Fusing Business Momentum and Value

Business Momentum Look at Investing from a New AngleThe following article comes from one of the best discussion board posts I’ve read. The post is republished below with the permission of the author. This enriching and entertaining article exemplifies a style of fusion investing, the fusion of business momentum and value.

I hope you enjoy reading and thinking about this article as much as I did. It’s a fantastic example of looking at things from a new angle.

What did we do right in 2009?

One year of good return may be just a result of high tide lifting all boats or simply mean-reversion from a terrible year. Nevertheless, my biggest take-away from 2009 was a subtle but important change to my investment philosophy – I have changed my focus from “good and cheap” to “better and cheap”. I care more about change in fundamentals – I prefer a bad company that is getting better over a good company with no change in story. This new philosophy has led to solid stock picking, which generally out-performed the market with what I believe to be lower risk (“permanent loss of capital”). Equally important, this new framework gives me better guidelines to size my bets, especially betting heavily in situations where both the story is getting better and stock is cheap.

When I started investing a few years ago, I was firmly in the value investing school – concepts like “intrinsic value” and “Mr. Market”, coined by Ben Graham and popularized by Warren Buffett, clicked for me instantly. I spent time studying company fundamentals, coming up with an estimate of the intrinsic value, and trying to buy at a cheap or discounted price. In short, I was trying to buy “good and cheap”, and results were satisfactory.

Balancing between business and momentum

However, I have come to realize the quality of the company and absolute discount to intrinsic value are not everything – one has also to consider the time and factors it takes for the discount to narrow, which typically depend on the business cycle. Thus my new approach comes down to balancing between value and momentum. Value refers to the price paid for the business. Momentum, not to be confused with price momentum in quant and technical analysis, refers to business momentum, i.e. how well the business is doing. Improving momentum can come in the form of higher margin, accelerating topline growth, or improving ROIC. With the exception of select great companies in their growth phase, most companies’ stock price and business momentum move in cycles/curves similar to sine waves with peaks and troughs.

These two curves are closely related – when business momentum is good, stock price tends to go up, and vice versa. However, there is often a lag between the two curves, and depending on the part of the cycle, stock price will react to the change in business momentum very differently. I believe this is the crux of investing – how you identify which part of the cycle the company is in, which drivers to watch for and which valuation metrics to use. For example, earning revision is a powerful factor but completely useless at business peaks and troughs. P/E may be a good valuation metric in general, but unadjusted for margins, it is useless or even dangerous at extremes. [I stopped highlighting here as it’s all so good the entire article should be highlighted!]

For example, assume a retailer’s intrinsic value is $20, and buying at $15 may give an expected return of 33%. However, the same $15 price may correspond to two points on the momentum curve – one where the curve is turning up (story getting better) and the other where the curve is trending down. In the former case, you will probably get to $20 in 6-12 months. In the latter case, you may have to wait 18-24 months before the retailer corrects excess inventory and produces positive SSS (curve turning up again) to reach the $20 intrinsic value.

There are two obvious problems with buying at the latter point. First, time adjusted return is obviously inferior. Second, the stock price may first plunge to $6 before recovering. While a pure value investor may think a lower price makes it a better buy (even more margin of safety), reality is that an adverse price movement will slowly but surely inject doubt into my mind. Have I made a mistake? Is this a value trap? Very seldom does stock price move down without some deterioration of business fundamentals and some changes to the initial investment thesis. So unless one has an iron stomach (I don’t), it is very tough to keep calm during the price downdraft and continue to average down.

There is an even bigger issue – if you are prepared to average down, chances are that you will not buy a full position initially, and inevitably you will end up establishing similar-sized partial positions for all new ideas. Yet some of those ideas will have good business momentum and they are your surer bets, so you lose potential profits in positions that actually have the best risk/time adjusted return.

Does quantitative investing capture business momentum?

