his shares, and eventually acquired CBS’s rival broadcast network ABC.

(Capital Cities/ABC, Inc. logo, via Wikimedia Commons)

Burke excelled in operations, while Murphy excelled in making acquisitions.  Together, they were a great team—unmatched, according to Warren Buffett.  Burke said his ‘job was to create free cash flow and Murphy’s was to spend it.’

During the mid-1970s, there was an extended bear market.  Murphy aggressively repurchased shares, mostly at single-digit price-to-earnings (P/E) multiples.

Thorndike writes that in January 1986, Murphy bought the ABC Network and its related broadcasting assets for $3.5 billion with financing from his friend Warren Buffett.  Thorndike comments:

Burke and Murphy wasted little time in implementing Capital Cities’ lean, decentralized approach—immediately cutting unnecessary perks, such as the executive elevator and the private dining room, and moving quickly to eliminate redundant positions, laying off fifteen hundred employees in the first several months after the transaction closed.  They also consolidated offices and sold off unnecessary real estate, collecting $175 million for the headquarters building in midtown Manhattan…

In the nine years after the transaction, revenues and cash flows grew significantly in every major ABC business line, including the TV stations, the publishing assets, and ESPN.  Even the network, which had been in last place at the time of the acquisition, was ranked number one in prime time ratings and was more profitable than either CBS or NBC.

In 1993, Burke retired.  And in 1995, Murphy, at Buffett’s suggestion, met with Michael Eisner, the CEO of Disney.  Over a few days, Murphy sold Capital Cities/ABC to Disney for $19 billion, which was 13.5 times cash flow and 28 times net income.  Thorndike:

He left behind an ecstatic group of shareholders—if you had invested a dollar with Tom Murphy as he became CEO in 1966, that dollar would have been worth $204 by the time he sold the company to Disney.  That’s a remarkable 19.9 percent internal rate of return over twenty-nine years, significantly outpacing the 10.1 percent return for the S&P 500 and 13.2 percent return for an index of leading media companies over the same period.

Thorndike points out that decentralization was one of the keys to success for Capital Cities.  There was a single paragraph on the inside cover of every Capital Cities annual report:

‘Decentralization is the cornerstone of our philosophy.  Our goal is to hire the best people we can and give them the responsibility and authority they need to perform their jobs.  All decisions are made at the local level… We expect our managers… to be forever cost conscious and to recognize and exploit sales potential.’

Headquarters had almost no staff.  There were no vice presidents in marketing, strategic planning, or human resources.  There was no corporate counsel and no public relations department.  The environment was ideal for entrepreneurial managers.  Costs were minimized at every level.

Burke developed an extremely detailed annual budgeting process for every operation.  Managers had to present operating and capital budgets for the coming year, and Burke (and his CFO, Ron Doerfler) went through the budgets line-by-line:

The budget sessions were not perfunctory and almost always produced material changes.  Particular attention was paid to capital expenditures and expenses.  Managers were expected to outperform their peers, and great attention was paid to margins, which Burke viewed as ‘a form of report card.’  Outside of these meetings, managers were left alone and sometimes went months without hearing from corporate.

High margins resulted not only from cost minimization, but also from Murphy and Burke’s focus on revenue growth and advertising market share.  They invested in their properties to ensure leadership in local markets.

When it came to acquisitions, Murphy was very patient and disciplined.  His benchmark ‘was a double-digit after-tax return over ten years without leverage.’  Murphy never won an auction as a result of his discipline.  Murphy also had a unique negotiating style.

Murphy thought that, in the best transactions, everyone comes away happy.  He believed in ‘leaving something on the table’ for the seller.  Murphy would often ask the seller what they thought the property was worth.  If Murphy thought the offer was fair, he would take it.  If he thought the offer was high, he would counter with his best price.  If the seller rejected his counter-offer, Murphy would walk away.  He thought this approach saved time and avoided unnecessary friction.

Thorndike concludes his discussion of Capital Cities:

Although the focus here is on quantifiable business performance, it is worth noting that Murphy built a universally admired company at Capital Cities with an exceptionally strong culture and esprit de corps (at least two different groups of executives still hold regular reunions).

 

HENRY SINGLETON AND TELEDYNE

Singleton earned bachelor’s, master’s, and PhD degrees in electrical engineering from MIT.  He programmed the first student computer at MIT.  He won the Putnam Medal as the top mathematics student in the country in 1939.  And he was 100 points away from being a chess grandmaster.

Singleton worked as a research engineer at North American Aviation and Hughes Aircraft in 1950.  Tex Thornton recruited him to Litton Industries in the late 1950s, where Singleton invented an inertial guidance system—still in use—for commercial and military aircraft.  By the end of the decade, Singleton had grown Litton’s Electronic Systems Group to be the company’s largest division with over $80 million in revenue.

Once he realized he wouldn’t succeed Thornton as CEO, Singleton left Litton and founded Teledyne with his colleague George Kozmetzky.  After acquiring three small electronics companies, Teledyne successfully bid for a large naval contract.  Teledyne became a public company in 1961.

(Photo of Teledyne logo by Piotr Trojanowski)

In the 1960’s, conglomerates had high price-to-earnings (P/E) ratios and were able to use their stock to buy operating companies at relatively low multiples.  Singleton took full advantage of this arbitrage opportunity.  From 1961 to 1969, he purchased 130 companies in industries from aviation electronics to specialty metals and insurance.  Thorndike elaborates:

Singleton’s approach to acquisitions, however, differed from that of other conglomerateurs.  He did not buy indiscriminately, avoiding turnaround situations, and focusing instead on profitable, growing companies with leading market positions, often in niche markets… Singleton was a very disciplined buyer, never paying more than twelve times earnings and purchasing most companies at significantly lower multiples.  This compares to the high P/E multiple on Teledyne’s stock, which ranged from a low of 20 to a high of 50 over this period.

In mid-1969, Teledyne was trading at a lower multiple, while acquisition prices were increasing.  So Singleton completely stopped acquiring companies.

Singleton ran a highly decentralized company.  Singleton also did not report earnings, but instead focused on free cash flow (FCF)—what Buffett calls owner earnings.  The value of any business is all future FCF discounted back to the present.

FCF = net income + DDA – capex

(There are also adjustments to FCF based on changes in working capital.  DDA is depreciation, depletion, and amortization.)

At Teledyne, bonus compensation for all business unit managers was based on the maximization of free cash flow.  Singleton—along with his roommate from the Naval Academy, George Roberts—worked to improve margins and significantly reduce working capital.  Return on assets at Teledyne was greater than 20 percent in the 1970s and 1980s.  Charlie Munger calls these results from Teledyne ‘miles higher than anybody else… utterly ridiculous.’  This high profitability generated a great deal of excess cash, which was sent to Singleton to allocate.

Starting in 1972, Singleton started buying back Teledyne stock because it was cheap.  During the next twelve years, Singleton repurchased over 90 percent of Teledyne’s stock.  Keep in mind that in the early 1970s, stock buybacks were seen as a lack of investment opportunity.  But Singleton realized buybacks were far more tax-efficient than dividends.  And buybacks done when the stock is noticeably cheap create much value.  Whenever the returns from a buyback seemed higher than any alternative use of cash, Singleton repurchased shares.  Singleton spent $2.5 billion on buybacks—an unbelievable amount at the time—at an average P/E multiple of 8.  (When Teledyne issued shares, the average P/E multiple was 25.)

In the insurance portfolios, Singleton invested 77 percent in equities, concentrated on just a few stocks.  His investments were in companies he knew well that had P/E ratios at or near record lows.

In 1986, Singleton started going in the opposite direction:  deconglomerating instead of conglomerating.  He was a pioneer of spinning off various divisions.  And in 1987, Singleton announced the first dividend.

From 1963 to 1990, when Singleton stepped down as chairman, Teledyne produced 20.4 percent compound annual returns versus 8.0 percent for the S&P 500 and 11.6 percent for other major conglomerates.  A dollar invested with Singleton in 1963 would have been worth $180.94 by 1990, nearly ninefold outperformance versus his peers and more than twelvefold outperformance versus the S&P 500.

 

BILL ANDERS AND GENERAL DYNAMICS

In 1989, the Berlin Wall came down and the U.S. defense industry’s business model had to be significantly downsized.  The policy of Soviet containment had become obsolete almost overnight.

General Dynamics had a long history selling major weapons to the Pentagon, including the B-29 bomber, the F-16 fighter plane, submarines, and land vehicles (such as tanks).  The company had diversified into missiles and space systems, as well as nondefense business including Cessna commercial planes.

(General Dynamics logo, via Wikimedia Commons)

When Bill Anders took over General Dynamics in January 1991, the company had $600 million in debt and negative cash flow.  Revenues were $10 billion, but the market capitalization was just $1 billion.  Many thought the company was headed into bankruptcy.  It was a turnaround situation.

Anders graduated from the Naval Academy in 1955 with an electrical engineering degree.  He was an airforce fighter pilot during the Cold War.  In 1963 he earned a master’s degree in nuclear engineering and was chosen to join NASA’s elite astronaut corps.  Thorndike writes:

As the lunar module pilot on the 1968 Apollo 8 mission, Anders took the now-iconic Earthrise photograph, which eventually appeared on the covers of Time, Life, and American Photography.

Anders was a major general when he left NASA.  He was made the first chairman of the Nuclear Regulatory Commission.  Then he served as ambassador to Norway.  After that, he worked at General Electric and was trained in their management approach.  In 1984, Anders was hired to run the commercial operations of Textron Corporation.  He was not impressed with the mediocre businesses and the bureaucratic culture.  In 1989, he was invited to join General Dynamics as vice-chairman for a year before becoming CEO.

Anders realized that the defense industry had a great deal of excess capacity after the end of the Cold War.  Following Welch’s approach, Anders concluded that General Dynamics should only be in businesses where it was number one or two.  General Dynamics would stick to businesses it knew well.  And it would exit businesses that didn’t meet these criteria.

Anders also wanted to change the culture.  Instead of an engineering focus on ‘larger, faster, more lethal’ weapons, Anders wanted a focus on metrics such as return on equity (ROE).  Anders concluded that maximizing shareholder returns should be the primary business goal.  To help streamline operations, Anders hired Jim Mellor as president and COO.  In the first half of 1991, Anders and Mellor replaced twenty-one of the top twenty-five executives.

