Thinking Independently about Independent Thinking

Ask anyone about the key characteristics of a successful investor, the term “independent thinking” almost always comes up. This is very reasonable since a successful investor has to make contrarian bets in which the odds are mis-priced. And if you do not think independently, you will be easily swayed by the market and hence have limited ability to identify money-making opportunities, which by definition are non-obvious. Given the underperformance of most active managers, independent thinking seems to be a rare resource. But why is this the case? Taking a step back, what does it really mean to be an “independent thinker”? More importantly, is it a quality that is inborn or can it be nurtured? As we are all striving to become better investors, I think the following question is worth pondering on: How can we become better “independent thinkers”? 

I have been contemplating this very topic over the past month. In this short essay, I explore (or more like recap) the concept of independent thinking, share my thoughts on what independent thinking entails, what it is not, and in my humble opinion, how we can all improve as independent thinkers.

Anatomy of Independent Thinking

Two weeks ago, I tweeted the following question and received four replies, which together I think capture the meaning of independent thinking quite fully. 

MBI set the stage for us. Independent thinking has long been associated with “Thinking based on first principle”. This means going through the logic flow, establishing how an argument goes from A to B to C and so on, before moving all the way to Z. This is what Chris meant by “analyzing your way to conclusions” and why looking at data sources is important. Ultimately, first principle thinking is really just breaking down a topic into subtopics and examining each in a logical way. This all sounds very simple. Therefore, in a sense, the rarity of independent thinking ought to come as a surprise. Everyone with an average intelligence capable of logical deduction should be able to “think independently”. (The level of intelligence influences the ability to reason correctly or come up with better explanations. But independent thinking does not necessarily mean being correct. Otherwise, no one in the financial markets are true “independent thinkers”, given the high failure rate in investing. And in most real-life situations, we are not asked to solve calculus. One just needs to be logical. Correctness should not be part of the measurement of independent thinking.) In reality though, there is often a sense that only a small group of people are capable of thinking independently. Why is this the case? 

Before I share my own thoughts, let me first highlight what independent thinking is not: Original thinking. I do believe original thinking is a rarity. The paragon of original thinkers, in my opinion, include people like Galileo, Einstein, Darwin, etc. These truly groundbreaking scientists, through their imagination and reasoning, imposed on all of humankind a completely new way to interpret the world. This however is not the case for even the greatest investors. From Buffett to Soros, and so on, they are all followers of certain existing principles. Buffett is the most famous student of Ben Graham and Soros is a disciple of Karl Popper. The difference between them and an average investor does not come from originality. Going against the crowd does not require the conjuring of bending space and time. 

If Originality is Not the Limiting Factor, then What Is?

When we read analyst reports or a piece of opinion on the FT, we are absorbing the analysis and judgement from another person. Essentially, we jump directly to Z. While the work may be beautifully articulated and the arguments made based on underlying data points, the integrity of the analysis cannot be guaranteed. The data could have been interpreted incorrectly, or worse still, flawed data were used, or part of the data set was ignored. To fully assess the analysis, one would therefore need to directly inspect the most fundamental level of arguments, the data points. This, however, presents a challenge. The cost of examining the accuracy of data and figuring out if they are collected without any biases is high and doing so for every argument presented to you is prohibitive. Instead, we need to treat this as an optimization problem, and choose an optimal point between efficiency and effectiveness. Where a problem belongs on this continuum depends on the seriousness of the subject on hand. If you are just deciding whether a restaurant is worth trying, it is unlikely to be imperative that you understand how your friend came up with the recommendation. But when it comes to whether you should take an experimental drug for your illness, then you probably want to dig deeper into the reasoning and proof of various recommendations to make the best decision. Most problems occur when it comes to a decision that is somewhere in between these two extremes. Given our human nature of laziness, unless the issue on hand is a matter of life and death, we tend to optimize our mental activities for efficiency rather than effectiveness. I believe this is why independent thinking is hard to come by in the financial markets. The intangible consequences and high uncertainty of investing tempts us to focus more on efficiency than effectiveness in our thinking process. In other words, I believe the rarity of independent thinking is derived from a paucity of patience. 

My own recent experience drives this point. I went through some difficult times over the summer, which greatly hampered my emotional capacity. This in turn reduced my ability to focus and diminished my patience. And without patience, I simply could not even sit still and reason each step the way I would normally do for the most important tasks on hand. As a result, for the first time in my adult life, I was described as lacking in independent thinking. However, I am sure I can think independently. Just last summer, we were given a very last-minute option of deferring our start at Columbia Business School. I still remember vividly that I pondered upon this decision very intensely over a weekend in July. It was a very difficult decision. By then I had already quit my job, so if I deferred, I would need to figure out what to do in the next year. On the other hand, having Zoom classes was obviously not ideal. But who knows when things will return to normal? I talked to more than a dozen mentors and discussed it with fellow classmates before ultimately making a decision that was truly my own. My experience was of course not unique. All of my classmates made a decision that best fit their situations and personal goals. It was a clear indication that when it comes to a subject that we care deeply about, we all have the ability to think independently and then make a decision that is right for us. To fully unleash this ability, the key is then to expand our attention, focus, and patience to other domains that are (or subconsciously perceived as) less pressing. 

Let us think through “independent thinking” again, this time using the framework of patience. Imagine a person with high emotional stability and an immense amount of patience. When the question of whether Tesla is going to dominate the electric vehicle industry is presented (I just read the latest Worm Capital investor letter which discusses Tesla), first she would be free of the emotions that come along with such a heated debate. Second, without being overwhelmed, she would be emotionally capable of breaking down such a large and complicated question into units of sub-questions through the simple urge to solve a puzzle. Bears say competitors are catching up, and they cite new model launches as evidence. But does new model launches necessarily imply a successful entrance? What should one track and examine to assess whether competitors are catching up? Bulls argue Tesla has a cost advantage with its vertical integration. But does vertical integration necessarily mean lower costs? How does it lower costs? Why doesn’t the automotive industry currently utilize vertical integration if it confers a cost advantage? And so on. With her unhurried and ever-present mind, going through all the above logic will be easy. (She might not be able to find the answers. But again, going through the logic is all independent thinking entails). And with adequate patience, it would be natural for her to go to the source materials and examine the data points accordingly. In fact, she most likely will even enjoy the process! 

I believe this interpretation of “independent thinking” bodes well for aspiring investors, because unlike originality, patience can be harnessed, at least to a certain extent. 

The Start of My Spiritual Journey

I have been extremely fortunate. While I was going through difficult times, I had support from close friends and mentors. The unifying theme of all the advice I received is that I need to practice self-compassion. The emotional paralysis I experienced in the summer and its dire consequences finally woke me up. I became fully aware that if I do not soon find ways to attain equanimity, I would never achieve sustained happiness and success in life. 

So, I began to practice meditation, which now I do every morning. And I picked up the books “The Surrender Experiment” and “The Power of Now”, thanks to the recommendations of two important mentors. The inspiring story of Michael Singer has compelled me to emulate him in surrendering to the flow of life, while Eckhart Tolle’s teaching has opened my mind to, well, the Power of Now. The act of surrendering and staying present-minded frees me from regrets of the past and fear of the future. As a result, I already began to sense that I am becoming more focused on the topic at hand. Being more present minded not only allows me to be more efficient, but it also makes me more patient. I am in much less of a hurry all the time and can think things through more clearly. Fear of being judged and worry of being wrong have both lessened since I now pay less attention to imaginary feelings in the future. The above is all work-in-progress for me. But I believe it will eventually culminate in my improvement as an independent thinker. Ultimately, I hope, paraphrasing Josh, to be “different without expending energy”. 

I also resumed journaling. Heeding the advice from another mentor, I now journal around three topics daily: (1) Time allocation in the day. We are what we do regularly. Thus, monitoring how we spend our time on a daily basis is critical. A review at the end of the day gives us a chance to assess our use of the most limited resource and make changes accordingly; (2) Emotional state of the day. Keeping a record of how my emotions fluctuate allows me to catch red flags of a bad emotional trend earlier; and (3) Investment related ideas and learnings. In terms of the medium of taking notes, I find it easiest to do my journaling digitally. I have been using the app Day One, which I think does the job very well.  

Conclusion: Temperament Means More Than I Realized

We all know that temperament is more important than intelligence in investing. But we usually say so since temperament determines how well one reacts to fluctuations in stock prices and whether one can stay rational in face of emotional distress. What I did not fully appreciate is how it can also affect one’s research process by influencing independent thinking. 

I am happy that I have embarked on this spiritual journey. Regardless of its actual effect on improving my independent thinking, just becoming calmer will be a big plus already. I hope you will join me. But I encourage you to find the way to improve your patience that works best for you.

Finally, I want to thank every person that has supported me over the past few months. I would not have been able to recover as soon as I have without any of you. Thank you all very much.

From Value to Growth: Some Thoughts on My First Semester at Columbia Business School

The Beginning: Asset Plays

Eight years ago, I picked up Poor Charlie’s Almanack, and ever since, investing has become an integral part of my life. Like most other value investing “addicts”, I started by reading everything I can on Warren Buffett/Benjamin Graham. Buying a dollar at 50 cents just makes intuitive sense to me. The key question, though, is how should we define or evaluate the value of the asset? The simplest way is of course to just use what is stated on the balance sheet. This is the cigar butt strategy that Benjamin Graham pioneered and focused on, especially the net-net approach with which he purchased companies trading below two-thirds of their net current asset value. This underpinned the first investment, China Agrotech, a chemical business based in China, that I made when I was 20 years old. I can still remember how excited I was about this opportunity after finding it through a net-net screen. I thought investing was that easy. It turned out to be a disaster. While it quickly went up more than 20% after I purchased my shares, fraud allegations about the firm cropped up soon afterwards, and I had to eventually sell my stake at a 50% loss.

I thought the lessons from my first investment were obvious. For instance, I should have checked on the company’s management team, since no valuation is cheap enough to make a fraudulent company worth investing in. Perhaps more importantly, I should have thought more about why such an “obvious” opportunity should even exist in the modern age of investing. With my newfound attention on management, I have never found another net-net to invest in since then.