So doesn’t quant investing capture “better and cheap”, as preached by the noted quant investor Cliff Asness? Yes and no. I believe there are two problems with quant investing. First, it mistakes cause with effect – price momentum is the result of business momentum, and while the two will resemble each other at certain part of the cycle, they will diverge significantly at critical turning points. Second, the effectiveness of various factors differs significantly from industry to industry as well as at different parts of the business cycle. Quite simply, quant investors lack the domain knowledge of each industry and use the same factors or same weightings across sectors during different points of the cycle.

For example, quant investors will universally use factors such as earning revision, revenue/EPS surprise/breadth to capture business momentum. While this does a satisfactory job overall, it will not capture key drivers for each industry, which often cannot be retrieved from standardized financial statements, such as inventory/store for retailers, or asset inflows for asset managers. Often changes in these key drivers will long precede actual changes in earnings, so generalized quant investing could easily miss the turn. As another example, six months ago, both KIRK and ARO got the highest rating in our internal quant system, yet the two retailers could not be more different in terms of where they were in the business and margin cycle, and the subsequent divergence in stock performance illustrated the flaw in the quant investing approach.

Catching the turn

I certainly do not want to leave the impression that other investing approaches are inferior. Indeed, there are many ways to achieve success in investing, and everyone needs to find approaches to fit his or her own traits. I believe I have found mine by balancing between value and momentum. Put simply, I aim to invest in situations where fundamentals are about to turn or have turned while valuation is reasonable. I am certainly not reinventing wheels here, as this is the approach advocated by both Peter Lynch (“catching the turn”) and Warren Buffett (“What we really like to see in situations is a condition where the company is making substantial progress in terms of improving earnings, increasing asset values, etc., but where the market price of the stock is doing very little while we continue to acquire it”).

Well, this approach may sound good on paper, but how many of these “perfect” situations exist, given how efficient market is with so many hungry and smart investors poring over every corner of the market? I believe these opportunities happen more often than one may think, especially if one can invest in small-cap or micro-cap land. For example, I monitor about 50 names closely in the retail industry (which I shamelessly consider to be my circle of competence). This year alone, I identified 4 separate names that fit the criteria. They respectively returned 50%, 70%, 100% and 900%.

One may counter that retail stocks have done very well in general this year and question whether throwing darts randomly would have generated similar if not better results. I would argue that much of the return (especially the out-sized ones) was hope-based, and rational investors could not have predicted those returns ex-ante with any confidence to place a big bet, as some of those names could easily turn out to be zeros. Yet in all four names I identified, I was reasonably certain of the business momentum and earning surprise, and could accordingly place out-sized bets (10%+), with confidence that even if it did not play out according to plan, I would suffer very small losses due to valuation.

While hindsight is 20/20, I could also identify at least two retail names annually over the last few years that fit my “better and cheap” criteria. So they definitely occur, and one just needs to have the patience and courage to bet big when they do come along, usually when market is bad. Those situations can occur in large-cap stocks as well, such as FDX throughout this year. FDX had over $20B market cap, was followed by 25 analysts, yet the stock was at trough EV/sales, even though earnings had bottomed and was poised to recover through cost cuts and market share gains. Earning estimates have moved up 60% in 6 months and stock went up over 150%.

As with anything in investing, there are also drawbacks to my approach. One is depth vs. width – I need to be able to identify and evaluate key drivers for the companies and industries, and this takes significant amount of time. The rarity of these “perfect” situations forces me to turn over a lot of rocks. To date, I am reasonably comfortable with retail industry, and to a much lesser degree with software, asset managers and transport industries. I may soon reach (if not already) a point where I can not physically monitor more names. The other problem is scalability – most of my top ideas are in small to micro-cap land, so it is questionable whether my approach can really handle more than say $50-100M of assets. But that will be a nice problem to have, and I suspect I will just have to make the trade-off between absolute performance and AUM.

 

Originally posted Mar 4, 2010 

It’s been too long

I don’t know where to start.

I guess with Peter’s death. To me Peter was one of the greatest living Irishmen. His warmth, generosity, kindness, fire and brilliant humour made life better.

I used to keep this picture of Peter with my son on my desk. The photo reminded me to live in the moment, to enjoy the moment, to love the moment.

Peter died from cancer this week.

I’ll write more soon.