Anders then proceeded to generate $5 billion in cash through the sales of noncore businesses and by a significant improvement in operations.  Anders and Mellor created a culture focused on maximizing shareholder returns.  Anders sold most of General Dynamics’ businesses.  He also sought to grow the company’s largest business units through acquisition.

When Anders went to acquire Lockheed’s smaller fighter plane division, he met with a surprise:  Lockheed’s CEO made a high counteroffer for General Dynamics’ F-16 business.  Because the fighter plane division was a core business for General Dynamics—not to mention that Anders was a fighter pilot and still loved to fly—this was a crucial moment for Anders.  He agreed to sell the business on the spot for a very high price of $1.5 billion.  Anders’ decision was rational in the context of maximizing shareholder returns.

With the cash pile growing, Anders next decided not to make additional acquisitions, but to return cash to shareholders.  First he declared three special dividends—which, because they were deemed ‘return of capital,’ were not subject to capital gains or ordinary income taxes.  Next, Anders announced an enormous $1 billion tender offer for 30 percent of the company’s stock.

A dollar invested when Anders took the helm would have been worth $30 seventeen years later.  That same dollar would have been worth $17 if invested in an index of peer companies and $6 if invested in the S&P.

 

JOHN MALONE AND TCI

While at McKinsey, John Malone came to realize how attractive the cable television business was.  Revenues were very predictable.  Taxes were low.  And the industry was growing very fast.  Malone decided to build a career in cable.

Malone’s father was a research engineer and his mother a former teacher.  Malone graduated from Yale with degrees in economics and electrical engineering.  Then Malone earned master’s and PhD degrees in operations research from Johns Hopkins.

Malone’s first job was at Bell Labs, the research arm of AT&T.  After a couple of years, he moved to McKinsey Consulting.  In 1970, a client, General Instrument, offered Malone the chance to run its cable television equipment division.  He jumped at the opportunity.

After a couple of years, Malone was sought by two of the largest cable companies, Warner Communications and Tele-Communications Inc. (TCI).  Malone chose TCI.  Although the salary would be 60 percent lower, he would get more equity at TCI.  Also, he and his wife preferred Denver to Manhattan.

(TCI logo, via Wikimedia Commons)

The industry had excellent tax characteristics:

Prudent cable operators could successfully shelter their cash flow from taxes by using debt to build new systems and by aggressively depreciating the costs of construction.  These substantial depreciation charges reduced taxable income as did the interest expense on the debt, with the result that well-run cable companies rarely showed net income, and as a result, rarely paid taxes, despite very healthy cash flows.  If an operator then used debt to buy or build additional systems and depreciated the newly acquired assets, he could continue to shelter his cash flow indefinitely.

Just after Malone took over as CEO of TCI in 1973, the 1973-1974 bear market left TCI in a dangerous position.  The company was on the edge of bankruptcy due to its very high debt levels.  Malone spent the next few years meeting with bankers and lenders to keep the company out of bankruptcy.  Also during this time, Malone instituted new discipline in operations, which resulted in a frugal, entrepreneurial culture.  Headquarters was austere.  Executives stayed together in motels while on the road.

Malone depended on COO J. C. Sparkman to oversee operations, while Malone focused on capital allocation.  TCI ended up having the highest margins in the industry as a result.  They earned a reputation for underpromising and overdelivering.

In 1977, the balance sheet was in much better shape.  Malone had learned that the key to creating value in cable television was financial leverage and leverage with suppliers (especially programmers).  Both types of leverage improved as the company became larger.  Malone had unwavering commitment to increasing the company’s size.

The largest cost in a cable television system is fees paid to programmers (HBO, MTV, ESPN, etc.).  Larger cable operators can negotiate lower programming costs per subscriber.  The more subscribers the cable company has, the lower its programming cost per subscriber.  This led to a virtuous cycle:

[If] you buy more systems, you lower your programming costs and increase your cash flow, which allows more financial leverage, which can then be used to buy more systems, which further improves your programming costs, and so on… no one else at the time pursued scale remotely as aggressively as Malone and TCI.

Malone also focused on minimizing reported earnings (and thus taxes).  At the time, this was highly unconventional since most companies focused on earnings per share.  TCI gained an important competitive advantage by minimizing earnings and taxes.  Terms like EBITDA were introduced by Malone.

Between 1973 and 1989, the company made 482 acquisitions.  The key was to maximize the number of subscribers.  (When TCI’s stock dropped, Malone repurchased shares.)

By the late 1970s and early 1980s, after the introduction of satellite-delivered channels such as HBO and MTV, cable television went from primarily rural customers to a new focus on urban markets.  The bidding for urban franchises quickly overheated.  Malone avoided the expensive urban franchise wars, and stayed focused on acquiring less expensive rural and suburban subscribers.  Thorndike:

When many of the early urban franchises collapsed under a combination of too much debt and uneconomic terms, Malone stepped forward and acquired control at a fraction of the original cost.

Malone also established various joint ventures, which led to a number of cable companies in which TCI held a minority stake.  Over time, Malone created a great deal of value for TCI by investing in young, talented entrepreneurs.

From 1973 to 1998, TCI shareholders enjoyed a compound annual return of 30.3 percent, compared to 20.4 percent for other publicly traded cable companies and 14.3 percent for the S&P 500.  A dollar invested in TCI at the beginning was worth over $900 by mid-1998.  The same dollar was worth $180 if invested in other publicly traded cable companies and $22 if invested in the S&P 500.

Malone never used spreadsheets.  He looked for no-brainers that could be understood with simple math.  Malone also delayed capital expenditures, generally until the economic viability of the investment had been proved.  When it came to acquisitions—of which there were many—Malone would only pay five times cash flow.

 

KATHARINE GRAHAM AND THE WASHINGTON POST COMPANY

Katharine Graham was the daughter of financier Eugene Meyer.  In 1940, she married Philip Graham, a brilliant lawyer.  Meyer hired Philip Graham to run The Washington Post Company in 1946.  He did an excellent job until his tragic suicide in 1963.

(The Washington Post logo, via Wikimedia Commons)

Katharine was unexpectedly thrust into the CEO role.  At age forty-six, she had virtually no preparation for this role and she was naturally shy.  But she ended up doing an amazing job.  From 1971 to 1993, the compound annual return to shareholders was 22.3 percent versus 12.4 percent for peers and 7.4 percent for the S&P 500.  A dollar invested in the IPO was worth $89 by the time she retired, versus $5 for the S&P and $14 for her peer group.  These are remarkable margins of outperformance.

After a few years of settling into the new role, she began to take charge.  In 1967, she replaced longtime editor in chief Russ Wiggins with the brash Ben Bradlee, who was forty-four years old.

In 1971, she took the company public to raise capital for acquisitions.  This was what the board had recommended.  At the same time, the newspaper encountered the Pentagon Papers crisis.  The company was going to publish a highly controversial (and negative) internal Pentagon opinion of the war in Vietnam that a court had barred the New York Times from publishing.  The Nixon administration threatened to challenge the company’s broadcast licenses if it published the report:

Such a challenge would have scuttled the stock offering and threatened one of the company’s primary profit centers.  Graham, faced with unclear legal advice, had to make the decision entirely on her own.  She decided to go ahead and print the story, and the Post’s editorial reputation was made.  The Nixon administration did not challenge the TV licenses, and the offering, which raised $16 million, was a success.

In 1972, with Graham’s full support, the paper began in-depth investigations into the Republican campaign lapses that would eventually become the Watergate scandal.  Bradlee and two young investigative reporters, Carl Bernstein and Bob Woodward, led the coverage of Watergate, which culminated with Nixon’s resignation in the summer of 1974.  This led to a Pulitzer for the Post—one of an astonishing eighteen during Bradlee’s editorship—and established the paper as the only peer of the New York Times.  All during the investigation, the Nixon administration threatened Graham and the Post.  Graham firmly ignored them.

In 1974, an unknown investor eventually bought 13 percent of the paper’s shares.  The board advised Graham not to meet with him.  Graham ignored the advice and met the investor, whose name was Warren Buffett.  Buffett quickly became Graham’s business mentor.

In 1975, the paper faced a huge strike led by the pressmen’s union.  Graham, after consulting Buffett and the board, decided to fight the strike.  Graham, Bradlee, and a very small crew managed to get the paper published for 139 consecutive days.  Then the pressmen finally agreed to concessions.  These concessions led to significantly improved profitability for the paper.  It was also the first time a major city paper had broken a strike.

Also on advice from Buffett, Graham began aggressively buying back stock.  Over the next few years, she repurchased nearly 40 percent of the company’s stock at very low prices (relative to intrinsic value).  No other major papers did so.

In 1981, the Post’s rival, the Washington Star, ceased publication.  This allowed the Post to significantly increase circulation.  At the same time, Graham hired Dick Simmons as COO.  Simmons successfully lowered costs and improved profits.  Simmons also emphasized bonus compensation based on performance relative to peer newspapers.

In the early 1980s, the Post spent years not acquiring any companies, even though other major newspapers were making more deals than ever.  Graham was criticized, but stuck to her financial discipline.  In 1983, however, after extensive research, the Post bought cellular telephone businesses in six major markets.  In 1984, the Post acquired the Stanley Kaplan test prep business.  And in 1986, the paper bought Capital Cities’ cable television assets for $350 million.  All of these acquisitions would prove valuable for the Post in the future.

In 1988, Graham sold the paper’s telephone assets for $197 million, a very high return on investment.  Thorndike continues:

During the recession of the early 1990s, when her overleveraged peers were forced to the sidelines, the company became uncharacteristically acquisitive, taking advantage of dramatically lower prices to opportunistically purchase cable television systems, underperforming TV stations, and a few education businesses.

When Kay Graham stepped down as chairman in 1993, the Post Company was by far the most diversified among its major newspaper peers, earning almost half its revenues and profits from non-print sources.  This diversification would position the company for further outperformance under her son Donald’s leadership.

 

BILL STIRITZ AND RALSTON PURINA

Bill Stiritz was at Ralston seventeen years before becoming CEO at age forty-seven.

This seemingly conventional background, however, masked a fiercely independent cast of mind that made him a highly effective, if unlikely, change agent.  When Stiritz assumed the CEO role, it would have been impossible to predict the radical transformation he would effect at Ralston and the broader influence it would have on his peers in the food and packaged goods industries.

(Purina logo, via Wikimedia Commons)

Stiritz attended the University of Arkansas for a year but then joined the navy for four years.  While in the navy, he developed his poker skills enough so that poker eventually would pay for his college tuition.  Stiritz completed his undergraduate degree at Northwestern, majoring in business.  (In his mid-thirties, he got a master’s degree in European history from Saint Louis University.)