Earnings, Fallen Angels, and Occasional GAUCPs

If extreme asset value mispricing cannot really be found anymore, the next logical step is to focus more on earnings. In this next period of my investing life, I turned my attention to identifying companies trading at “normalized” operating earnings of no more than ten times. Adding the term “normalized” is to flatter myself. A lot of times, it would just be looking for companies trading at low multiples based on existing numbers. At other times, normalizing the earnings is just taking the average margins of the past three or five years and applying the averages to the current revenue. (This obviously only makes sense if the underlying business exhibits a high degree of stability and is at its mature state)

I focused mostly on this opportunity set when I was working at my previous firm. Certainly, these companies do not trade at such low valuation for no reason. Often, these companies would have traded at a much higher multiple but were recently punished by the market due to near-term headwinds or newfound concerns. These, internally, we referred to as “fallen angels”. Our research focus was therefore to understand why and whether the market has overreacted. Is this a fraud? Is earning power going to evaporate in the next couple of years? Is the company in terminal decline? The bet would be that none of the above questions have an affirmative answer. And the returns will either come from a high dividend yield, and/or some reversion to mean in terms of the valuation multiple expanding once the market realizes its initial concerns on the business are too pessimistic.

Occasionally, we would have homeruns, which come about when the underlying businesses turns out to grow very rapidly. I like to call these investments Growth at Unreasonably Cheap Price (GAUCP). By way of example, there was a company that provides engineering services to the semiconductor industry. It was trading at around 4-5x EV/EBIT. The business is totally asset light and cash rich. The only thing negative that we found is the fact that there were accusations of the management team skimming cash off the company. We did our research, understood what happened, and were comfortable that there were not any actual shenanigans going on. The stock nearly tripled in the subsequent 2-3 years after earnings exploded as the company rode on the huge investment cycle by the biggest semiconductor manufacturers. (Since our research approach was more focused on downside assessment, the degree of earning increase was a surprise to us. As such, we sold too early, earning only a double)

Some observations about the mindset that I developed during this period

While the historical performance of a business logically forms the basis of financial analysis, this focus on low multiple companies can induce in the investor an undue emphasis on the historical results. Here is why: First, the company must already be making a profit for it to have a low earning multiple. Second, when we screen for companies, we rely on historical financials to calculate key metrics, such as gross margins, EBIT margins, ROIC, etc. All this potentially results in a mindset that is unaccepting of companies that do not already exhibit profitability. Personally, I even treated any investments in currently unprofitable listed companies as speculative. This is the extent to which I rely on historical numbers to judge a business. If the company has not generated any profits, how can we know or evaluate the existence of a moat? If the company does not have positive margins, how do we determine what are its normalized margins? And without an opinion on both moat and earning power, how can we make an intelligent investment?

The bottom line to me was: Margin of safety is the most important concept in investing, and without actual historical results, where do we ground our expectations against which we measure the margins of safety? Aren’t we all taught so? Looking back, I think a good way to summarize my previous thoughts is that I thought of moat and profitability as more of static concepts. 

I was also biased against growth. Not the predictable and measured growth, but the rapid 30%+ growth. I had the assumption that swift changes in an industry imply vastly altering customer behaviors, which makes it difficult to predict the winner in an evolving market. And despite the success I witnessed at opportunities such as the aforementioned semiconductor engineering service provider, I saw such opportunities more as one-offs and treated rapid growth more as an added benefit rather than something to demand upfront.   

Ready for Personal Growth

But after thinking in this way for seven or so years, a lingering dissatisfaction began to build up in my mind. Doubtless, the high growth market we have observed in the past decade is a major culprit. Most of the value investments simply have not worked out well. However, I was also ready to take a step back in order to reflect upon all that I had learnt because I felt like I had reached a plateau in my investing learning curve. In a sense, my analytical approach had become “automatic”, and I was no longer thinking about things as deeply as I wanted. In other words, I believed my framework had turned rigid and stagnant. I needed some sparks in my relationship with investing!

I was not expecting to “give up” on a value-driven approach, but investing is so multifaceted that I was sure I could expand my horizon by being in a new environment, making new friends, and learning from other investing enthusiasts. Had I developed some dogmas or blind spots that were inhibiting me from seeing the world in certain ways that were closer to the truth? Are there other ways to assess moats that I never considered? How should a value investor navigate a growth driven market? How can I enrich my thinking about investing?

I was sure Columbia Business School would be an awesome place to have my reflections, but what I have actually learnt in my first semester turned out to be completely unexpected.

The Learnings

Columbia Business School is world renown as the birthplace of value investing. This is where Benjamin Graham taught his net-net investing approach, and where Bruce Greenwald revived the Value Investing Program, espousing the asset value approach to investing. As an upshot, it simply never crossed my mind that I would undergo a transformation of such magnitude in such a short period of time: Only after three months, I no longer see myself as a “value” investor. I understand that “value” and “growth” are in a sense a false dichotomy, and I did not learn to disregard valuation as a key consideration. However, I became unbounded by the self-imposed restrictions I discussed above. I no longer see myself as a “value” investor because I do not want to frame myself into a specific box of investing style that I now see as hugely restrictive.

Before I detail the changes in my thoughts, let me first take a moment to sincerely share my appreciation toward Professor Christopher Begg for his Security Analysis course, which has been instrumental for my transformation. In one single semester, Professor Begg managed to invite 48 guest speakers to our 33 different sessions. All these are top-notch investors, including Nick Sleep, Brad Gerstner, Alex Sacerdote, Bill Oberndorf, and Todd Combs, all of whom I would never have the chance to meet and learn from directly.

Let’s now dive into how my thoughts on investing have changed.

1. Change or No Change – The Proper Dichotomy

As I explained above, my previous view on moat was relatively static, or leaned heavily toward the status quo. I focused on what has happened in the past and assessed whether the underlying competitive dynamics will remain unchanged in the future. In my humble opinion, I believe this is Buffett’s modus operandi as well. If you think about some of his most celebrated investments, such as American Express during the salad oil scandal, See’s Candies, GEICO in the late 1970s, Coca Cola in the late 1980s, and BNSF during the GFC, you can see that all these were businesses with a highly profitable operating history, and when Buffett made his investments in them, he was essentially betting that there would be no change to their dominance or industry economics going forward. (Okay, to be fair, for Coca-Cola, while Buffett was betting on a continuation of human’s crave for sugar, he was also betting on the change in capital allocation of the company)

This stands in stark contrast with a recent investment which Todd Combs made, Snowflake. Data warehousing is a relatively new concept, and the success of Snowflake rests upon its ability to upend the existing order. Herein, as I now believe, lies the biggest difference between a “value” driven strategy and one that is usually deemed “growth”. The former tends to be a bet on the status quo, while the later seeks changes in the current situation for potentially massive value creation for the new winners.

Obviously, either can be highly profitable. I am not making a judgement on which one is the better way to invest. But I believe this is a much better way to distinguish between different investment approaches than simply “value versus growth”.

2. Certainty Comes from the Right Point During Change

The appeal of betting on no change is that there is a general inertia of the status quo. And for a market that is in flux, it tends to be difficult to know which player will turn out to be the winner, since most competitive advantages are not sustainable and marginal returns usually diminish as most businesses scale. Yet, what I have learnt is that there are instances in which a company with unique capabilities could be at the right point on an S-curve where profitable growth is most certain. The key is to understand where we are on such S-Curves and identify the companies with the best offering and execution capability in such industries undergoing inevitable change.

I think the following company that I have come to know well fits this bill: Farfetch. While ecommerce is nothing new, luxury ecommerce as a category has long lagged other verticals. It is only in the past few years when the momentum for luxury goods ecommerce has picked up. And within this field Farfetch is clearly the unique asset. It has built up the only global marketplace with scale and has created trust with thousands of suppliers and millions of customers. And crucially, trust from both the supplier and customer sides compounds as the platform grows. As such, while it remains unprofitable, the moat is already there, and it keeps expanding. (Especially after the investments from Alibaba and Richemont)

In a fast-growing market, I used to think that the momentum is for each company to grow its competitiveness, and sooner than later, the lead of the top player will be eroded. But if there are certain factors that either allow the biggest and fastest growing player to expand its moat at an increasing rate or prevent the rest from copying the same tactics, then instead of being competed away, its lead can actually be strengthened as it grows. This, I only came to appreciate after learning more about how Nick Sleep thought about Amazon in the mid-2000s.

3. Valuation is Not the Only Source of Margin of Safety

Traditionally, the margin of safety of an investment is evaluated in terms of the difference between the current valuation of the company and the estimated intrinsic value. This is a static interpretation of the key concept. I now realize this is like evaluating your positioning in a war with static goalposts. What matters more is how your momentum is trending. We have to think ahead. Are you (in the process of ) winning the war or losing it? Even if you have only a small advantage now, if you are moving into the right direction where you will eventually have a huge lead, this constitutes a much bigger margin of safety than buying a melting ice cube at half the book value. The melting ice cube may be worth more than what the market is valuing it at now. But if you cannot unlock its value immediately, your potential return just keeps diminishing.

This is most prevalent in the world of disruption. As a new entrant, you might currently have little to show for. Nevertheless, if you are riding on a new technology trend that the incumbents cannot benefit from due to legacy reasons, you will have an increasingly expanding moat. As examples, consider the cloud companies versus the legacy on-premise server players.  

After learning to treat moats and margin of safety as dynamic concepts, I now deem an expanding moat as the more desirable margin of safety in an investment than just a valuation gap.

4. Loss Aversion? The Real Cost Lies in Missing the Upside

Buffett has a great quote that every investor can recite: Rule number one is don’t lose money. Rule number two is don’t forget rule number one. This is an amazing principle on many different levels. The game of investing is one of survival. To remain ergodic, you cannot have a wipe-out. This is to say, to remain in the game, you must first survive. Unfortunately, this is a hard concept for many new investors to grasp. This is because, to them, investing in the stock market resembles gambling, and in gambling, it is the rush for gains that motivates people to participate. The potential for outlandish gains thus easily lures new investors into irrational behaviors, such as leveraging up to the point where a market downturn can wipe them out.

An experienced value investor, on the other hand, understands this very well and has most likely developed a preference for first looking at the downside. But there is a paradox of expertise: As one becomes more proficient at a certain skill, there is a danger of overdeveloping a certain way of thinking that eventually creates a blind spot. In our context of investing, I think a sheer focus on the downside has distracted me from giving potential upside enough considerations. The most you can lose in any equity investment is 100% of the invested capital. But the upside is theoretically unlimited. This is the well-known asymmetry in equity investing on the long side. What I failed to appreciate is that this is the real reason why errors of omission are more costly than commission. In psychological terms, humans have a strong sense of “loss aversion”. However, actual losses tend to be more “visible” and top-of-the-mind than opportunity costs. This tilts our focus toward the potential 100% losses and away from the cost of missing out a multi-bagger.