Investing Myths and Disjunction Fallacy

Here are the results from a twitter poll I ran yesterday.

gain loss quiz

It was a small sample size. Only 30 people. I assume most were financially literate.

I wonder what people thought when they saw the results, after answering the poll. Did they feel more or less sure of their answer? Did they feel validated or perhaps confident in their contrary position?

It seems most people believe that a 50 percent loss takes a 100 percent to make it whole again. That a 90 percent loss takes a massive 900 percent to offset it.

That my friends is bullshit. It is one of the most widely perpetuated myths in investing.

Investing is a parallel pursuit. A 50 percent loss in one investment is offset by a 50 percent gain in another investment of the same size. A 90% loss is made whole by a 90% gain.

the real gain loss picture

Yes if you loose 80% of your total portfolio you’ll need to make 400% to get back to scratch. While that concept is important, I consider focusing on outcomes for individual investments more crucial. I’ve always liked the saying, look after your pennies and the pounds will look after themselves.

There is no need to be terrified of losses. The upside is infinite the maximum downside is only 100 percent (ignoring leverage). I don’t wish to encourage you to be a bag holder and take big losses. My aim is simply to make you wonder why almost everyone is hell bent on convincing you that deepening losses require exponentially higher returns to offset.

Now for anyone thinking, but you didn’t say an investment I thought you were talking about a portfolio, let’s talk about disjunction fallacy.

In short disjunction fallacy is thinking that a member is more likely to be part of a subset rather than a member of the set which contains the subset. In the above poll, both 50% and 100% are subsets of it depends.

This is similar to the better known Linda effect or conjunction fallacy, when people guess that the odds of two events co-occurring is greater than either one occurring alone.

The return required to make you whole depends on whether you’re considering a portfolio or an investment and the position size of each investment.

Is your mobile phone glued to your hand?

“Never invest in any idea you can’t illustrate with a crayon.” Peter Lynch

Mobile Embrace (ASX:MBE) is a fast growing, mobile marketing company.

Passionate founders, hugely scalable, high margins and massive tailwinds.

Crayons are so yesterday! Here’s my Mobile Embrace illustration.

Mobile Embrace business

 

If you want to read more go read the annual and half year reports.

Or be influenced by Marcus Hamilton at Taylor Collison.

MBE looks cheap for a fast-growing, mobile-focused company with a strong track record of delivering organic and acquisitive growth. Accordingly, we reiterate our Outperform recommendation and $0.45/sh price target.

Long Mobile Embrace. My target is $1 within 2 to 5 years, reassessing as it goes.

Regulatory and technology risks.

Dismantle your binary thinking

Most of us are programmed from birth to think in binary terms.

Right and wrong, good vs evil, heaven and hell, cops and robbers, snake and ladders, to name but a few.

Binary thinking keeps things simple at the expense of reality.

Break the binary chains restraining your mind

Look at Investing from a New Angle

We do not live in a binary world. We live in a multivariate world.

The core of investing is assessing probabilities. If you think in binary terms you’re closing your mind to the raft of possible outcomes.

This is a quick rant, inspired by the following example of binary thinking resulting in a logical fallacy.

When 50-60% of your revenue is “highly likely” to reoccur, then by definition 40-50% of your revenue is “highly unlikely” to reoccur.

That sentence is at the end of this great write-up on billing software company Gentrack. [Update: author was being humourous, it was a play on words.]

If 50-60 percent of revenue is highly likely to reoccur then all you know is that 40-50 percent is not highly likely to reoccur. 20 percent may be likely to reoccur.

Open your mind to a world of possibilities.

How to tell if management will reward shareholders

The extravagance of any corporate office is directly proportional to management’s reluctance to reward the shareholders.  Peter Lynch

Director’s and management’s salary packages are inversely proportional to their willingness to reward shareholders.

Those wasting shareholder money on remuneration consultants don’t deserve your trust. Hiring remuneration consultants is managements way of telling you they want more of your money than they deserve. It indicates management are profligate and will waste your money on non-profitable activities, such as those consultants.