Stiritz first worked at the Pillsbury Company as a field rep putting cereal on store shelves.  He was promoted to product manager and he learned about consumer packaged goods (CPG) marketing.  Wanting to understand advertising and media better, he started working two years later at the Gardner Advertising agency in St. Louis.  He focused on quantitative approaches to marketing such as the new Nielsen ratings service, which gave a detailed view of market share as a function of promotional spending.

In 1964, Stiritz joined Ralston Purina in the grocery products division (pet food and cereals).  He became general manager of the division in 1971.  While Stiritz was there, operating profits increased fiftyfold due to new product introductions and line extensions.  Thorndike:

Stiritz personally oversaw the introduction of Purina Puppy and Cat Chow, two of the most successful launches in the history of the pet food industry.  For a marketer, Stiritz was highly analytical, with a natural facility for numbers and a skeptical, almost prickly temperament.

Thorndike continues:

On assuming the CEO role in 1981, Stiritz wasted little time in aggressively restructuring the company.  He fully appreciated the exceptionally attractive economics of the company’s portfolio of consumer brands and promptly reorganized the company around these businesses, which he believed offered an attractive combination of high margins and low capital requirements.  He immediately began to remove the underpinnings of his predecessor’s strategy, and his first moves involved actively divesting businesses that did not meet his criteria for profitability and returns.

After a number of divestitures, Ralston was a pure branded products company.  In the early 1980s, Stiritz began repurchasing stock aggressively.  No other major branded products company was repurchasing stock at that time.

Stiritz then bought Continental Baking, the maker of Twinkies and Wonder Bread.  He expanded distribution, cut costs, introduced new products, and increased cash flow materially, creating much value for shareholders.

Then in 1986, Stiritz bought the Energizer Battery division from Union Carbide for $1.5 billion.  The business had been a neglected operation at Union Carbide.  Stiritz thought it was undermanaged and also part of a growing duopoly market.

By the late 1980s, almost 90 percent of Ralston’s revenues were from consumer packaged goods.  Pretax profit margins increased from 9 to 15 percent.  ROE went from 15 to 37 percent.  Since the share base was reduced by aggressive buybacks, earnings and cash flow per share increased dramatically.  Stiritz continued making very careful acquisitions and divestitures, with each decision based on an in-depth analysis of potential returns for shareholders.

Stiritz also began spinning off some businesses he thought were not receiving the attention they deserved—either internally or from Wall Street.  Spin-offs not only can highlight the value of certain business units.  Spin-offs also allow the deferral of capital gains taxes.

Finally, Stiritz sold Ralston itself to Nestle for $10.4 billion, or fourteen times cash flow.  This successfully concluded Stiritz’ career at Ralston.  A dollar invested with Stiritz when he became CEO was worth $57 nineteen years later.  The compound return was 20.0 percent versus 17.7 percent for peers and 14.7 percent for the S&P 500.

Stiritz didn’t like the false precision of detailed financial models.  Instead, he focused only on the few key variables that mattered, including growth and competitive dynamics.  When Ralston bought Energizer, Stiritz and his protégé Pat Mulcahy, along with a small group, took a look at Energizer’s books and then wrote down a simple, back of the envelope LBO model.  That was it.

Since selling Ralston, Stiritz has energetically managed an investment partnership made up primarily of his own capital.

 

DICK SMITH AND GENERAL CINEMA

In 1922, Phillip Smith borrowed money from friends and family, and opened a theater in Boston’s North End.  Over the next forty years, Smith built a successful chain of theaters.  In 1961, Phillip Smith took the company public to raise capital.  But in 1962, Smith passed away.  His son, Dick Smith, took over as CEO.  He was thirty-seven years old.

(General Cinema logo, via Wikimedia Commons)

Dick Smith demonstrated a high degree of patience in using the company’s cash flow to diversify away from the maturing drive-in movie business.

Smith would alternate long periods of inactivity with the occasional very large transaction.  During his tenure, he would make three significant acquisitions (one in the late 1960s, one in the mid-1980s, and one in the early 1990s) in unrelated businesses:  soft drink bottling (American Beverage Company), retailing (Carter Hawley Hale), and publishing (Harcourt Brace Jovanovich).  This series of transactions transformed the regional drive-in company into an enormously successful consumer conglomerate.

Dick Smith later sold businesses that he had earlier acquired.  His timing was extraordinarily good, with one sale in the late 1980s, one in 2003, and one in 2006.  Thorndike writes:

This accordion-like pattern of expansion and contraction, of diversification and divestiture, was highly unusual (although similar in some ways to Henry Singleton’s at Teledyne) and paid enormous benefits for General Cinema’s shareholders.

Smith graduated from Harvard with an engineering degree in 1946.  He worked as a naval engineer during World War II.  After the war, he didn’t want an MBA.  He wanted to join the family business.  In 1956, Dick Smith’s father made him a full partner.

Dick Smith recognized before most others that suburban theaters were benefitting from strong demographic trends.  This led him to develop two new practices.

First, it had been assumed that theater owners should own the underlying land.  But Smith realized that a theater in the right location could fairly quickly generate predictable cash flow.  So he pioneered lease financing for new theaters, which significantly reduced the upfront investment.

Second, he added more screens to each theater, thereby attracting more people, who in turn bought more high-margin concessions.

Throughout the 1960s and into the early 1970s, General Cinema was getting very high returns on its investment in new theaters.  But Smith realized that such growth was not likely to continue indefinitely.  He started searching for new businesses with better long-term prospects.

In 1968, Smith acquired the American Beverage Company (ABC), the largest, independent Pepsi bottler in the country.  Smith knew about the beverage business based on his experience with theater concessions.  Smith paid five times cash flow and it was a very large acquisition for General Cinema at the time.  Thorndike notes:

Smith had grown up in the bricks-and-mortar world of movie theaters, and ABC was his first exposure to the value of businesses with intangible assets, like beverage brands.  Smith grew to love the beverage business, which was an oligopoly with very high returns on capital and attractive long-term growth trends.  He particularly liked the dynamics within the Pepsi bottler universe, which was fragmented and had many second- and third-generation owners who were potential sellers (unlike the Coke system, which was dominated by a smaller number of large independents).  Because Pepsi was the number two brand, its franchises often traded at lower valuations than Coke’s.

ABC was a platform companyother companies could be added easily and efficiently.  Smith could buy new franchises at seemingly high multiples of the seller’s cash flow and then quickly reduce the effective price through reducing expenses, minimizing taxes, and improving marketing.  So Smith acquired other franchises.

Due to constant efforts to reduce costs by Smith and his team, ABC had industry-leading margins.  Soon thereafter, ABC invested $20 million to launch Sunkist.  In 1984, Smith sold Sunkist to Canada Dry for $87 million.

Smith sought another large business to purchase.  He made a number of smaller acquisitions in the broadcast media business.  But his price discipline prevented him from buying very much.

Eventually General Cinema bought Carter Hawley Hale (CHH), a retail conglomerate with several department store and specialty retail chains.  Woody Ives, General Cinema’s CFO, was able to negotiate attractive terms:

Ives negotiated a preferred security that guaranteed General Cinema a 10 percent return, allowed it to convert its interest into 40 percent of the common stock if the business performed well, and included a fixed-price option to buy Waldenbooks, a wholly owned subsidiary of CHH…

Eventually General Cinema would exchange its 40 percent ownership in CHH shares for a controlling 60 percent stake in the company’s specialty retail division, whose primary asset was the Neiman Marcus chain.  The long-term returns on the company’s CHH investment were an extraordinary 51.2 percent.  The CHH transaction moved General Cinema decisively into retailing, a new business whose attractive growth prospects were not correlated with either the beverage or the theater businesses.

In the late 1980s, Smith noticed that a newly energetic Coke was attacking Pepsi in local markets.  At the same time, beverage franchises were selling for much higher prices as their good economics were more widely recognized.  So Smith sold the bottling business in 1989 to Pepsi for a record price.  After the sale, General Cinema was sitting on $1 billion in cash.  Smith started looking for another diversifying acquisition.

It didn’t take him long to find one.  In 1991, after a tortuous eighteen-month process, Smith made his largest and last acquisition, buying publisher Harcourt Brace Jovanovich (HBJ) in a complex auction process and assembling General Cinema’s final third leg.  HBJ was a leading educational and scientific publisher that also owned a testing business and an outplacement firm.  Since the mid-1960s, the firm had been run as a personal fiefdom by CEO William Jovanovich.  In 1986, the company received a hostile takeover bid from the renegade British publisher Robert Maxwell, and in response Jovanovich had taken on large amounts of debt, sold off HBJ’s amusement park business, and made a large distribution to shareholders.

General Cinema management concluded, after examining the business, that HBJ would fit their acquisition criteria.  Moreover, General Cinema managers thought HBJ’s complex balance sheet would probably deter other buyers.  Thorndike writes:

After extensive negotiations with the company’s many debt holders, Smith agreed to purchase the company for $1.56 billion, which represented 62 percent of General Cinema’s enterprise value at the time—an enormous bet.  This price equaled a multiple of six times cash flow for HBJ’s core publishing assets, an attractive price relative to comparable transactions (Smith would eventually sell those businesses for eleven times cash flow).

Thorndike continues:

Following the HBJ acquisition in 1991, General Cinema spun off its mature theater business into a separate publicly traded entity, GC Companies (GCC), allowing management to focus its attention on the larger retail and publishing businesses.  Smith and his management team proceeded to operate both the retail and the publishing businesses over the next decade.  In 2003, Smith sold the HBJ publishing assets to Reed Elsevier, and in 2006 he sold Neiman Marcus, the last vestige of the General Cinema portfolio, to a consortium of private equity buyers.  Both transactions set valuation records within their industries, capping an extraordinary run for Smith and General Cinema shareholders.

From 1962 to 1991, Smith had generated 16.1 percent compound annual return versus 9 percent for the S&P 500 and 9.8 percent for GE.  A dollar invested with Dick Smith in 1962 would be worth $684 by 1991.  The same dollar would $43 if invested in the S&P and $60 if invested in GE.