I am not advocating for a disregard for the downside. Instead, what I have learnt is that I never thought enough about the upside, and I think this is a huge mistake that many value-driven investors also make.

Is My New Thinking Just a Function of the Decade-long Bull Market?

The honest answer is I do not know. I can easily envision a scenario in which a couple years later, the bull market completely collapses and my sudden advocacy for higher growth and change-enabling businesses turns out to be foolish. However, if we look at the type of money that is currently dominating the market, such as quant funds and index funds, it is not hard to see the argument that quantitative measures should be very well exploited already. (The only reason we still see such opportunities back in my old firm is because those are illiquid investments untouchable by most funds) It is hard to compete against machines based on quantitative strategies. As one of my favorite guest speakers and mentors, Alix, wisely told us, what we should learn to focus on is the elements that cannot be easily quantified. As discussed above, change-enabling companies have much less numbers to show their worth. And humans are difficult to quantify. As a result, I foresee opportunities that combine a disruptive business model, a new technology, and a top-notch management team to remain out of reach for the machines in the near future.

More Than Just Investing

This semester has been so much more than just investing though. My most memorable session is with Peter Kaufman from Glenair. I was deeply touched by the wisdom and generosity Uncle Peter shared with us. And I have made it a lifelong goal to continuously develop the nine desirable qualities that he highlighted for us: Trustworthy, Principled, Competent, Courageous, Kind, Loyal, Forgiving, Unselfish, and Stone-cold Reliable. Dee Hock is another person whom I have come to greatly respect. His philosophy on the co-existence of competition and collaboration, the need to first manage your own self, as well as the importance of educing others is an inspiring note to me. I will seek to be a leader who utilizes the same leadership principles.

Most importantly, I have had the great honor of establishing personal relationships with some of the guest speakers. Recruiting is the number one goal for most business school students. But for me personally, I think finding genuine mentors whom I can learn from for a lifetime will be the biggest value driver. Security Analysis has given me more than I expected or deserve. And for that, I will remain eternally grateful to Professor Christopher Begg.

Thank you again, sir.  

What is Good?

This blog is about fundamental investing. As the first post to rekindle this blog, I believe a discussion on the very core of fundamental investing would be most appropriate. And for investing, nothing is more fundamental than understanding a business — The core function of the fundamental investor is not stock analysis but business analysis. It is only through understanding a business that one can assign a range of value to it.

But what is the exact linkage between business quality and valuation? Why do investors tend to assign a higher valuation multiple to businesses of higher quality? Sometimes if the valuation is cheap enough, investors might be willing to overlook some of the deficiencies of a business. But as Buffett said: time is the friend of a good business but the enemy of a bad one. What does he mean? And why does owning a good business matter?

Actually, what does “good” mean?

I hope to provide my answers to the above questions in this post.

Like most investors, I have learnt a ton from Warren Buffett. But what I am summarizing below comes more from Geoff Gannon, whom I consider my most important mentor on investing. I will not be able to write better articles on the philosophy of investing than Geoff. And it would have been easier to just refer the reader to the relevant blog posts from Geoff (He is one of the earliest investment bloggers ever) Unfortunately, he has shut down his blog. (And he has transitioned to http://www.focuscompounding.com) Below, I attempt to summarize his thoughts on a very simple concept that most of you should already understand but do not think in the same angle.

What Is the Definition of “Good”?

When I was young and first learnt about businesses, I was mostly magnatized by companies that generate the biggest revenues. I naively thought that revenue and size itself signifies the quality of a business. Later on, I discovered “margins”. And I would try to memorize the typical margin levels of different businesses, and rank them accordingly — the higher the margin, the better the business I supposed.

But then I discovered Buffett. As I learnt more and more about him, I realized something is amiss. If revenue and margins are paramount, why does Buffett acquire businesses that produce slim margins? Why doesn’t he only favor companies that produce the most revenues?

The Key Metric – ROIC

The reason is that revenues and margins are just parts of the real key metric for a business — the Return on Invested Capital (ROIC). ROIC can be broken down into Revenue times EBIT Margin divided by Invested Capital. In other words, what was missing for me is that I did not pay attention to the amount of assets required to run a business.

This emphasis on ROIC should make intuitive sense. After all, choosing which business to get into is not all that different from picking a stock: you favor an asset that has better economics and a higher return profile. The only difference is that you compare the earnings with the required amount of assets to run the business rather than compare the stock price return with the price you paid. Essentially, you are imagining that you own the business in full or even start it from scratch — How much startup capital would one need to invest into this business for it to generate this amount of earnings? ROIC is the metric that answers the above questions. And since capital is scarce, it is obviously a better proposition if a business requires less capital to generate a given amount of earnings. (There are many other ways to measure the return on assets of a business. Why is ROIC preferred? We will leave this topic for another post)

The above is almost self-evident and widely used as a framework for analyzing businesses. But it is not always correctly used. If we look at ROIC simply as a historical or static metric, it actually has no bearing on what valuation the company should trade at. And this is a mistake even experienced investment managers may make. They mistake past glories of a business with what investors can benefit from in the future. They forgot that a company’s historical ROIC only benefited past owners while the current investors can only gain from future returns.

The Tax on Growth

Now, here comes one of the key insights Geoff taught me. He very much pays attention to the return a business generates from its assets. Yet, he doesn’t look at it the way most investors do. Instead, he flips it. Let’s use a simple example to illustrate this point:

Imagine we have two companies with the following characteristics:

Company A
Asset: $100
EBIT: $20

Company B
Asset: $100
EBIT $10

We also assume the two companies are both very well run and have reached a scale and level of efficiency that no further margin improvements or gains in capital efficiency can be achieved. This means the current return profiles reflect the optimal economics of the businesses.

Many investors will look at the two companies and conclude that Company A is the better business because it has a higher ROIC of 20% versus 10% for Company B. Geoff would agree with that conclusion, but not with the exact same reason. Instead, he sees Company A as the better business because it requires less resources to grow. In other words, he thinks of ROIC as the “tax for growth”. A higher ROIC implies a lower “tax”. This is a crucial concept as it explains why a company which has a higher ROIC can potentially be valued at a higher multiple.

Let’s return to the above example. Here we assume both Company A and Company B aim to grow earnings at 10% a year. How much capital would each company need to retain to achieve this growth target? Growing earnings by 10% to $11 would require an asset base of $110 (as we assume ROIC remains the same). To get to this level of asset, unless Company B increases its leverage, it would need to retain 100% of its earnings. On the other hand, Company A, also needing an asset base of $110, would only need to retain half of its earnings. The other $10 it generated can then be taken out of the business and returned to its shareholders. In Geoff’s mind, the tax for growth for Company B is at 100% but only 50% for Company A.

The long-term return of holding a stock can be approximated by the following equation: yield of capital returned + earnings growth + multiple expansion. If we assume multiple expansion to be nonexistent, adding a yield of capital returned to the same earnings growth rate will only add to the overall return of the stock to the investor.

Using the above example, we can understand why despite growing at the same rate, Company A deserves a premium. In addition to the 10% growth your company achieves, it is also returning a proportion of earnings to you every year. And you can choose to reinvest those cash flows elsewhere to further compound your money.

(Alternatively, Company A, with the higher ROIC, will be able to achieve a higher level of growth if it also reinvests all of its earnings)

The importance of looking at ROIC as the tax of growth is that it forces you to appreciate a high ROIC only if the company has ways to reinvest at this level. Otherwise, ROIC is just an archaeological record.

This mindset, for instance, would have stopped some investors from getting too excited about highly mature companies with very high ROICs but absolutely no room for reinvestments. In such a case, what an investor needs to understand is what the company will do with its earnings. Will it just pile up the cash? Or are the earnings paid out as dividends? Or does the company look to invest in new business areas whose return is unknown? Your long-term buy-and-hold return in the stock is only as good as the incremental return the company gets far into the future.

Lower tax rate is obviously better than a higher one. And negative is even better! This is becoming more commonplace these days as the SaaS business model turns more mainstream. A more traditional example would be the advertising agencies. These companies receive payments from clients before offering their products or services. And of course, there is the prime example that made Buffett extraordinary rich: insurance, in which the company receives premiums before paying out insurance claims. For such companies, the faster they grow, the more cash inflows they generate.

The Longer The Better

The power of compounding comes with time, and meaningful value creation only happens if a business can sustain a high incremental ROIC and achieve healthy growth rates for a long period of time. The maths is undeniable. But figuring out how incremental ROIC will trend and whether a company can sustain a high incremental ROIC are where the real difficulty of investing lies in.

This is why we study competitive advantages, competition dynamics, demand durability, management’s capital allocation strategy and so on. All that you learn about is to understand 1) What kind of return a business will get on its retained earnings; 2) How fast it can grow; and 3) How much cash will be returned to shareholders in the meantime.

I’m Back

Time flies.

It has been nearly five years since I last wrote anything for this blog.

I am still passionate about investing as much as I did back then. In fact, I am going to make the biggest investment in my life thus far: an M.B.A. from Columbia Business School.

I am super excited and grateful for the opporunity to join CBS. This is an expensive investment, but I think it will be worth it for the people and the opportunities I am going to get, especially within the investing community. To make the most out of my experience, I plan to start writing again. Not only to reflect upon my own investing thinking, but perhaps also to use this platform to chronicle my journey at CBS.

Despite the pandemic, school will start this fall. I have no idea what to write yet. But hopefully, you will find out soon.

Bill Ackman and Platform Specialty Products… Revisited

It was on 9 December, 2014 that I published an article on Platform Specialty Products. (PAH)

Back then I gave a rather detailed analysis on the company. Initially I thought I was getting a real bargain, but that’s due to using the wrong numbers. I then explained the correct estimation of the then leveraged earnings yield should be closer to 7.5%. After giving it some more thoughts back then, I decided to pass on the opportunity. (At last I “wisely” put more money into WTW instead…)

In the subsequent months, PAH went as high as $28.35/share, comparing to the $22.05/share when I first wrote about it. However, PAH has since come back down to $22.48 as of today. This of course prompts me to take a look into PAH again.

How I have missed you, PAH!

Let’s take a look at what our friend PAH has been up to in the past 8 months.