Unfortunately Nearmap Limited (ASX:NEA) have gone one step further and are wasting even more money. Nearmap are holding a special general meeting for shareholders to approve two option grants valued at over $200,000 each. The two directors are new and are on already on $70,000 annual packages.

The two directors, Ian Morris and Peter James, don’t even have any of their own skin in the game. Neither has invested one cent in Nearmap.

The cost of these options grants includes:

  • the time/opportunity cost the directors should have spent improving the fortunes of the company instead of figuring out how to enrich each other
  • the cost of the remuneration consultant
  • the costs of the general meeting, including documentation, director’s and management’s time, cost of venue and associated costs
  • the value of the options $434,000

The directors and management of Nearmap should concentrate on improving the business and spend less time wasting valuable shareholder funds and enriching themselves.

MMC Contrarian Share Buy Back - Vote No

How low can WorleyParsons go?

A little under two years ago I met the then CFO of WorleyParsons Limited (ASX:WOR) over drinks at my daughter’s new school. The next day I looked at WOR for the very first time. The shares were then trading at around $16, down 70 percent from the all time of $54.19 and down 30 percent over the last year.

On trailing financials WOR looked interesting, but with an uncertain future and stacks of mining and energy services falling hard I decided to wait.

and wait

and wait some more.

While biding my time a neighbour mentioned buying WorleyParsons. As I recall that was around $10 and despite the near on 40 percent fall since I first looked at WOR the deterioration in the sector appeared to be accelerating.  I held my tongue, as nobody appreciates contrary views to their purchases.

WorleyParsons 2016 top pick for the brave

Credit Suisse have now listed WorleyParsons as one of its top six 2016 stocks picks for the brave. With a projected return of 150 percent.

Buyers beware! That projected return should be taken with a grain, nay a big bag of salt. Back in September 2013 Credit Suisse upgraded WorleyParsons to outperform and increased the target price to $26.60. Credit Suisee said WorleyParsons’ 14-times price-to-earnings ratio and 5 percent dividend yield were compelling.

Someone should have schooled that analyst in the danger of driving forward while looking in the rare view mirror.

 

WOR falling knife

Today WOR trades at $3.35! Has this falling knife bottomed? Is a 94 percent fall from its all time high far enough?

I’m sure I don’t know the answer. However, despite legal action to the contrary management appear to be doing a decent job of navigating difficult times. What I do know is market conditions will one day improve and a leaner WorleyParsons will deliver a 150 percent return and more. It has the balance sheet and cash flow to survive.

After two years of watching and waiting I’m finally confident enough to say WorleyParsons deserves a place on your watchlist.

More importantly, don’t try to catch falling knives! 

Are you concentrating hard enough?

I sure am!

The top two shares account for 78 percent of our concentrated share fund. The top three 92 percent.

So yes, we’re concentrated!

Two great investing principles

The five shares in the portfolio reflect two simple investing principles.

Two rules from two great investors, Peter Lynch and Warren Buffett.

Water your flowers and pull out the weeds, and only own a handful of companies.

I learnt both rules from Peter Lynch. Though it was Warren Buffett who popularised the concentrated approach with his catchy 20 ticket punch card analogy and his ‘You don’t have to swing at everything — you can wait for your pitch’ phrase.

Lynch was more mater-of-fact.

‘The smallest investor can follow the Rule of Five and limit the portfolio to five issues. If just one of those is a 10-bagger and the other four combined go nowhere, you’ve still tripled your money.’

I illustrated that point in this post highlighting how the view of ‘the greater the loss the ever greater the gain required to make you whole again’, was wrong. For example instead of requiring a 400 percent gain to make up for an 80 percent loss as contended, due to the parallel nature of investing an 80 percent loss is balanced by an 80 percent gain.

The two largest positions are a result of watering of the flowers. Adding on the way up and then simply holding on. Though the second largest has now been trimmed three times. A potential fourth haircut inspired this post.

There are only five companies in the portfolio as the weeds have been pulled.

The third largest portfolio position deserves some water. It’s management are frugal and appear focused on safely growing and rewarding shareholders.