 

WARREN BUFFETT AND BERKSHIRE HATHAWAY

Buffett was first attracted to the old textile mill Berkshire Hathaway because its price was cheap compared to book value.  Thorndike tells the story:

At the time, the company had only a weak market position in a brutally competitive commodity business (suit linings) and a mere $18 million in market capitalization.  From this undistinguished start, unprecedented returns followed;  and measured by long-term stock performance, the formerly crew-cut Nebraskan is simply on another planet from all other CEOs.  These otherworldly returns had their origin in that aging New England textile company, which today has a market capitalization of $140 billion and virtually the same number of shares.  Buffett bought his first share of Berkshire for $7;  today it trades for over $120,000 share.  [Value of Berkshire share as of 10/21/18:  $517.2 billion market capitalization, or $314,477 a share]

(Company logo, by Berkshire Hathaway Inc., via Wikimedia Commons)

Buffett was born in 1930 in Omaha, Nebraska.  His grandfather ran a well-known local grocery store.  His father was a stockbroker in downtown Omaha and later a congressman.  Starting at age six, Buffett started various entrepreneurial ventures.  He would buy a 6-pack of Coke for 25 cents and resell each one for 5 cents.  He later had several paper routes and then pinball machines, too.  Buffett attended Wharton, but didn’t feel he could learn much.  So he returned to Omaha and graduated from the University of Nebraska at age 20.

He’d always been interested in the stock market.  But it wasn’t until he was nineteen that he discovered The Intelligent Investor, by Benjamin Graham.  Buffett immediately realized that value investing—as explained by Graham in simple terms—was the key to making money in the stock market.

Buffett was rejected by Harvard Business School, which was a blessing in that Buffett attended Columbia University where Graham was teaching.  Buffett was the star in Graham’s class, getting the only A+ Graham ever gave in more than twenty years of teaching.  Others in that particular course said the class was often like a conversation between Graham and Buffett.

Buffett graduated from Columbia in 1952.  He applied to work for Graham, but Graham turned him down.  At the time, Jewish analysts were having a hard time finding work on Wall Street, so Graham only hired Jewish people.  Buffett returned to Omaha and worked as a stockbroker.

One idea Buffett had tried to pitch while he was a stockbroker was GEICO.  He realized that GEICO had a sustainable competitive advantage:  a permanently lower cost structure because GEICO sold car insurance direct, without agents or branches.  Buffett had trouble convincing clients to buy GEICO, but he himself loaded up in his own account.

Meanwhile, Buffett regularly mailed investment ideas to Graham.  After a couple of years, in 1954, Graham hired Buffett.

In 1956, Graham dissolved the partnership to focus on other interests.  Buffett returned to Omaha and launched a small investment partnership with $105,000 under management.  Buffett himself was worth $140,000 at the time (over $1 million today).

Over the next thirteen years, Buffett crushed the market averages.  Early on, he was applying Graham’s methods by buying stocks that were cheap relative to net asset value.  But in the mid-1960s, Buffett made two large investments—in American Express and Disney—that were based more on normalized earnings than net asset value.  This was the beginning of a transition Buffett made from buying statistically cheap cigar butts to buying higher quality companies.

  • Buffett referred to deep value opportunities—stocks bought far below net asset value—as cigar butts. Like a soggy cigar butt found on a street corner, a deep value investment would often give “one free puff.”  Such a cigar butt is disgusting, but that one puff is “all profit.”

Buffett started acquiring shares in Berkshire Hathaway—a cigar butt—in 1965.  In the late 1960s, Buffett was having trouble finding cheap stocks, so he closed down the Buffett partnership.

After getting control of Berkshire Hathaway, Buffett put in a new CEO, Ken Chace.  The company generated $14 million in cash as Chace reduced inventories and sold excess plants and equipment.  Buffett used most of this cash to acquire National Indemnity, a niche insurance company.  Buffett invested National Indemnity’s float quite well, buying other businesses like the Omaha Sun, a weekly newspaper, and a bank in Rockford, Illinois.

During this period, Buffett met Charlie Munger, another Omaha native who was then a brilliant lawyer in Los Angeles.  Buffett convinced Munger to run his own investment partnership, which he did with excellent results.  Later on, Munger became vice-chairman at Berkshire Hathaway.

Partly by reading the works of Phil Fisher, but more from Munger’s influence, Buffett realized that a wonderful company at a fair price was better than a fair company at a wonderful price.  A wonderful company would have a sustainably high ROIC, which meant that its intrinsic value would compound over time.  In order to estimate intrinsic value, Buffett now relied more on DCF (discounted cash flow) and private market value—methods well-suited to valuing good businesses (often at fair prices)—rather than an estimate of liquidation value—a method well-suited to valuing cigar butts (mediocre businesses at cheap prices).

In the 1970s, Buffett and Munger invested in See’s Candies and the Buffalo News.  And they bought large stock positions in the Washington Post, GEICO, and General Foods.

In the first half of the 1980s, Buffett bought the Nebraska Furniture Mart for $60 million and Scott Fetzer, a conglomerate of niche industrial businesses, for $315 million.  In 1986, Buffett invested $500 million helping his friend Tom Murphy, CEO of Capital Cities, acquire ABC.

Buffett then made no public market investments for several years.  Finally in 1989, Buffett announced that he invested $1.02 billion, a quarter of Berkshire’s investment portfolio, in Coca-Cola, paying five times book value and fifteen times earnings.  The return on this investment over the ensuing decade was 10x.

(Coca-Cola Company logo, via Wikimedia Commons)

Also in the late 1980s, Buffett invested in convertible preferred securities in Salomon Brothers, Gillette, US Airways, and Champion Industries.  The dividends were tax-advantaged, and he could convert to common stock if the companies did well.

In 1991, Salomon Brothers was in a major scandal based on fixing prices in government Treasury bill auctions.  Buffett ended up as interim CEO for nine months.  Buffett told Salomon employees:

“Lose money for the firm and I will be understanding.  Lose even a shred of reputation for the firm, and I will be ruthless.”

In 1996, Salomon was sold to Sandy Weill’s Travelers Corporation for $9 billion, which was a large return on investment for Berkshire.

In the early 1990s, Buffett invested—taking large positions—in Wells Fargo (1990), General Dynamics (1992), and American Express (1994).  In 1996, Berkshire acquired the half of GEICO it didn’t own.  Berkshire also purchased the reinsurer General Re in 1998 for $22 billion in Berkshire stock.

In the late 1990s and early 2000s, Buffett bought a string of private companies, including Shaw Carpets, Benjamin Moore Paints, and Clayton Homes.  He also invested in the electric utility industry through MidAmerican Energy.  In 2006, Berkshire announced its first international acquisition, a $5 billion investment in Iscar, an Israeli manufacturer of cutting tools and blades.

In early 2010, Berkshire purchased the nation’s largest railroad, the Burlington Northern Santa Fe, for $34.2 billion.

From June 1965, when Buffett assumed control of Berkshire, through 2011, the value of the company’s shares increased at a compound rate of 20.7 percent compared to 9.3 percent for the S&P 500.  A dollar invested in Berkshire was worth $6,265 forty-five years later.  The same dollar invested in the S&P 500 was worth $62.

The Nuts and Bolts

Having learned from Murphy, Buffett and Munger created Berkshire to be radically decentralized.  Business managers are given total autonomy over everything except large capital allocation decisions.  Buffett makes the capital allocation decisions, and Buffett is an even better investor than Henry Singleton.

Another key to Berkshire’s success is that the insurance and reinsurance operations are profitable over time, and meanwhile Buffett invests most of the float.  Effectively, the float has an extremely low cost (occasionally negative) because the insurance and reinsurance operations are profitable.  Buffett always reminds Berkshire shareholders that hiring Ajit Jain to run reinsurance was one of the best investments ever for Berkshire.

As mentioned, Buffett is in charge of capital allocation.  He is arguably the best investor ever based on the longevity of his phenomenal track record.

Buffett and Munger have always believed in concentrated portfolios.  It makes sense to take very large positions in your best ideas.  Buffett invested 40 percent of the Buffett partnership in American Express after the salad oil scandal in 1963.  In 1989, Buffett invested 25 percent of the Berkshire portfolio—$1.02 billion—in Coca-Cola.

Buffett and Munger still have a very concentrated portfolio.  But sheer size requires them to have more positions than before.  It also means that they can no longer look at most companies, which are too small to move the needle.

Buffett and Munger also believe in holding their positions for decades.  Over time, this saves a great deal of money by minimizing taxes and transaction costs.

Thorndike:

Buffett’s approach to investor relations is also unique and homegrown.  Buffett estimates that the average CEO spends 20 percent of his time communicating with Wall Street.  In contrast, he spends no time with analysts, never attends investment conferences, and has never provided quarterly earnings guidance.  He prefers to communicate with his investors through detailed annual reports and meetings, both of which are unique.

… The annual reports and meetings reinforce a powerful culture that values frugality, independent thinking, and long-term stewardship.

 

 

RADICAL RATIONALITY:  THE OUTSIDER’S MINDSET

You’re neither right nor wrong because other people agree with you.  You’re right because your facts are right and your reasoning is right—and that’s the only thing that makes you right.  And if your facts and reasoning are right, you don’t have to worry about anybody else. – Warren Buffett

Thorndike sums up the outsider’s mindset:

  • Always Do the Math
  • The Denominator Matters
  • A Feisty Independence
  • Charisma is Overrated
  • A Crocodile-Like Temperament That Mixes Patience with Occasional Bold Action
  • The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small
  • A Long-Term Perspective

Always Do the Math

The outsider CEOs always focus on the ROIC for any potential investment.  They do the analysis themselves just using the key variables and without using a financial model.  Outsider CEOs realize that it’s the assumptions about the key variables that really matter.

The Denominator Matters

The outsider CEOs focus on maximizing value per share.  Thus, the focus is not only on maximizing the numerator—the value—but also on minimizing the denominator—the number of shares.  Outsider CEOs opportunistically repurchase shares when the shares are cheap.  And they are careful when they finance investment projects.

A Feisty Independence

The outsider CEOs all ran very decentralized organizations.  They gave people responsibility for their respective operations.  But outsider CEOs kept control over capital allocation decisions.  And when they did make decisions, outsider CEOs didn’t seek others’ opinions.  Instead, they liked to gather all the information, and then think and decide with as much independence and rationality as possible.

Charisma Is Overrated

The outsider CEOs tended to be humble and unpromotional.  They tried to spend the absolute minimum amount of time interacting with Wall Street.  Outsider CEOs did not offer quarterly guidance and they did not participate in Wall Street conferences.

A Crocodile-Like Temperament That Mixes Patience With Occasional Bold Action

The outsider CEOs were willing to wait very long periods of time for the right opportunity to emerge.