On June 1, 2015, PAH made an offer to acquire OM Group’s Electronic Chemicals and Photomasks businesses for $365 million. That part of the business earned approximately $28 million in adjusted EBITDA. As such, they effectively are paying a price to EBITDA multiple of 13.03. Interestingly though, Platform is expecting to achieve synergy in access of $20 million over the next two years! If I am thinking this right, then they are really paying $365 million to capture $48 million in EBITDA, a multiple of 7.6 only. This makes it a bargain deal for Platform.

Then on July 13, 2015, they announced the big deal of the year of acquiring Alent plc, their main competitor in the Performance segment from the U.K. for approximately $2.3 billion. (a 49% premium to the then stock price of Alent) In 2014, Alent earned $680 million in revenue and $172 million in adjusted EBITDA, spending $19 million in capex. They plan to pay 78% in cash, and the rest in stock.

So what is the earning power we should expect from the present Platform? Let’s take a quick look at what I came up with.

According to their investor day presentation, Platform should have earned $570 million in pro-forma EBITDA – CapEx in 2014.

In the subsequent presentation after they announced their intention to acquire Alent, they showed the 2014 PF earnings including Alent, would have been $814 million, with EBITDA – CapEx at $721 million.

Interestingly though, it seems this number doesn’t include the earnings they will get from the assets acquired from OM Group. When we add the $28 million, PF EBITDA for 2014 should be $842 million. I would assume those assets require capital expenditure needs on a similar scale as the other assets, meaning $3 million of CapEx. As such, the PF EBITDA – CapEx should be roughly $746 million in 2014.

The earnings calculation is the easy part though. The valuation we will be paying for the company now is the much trickier one.

According to Bloomberg, at $22.48/share with 210.861 million shares, the current market cap is $4.74 billion. Now, it’s important to know that this share count includes the equity offering they did for the OM Group’s asset acquisition.  Even more important though, is to remember this does not include shares to be issued for Alent. Again, Platform plans to pay 78% of that purchase in cash, and the remaining 22% in stock. The only thing left to determine is how much of that cash will be from more equity raising from the public or debt issuance.

One hint I used from management is their desire to get a 10% cash on cash return from their initial equity investment. (This means cash return after burdening of everything from capital expenditure, interest payments, cash tax and working capital changes) In order for Platform to really earn that 10%, they can’t raise more than the 22% in stock to Alent shareholders. As such, they probably won’t issue more shares on top of that 22%. (This also means they can’t really get 10% cash on cash return this time)

78% in cash equates $1,758 million. Do they need to raising debt for all of that?

On March 31, 2015, they say they have $297.3 million in cash. They raised $483 million from the equity offering in June. $365 million will be paid to Apollo with regards to the OM Group’s transaction. This means they should have $415.3 million in cash left. Assuming they don’t plan to have any cash buffer left, they only need to issue $1,342.7 million in debt.

Adding that to the debt level of $3,618.5 million on March 31, 2015, total debt will become $4,961.2 million.

Market cap is not the current level of $4,740 million though! This is because they still haven’t issued shares for the remaining 22% transaction value. Including that amount of $495.88 million, the total market cap will be $5,235.88 million. Capital IQ tells me there is preferred shares valued at $645.9 million and minority interest of $109.1 million. Adding all this together will bring us an Enterprise Value of $10,952.08 million.

Comparing this with PF EBITDA of $842 million (see calculation above), the resulting multiple will be 13.

What about the leveraged cash flow which I said should be the focus? We need some more assumptions.

Let’s assume the average interest rate on that debt load to be 6%, effective tax rate at 30% (a good estimation I think due to their global footprint). Interest rate will then be $297.7 million. With PF EBITDA – CapEx of $746 million, the estimated after tax free cash flow will be  $313.8 million. The adjusted free cash flow yield ($313.8/$5,235.88) is then… 6%. Oh! Wow! After two potential acquisitions, one being big, and without any price being flat essentially, the leveraged earning yield dropped?! What happened? Did they destroy value?! What’s with all this acquisition they think is value adding? How are they supposed to generate 20% increase in intrinsic value per share p.a.?

This troubled me for like half an hour before I realize the above earnings number probably didn’t include they synergy they are expecting.

Management is saying they expect $150 million in synergies from all the transactions they did in the past two years. (including the OM Group’s transaction) Now, adding back into the equations, the estimated free cash flow will be $437.21 million, resulting in an leveraged cash flow yield of 8.4%! Now that looks much more attractive! Given the business quality of Platform, I would say it’s genuinely attractively priced. (They probably won’t realize all the synergies at once though, so the immediate free cash flow yield is probably between 6% to 8.4% in reality)

The only problem to me is the leverage Platform will have after the acquisition of Alent is completed. EBITDA should be roughly $992 million post synergies. Then the Debt/EBITDA will be 5, and EBITDA/interest at 3.33 if the weighted interest rate is 6%.

Is an 8.4% free cash flow yield a good enough return under such a debt load?

Hmmm… I don’t know yet. I guess I again need some time to consider my options….

What about you? What do you think? Any advice to share?

The Question on Position Sizing/Diversification and… Lessons Learnt

I haven’t written a post for quite some time. I currently have a few topics in mind. Hopefully, I will have them written down in a short period of time.

As a starter, I would like to talk about diversification/position sizing, which is something I have been thinking heavily about. But first, let me explain why I came to contemplate this.

It has something to do with the investment record I have thus far compiled. And it can be described in one single word: abysmal. Yes, more than terrible, my record until now has been really abysmal.

I have really just meaningfully invested in three stocks since 5th September 2013, the day I bought my first stock. China Agrotech, Weight Watchers (WTW) and Town Sports International (CLUB). A lot more money (in relation to my net worth) was invested in the latter two. But all of them have given me more than 50% of losses. (>~70% for the later two) Realized loss for the first and unrealized for the latter two. Naturally, it bugs me and gets me into thinking what went wrong?! Self-afflicting and self-condemning aside, at least we ought to figure out what we can learn from our mistakes.

I made the first investment solely on my own. It was cheap. Maybe dirt cheap, since it was a net-net when I first found it. However, it turns out to be some sort of a fraud. The stock stopped trading after one of its creditors (I think it’s Standard Chartered) demanded they repay their loan. I summarised my lesson on a previous post. The focus here will thus be the latter two.

I invested in both WTW and CLUB alongside Geoff and Quan, both of them I consider my mentors. While WTW has awesome business economics and CLUB only has a so-so one, they were both cheap enough to get anyone’s attention when we bought into them. Yet, at the same time, they were both cheap for a reason. As weight-loss businesses, they were in constant need of replenishing their customer base. But they just haven’t been doing a good job at that. Some of that is due to new technology (like free apps and wearable technology attacting WTW’s basic business), and some of it comes from new exercise regimes (like studios taking customers away from CLUB’s traditional gyms) Worse still, they are also carrying meaningful amount of debt. So why did we still like them?

Basically, we believe they had certain moats around them that will make the challenges only temporary. We also believe both have the capacity to handle their debt obligation. The verdict for whether they can handle their debt is still out because they don’t have to repay or refinance their debt in a few years. But with both their revenue declining non-stop, we have been very wrong about their moat so far. And we may well be proved wrong about their capacity to handle their debt for the same ultimate reason.

The argument for WTW’s moat is simply that they are the most effective weight losing program out there. While free app is easy to get and use, they just aren’t as effective. People don’t stay with something they got for free easily long. And without sticking with the same program, there is no way you can lose meaningful weight with it. We have always envisioned it will take three or more years for things to get back to normal. Or in other words, for the fad in free apps to die down. But what about Apple Watch? With wearable technology maybe starting to get ingrained in people’s lives, wouldn’t there be more ways for such free apps to do its damage in the longer run? Or maybe as a gadget, it does help people lose weight easier, but can’t replace the psychological help found in a weight watchers program? I don’t know the answer to be honest. Geoff and Quan think the initial thesis is still pretty much intact. I personally ain’t as certain about it anymore.

CLUB, on the other hand, is all about economies of scale. They have the densest network of gyms in NYC. And it’s almost impossible to replicate it without throwing a lot of money into the sea. Even if studios really can gain traction in the longer term, we reckoned that they will certainly have enough time to convert their gyms into studios. Moreover, they were at the lower range in terms of leverage historically. But after more than 1.5 years, things just weren’t getting any better for either of them. We all agree CLUB is in the weaker position between the two. And that’s because in addition to its debt, it also has high operating leverage in operating leases. Now, that’s really a problem.

For WTW, it at least can adjust its marketing cost by its own will to gain more time for a turnaround. Maybe, in theory, CLUB can really gradually convert all their gyms into another format that fits what customers are looking for at the moment. But in reality, CLUB may already be bust before they can do anything close to that. Not only did we already lose money in CLUB, we also “lost money” in an opportunity cost fashion of missing the price uptick in LTM, another gym operator, due to the LBO of that company. CLUB, LTM and WTW are not the only stocks that Geoff and Quan (and later, we) looked into. If you take a look at the market price changes of everything that was looked at, you would certainly point out how silly it was for us to have actually invested in these two. (Quan has talked about the experience so far in this post, http://gannonandhoangoninvesting.com/blog/2015/4/23/stock-picks-review-and-lessons-learned. You can see how the other stocks performed there) This begs the question for us. Should we have been more diversified?

All the three of us were pretty concentrated with our investments. I just agreed with them that going for a more concentrated portfolio is the way to a better than decent investment record. If you pile up a list of investors that have a long term track record of compounding money in the 20s percent per year for over a decade, you will mostly come up with a list of investors that favor concentration. For instance, Joel Greenblatt, Eddie Lampert, Bill Ackman, Glenn Greenberg, Ted Weschler, Allan Mecham, and so on… They all basically had a pretty concentrated portfolio of having most of their capital in below 10 stocks.

I also came to think about diversification because of my current new job, where I am being fed a lot more attractive opportunities than ever before. When you are given 10+ names a time, you would naturally think whether it’s actually better just buy all of them instead of trying to make a judgement on which one to pick. Then, there is the fact that Buffett once held 40 stocks at a time during his partnership days.

That was the question I asked myself. Was it wrong to be so concentrated?

And here’s how I came to my own conclusion on the subject. I don’t think the degree of concentration was wrong. A more diversified portfolio of owning everything we looked into would have yielded much better results that what I have gotten so far for sure. But that’s missing the point. That’s not the real lessons that is being offered here. Now, to the real lessons from my investing failure. Really, instead of not diversifying, we simply made the most sinful mistake in investing. Selection mistake. One that is due from greed.