The smallest two positions are speculative long shots. They’ll only receive water if their odds of success shorten.

Please keep in mind there are many right paths. We hold close to 20 companies in our super fund. Plus our concentrated fund has and likely will hold more companies.

3 Ways a Stock Should Pay You

Do you get a lot of useless mass emails? I know I do.

You know the type of emails I’m talking about. They have a catchy headline and a thin veneer of information, but really they’re simply advertising. Mutton dressed up as lamb.

Among the deluge of email noise, Tom Jacobs stands tall. I asked his permission to reprint the following email, as both it and Tom deserve more attention. I’ve followed, liked and learnt from him for 15 years. I recommend you do too.

3 Ways a Stock Should Pay You

Many people incorrectly think there is magic to stock gains and losses because they consider only price. Rather, what matters is whether the business creates what’s called shareholder value. If it does, the stock price will eventually follow. Very simple.

You’d think creating shareholder value would be the goal of every company, right? Sell products and services, take in more money than you spend, and reinvest the excess cash to earn more than if it sits in the checking account. This creates value for owners, whether of a lemonade stand, coffee shop, or Apple, and someone would pay more to buy the business-through our shares.

Yet many businesses are in business to create value for management, not owner-shareholders. And even those who try to be shareholder friendly aren’t often good at it. There are very few truly good CEOs, or every company would make shareholders better off. How do we find good management?

 

The Five Choices

There are five places execs can spend cash beyond what’s needed to run the business: (1) property, plant, equipment, research and development; (2) mergers and acquisitions; (3) dividends; (4) buying back the company’s own undervalued stock; and (5) paying down higher interest debt.

The first two are growth investing. Here, companies build more manufacturing and distribution facilities, hire more software developers, buy other companies and grow empires! More often than not, these fail to create a more valuable company. These investments don’t earn a sufficient return, and roughly 85% of M&A activity fails to add shareholder value. Simply, most CEOs don’t spend shareholder cash well.

 

The Virtuous Cash Cycle

The other three choices help prevent management from blowing our money on skittles and beer. They provide shareholder yield. Paying down debt saves on interest payments, freeing up more cash. If the company’s shares are selling at a price that places a very low value on the company, buying its own stock is a good investment. And when the company buys back shares, our shares own more of the company, and earnings and cash flow per share rise, usually leading to stock gains.

Plus, if a company pays dividends, every share it buys back eliminates paying the dividend on that share forever. If the dividend yield is 4% a share, the company “earns” 4% a year forever just by not having spend it anymore. Even more cash is available to increase the dividends, buybacks, and debt paydowns. It’s a virtuous cycle.

Despite this simple thinking, most investors avoid companies that pay dividends and buy back stock, believing their best days are over. Quite the opposite. The best days for management moon-shot paydays may be gone, but the sweet paydays for shareholders have just begun.

Don’t worry about our vibrant entrepreneurial culture. Venture capitalists and institutional investors will always provide capital for companies with new ideas, products and services to enhance our lives. However, let’s leave it to them to speculate.

Instead, we will buy cheaply and get paid. It’s as simple as that.

 

Tom Jacobs is the co-author of What’s Behind the Numbers? A Guide to Exposing Financial Chicanery and Avoiding Huge Losses in Your Portfolio. He is an Investment Advisor for separately managed accounts at Dallas’s Echelon Investment Management and serves clients worldwide. You may reach him at tjacobs@echelonim.com.

Rene sure knows his acquisition sauce

My Net Fone Ltd (MNF.AX) CEO Rene Sugo sure knows his acquisition sauce.

The acquisition of Telecom New Zealand International voice business is another excellent bolt on for My Net Fone. The TNZI network that MNF are buying from Spark New Zealand Limited (SPK.AX) expands its reach.

$90-100 million of revenue and $3.5 million EBITDA before synergies. This deal will surely be less than 6 times EBITDA in the first year, maybe as low as 5. Anywhere in that range for a growing complementary business is good buying. This deal adds scale, global reach, a good brand and more. Two thumbs up!

Anyone want to talk about it? Or why Spark are selling?

Disclosure: Long MNF

 

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