Like Katharine Graham, many of them created enormous shareholder value by simply avoiding overpriced ‘strategic’ acquisitions, staying on the sidelines during periods of acquisition feeding frenzy.

On the rare occasions when there was something to do, the outsider CEOs acted boldly and aggressively.  Tom Murphy made an acquisition of a company (ABC) larger than the one he managed (Capital Cities).  Henry Singleton repeatedly repurchased huge amounts of stock at cheap prices, eventually buying back over 90 percent of Teledyne’s shares.

The Consistent Application of a Rational, Analytical Approach to Decisions Large and Small

The total value that any company creates over time is the cumulative difference between ROIC and the cost of capital.  The outsider CEOs made every capital allocation decision in order to maximize ROIC over time, thereby maximizing long-term shareholder value.

These CEOs knew precisely what they were looking for, and so did their employees.  They didn’t overanalyze or overmodel, and they didn’t look to outside consultants or bankers to confirm their thinking—they pounced.

A Long-Term Perspective

The outsider CEOs would make investments in their business as long as they thought that it would contribute to maximizing long-term ROIC and long-term shareholder value.  The outsiders were always willing to take short-term pain for long-term gain:

[They] disdained dividends, made disciplined (occasionally large) acquisitions, used leverage selectively, bought back a lot of stock, minimized taxes, ran decentralized organizations, and focused on cash flow over reported net income.

Thorndike notes that the advantage the outsider CEOs had was temperament, not intellect (although they were all highly intelligent).  They understood that what mattered was rationality and patience.

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

A Few Lessons from Sherlock Holmes

July 31, 2022

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

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

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

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

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

Sherlock Holmes:

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

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

Here’s an outline for this blog post:

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

 

SOME LESSONS

Bevelin quotes the science writer Martin Gardner on Sherlock Holmes:

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

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

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

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

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

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

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

Knowledge of human nature is obviously important.  Holmes:

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

Holmes again:

Jealousy is a strange transformer of characters.

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

Judgment can do without knowledge but not knowledge without judgment.

Learning is lifelong.  Holmes:

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

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

 

ON SOLVING A CASE—Observation and Inference

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

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

Holmes:

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

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

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

Holmes talking to Watson:

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

 

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

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

More is missed by not looking than not knowing.

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

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

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

Bevelin also quotes Charles Darwin:

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

Holmes:

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

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

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

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

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

Consider why someone might be lying.  Holmes:

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

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

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

Holmes again:

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

Bevelin quotes the Canadian physician William Osler:

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

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

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

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

Holmes again:

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

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

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

Belevin also quotes Dr. Joseph Bell:

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

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

 

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

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

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

Often the solution is simple.  Holmes:

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

History frequently repeats.  Holmes:

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

Holmes:

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

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

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

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

Holmes again:

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

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

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

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

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

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

 

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

What seems obvious can be very misleading.  Holmes:

There is nothing more deceptive than an obvious fact.

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

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

Holmes again:

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

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

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

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

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

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

 

SOME OTHER TOOLS

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

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

Others may be of help.  Holmes:

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

Watson was a great help to Holmes.  Watson:

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

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

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

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

Holmes makes the same point:

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

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

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

Mistakes are inevitable.  Holmes:

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

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

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

Bevelin quotes the physician Oliver Wendell Holmes, Sr.:

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

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

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

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

Buffett again:

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

Munger:

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

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

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

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

Invest Like Sherlock Holmes

June 5, 2022

Robert G. Hagstrom has written a number of excellent books on investing.  One of his best is The Detective and the Investor  (Texere, 2002).

Many investors are too focused on the short term, are overwhelmed with information, take shortcuts, or fall prey to cognitive biases.  Hagstrom argues that investors can learn from the Great Detectives as well as from top investigative journalists.

Great detectives very patiently gather information from a wide variety of sources.  They discard facts that turn out to be irrelevant and keep looking for new facts that are relevant.  They painstakingly use logic to analyze the given information and reach the correct conclusion.  They’re quite willing to discard a hypothesis, no matter how well-supported, if new facts lead in a different direction.

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

Top investigative journalists follow a similar method.

Outline for this blog post:

  • The Detective and the Investor
  • Auguste Dupin
  • Jonathan Laing and Sunbeam
  • Top Investigative Journalists
  • Edna Buchanan—Pulitzer Prize Winner
  • Sherlock Holmes
  • Arthur Conan Doyle
  • Holmes on Wall Street
  • Father Brown
  • How to Become a Great Detective

The first Great Detective is Auguste Dupin, an invention of Edgar Allan Poe.  The financial journalist Jonathan Laing’s patient and logical analysis of the Sunbeam Corporation bears similarity to Dupin’s methods.

Top investigative journalists are great detectives.  The Pulitzer Prize-winning journalist Edna Buchanan is an excellent example.

Sherlock Holmes is the most famous Great Detective.  Holmes was invented by Dr. Arthur Conan Doyle.

Last but not least, Father Brown is the third Great Detective discussed by Hagstrom.  Father Brown was invented by G. K. Chesterton.

The last section—How To Become a Great Detective—sums up what you as an investor can learn from the three Great Detectives.

 

THE DETECTIVE AND THE INVESTOR

Hagstrom writes that many investors, both professional and amateur, have fallen into bad habits, including the following:

  • Short-term thinking: Many professional investors advertise their short-term track records, and many clients sign up on this basis.  But short-term performance is largely random, and usually cannot be maintained.  What matters (at a minimum) is performance over rolling five-year periods.
  • Infatuation with speculation: Speculation is guessing what other investors will do in the short term.  Investing, on the other hand, is figuring out the value of a given business and only buying when the price is well below that value.
  • Overload of information: The internet has led to an overabundance of information.  This makes it crucial that you, as an investor, know how to interpret and analyze the information.
  • Mental shortcuts: We know from Daniel Kahneman (see Thinking, Fast and Slow) that most people rely on System 1 (intuition) rather than System 2 (logic and math) when making decisions under uncertainty.  Most investors jump to conclusions based on easy explanations, and then—due to confirmation bias—only see evidence that supports their conclusions.
  • Emotional potholes: In addition to confirmation bias, investors suffer from overconfidence, hindsight bias, loss aversion, and several other cognitive biases.  These cognitive biases regularly cause investors to make mistakes in their investment decisions.  I wrote about cognitive biases here: http://boolefund.com/cognitive-biases/

How can investors develop better habits?  Hagstrom:

The core premise of this book is that the same mental skills that characterize a good detective also characterize a good investor… To say this another way, the analytical methods displayed by the best fictional detectives are in fact high-level decision-making tools that can be learned and applied to the investment world.

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

Hagstrom asks if it is possible to combine the methods of the three Great Detectives.  If so, what would the ideal detective’s approach to investing be?

First, our investor-detective would have to keep an open mind, be prepared to analyze each new opportunity without any preset opinions.  He or she would be well versed in the basic methods of inquiry, and so would avoid making any premature and possibly inaccurate assumptions.  Of course, our investor-detective would presume that the truth might be hidden below the surface and so would distrust the obvious.  The investor-detective would operate with cool calculation and not allow emotions to distract clear thinking.  The investor-detective would also be able to deconstruct the complex situation into its analyzable parts.  And perhaps most important, our investor-detective would have a passion for truth, and, driven by a nagging premonition that things are not what they seem to be, would keep digging away until all the evidence had been uncovered.

 

AUGUSTE DUPIN

(Illustration—by Frédéric Théodore Lix—to The Purloined Letter, via Wikimedia Commons)

The Murders in the Rue Morgue exemplifies Dupin’s skill as a detective.  The case involves Madame L’Espanaye and her daughter.  Madame L’Espanaye was found behind the house in the yard with multiple broken bones and her head almost severed.  The daughter was found strangled to death and stuffed upside down into a chimney.  The murders occurred in a fourth-floor room that was locked from the inside.  On the floor were a bloody straight razor, several bloody tufts of grey hair, and two bags of gold coins.

Several witnesses heard voices, but no one could say for sure which language it was.  After deliberation, Dupin concludes that they must not have been hearing a human voice at all.  He also dismisses the possibility of robbery, since the gold coins weren’t taken.  Moreover, the murderer would have to possess superhuman strength to stuff the daughter’s body up the chimney.  As for getting into a locked room, the murderer could have gotten in through a window.  Finally, Dupin demonstrates that the daughter could not have been strangled by a human hand.  Dupin concludes that Madame L’Espanaye and her daughter were killed by an orangutan.

Dupin places an advertisement in the local newspaper asking if anyone had lost an orangutan.  A sailor arrives looking for it.  The sailor explains that he had seen the orangutan with a razor, imitating the sailor shaving.  The orangutan had then fled.  Once it got into the room with Madame L’Espanaye and her daughter, the orangutan probably grabbed Madame’s hair and was waving the razor, imitating a barber.  When the woman screamed in fear, the orangutan grew furious and killed her and her daughter.

Thus Dupin solves what at first seemed like an impossible case.  The solution is completely unexpected but is the only logical possibility, given all the facts.

Hagstrom writes that investors can learn important lessons from the Great Detective Auguste Dupin:

First, look in all directions, observe carefully and thoughtfully everything you see, and do not make assumptions from inadequate information.  On the other hand, do not blindly accept what you find.  Whatever you read, hear, or overhear about a certain stock or company may not necessarily be true.  Keep on with your research;  give yourself time to dig beneath the surface.

If you’re a small investor, it’s often best to invest in microcap stocks.  (This presumes that you have access to a proven investment process.)  There are hundreds of tiny companies much too small for most professional investors even to consider.  Thus, there is much more mispricing among micro caps.  Moreover, many microcap companies are relatively easy to analyze and understand.  (The Boole Microcap Fund invests in microcap companies.)

 

JONATHAN LAING AND SUNBEAM

(Sunbeam logo, via Wikimedia Commons)

Hagstrom writes that, in the spring of 1997, Wall Street was in love with the self-proclaimed ‘turnaround genius’ Al Dunlap.  Dunlap was asked to take over the troubled Sunbeam Corporation, a maker of electric home appliances.  Dunlap would repeat the strategy he used on previous turnarounds:

[Drive] up the stock price by any means necessary, sell the company, and cash in his stock options at the inflated price.