A declining business is usually not a good investment proposition. It’s only “usually” because in cases where you can control the pace of decline of the business or there are some structural characteristics ensuring a gradual decline and easily adjustable cost base, then you can probably exit the business in a profitable way. But in cases where there is essentially a “customer problem”? Then sorry. At best it would be a terrible experience before you break even at the end; and at worst, permanent loss of money. Adding leverage to it makes things maybe ten times worse and much more skewed to the worst scenario. Well, if you add in more than one layers of debt? You are primed for a disaster.

By customer problem, I meant a fickle customer base where they don’t naturally like your product/services or are susceptible to fads and trends. Geoff and Quan did mention they have to replace 1/3 of their customer base every year. This challenge never really caught my attention until now. If CLUB instead is a company that sells cigarettes, soda, chocolate, system software and so on, it would be a totally different story now… That’s lesson number 1 for me.

The second one is more general. As I pointed out, CLUB has been primed for disaster all along. And the major reason why it’s in a worse situation than WTW is it has both debt and operating lease. So what if CLUB owns all the places that hold its gyms?! Ah… maybe then they can deal with the turnaround with much greater ease. That sounds obvious to us now. How I wish I was this wise before. Essentially, we did study a gym operator without debt. And that is Life Time Fitness (LTM). Unlikes CLUB, it operates huge facilities that pretty much act like a country club to its members. They own most of their facilities, with many already mortgage-free. And yes, we believed it’s a better buy-and-hold candidate from the start. Yet, we still went for CLUB in lieu of LTM. WHY? Well, the answer is simple. We were greedy. That’s it. Instead of choosing something that is much safer, we opted for the one that provides the higher leveraged yield. And I, specifically, was lusting for the potential 3 bagger built into the stock of CLUB.

I thought I read enough about “focusing on the downside and the upside will take care of itself”. Turns out I was as clueless as ever. Maybe there really are things you cannot learn from books, but only from pain. Don’t be greedy is the lesson number 2 for me.

Diversifying is only a way of hiding from the real mistake of making a wrong selection here. While the above points out my own personal experience isn’t a logical argument for diversification. It doesn’t mean I have successfully argue against diversification. In fact, I don’t think I will ever be able to do so. But I did finally come up with my own personal view on the subject.

My own answer for that comes from my new working experience in a hedge fund and an excellent answer I got from Geoff. (Which you can read from here: http://gannonandhoangoninvesting.com/blog/2015/5/19/when-should-you-diversify) I think most importantly, the level of correct diversification, for me personally, is pretty much limited by my own time and ability to absorb information needed to support that level of diversification.

From a risk management perspective, the biggest advantage of diversifying more is reducing the impact of a blow from any single investment. However, to successfully implement a more diversified portfolio, I think you have to first pass the hurdle of getting enough time to understand all that are in your portfolio. The problem I am starting to experience is I simply don’t know enough about a few of the investments currently in the portfolio of the hedge fund I am working in now. When a piece of negative news crops up about any one of them, I simply have to do a lot of work before I can add valuable comments to the team. (Trust me, when you are managing other people’s money, even if it’s only a 5% position, you want to know everything and make the right decision of either selling or averaging down) Having too many stocks in your portfolio simply dilutes the effort you put into each stock.

Or so I thought. But Geoff reminded me this isn’t necessarily the case. In fact, what is the most brilliant part of his response as mentioned above is that you can hold 10 or 30 stocks and still be putting up the same effort before you buy each stock. The only difference is you will have to hold, on average, each stock much longer if you were to hold 30 of them instead of 10. The key is not to dilute your effort you put into each stock.

The second important factor is of course the amount of bargains being offered by Mr. Market. It makes natural sense to buy more in times like 2009 when many obviously high quality businesses are selling on the cheap, or when you can find stocks that have a long history of profitability selling below net cash. Being stubborn and study every one of them to unnecessary levels of depth will be a costly mistake for sure. But barring such obvious cases or unusual times, real bargains should be scarce.

Combining the above two points, it just seems better to concentrate a bit more to me.

Warren Buffett and “Rule #1: Don’t Lose Money”

I have a setting on my Google account that helps me track all news on Warren Buffett. (I also follow, who else?, Bill Ackman and Sardar Biglari)

And there was this very interesting title that appears on my email yesterday. “1 Piece of Advice From Warren Buffett That You Can Ignore” (Read more: http://www.fool.com/how-to-invest/personal-finance/2014/12/13/1-piece-of-advice-from-warren-buffett-that-you-can.aspx#ixzz3M1ltzJPC)

Now Warren Buffett is my greatest hero. But I do not exactly treat him like a God. And whenever there is an opportunity to learn about investing, I usually pound at it. I was actually excited to see there might be some interesting angles into what we should NOT learn from the greatest.

Unfortunately, I was disappointed.

In the article, the author points to the famous “Rule #1: Never lose money” as the thing he would advise us not to follow. To defend his proposition, he is basically telling us that it’s okay to be wrong, and the Utopian strategy of never losing money will not work and perhaps entails you to put your whole portfolio into US treasuries.

Now, this is interesting. I basically agree with his points. It’s just that his misunderstanding of Buffett’s quote makes me feel compelled to write this post.

First of all, I actually never recall the actual quote being “Never lose money”. Instead, I always think it is “Rule #1: Don’t lose money” And there is a huge difference between the two. When Buffett espouses his investment philosophy, he always tells us that even though he aims at crossing the one foot bar, he will keep making mistakes. It was never a shame thing for him to admit his own mistakes, as you can read from his shareholder letters. For a man so willing to admit his own mistakes, it sounds strange for him to ask people to never lose money. In other words, it’s simply wrong to imply from this perhaps erroneous quote that Buffett believes losing money is unacceptable.

So what is Buffett really saying?

He is talking about “Don’t lose money”. And that is a totally different idea. This is actually a really really important idea from Buffett. So it is better we do not misunderstand him. The notion behind this famous saying is not to ask people to never lose any money, but to remind people what to really focus on. And that’s to frame your mind into thinking about the downside, instead purely of the upside.

(A little sidetrack here: Even though Buffett is the most followed investor of all time, he is actually not that well understood. There are a lot of superficial “explanation” of Buffett on the Internet. To really learn from him it’s important to know what to absorb and equally important, what not to. Two great sources that come to my mind immediately are Alice Schroeder and Geoff Gannon.)

If you go to YouTube and search for Alice Schroeder, you will find a value investing congress video featuring Alice. That is one of the most important videos on investing you will find on YouTube. One point for you to really digest is what Alice points out as one of a few unique things about Buffett’s investment process: (not quoting from the video at all) Now Buffett is different. Unlike almost everyone else, instead of looking at the upside, Buffett immediately skips looking at a lot of investments because of the potential cat risk involved. He does so by asking one simple question before doing any work on a prospective investment. The question is basically: What are the odds that this investment could fail because of catastrophe risk? In other words, what are the major things that could go wrong? And if he feels like that he can’t size that risk up, he will not consider investing at all, no matter the upside.

Going back to the Motley Fool article, the author obviously lost money with his early investments because he didn’t spend much time thinking about the downside. He thought he would never lose money, in lieu of trying to not lose money by focusing on the downside.  

Now, that is not a good example to follow. The author’s last advice, “…never losing money is a Buffetism that I believe can be easily ignored”, is another one to not follow.

Bill Ackman and Platform Specialty Products

I didn’t plan to write a series of articles about Bill Ackman. In fact, this article is mainly about Platfrom Specialty Products (PAH) instead of Mr. Ackman. But I put his name in the title just to make this look like a series. 😛

Opening Remarks: A Newsletter Recommendation

First off, I would like to promote and congratulate my friends over at http://www.gannonandhoangoninvesting.com/

They should be familiar bloggers to you. Their rebranded newsletter is officially out now. It is renamed Singular Diligence. You can find it on http://www.singulardiligence.com/

It will be the best investment newsletter you can find, especially if you are into moat, buy and hold, investing. I believe Geoff is the most Buffett-like investor I am aware of. I mean in terms of how he thinks about businesses and stock investments. Quan, of course, is brilliant as well. I have learnt so much from them. And I think you will too. Interestingly, the newsletter will now be promoted by their new publisher, Mr. Tobias Carlisle. Another name that you should already be familiar with. Doubtless, it’s pretty expensive, especially on a relative basis. But it’s of tremendous value absolutely. Trust me, you would learn a lot when you read about how they think about businesses, what they focus on, what evidence they like to gather and etc. It will be worth the money, especially if you don’t just want some good stock ideas, but also are eager to learn. (FYI, I earn nothing if you do subscribe to their newsletter. In fact, it would cost me because more competitors would be created for me!)

Platform Specialty Products

Okay, let’s now start talking about the main character of this article, Platform Specialty Products Corp. (PAH), which I believe is a stock that is worth considering as a long term buy and hold investment, even though it isn’t as attractive as I initially thought.

PAH is essentially a holding company that aims at consolidating the specialty chemicals industry. Initially founded by Martin Franklin and Nicolas Berggruen as a special-purpose acquisition company (SPAC), it later also received a substantial investment from Bill Ackman (hence the title). I will talk a little bit about these key people later.

Even though they are acquisitive, they are pretty selective in what kind of specialty chemicals companies they would buy.

To make it short, it catches my attention because of the product economics of the target companies they are after, the founders’ superior track record and the vote of approval from Mr. Ackman.

Interestingly (ironically?!), I am quite sure this won’t be a stock that interests Geoff and Quan. (I will explain why later)

Despite this not being a Singular Diligence stock, we can still basically use their checklist to think about this company. Let’s consider the following few areas: 1) Durability, 2) Moat, 3) Quality and 4) Capital Allocation, and 5) Value. We will conclude the discussion with 6) Misjudgement.

1. Durability

I am not an expert in specialty chemicals. But I don’t see how this industry will be eliminated in ten or fifteen years. This isn’t a retail business or the newspaper business facing the problem of a wholly new and different distribution method being created out of thin air, like literally. This also isn’t a faddish product. When it comes to technological change/innovation, incumbents should be in a better position to develop them given their expertise and continuous R&D investments.