Although Dunlap made massive cost cuts, some journalists were skeptical, viewing Sunbeam as being in a weak competitive position in a harsh industry.  Jonathan Laing of Barron’s, in particular, took a close look at Sunbeam.  Laing focused on accounting practices:

First, Laing pointed out that Sunbeam took a huge restructuring charge ($337 million) in the last quarter of 1996, resulting in a net loss for the year of $228.3 million.  The charges included moving reserves from 1996 to 1997 (where they could later be recharacterized as income);  prepaying advertising expenses to make the new year’s numbers look better;  a suspiciously high charge for bad-debt allowance;  a $90 million write-off for inventory that, if sold at a later date, could turn up in future profits;  and write-offs for plants, equipment, and trademarks used by business lines that were still operating.

To Laing, it looked very much like Sunbeam was trying to find every possible way to transfer 1997 projected losses to 1996 (and write 1996 off as a lost year, claiming it was ruined by previous management) while at the same time switching 1996 income into 1997…

(Photo by Evgeny Ivanov)

Hagstrom continues:

Even though Sunbeam’s first-quarter 1997 numbers did indeed show a strong increase in sales volume, Laing had collected evidence that the company was engaging in the practice known as ‘inventory stuffing’—getting retailers to place abnormally large orders either through high-pressure sales tactics or by offering them deep discounts (using the written-off inventory from 1996).  Looking closely at Sunbeam’s financial reports, Laing also found a hodgepodge of other maneuvers designed to boost sales numbers, such as delaying delivery of sales made in 1996 so they could go on the books as 1997 sales, shipping more units than the customer had actually ordered, and counting as sales orders that had already been canceled.

The bottom line was simply that much of 1997’s results would be artificial.  Hagstrom summarizes the lesson from Dupin and Laing:

The core lesson for investors here can be expressed simply:  Take nothing for granted, whether it comes from the prefect of police or the CEO of a major corporation.  This is, in fact, a key theme of this chapter.  If something doesn’t make sense to you—no matter who says it—that’s your cue to start digging.

By July 1998, Sunbeam stock had lost 80 percent of its value and was lower than when Dunlap took over.  The board of directors fired Dunlap and admitted that its 1997 financial statements were unreliable and were being audited by a new accounting firm.  In February 2001, Sunbeam filed for Chapter 11 bankruptcy protection.  On May 15, 2001, the Securities and Exchange Commission filed suit against Dunlap and four senior Sunbeam executives, along with their accounting firm, Arthur Andersen.  The SEC charged them with a fraudulent scheme to create the illusion of a successful restructuring.

Hagstrom points out what made Laing successful as an investigative journalist:

He read more background material, dissected more financial statements, talked to more people, and painstakingly pieced together what many others failed to see.

 

TOP INVESTIGATIVE JOURNALISTS

Hagstrom mentions Professor Linn B. Washington, Jr., a talented teacher and experienced investigative reporter.  (Washington was awarded the Robert F. Kennedy Prize for his series of articles on drug wars in the Richard Allen housing project.)  Hagstrom quotes Washington:

Investigative journalism is not a nine-to-five job.  All good investigative journalists are first and foremost hard workers.  They are diggers.  They don’t stop at the first thing they come to but rather they feel a need to persist.  They are often passionate about the story they are working on and this passion helps fuel the relentless pursuit of information.  You can’t teach that.  They either have it or they don’t.

…I think most reporters have a sense of morality.  They are outraged by corruption and they believe their investigations have a real purpose, an almost sacred duty to fulfill.  Good investigative reporters want to right the wrong, to fight for the underdog.  And they believe there is a real responsibility attached to the First Amendment.

(Photo by Robyn Mackenzie)

Hagstrom then refers to The Reporter’s Handbook, written by Steve Weinberg for investigative journalists.  Weinberg maintains that gathering information involves two categories: documents and people.  Hagstrom:

Weinberg asks readers to imagine three concentric circles.  The outmost one is ‘secondary sources,’ the middle one ‘primary sources.’  Both are composed primarily of documents.  The inner circle, ‘human sources,’ is made up of people—a wide range of individuals who hold some tidbit of information to add to the picture the reporter is building.

Ideally, the reporter starts with secondary sources and then primary sources:

At these two levels of the investigation, the best reporters rely on what has been called a ‘documents state of mind.’  This way of looking at the world has been articulated by James Steele and Donald Bartlett, an investigative team from the Philadephia Inquirer.  It means that the reporter starts from day one with the belief that a good record exists somewhere, just waiting to be found.

Once good background knowledge is accumulated from all the primary and secondary documents, the reporter is ready to turn to the human sources…

Photo by intheskies

Time equals truth:

As they start down this research track, reporters also need to remember another vital concept from the handbook:  ‘Time equals truth.’  Doing a complete job of research takes time, whether the researcher is a reporter following a story or an investor following a company—or for that matter, a detective following the evidence at a crime scene.  Journalists, investors, and detectives must always keep in mind that the degree of truth one finds is directly proportional to the amount of time one spends in the search.  The road to truth permits no shortcuts.

The Reporter’s Handbook also urges reporters to question conventional wisdom, to remember that whatever they learn in their investigation may be biased, superficial, self-serving for the source, or just plain wrong.  It’s another way of saying ‘Take nothing for granted.’  It is the journalist’s responsibility—and the investor’s—to penetrate the conventional wisdom and find what is on the other side.

The three concepts discussed above—‘adopt a documents state of mind,’ ‘time equals truth,’ and ‘question conventional wisdom;  take nothing for granted’—may be key operating principles for journalists, but I see them also as new watchwords for investors.

 

EDNA BUCHANAN—PULITZER PRIZE WINNER

Edna Buchanan, working for the Miami Herald and covering the police beat, won a Pulitzer Prize in 1986.  Hagstrom lists some of Buchanan’s principles:

  • Do a complete background check on all the key players.  Find out how a person treats employees, women, the environment, animals, and strangers who can do nothing for them.  Discover if they have a history of unethical and/or illegal behavior.
  • Cast a wide net.  Talk to as many people as you possibly can.  There is always more information.  You just have to find it.  Often that requires being creative.
  • Take the time.  Learning the truth is proportional to the time and effort you invest.  There is always more that you can do.  And you may uncover something crucial.  Never take shortcuts.
  • Use common sense.  Often official promises and pronouncements simply don’t fit the evidence.  Often people lie, whether due to conformity to the crowd, peer pressure, loyalty (like those trying to protect Nixon et al. during Watergate), trying to protect themselves, fear, or any number of reasons.  As for investing, some stories take a long time to figure out, while other stories (especially for tiny companies) are relatively simple.
  • Take no one’s word.  Find out for yourself.  Always be skeptical and read between the lines.  Very often official press releases have been vetted by lawyers and leave out critical information.  Take nothing for granted.
  • Double-check your facts, and then check them again.  For a good reporter, double-checking facts is like breathing.  Find multiples sources of information.  Again, there are no shortcuts.  If you’re an investor, you usually need the full range of good information in order to make a good decision.

In most situations, to get it right requires a great deal of work.  You must look for information from a broad range of sources.  Typically you will find differing opinions.  Not all information has the same value.  Always be skeptical of conventional wisdom, or what ‘everybody knows.’

 

SHERLOCK HOLMES

Image by snaptitude

Sherlock Holmes approaches every problem by following three steps:

  • First, he makes a calm, meticulous examination of the situation, taking care to remain objective and avoid the undue influence of emotion.  Nothing, not even the tiniest detail, escapes his keen eye.
  • Next, he takes what he observes and puts it in context by incorporating elements from his existing store of knowledge.  From his encyclopedic mind, he extracts information about the thing observed that enables him to understand its significance.
  • Finally, he evaluates what he observed in the light of this context and, using sound deductive reasoning, analyzes what it means to come up with the answer.

These steps occur and re-occur in an iterative search for all the facts and for the best hypothesis.

There was a case involving a young doctor, Percy Trevelyan.  Some time ago, an older gentleman named Blessington offered to set up a medical practice for Trevelyan in return for a share of the profits.  Trevelyan agreed.

A patient suffering from catalepsy—a specialty of the doctor—came to the doctor’s office one day.  The patient also had his son with him.  During the examination, the patient suffered a cataleptic attack.  The doctor ran from the room to grab the treatment medicine.  But when he got back, the patient and his son were gone.  The two men returned the following day, giving a reasonable explanation for the mix-up, and the exam continued.  (On both visits, the son had stayed in the waiting room.)

Shortly after the second visit, Blessington burst into the exam room, demanding to know who had been in his private rooms.  The doctor tried to assure him that no one had.  But upon going to Blessington’s room, he saw a strange set of footprints.  Only after Trevelyan promises to bring Sherlock Holmes to the case does Blessington calm down.

Holmes talks with Blessington.  Blessington claims not to know who is after him, but Holmes can tell that he is lying.  Holmes later tells his assistant Watson that the patient and his son were fakes and had some sinister reason for wanting to get Blessington.

Holmes is right.  The next morning, Holmes and Watson are called to the house again.  This time, Blessington is dead, apparently having hung himself.

But Holmes deduces that it wasn’t a suicide but a murder.  For one thing, there were four cigar butts found in the fireplace, which led the policeman to conclude that Blessington had stayed up late agonizing over his decision.  But Holmes recognizes that Blessington’s cigar is a Havana, but the other three cigars had been imported by the Dutch from East India.  Furthermore, two had been smoked from a holder and two without.  So there were at least two other people in the room with Blessington.

Holmes does his usual very methodical examination of the room and the house.  He finds three sets of footprints on the stairs, clearly showing that three men had crept up the stairs.  The men had forced the lock, as Holmes deduced from scratches on it.

Holmes also realized the three men had come to commit murder.  There was a screwdriver left behind.  And he could further deduce (by the ashes dropped) where each man sat as the three men deliberated over how to kill Blessington.  Eventually, they hung Blessington.  Two killers left the house and the third barred the door, implying that the third murderer must be a part of the doctor’s household.

All these signs were visible:  the three sets of footprints, the scratches on the lock, the cigars that were not Blessington’s type, the screwdriver, the fact that the front door was barred when the police arrived.  But it took Holmes to put them all together and deduce their meaning:  murder, not suicide.  As Holmes himself remarked in another context, ‘The world is full of obvious things which nobody by any chance ever observes.’

…He knows Blessington was killed by people well known to him.  He also knows, from Trevelyan’s description, what the fake patient and his son look like.  And he has found a photograph of Blessington in the apartment.  A quick stop at policy headquarters is all Holmes needs to pinpoint their identity.  The killers, no strangers to the police, were a gang of bank robbers who had gone to prison after being betrayed by their partner, who then took off with all the money—the very money he used to set Dr. Trevelyan up in practice.  Recently released from prison, the gang tracked Blessington down and finally executed him.

Spelled out thus, one logical point after another, it seems a simple solution.  Indeed, that is Holmes’s genius:  Everything IS simple, once he explains it.

Hagstrom then adds:

Holmes operates from the presumption that all things are explainable;  that the clues are always present, awaiting discovery. 

The first step—gathering all the facts—usually requires a great deal of careful effort and attention.  One single fact can be the key to deducing the true hypothesis.  The current hypothesis is revisable if there may be relevant facts not yet known.  Therefore, a heightened degree of awareness is always essential.  With practice, a heightened state of alertness becomes natural for the detective (or the investor).

“Details contain the vital essence of the whole matter.” — Sherlock Holmes

Moreover, it’s essential to keep emotion out of the process of discovery:

One reason Holmes is able to see fully what others miss is that he maintains a level of detached objectivity toward the people involved.  He is careful not to be unduly influenced by emotion, but to look at the facts with calm, dispassionate regard.  He sees everything that is there—and nothing that is not.  For Holmes knows that when emotion seeps in, one’s vision of what is true can become compromised.  As he once remarked to Dr. Watson, ‘Emotional qualities are antagonistic to clear reasoning… Detection is, or ought to be, an exact science and should be treated in the same cold and unemotional manner.  You have attempted to tinge it with romanticism, which produces much the same effect as if you worked a love story or an elopement into the fifth proposition of Euclid.’

Image by snaptitude

Holmes himself is rather aloof and even antisocial, which helps him to maintain objectivity when collecting and analyzing data.

‘I make a point of never having any prejudices and of following docilely wherever fact may lead me.’  He starts, that is, with no preformed idea, and merely collects data.  But it is part of Holmes’s brilliance that he does not settle for the easy answer.  Even when he has gathered together enough facts to suggest one logical possibility, he always knows that this answer may not be the correct one.  He keeps searching until he has found everything, even if subsequent facts point in another direction.  He does not reject the new facts simply because they’re antithetical to what he’s already found, as so many others might.

Hagstrom observes that many investors are susceptible to confirmation bias:

…Ironically, it is the investors eager to do their homework who may be the most susceptible.  At a certain point in their research, they have collected enough information that a pattern becomes clear, and they assume they have found the answer.  If subsequent information then contradicts that pattern, they cannot bring themselves to abandon the theory they worked so hard to develop, so they reject the new facts.

Gathering information about an investment you are considering means gather all the information, no matter where it ultimately leads you.  If you find something that does not fit your original thesis, don’t discard the new information—change the thesis.

 

ARTHUR CONAN DOYLE

Arthur Conan Doyle was a Scottish doctor.  One of his professors, Dr. Bell, challenged his students to hone their skills of observation.  Bell believed that a correct diagnosis required alert attention to all aspects of the patient, not just the stated problem.  Doyle later worked for Dr. Bell.  Doyle’s job was to note the patients’ problem along with all possibly relevant details.

Doyle had a very slow start as a doctor.  He had virtually no patients.  He spent his spare time writing, which he had loved doing since boarding school.  Doyle’s main interest was historical fiction.  But he didn’t get much money from what he wrote.

One day he wrote a short novel, A Study in Scarlet, which introduced a private detective, Sherlock Holmes.  Hagstrom quotes Doyle:

I thought I would try my hand at writing a story where the hero would treat crime as Dr. Bell treated disease, and where science would take the place of chance.

Doyle soon realized that he might be able to sell short stories about Sherlock Holmes as a way to get some extra income.  Doyle preferred historical novels, but his short stories about Sherlock Holmes started selling surprisingly well.  Because Doyle continued to emphasize historical novels and the practice of medicine, he demanded higher and higher fees for his short stories about Sherlock Holmes.  But the stories were so popular that magazine editors kept agreeing to the fee increases.

Photo by davehanlon

Soon thereafter, Doyle, having hardly a single patient, decided to abandon medicine and focus on writing.  Doyle still wanted to do other types of writing besides the short stories.  He asked for a very large sum for the Sherlock Holmes stories so that the editors would stop bothering him.  Instead, the editors immediately agreed to the huge fee.

Many years later, Doyle was quite tired of Holmes and Watson after having written fifty-six short stories and four novels about them.  But readers never could get enough.  And the stories are still highly popular to this day, which attests to Doyle’s genius.  Doyle has always been credited with launching the tradition of the scientific sleuth.

 

HOLMES ON WALL STREET

Sherlock Holmes is the most famous Great Detective for good reason.  He is exceptionally thorough, unemotional, and logical.

Holmes knows a great deal about many different things, which is essential in order for him to arrange and analyze all the facts:

The list of things Holmes knows about is staggering:  the typefaces used by different newspapers, what the shape of a skull reveals about race, the geography of London, the configuration of railway lines in cities versus suburbs, and the types of knots used by sailors, for a few examples.  He has authored numerous scientific monographs on such topics as tattoos, ciphers, tobacco ash, variations in human ears, what can be learned from typewriter keys, preserving footprints with plaster of Paris, how a man’s trade affects the shape of his hands, and what a dog’s manner can reveal about the character of its owner.

(Illustration of Sherlock Holmes with various tools, by Elena Kreys)

Consider what Holmes says about his monograph on the subject of tobacco:

“In it I enumerate 140 forms of cigar, cigarette, and pipe tobacco… It is sometimes of supreme importance as a clue.  If you can say definitely, for example, that some murder has been done by a man who was smoking an Indian lunkah, it obviously narrows your field of search.”

It’s very important to keep gathering and re-gathering facts to ensure that you haven’t missed anything.  Holmes:

“It is a capital mistake to theorize before you have all the evidence.  It biases the judgment.”

“The temptation to form premature theories upon insufficient data is the bane of our profession.”

Although gathering all facts is essential, at the same time, you must be organizing those facts since not all facts are relevant to the case at hand.  Of course, this is an iterative process. You may discard a fact as irrelevant and realize later that it is relevant.

Part of the sorting process involves a logical analysis of various combinations of facts.  You reject combinations that are logically impossible.  As Holmes famously said:

“When you have eliminated the impossible, whatever remains, however improbable, must be the truth.”

Often there is more than one logical possibility that is consistent with the known facts.  Be careful not to be deceived by obvious hypotheses.  Often what is ‘obvious’ is completely wrong.

Sometimes finding the solution requires additional research.  Entertaining several possible hypotheses may also be required.  Holmes:

“When you follow two separate chains of thought you will find some point of intersection which should approximate to the truth.”

But be careful to keep facts and hypotheses separate, as Holmes asserts:

“The difficulty is to detach the frame of absolute undeniable facts from the embellishments of theorists.  Then, having established ourselves upon this sound basis, it is our duty to see what inferences may be drawn and what are the special points upon which the whole mystery turns.”

For example, there was a case involving the disappearance of a valuable racehorse.  The chief undeniable fact was that the dog did not bark, which meant that the intruder had to be familiar to the dog.

Sherlock Holmes As Investor

How would Holmes approach investing?  Hagstrom:

Here’s what we know of his methods:  He begins an examination with an objective mind, untainted by prejudice.  He observes acutely and catalogues all the information, down to the tiniest detail, and draws on his broad knowledge to put those details into context.  Then, armed with the facts, he walks logically, rationally, thoughtfully toward a conclusion, always on the lookout for new, sometimes contrary information that might alter the outcome.

It’s worth repeating that much of the process of gathering facts can be tedious and boring.  This is the price you must pay to ensure you get all the facts.  Similarly, analyzing all the facts often requires patience and can take a long time.  No shortcuts.

 

FATHER BROWN

Hagstrom opens the chapter with a scene in which Aristide Valentin—head of Paris police and the most famous investigator in Europe—is chasing Hercule Flambeau, a wealthy and famous French jewel thief.  Both Valentin and Flambeau are on the same train.  But Valentin gets distracted by the behavior of a very short Catholic priest with a round face.  The priest is carrying several brown paper parcels, and he keeps dropping one or the other, or dropping his umbrella.

When the train reaches London, Valentin isn’t exactly sure where Flambeau went.  So Valentin decides to go systematically to the ‘wrong places.’  Valentin ends up at a certain restaurant that caught his attention.  A sugar bowl has salt in it, while the saltcellar contains sugar.  He learns from a waiter that two clergymen had been there earlier, and that one had thrown a half-empty cup of soup against the wall.  Valentin inquires which way the priests went.

Valentin goes to Carstairs Street.  He passes a greengrocer’s stand where the signs for oranges and nuts have been switched.  The owner is still upset about a recent incident in which a parson knocked over his bin of apples.

Valentin keeps looking and notices a restaurant that has a broken window.  He questions the waiter, who explains to him that two foreign parsons had been there.  Apparently, they overpaid.  The waiter told the two parsons of their mistake, at which point one parson said, ‘Sorry for the confusion.  But the extra amount will pay for the window I’m about to break.’  Then the parson broke the window.

Valentin finally ends up in a public park, where he sees two men, one short and one tall, both wearing clerical garb.  Valentin approaches and recognizes that the short man is the same clumsy priest from the train.  The short priest suspected all along that the tall man was not a priest but a criminal.  The short priest, Father Brown, had left the trail of hints for the police.  At that moment, even without turning around, Father Brown knew the police were nearby ready to arrest Flambeau.

Father Brown was invented by G. K. Chesterton.  Father Brown is very compassionate and has deep insight into human psychology, which often helps him to solve crimes.

He knows, from hearing confessions and ministering in times of trouble, how people act when they have done something wrong.  From observing a person’s behavior—facial expressions, ways of walking and talking, general demeanor—he can tell much about that person.  In a word, he can see inside someone’s heart and mind, and form a clear impression about character…

His feats of detection have their roots in this knowledge of human nature, which comes from two sources:  his years in the confessional, and his own self-awareness.  What makes Father Brown truly exceptional is that he acknowledges the capacity for evildoing in himself.  In ‘The Hammer of God’ he says, ‘I am a man and therefore have all devils in my heart.’

Because of this compassionate understanding of human weakness, from both within and without, he can see into the darkest corners of the human heart.  The ability to identify with the criminal, to feel what he is feeling, is what leads him to find the identity of the criminal—even, sometimes, to predict the crime, for he knows the point at which human emotions such as fear or jealousy tip over from acceptable expression into crime.  Even then, he believes in the inherent goodness of mankind, and sets the redemption of the wrongdoer as his main goal.