Even the durability of the customers who buy such specialty chemical products from them may not be important, since basic or performance enhancing chemicals will always be needed to manufacture physical goods or for major commodity productions. Moreover, incumbents have the option to quickly adopt the new trend and create new products. An example would be how PAH’s first acquisition, MacDermid has started supplying their products to smartphone manufacturers as the old mobile phone manufacturers die off.

In a word, I do not see a huge problem with durability of the specialty chemicals industry in general.

2. Moat 

Here, I think moat is the most interesting aspect to talk about with this industry, especially the kind of specialty chemicals that PAH targets. In a sense, I think it’s pretty much a dream business to be in in terms of moats.

The first thing to highlight is a general point about specialty chemicals: they are mostly pixie dust businesses. (A term learnt from Geoff)

To quote Geoff: “In a pixie dust business – the per unit cost contributed by the capital good is a small part of the cost of the finished product; however, success of the capital good results in an outsized influence on the success of the final product.” For instance, Geoff asks us to think of the slogan of BASF (the world largest chemical maker) when it comes to a pixie dust business, “At BASF, we don’t make a lot of the products you buy. We make a lot of the products you buy better.”

The beauty of a pixie dust business is the pricing power you are likely able to get. If your products are only a small cost to your customers relative to their total production cost, and at the same time are important to them, your customers won’t be as price sensitive as most other capital goods customers.

Couple this with the following that is more specific to their target companies for acquisition.

In their first annual report, CEO Daniel Leever taught us there are mainly four types of specialty chemical businesses.

“Our business model. The specialty chemical industry where we have chosen to focus is very broad. We estimate the
companies in the specialty chemical industry generate about $1 trillion in total revenues. Not all specialty chemical
companies follow the same business model. There are at least four distinct models that employ very different strategies
and styles.
1) Manufacturing Intensive, use large amounts of capital creating unique molecules where the real competitive
advantage lies in engineering and manufacturing;
2) Blended or formulated chemistry model, mixes or blends molecules supplied by others to create unique
value added formulas;
3) Distribution model, depends on a global distribution network for success; and
4) Technical development/service model, provides technical service for their differentiation”

PAH emphasises their focus on “Asset-Lite” and “High Touch” business model. In other words, a combination of type 2 and type 4. Because they mainly do blend and mix, they do not have to keep sinking money into hard assets. And due to the fact that their customers rely a lot on their technical/service help, customers are less likely to change a supplier for fear of disruption. Such an emphasis, alongside the general pixie dust nature of chemical businesses make customers generally pretty sticky. It’s just pretty damn hard to convince a customer to switch if they are not very price sensitive at the first place, and all the while needing constant help from their existing suppliers. (In fact, specialty chemicals businesses will also have the chance to innovate and create new products to serve the growing/changing needs of their customers because of their constant close contact that allows them to get up-to-date information about customer needs.)

And we still haven’t even talked about the technical difficulty of coming up with the products from scratch without years of perfecting the formula through R&D.

But there are more! In addition to “Asset-Lite” and “High Touch”, PAH also focuses on specialty chemicals businesses that operates in niche markets. The advantage of an incumbent in a niche market is that they are more likely to be enjoying scale advantage, and the small size of the market deters potential competitors from joining the party.

To add a little bit more spice into the mix, we can take a look into why Buffett bought Lubrizol. A very good and educational explanation by Pat Dorsey (author of The Little Book that Build Wealth) can be found here: http://www.morningstar.com/Cover/videoCenter.aspx?id=380620
(Pretty much a better summary of what I already wrote above)

And to get a deeper insight into the kind of companies PAH looks for, you can start with studying their first acquisition, MacDermid. Founded in 1922, it is old like most other chemical companies. It was a public company before being taken private in 2007. You can go and find their previous annual reports for both gaining a deeper insight into the business, as well as knowing more about the CEO. Or to save time you can read this excellent article from The Brooklyn Investor: http://brooklyninvestor.blogspot.hk/2013/11/platform-specialty-products.html. MacDermid’s results is roughly discussed there.

Anyhow, you will understand they make a good choice in terms of the business to start with, as well as choosing the right person to be the CEO.

I think there are enough sources of moat that make specialty chemicals a very attractive business, moat wise.

3. Quality

The above actually already highlights the quality of PAH. Here, quality concerns how much cash you can get out of the business. Cash generative and low capital investment required for growth are usually considered characteristics of high quality business. And this is exactly the kind of business PAH aims at acquiring.

In fact they have been pretty open with this. They want to target companies that only have to invest roughly 2% of sales in capex each year. And this is what MacDermid has done for a long time. The reason why they can have such low capex requirements is discussed above already. In addition, they like gross margins of over 40%, and adjusted EBITDA margins of more than 20%. With expected capex margin of roughly 2% – 3%, this results in an EBIT margins of around 17% – 18%. Pretty nice.

In fact, I believe to a certain extent, we can think of the business as something like a consultant or an investment bank. Remember, their focus is Asset Lite and High Touch. They do not invest too much in hard asset. But to keep up with the customer services/innovation, what do they really invest in? Human resources. Another point the CEO likes to highlight is they love companies that have a large proportion of their workforce working in the “bookend”, which include mainly their sales force and R&D people. And one major benefit of their acquisitions would be bringing in experienced and talent senior management.

Their moat and the capital light business model, together, then result in their high return on capital performance. (MacDermid has averaged around 20% ROC as you can see from the blog post from The Brooklyn Investor)

Nonetheless, PAH is a much different company now then it was founded. (This will be one big risk that I will refer back to below) Just during the past year PAH has already created another pillar in agrochemical businesses. I have not tried to seriously find the historical record for those three businesses they acquired this past year. (It might not even be possible because they can be closely held for the past ten years or so, like Arysta LifeScience) But reading from their latest investor presentation, it seems those three targets pretty much are in line with what they told us they would acquire. The pro forma ROIC (their definition is not the one I normally use though) of the combined business is at a respectable 19.4%. The highest among the selected group for comparison.

Yes, I think this can be considered high quality.

4. Capital Allocation

Even though a high free cash flow generative company is pretty much the prize we all look for, they do not immediately equate the right investment, even at an attractive price. This is perhaps one area that is not discussed as much as it should be.

Like anything of intrinsic value, free cash flow is only good and valuable when it is being treasured and used wisely. (Youth is a great thing, but not so much if you waste it…) As such, one of the biggest risks to owning a cash generative company is the uncertainty in future capital allocation policy.

This is why Buffett loves companies that buy back their own stock or pay out dividend. And this is why capital allocation is always a big factor that Quan and Geoff study. (If you favor moat investing, the capital allocation of the company kind of becomes even more important as compared to cigar butt/net net investing, because people do dumb things when they are awash in cash.)

Fortunately, capital allocation is another equally exciting part of this investment thesis.

One thing for sure, PAH will not be paying dividends anytime soon. It is very unlikely that they will repurchase their own shares anytime soon either. What they will do with all those excess cash will be acquisitions. Lots and lots of it.

The rewards from possible future capital allocation polices usually follow the high risk, high return pattern. If we know the company will mostly be paying out their earnings in terms of dividend, the chance of destroying value through poor capital allocation is pretty minimal. Yet, investors will have to share some of their profits with Uncle Sam or his counterparts in other countries. A share buyback would help investors stay “selfish” and thus get a higher return. But in this case, u face the danger that the company buys back all the shares it can, regardless of price. This makes the returns the second option could bring about less certain. Then finally, there is the acquisition method. Given the bad name M&A already has, I guess there is no need for me to explain why it’s risky to bet on continuous smart acquisitions. However, it is also equally unnecessary for me to explain the upside. Just think of Berkshire! (Or Valeant anyone?)

As such, to accept acquisitions to be the main future capital allocation policy, we are accepting a lot more risk than perhaps necessary. (This in fact is one of the reasons I think Geoff and Quan would not like this investment)

Unless, of course, we have a proven track record of the capital allocator. Or else you shouldn’t invest in Berkshire anyhow.

And it is here that we turn to discussing the key figures in this firm. Probably close to a dream team.

Team Captain or the Architect: Martin Franklin

Franklin is one of the founders of original the SPAC, with the title of Chairman of the Board and Executive Chairman. He is basically the capital allocator of this venture. Monitoring potential targets, the capital structure, the negotiation process and so on.

His record tells us he knows what he does. The biggest proof is his accomplishment at Jarden Corporation. He took the CEO job there in 2001, and relinquished that role in 2011. (he stayed as executive chairman) During those years, revenue rose from $300 million to $8 billion, and the stock compounded at 34.4% annually!! All he did was selling non core assets and buying things he deems interesting and cash flow generative within the consumer product space. Sound familiar?

Franklin has his Robin, Ian Ashken, as CFO in Jarden. And now he has also brought him in as another co-founder.

Point Guard or the Builder: Daniel Leever

Leever has been the CEO of MacDermid for 24 years and has been with the firm for 34 years. During Daniel Leever’s tenure, MacDermid increased revenues five times. That’s a modest 7%/year in revenue growth; 5x in 24 years = 7%/year. He increased the value of the company from $80 million to the current $1.8 billion through those years, equating to +13.9%/year since 1990. That’s pretty decent! And according to The Brooklyn Investor, this growth includes acquisitions, but no equity raises. (yes, you can get this information from the article I posted earlier)

So what we have here is an industry veteran running the show, doing the hands on work. And we have an experienced capital allocator do the job of financing for acquisition deals and planning ahead. I think such division of labor can work well.

Now, we must remember there are many different kinds of specialty chemicald businesses, and they will have more kinds of it under their roof later on. To really make the integration work, PAH will retain the management team of the companies they acquired and select the best to manage that particular group of companies. So we don’t have to worry that Leever will try to manage a agrochemicals business hands on even he only has expert knowledge in performance materials and graphics solutions.

Minority Owner: Nicolas Berggruen [http://www.businessweek.com/articles/2012-09-27/deep-thoughts-with-the-homeless-billionaire]

Berggruen is known as the “homeless billionaire”. After inheriting a sum of around $250,000. He grew that capital and became a billionaire through investments and private-equity like deals through his privately held investment vehicle Berggruen Holdings.

There are several articles about him you can find online. The most informed one is posted above. I would suggest he looks like a savvy businessmen. And he co-founded the SPAC with Franklin. He is also on the board of PAH now. Though I do not think he has any active roles, he having a stake, sitting on the board does give me certain feelings of protection.

Majority owner: Bill Ackman

Now we are finally here (lol): Bill Ackman. Again, he is my favorite hedge fund manager who is still active. I suppose he is the most famous one here. So no further introduction seems necessary. The interesting point is that Pershing Square has been an investor ever since the SPAC was formed. His stake is quite substantial, at around 27%. He put in more money to help the company do those acquisitions recently. Ackman is obviously very excited about the company. He thinks of PAH as an avenue to deploy a significant sum of capital with attractive returns.

And the opportunity seems large indeed. Leever told us the specialty chemicals industry has around $1 trillion in revenue. He believes 20% of that have that “Asset-Lite” and “High Touch” characteristics. And the industry is pretty fragmented. Even the potential targets are so as well. As per management’s estimation, there are hundreds of specialty chemicals companies that fall in their target end market with less than $1 billion in revenue; 50 with revenue between $1 billion and $5 billion; 10 between $5 billion and $10 billion in revenue; and 3 to 5 companies with revenue of $10+ billion. That’s a huge hunting ground considering they only have pro forma revenue at $2.9 billion at the moment.

Anyway, I think the resume of this group of investors is pretty impressive. But let’s say you are truly picky. Instead of taking the face value of their individual accomplishments, you are worried how they will work together. Fair enough. But there is, again, something more! This PAH thing is actually their second act together.

Back in February 2011, Martin Franklin, Nicolas Berggruen, and Bill Ackman founded Justice Holdings, a SPAC. The company later mergered with 3G Capital-controlled Burger King. And well… you know the rest…

5. Value

So essentially, I see this as the opportunity to partner with these three guys, alongside the proven managers/experts in the field they have chosen. That leaves one last question: On what terms are we given this opportunity? Or in other words, how much would it cost to partner with them?

5.1 Founders Preferred Shares

The first thing to highlight is the fact that the agreement the two founders (Martin and Nicolas) have with PAH makes it look quite like a hedge fund compensation arrangement. The two founders are entitled to sharing 20% of the increase in share price times the original amount of shares listed during the IPO (corrected the previous mistake of saying it’s based on share count at the beginning of every year), subject to a sort of high water mark.

Given the spectacular performance of PAH shares in 2014 (around 48% YTD and an actual increase of 120.5% relative to the initial offering stock price of $10/share), the founders will be entitled around 9,891,383 shares of common shares if the average share price of the last ten trading days weighted by trading volume is equal to that of now ($22.05/share at Dec 12th 2014) That’s a pay day of more than $218 million for two people. Quite a sum. But they did increase the value of the original equity raised from their IPO of $876 million to the current market cap of around $4 billion, even though it’s with the help of a number of equity raisings.

Whether you want to continue this blog post depends on how fair you believe this compensation is to other shareholders.

5.2 Quick and Dirty Valuation Part 1: The Acquirer Multiple

There are a number of ways to value a company, with the most popular one being a discounted cash flow model. But since I am taught not to use it, let’s just focus on a peer comparison method plus multiples method here.

We have to thank The Brooklyn Investor again with this. Through his research he found that specialty chemicals deals are usually done at…

Quoted from that article: “So anyway, this analysis includes transactions between 2004 and 2011 so includes a lot of deals.  The core selected group deals were done at a mean of 8.3x EV/LTM EBITDA which looks lower than the current MacDermid deal.  For all transactions, the multiple is 9.0x.  Platform paid 10.0x last twelve months adjusted EBITDA so looks higher than previous deals.”

PAH would stick with that multiple of around 10.0X EV/LTM Adjusted EBITDA. Again remember they look for companies that are not capital intensive. The actual EV/Adjusted EBIT multiple is thus usually in the range of 11-13. Not bad for a moaty company with reasonable growth expectation. These guys are the expert, and they are telling you that buying an “Asset-Lite” and “High Touch” company with this multiple can work out well. Wouldn’t this multiple sound like one you can use to value a specialty chemicals company that you found with similar economics?

Unfortunately, this is where I realized it isn’t as attractive as I first thought.

Initially, I was really excited about this opportunity to partner with them because I thought their current EV/Adjusted EBITDA is around 8.65. I  calcuated the estimated EV at $4.0b + $729m [interest bearing debt] + $600m[seller preferred for Arysta LifeScience]. This turns out to be very wrong. I was using their debt level as of 30 Sept 2014, but using the pro forma Adjusted EBITDA ($616 million) that reflects the integration of Arysta.

After further perusing their latest 10Q and an email to the IR department, I got a reply from the CFO, confirming my estimation of approximately $3.5 billion pro forma total debt instead. Now, this changes the whole story immediately. With $3.5 billion in total debt, plus $600 million in preferred shares issued for the Arysta acquisition and the $4.0 billion in market cap, the resulting pro forma EV will be $8.1 billion. (I assume no cash left) The $616 million is pro forma FY2013 Adjusted EBITDA. Let’s conservatively estimate that it increased 5% to about $650 million for FY2014. Then the current EV/Adjusted EBITDA multiple will be 12.46. That’s quite a bit over the multiple the management would like to pay for their own acquisitions. (Even the Arysta acquisition was done at a multiple of around 12) Moreover, do not forget we haven’t even counted the aforementioned Founders’ Preferred Shares.

5.3 Quick and Dirty Valuation Part 2: The Equity Owners Earning Mulitple

PAH, due to its focus of growth through acquisitions, is likely to stay leveraged at a ratio of around 4.5 times net debt/Adjusted EBITDA. As such, given such a “fixed” capital structure,  it might be more suitable to value the equity part only instead.

The current market cap is $ 4.0 billion. We will use the figures from their latest investor presentation (Citi 2014 Basic Materials on Dec 4) for the pretax owner earnings. The adjusted EBITDA for FY2013 is $616 million, with capex at $64 million. Because we should use the figure of FY2014, let’s conservatively assume a growth of 5%. This results in our adjusted EBITDA – capex figure being around $580 million.  According to the CFO reply, pro forma interest bearing debt is expected to be at $3.5 billion. Assuming an average interest rate at 5%, the interest rate will be around $175 million. This results in adjusted net profits before tax at around $405 million. If tax rate is 35%, then free cash flow should be around $263 million. This actually compares well with the guidance given by the CFO during the latest conference call. He mentioned that the expected free cash flow for FY2015 to be around $300 million. (So maybe we really are conservative with the growth in adjusted EBITDA) Compared that to the market cap of $4 billion, the forward multiple is only around 13.3. That’s a leveraged free cash flow yield of 7.5%. Not bad in this low interest rate environment.

Even though the price is no where as attractive as I initially thought. The leveraged cash flow yield turns out to be not too shabby. And we again have Bill Ackman’s vote of approval here. Pershing Square bought more shares in early October through the private placement at a price of around $25.59/share. He cited it as undervaluing the company. (But PAH did subsequently issue more shares, around 10%, through a public offering) At the current share price of $22.05, I think it still looks fairly attractive.

To sum up, PAH operates in a very interesting and high cash generative industry, with an excellent management team, as well as being currently fairly attractively priced. And don’t forget the huge amount of opportunities for more capital deployment at attractive returns.

6. Misjudgement

Okay I talked a lottttttt about the upside potential. But remembering Buffett’s motto, we must really think about the downside. What could go wrong?

6a. Future Capital Structure and Equity Holders Dilution

PAH is similar to Berkshire Hathaway, but with two major differences: 1) It focuses only on one single industry, 2) It is much more willing to use debt and equity for acquisition.

The biggest risk I see is therefore excessive debt or excessive share issuance. In other words, I am worried about how the future capital structure will look like given their plan to be very acquisitive.

Addressing the leverage issue, as mentioned, Martin Franklin has imposed a maximum 4.5 Net Debt/EBITDA restriction on themselves. I feel comfortable with that level of debt given their nature of being very cash generative.

The potential problem of excessive share dilution seems more pronounced. The use of equity for acquisition is not bad per se. But it’s a very tricky tool to use. It’s hard to stay discipline and when things go wrong, it will tend to multiply the cost. Franklin and Berggruen have their skin in the game, but they are also entitled with Founder Preferred Shares, which pay them handsomely if certain performance metrics of the share prices are met. The only defense we have here is Bill Ackman. He owns around 27% of the company now. And he doesn’t own any of those Founder Preferred Shares as Franklin and Berggruen do. He is the big shareholder who pretty much have the same rights as most other retail investors, barring having more votes and having a seat on the board through one of the partners from Pershing Square. I personally trust him enough.

6b. This is NOT a Self-Replicating Business

This will be the biggest reason why this will not be on Singular Diligence. PAH’s future cannot be referenced from the past directly. When we envision the future of PAH, we are actually mostly relying on the management. This is thus a jockey stock, much more than it is an investment in the business itself. This is not Walmart from the eighties. The good thing is the current price seems to be attractive enough for the existing business alone. But of course, the dream team can disappoint us.

6c. Franklin and Berggruen Have Made Serious Mistakes Together Before

Before Platform Acquisition Holding and Justice Holding, the pair listed three other SPACs, Freedom Acquisition Holding, Justice Acquisition Holdings and Justice International Acquisition.

Freedom merged with alternative investment firm GLG in 2007. GLG was later absorbed by Man Group in 2010 after the financial crisis hit them hard. In this three year period, the stockholders of the combined company lost more than 50%.

In 2010, Justice Acquisition Holdings merged with Prisa, a Spanish media conglomerate, infusing around $900 million of cash into the Spanish company.  That hasn’t worked out well so far either, with the share price down like 80+%. (With all those assets they have, could Prisa be an interesting opportunity now?)

Those sound scary. But PAH is not the same. First, it won’t be as affected by the next global financial turmoil as GLG did. Second, the company is not a very leveraged one like Prisa. Neither is PAH very much dependent on a weakening Eurozone economy (i.e. Spain) like Prisa. Things could still go wrong, but not for the reason that GLG and Prisa did.

Moreover, the nature of this PAH venture are also very different from those before. PAH is a long term venture for the team, while the previous deals are more for reverse merger usage.

6d. 1.25 Times the Market Performance Has to Be Achieved to Equal the Market

Of course, just like any other investment funds, the actual performance of PAH has to be a bit higher than the general market returns for deducting all those management fees and performance fees to even equal the market performance. Will PAH be able to do that? We will never know beforehand for sure. But Martin did return 34.4% annually for 13 years. Even if PAH can only return 15% a year the next five to ten years, the resulting 12% ought to be more than enough to beat the market. To achieve the 15% return, PAH will have to grow at 7.5% a year annually for the next five to ten years. (7.5% in the current free cash flow yield + 7.5% in growth = 15% total return) And if we only want 10% a year, PAH only has to return 12.5% a year. In that case, we only need it to grow at 5% per year. That doesn’t seem too outrageous as they aim at double digit cash on cash returns for their acquisitions.