While Father Brown excels in understanding human psychology, he also excels at logical analysis of the facts.  He is always open to alternative explanations.

(Frontispiece to G. K. Chesterton’s The Wisdom of Father Brown, Illustration by Sydney Semour Lucas, via Wikimedia Commons)

Later the great thief Flambeau is persuaded by Father Brown to give up a life of crime and become a private investigator.  Meanwhile, Valentin, the famous detective, turns to crime and nearly gets away with murder.  Chesterton loves such ironic twists.

Chesterton was a brilliant writer who wrote in an amazing number of different fields.  Chesterton was very compassionate, with a highly developed sense of social justice, notes Hagstrom.  The Father Brown stories are undoubtedly entertaining, but they also deal with questions of justice and morality.  Hagstrom quotes an admirer of Chesterton, who said:  ‘Sherlock Holmes fights criminals;  Father Brown fights the devil.’  Whenever possible, Father Brown wants the criminal to find redemption.

Hagstrom lists what could be Father Brown’s investment guidelines:

  • Look carefully at the circumstances;  do whatever it takes to gather all the clues.
  • Cultivate the understanding of intangibles.
  • Using both tangible and intangible evidence, develop such a full knowledge of potential investments that you can honestly say you know them inside out.
  • Trust your instincts.  Intuition is invaluable.
  • Remain open to the possibility that something else may be happening, something different from that which first appears; remember that the full truth may be hidden beneath the surface.

Hagstrom mentions that psychology can be useful for investing:

Just as Father Brown’s skill as an analytical detective was greatly improved by incorporating the study of psychology with the method of observations, so too can individuals improve their investment performance by combining the study of psychology with the physical evidence of financial statement analysis.

 

HOW TO BECOME A GREAT DETECTIVE

Hagstrom lists the habits of mind of the Great Detectives:

Auguste Dupin

  • Develop a skeptic’s mindset;  don’t automatically accept conventional wisdom.
  • Conduct a thorough investigation.

Sherlock Holmes

  • Begin an investigation with an objective and unemotional viewpoint.
  • Pay attention to the tiniest details.
  • Remain open-minded to new, even contrary, information.
  • Apply a process of logical reasoning to all you learn.

Father Brown

  • Become a student of psychology.
  • Have faith in your intuition.
  • Seek alternative explanations and re-descriptions.

Hagstrom argues that these habits of mind, if diligently and consistently applied, can help you to do better as an investor over time.

Furthermore, the true hero is reason, a lesson directly applicable to investing:

As I think back over all the mystery stories I have read, I realize there were many detectives but only one hero.  That hero is reason.  No matter who the detective was—Dupin, Holmes, Father Brown, Nero Wolfe, or any number of modern counterparts—it was reason that solved the crime and captured the criminal.  For the Great Detectives, reason is everything.  It controls their thinking, illuminates their investigation, and helps them solve the mystery.

Illustration by yadali

Hagstrom continues:

Now think of yourself as an investor.  Do you want greater insight about a perplexing market?  Reason will clarify your investment approach.

Do you want to escape the trap of irrational, emotion-based action and instead make decisions with calm deliberation?  Reason will steady your thinking.

Do you want to be in possession of all the relevant investment facts before making a purchase?  Reason will help you uncover the truth.

Do you want to improve your investment results by purchasing profitable stocks?  Reason will help you capture the market’s mispricing.

In sum, conduct a thorough investigation.  Painstakingly gather all the facts and keep your emotions entirely out of it.  Skeptically question conventional wisdom and ‘what is obvious.’  Carefully use logic to reason through possible hypotheses.  Eliminate hypotheses that cannot explain all the facts.  Stay open to new information and be willing to discard the best current hypothesis if new facts lead in a different direction.  Finally, be a student of psychology.

 

BOOLE MICROCAP FUND

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

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

 

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

CASE STUDY: Pine Cliff Energy

May 29, 2022

Pine Cliff Energy (PIFYF) is a Canadian natural gas producer.  Pine Cliff Energy has a low-risk, low decline, natural gas asset consolidation strategy in Western Canada with 11 acquisitions since 2012.  PIFYF has one of the lowest decline rates in the oil and gas sector with a base decline rate of about 6% on base production.

Demand for natural gas is likely to continue to surprise to the upside.  Power burn demand is likely to remain high.  At the same time, there is a shortage of global LNG.  New LNG export capacity is being added in the U.S. and Canada.  High power burn plus high LNG gas exports is causing total natural gas demand to be very high.

Furthermore, natural gas storage in the U.S. is 16% below its 5-year average.  And natural gas storage in Canada is at an unprecedented low level.

Natural gas production in the U.S. remains flat.

With high demand, low storage, and flat supply, natural gas prices are likely to remain high and will probably go higher.  The AECO near-month price is $7.53 (CAD/GJ) while the NYMEX near-month price is $8.67 ($/mmbtu).

Here is the Pine Cliff Energy’s most recent investor presentation: https://pinecliff-pull.b-cdn.net/Corporate%20Presentation%202022%2005%2004%20-%20Final.pdf

For 2022, revenue will be about $175 million, EBITDA $146 million, cash flow $135 million, and earnings $95 million.  The current market cap is $503.6 million, while enterprise value (EV) is $526.5 million.

Using these figures, we get the following multiples:

    • EV/EBITDA = 3.61
    • P/E = 5.30
    • P/B = 3.49
    • P/CF = 3.73
    • P/S = 2.88

Insider ownership is 12.9%, which is good.  TL/TA (total liabilities/total assets) is 21.6%, which is very good.  ROE is 828.24%, which is outstanding.

The Piotroski F_score is 9, which is excellent.

Intrinsic value scenarios:

    • Low case: Natural gas prices could fall during a global recession.  The stock of PIFYF could decline 50% or more.
    • Mid case: Current EV/CF (where CF is cash flow) is 3.9.  The average EV/CF for Pine Cliff Energy historically is 8.0.  With EV/CF at 8.0, the stock would be worth $3.12, which is 105% higher than today’s $1.52.
    • High case: Natural gas prices could increase significantly, which means Pine Cliff Energy’s cash flow would increase significantly.  The stock could be worth at least $4.50, which is close to 200% higher than today’s $1.52.

Risks

There will probably be a bear market and/or global recession during which natural gas prices fall temporarily but then quickly rebound.  In this case, PIFYF stock would fall temporarily but then quickly rebound.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

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

CASE STUDY: Cardinal Energy (CRLFF)

May 1, 2022

Cardinal Energy (CRLFF) is a Canadian oil producer.

Here is the company’s most recent investor presentation: https://cardinalenergy.ca/wp-content/uploads/2022/03/April-2022-Corporate-Presentation.pdf

For 2022, revenue will be about $673 million, EBITDA $365 million, cash flow $337 million, and earnings $240 million.  The current market cap is $804.7 million, while enterprise value (EV) is $924.8 million.

Book value at the end of 2022 will be about $742.7 million.

Using these figures, we get the following multiples:

    • EV/EBITDA = 2.53
    • P/E = 3.35
    • P/B = 1.08
    • P/CF = 2.39
    • P/S = 1.20

Insider ownership is 18%, which is very good.  TL/TA (total liabilities/total assets) is 33.1%, which is good.  ROE is 52.1%, which is excellent.

The Piotroski F_score is 8, which is very good.

Due to years of underinvestment from oil producers, oil supply is constrained.  (Government policy has also discouraged oil investment.)  Moreover, due to money printing by central banks plus strong fiscal stimulus, oil demand is strong and increasing.

The net result of constrained supply and strong demand is a structural bull market for oil that is likely to last years.  The oil price is likely to remain high at $90-110 per barrel (WTI) and later perhaps even higher.

Intrinsic value scenarios:

    • Low case: Book value per share at the end of 2022 will be about $4.94.  This is 7% lower than today’s stock price of $5.29.
    • Mid case: Free cash flow in 2022 will be about $233 million.  Because this is probably the beginning of a structural bull market for oil, $233 million in free cash flow is a mid-cycle figure and the stock is worth a free cash flow multiple of at least 8.  That works out to $12.39, which is 135% higher than today’s $5.29.
    • High case: Free cash flow is likely to reach $470 million in the next few years.  With a free cash flow multiple of 6, the stock would be worth $18.75, over 250% higher than today’s $5.29.

Risks

There will probably be a bear market and/or recession during which oil prices fall temporarily but then quickly rebound.  In this case, CRLFF stock would fall temporarily but then quickly rebound.

 

BOOLE MICROCAP FUND

An equal weighted group of micro caps generally far outperforms an equal weighted (or cap-weighted) group of larger stocks over time.

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

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

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

 

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

My e-mail: jb@boolefund.com

 

 

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

CASE STUDY: InPlay Oil (IPOOF)

April 24, 2022

InPlay Oil (IPOOF) is an oil producer based in Alberta, Canada.

Here is the company’s most recent investor presentation: https://www.inplayoil.com/sites/2/files/documents/inplay_march_presentation_web_0.pdf

For 2022, revenue will be about $300 million, EBITDA $160 million, cash flow $150 million, and earnings $90 million.  The current market cap is $261.7 million, while enterprise value (EV) is $307.5 million.

Using these figures, we get the following multiples:

    • EV/EBITDA = 1.92
    • P/E = 2.91
    • P/B = 0.93
    • P/CF = 1.74
    • P/S = 0.87

Insider ownership is 29.7%, which is excellent.  TL/TA (total liabilities/total assets) is 53.4%, which is decent.  ROE is 97.9%, which is outstanding.

The Piotroski F_score is 8, which is very good.

Intrinsic value scenarios:

    • Low case: Book value per share at the end of 2022 will be about $3.24.  This is 7% higher than today’s stock price of $3.03.
    • Mid case: Free cash flow in 2022 will be about $90 million.  Because this is probably the beginning of a structural bull market for oil—based on strong demand and constrained supply over the next 3 to 10 years—$90 million in free cash flow is a mid-cycle figure and the stock is worth a free cash flow multiple of at least 8.  That works out to $8.35, which is 175% higher than today’s $3.03.
    • High case: Because it’s probably a structural bull market for oil, free cash flow is likely to reach $180 million in the next few years.  With a free cash flow multiple of 6, the stock would be worth $12.53, over 310% higher than today’s $3.03.

Risks

There will probably be a bear market and/or recession during which oil prices fall temporarily but then quickly rebound.  In this case, IPOOF stock would fall temporarily but then quickly rebound.

 

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.