6e. Is the Adjusted EBITDA – Capex Provided by Management Really Reflective of Real and Sustainable Cash Flow

The figures we used for valuation are all non-GAAP. And if you just look at those EBITDA, EBIT figures from Bloomberg or Reuters, you will actually see those numbers in red. Such is the confusion and pain with GAAP accounting for an acquisitive company.

The question is whether those acquisition related costs ought to be added back or not. Perhaps it can be argued that since we expect them to keep on doing acquisitions, those related costs should be deducted. But that would be same as suggesting we take all the capex out for a fast growing company like Cabro Ceramics to come up with their owners earning.

In addition, this is not a similar situation as Valeant. Even though PAH will keep taking over companies, the management is not controversially considering doing a lot of cost cutting to make the price paid right. (I am not suggesting Valeant is destroying value though. I do not know that situation enough to comment) Moreover, MacDermid is having an historical quarter through organic growth of its own. (This is why I said a 5% increase could be conservative) There seems little doubt that the underlying businesses are doing quite well lately, unlike the accused faltering underlying businesses within Valeant.

6f. Expectation too high?

The other thing to pay attention to is not to have too high an expectation on this investment. I believe there is a good chance this will match or outperform the market over the next five to ten years. Just don’t immediately expect to get 30+% annual return. The YTD performance of close to 50% obviously is not helping you manage your expectation either. So really think about this. Do consider how much of that 7.5% growth can be realistically achieved yourself.

7. Conclusion

Just a very short recap.

Platform Specialty Products Corp., founded, managed and sponsored by a very talented and proven group of people, operates in a very attractive industry, with a hunting ground of huge potential. If they execute as planned, the expected shareholder value that can be created should be very rewarding.

The shortcomings/risks include PAH not being extremely attractively priced (as I thought initially), and is pretty much a jockey stock.

Before I got the current EV right, I basically had already decided to invest in it. Now I am less certain myself. I have to wait for another few weeks before I make a decision anyway. (Waiting for the salary to come in)

I most probably would still invest in it, albeit with a smaller allocation than planned before. I will tell you guys when I make the final decision.

Disclaimer: The above is merely for sharing purposes, and should not be considered an investment proposal/advice. Please do your own research before you make the investment decision. I currently do not hold any shares in PAH.

Bill Ackman and Activist Investing

I didn’t intend to write about Bill Ackman again so soon. But that was until I read another article mentioning Mr. Ackman.

“How activist hedge funds ‘on steroids’ have become a boardroom enemy” – That’s the title of the article from Financial Post. (http://business.financialpost.com/2014/11/15/how-activist-hedge-funds-on-steroids-have-become-a-boardroom-enemy/)

The gist of the article is briefly this: With the current, renewed hot trend of activist investing, many “experts” believe the majority of corporates are under danger of assault. Activists, due to their mandate of only serving themselves, in the quest for their own profits, usually put shareholders’ interests behind their own. As such, they tend to seek short term performance rather than long term ones. The article also mentioned a study done by a professor from Columbia showing activists do not help generate long term outperformance to their targets.

Without reading the actual study, as well as given what we know about human nature, I am not here to contend that activist investing is doubtless an act of virtue. I think it depends. Yet, I believe it would definitely be wrong to suggest activist investing, per se, is detrimental.

How can it be? Really?

As mentioned, the biggest accusation against activist investing is that they tend to flip their investments. They pressure the board to pay out cash, buyback stocks, cut cost and so on, then cash in the resulting gain and leave the company behind in a weaker form. Because of their presence, management cannot focus on implementing the correct long term strategies. What all this means is that activists are inclined to attend to their own self interest while hurting that of the majority shareholders. Right. But are activist the only portions of the whole human race that exhibit such self serving biases?? Are you telling me management teams are all public servants to shareholders, carefully attending to shareholders’ needs without an iota of exploitation??? Oh, where has that famous agency problem gone????

People, when condemning activist investors, love to mention the book “Barbarians at the Gate”, which documents brilliantly the saga of the LBO of RJR. (Disclaimer: I love the book) They find it the perfect illustration of what private investors can do to destroy values with the aid of billions in capital the lack of mandate to protect shareholder interests. Indeed, that drama showcased the greed from people in KKR and other players involved. What is interesting is how often people forget the management team of RJR back was among the players involved in the deal. The excesses of the management doesn’t look like a lesson on how to treat shareholders’ assets to me. While there are laws protecting shareholders’ interests in the USA, the fact is simply that laws are not always effective. I don’t believe this is a point that I need to elaborate on.

Moreover, as Ackman himself has repeated many times during different interviews, the modern day activist investing playbook requires the support of other shareholders in a company. It’s no longer the era when a corporate raider can simply takeover a company secretly and tear it apart. In order for an activist to be successful, it usually requires a vote of support from other passive shareholders. And how can this be a bad thing? Are you suggesting the other shareholders are not sophisticated enough to make the right call here? If so, then why should you believe they are sophisticated enough to choose the right CEO at the first place or wise enough to assess the management team on a ongoing basis? 

Certainly, the article’s use of Ackman as the main “antagonist” gave me the biggest reason to write this post. Using Ackman is simply wrong or maybe even deceptive. Again, people love to show one aspect while hiding the other. Knowingly, Ackman made a mistake in JC Penny (but it wasn’t only his mistake. Watch his interview with Charlie Rose last year for this). However, Ackman made billions in Canadian Pacific, GGP and most recently Allergan. The two former cases are perfect examples of an activist bringing long term value into the deal. And no, Ackman aims to hold his core investments for four to six years. When you point out that the average holding period for an activist is 9 months, please use an investor who usually holds an investment that long as your main example.

Another point I want to point out concerns the quote from Claude Lamoureux, former CEO of the Ontario Teachers Pension Plan and co-founder of the Canadian Coalition for Good Governance. He said he prefers the long term strategy of Warren Buffett to that of Ackman’s. Both are my heroes. And while their strategies do usually differ, that doesn’t mean Warren must disagree with what someone like Ackman or even Icahn wants companies to do. The best proof is Apple. Warren mentioned on CNBC once that Steve Jobs consulted him what to do with all the billions in cash Apple has. After some Socratic style of questions, Warren obviously hinted that buying back Apple shares would be an intelligent thing to do if Jobs believed his company’s shares were massively undervalued. Oh! Doesn’t that sound familiar? The only difference is Carl Icahn and David Einhorn did actually voice out their opinion publicly. One might even argue that, in this case, Warren hasn’t been doing enough to create shareholder value!

I believe it’s futile to discuss whether activist investing in general is good or bad. I find it a necessary thing to help balance the advantages management teams having no skin in the game usually have over shareholders who do. But of course, their growing power can also be misused. The only scenario in which I believe a valid debate is warranted is when we are discussing a specific case of activist investing. Only with the specifications of a specific case, can we really judge whether the activist is creating real value or not.

In a word, I believe activist investing is just like a knife. People can use it for surgery, eating, surviving and so on. And people can also use it for torturing, stealing or even murdering. Is knife a necessary tool to us? Yes. But is it good or bad? It depends.

Bill Ackman and Investment Risks

Bill Ackman of Pershing Square Capital Management is my favourite hedge fund manager among currently active hedge fund managers.

To be honest, I completely idolize him. The biggest attraction to me is the way he invests. He takes a concentrated, value approach. He doesn’t pay much attention to the macro environment. And he only looks for good companies, those that are cash-flow generative, dominant, not levered, resilient throughout economic cycles. Basically, he invests the way our biggest hero, Warren Buffett, would. (Except Ackman likes to effect changes) And that absolutely absorbs me.
Ackman is more than 30 years younger than Buffett. But he keeps things simple the way Buffett does and then goes on to create so much value. I can almost imagine him in college thinking to himself: I am going to do what Buffett has done. Basically I am saying he has done the thing I really want to do myself. And his successful example simple rings such a big bell in me, always giving me a huge sense of motivation to work hard. (Of course, I am sure Ackman is a much more competent guy than I am)

I simply believe any moves he makes is of immense learning value to us value investors. Obviously, given his high profile, most of his investments are already well discussed in the media. So I do not plan to get into that now. But there is one thing I would like to discuss in this post.

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That is: Portfolio construction or the degree of portfolio concentration.

I have read a number of articles proclaiming how risky Ackman’s investing style is. One article cited one investment professional saying Ackman’s close-to-40% allocation in Allergan is a prime example of reckless risk management. Other examples include how Ackman lost $500+million in JC Penney and once more than 90% in the Target investment. Clearly, they are equating a concentrated portfolio as risky investing. And pointed out two examples as proof of this claim.

But is this correct? I doubt so.

One way of rebutting their claim is to think about how Ackman performed during the financial crisis. If you think someone is running a very risky portfolio, wouldn’t it show during one of the worst market condition ever happened? The fact is Ackman outperformed the market during that period of time. He was down in 2008, but less so than the market. And his hedge fund certainly didn’t blow up. I am quite sure most people who owned a more diversified portfolio performed worse than Ackman did during those dark days.

The key is what you own, instead of how many you own.

Indeed, I am not specifically saying a concentrated portfolio is the only way to go. (Even though I do personally prefer so) But what I am trying to say is it’s totally unintelligent to discuss how risky one’s portfolio is without talking about the quality of the investments that person owns. Certainly, you should also think about whether he/she is employing excessive leverage or not. (In the case of Ackman, he rarely uses any)

The only thing we can derive from the number of investments one has in his/her portfolio is the fluctuation of that portfolio will generally be bigger than a more diversified one. (i.e. higher volatility) However, it’s important not to confuse volatility with risk. Risk, as both Buffett and Ackman contend, is the probability of facing a permanent loss. Whether the price of the asset goes up or down widely between the time of your purchase and the time of your sale should be irrelevant, as long as you are not bound to act stupidly during that period, either due to leverage or some other reasons.

Since Ackman specifically looks for quality businesses with some fixable problems, alongside his willingness to do things actively, including effecting changes in top management and changing capital allocation strategies, both of which actually act as a safety net to one’s investment, is Ackman really running excess risk?