You can read the first part of The investment manifesto (1/2) here.
The exclusion process
In the previous post on the investment manifesto I ended with a presentation of my margin of safety definition. The purpose of that definition is to sort out those companies that I won’t allow myself to invest in. In a sense, I use my margin of safety definition as a exclusion process. In other words, the exclusion process is a negative screen to sort out companies that I don’t think I can satisfactorily determine their downside protection. Those companies get excluded and automatically put in my too-hard-pile. Thinking about investing, at least initially, as a negative art, what you don’t want to own, is an underappreciated approach in my opinion. This is based on a belief that risk- (i.e. permanent loss of capital) control should be the main emphasis for all investors. A quote that reminds me of the importance of controlling risk is this one:
“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.” – W. Buffett
However, a quote that in my opinion best explains the reason for the importance of risk control is this one:
Never forget the six-foot-tall man who drowned crossing the stream that was five feet deep on average. Margin for error gives you staying power and gets you through the low spots. – H. Marks
Or as one of my favorite authors stated in his newly published book Skin in the Game:
“In order to succeed, you must first survive.” – N. Taleb
The statements and thinking above goes back to my belief that only after one has established a population of ideas with solid downside protection should one move on and start to think about their upside potential. In conclusion so far, downside protection (survival) is more important than upside potential (returns) as one starts to think about which companies to invest in. As you will see in this post, I won’t go as far as; Focus on the Downside, and Let the Upside Take Care of Itself, but almost…
The inclusion process
The population of companies that have survived the exclusion process I termed; The Liquidation Oxymoron’s in the last post. If you haven’t already figured out my reasoning for choosing this name I’ll make sure to explain it now. The companies that have survived the exclusion process all fit under the following oxymoronic statement;
They are going concerns selling below their liquidation value.
My belief is that the population of liquidation oxymoron’s creates a powerful starting point of companies to potentially invest in. The basis for that belief is that the oxymoronic statement establish that there exists a fundamental difference between consensus and value for these companies. In a recent post you can read about why I consider this difference to be the most important thing to establish and take into consideration if one strives to be a successful investor: Consensus is what you pay; the relationship between consensus and value determines what you get.
But now, let’s move on from the margin of safety and downside protection argument and take a look at my inclusion process. The positive screen if you like. I will divide the presentation for this process under three headings; 1) upside potential, 2) catalysts and 3) other factors and characteristics. Remember, the companies I look at during the inclusion process (the companies that have survived my exclusion process) are all potential investment ideas that I would be willing to invest in. More specifically, the inclusion process is about determining if I’m going to invest in company A, B or C at a certain point in time. I will come back to my reasoning for this approach of picking stocks when I present my thoughts for the buying- and selling process for the Liquidation Oxymoron portfolio.
As you would expect, most companies get excluded as a result of the first criteria in my margin of safety definition. That is: Selling below liquidation value (i.e. price below readily ascertainable net asset value = raNAV). The reason why I have put this criterion first is because I think the valuation aspect as it relates to downside protection is the most important one, independent of how one defines “value”, to take into consideration as an investor. Furthermore, I think the same holds true about the valuation aspect from an upside potential perspective. Again, if you are interested in my reasoning for these statements you can read more about that topic in the following post: Consensus is what you pay; the relationship between consensus and value determines what you get.
However, the valuation aspect is far from what describes the complete picture regarding the upside potential of companies. Unlike the margin of safety definition that should be developed individually, the definition for upside potential is an universal one I would argue. The best way, in my opinion, to think about upside potential is to think of a return formula with three components. One should note that I’m by no means the inventor of this formula. For this I would like to give credit to Fred Lui at Hayden Capital and more specifically his Investor presentation and Calculating Incremental ROIC’s presentation but also John Huber at the Base Hit Investing blog and all posts on ROIIC.
What the two investors just mentioned have concluded is that the upside potential (i.e. future returns) is to be determined by the following three components (some minor adjustments done by me). I have termed this the return formula:
1. Intrinsic value compounding yield (ROIC × reinvestment rate = earnings growth)
2. Shareholder yield (stock buybacks / issuance + dividends + net borrowings)
3. Valuation yield (valuation multiple expansion / contraction)
= upside potential (i.e. future returns)
Although the return formula might seem like a manageable calculation exercise one should not be fooled into a sense security or precision. In investing, should happen ≠ will happen. Therefore, I would again like to stress the importance to only engage with the return formula once one is done with the exclusion process. Furthermore, I would like to point out that one should not cry oneself to sleep if one struggles with all the components of the return formula. For some investment ideas, the calculation of intrinsic value compounding yield will almost be impossible to calculate. Or it might be almost impossible to determine what a fair valuation multiple is for a specific investment idea. Nonetheless, those statements begs the question: Should one stay away from companies for which you can’t calculate their upside potential?
My opinion is; no, companies whose upside potential that is hard to determine should not per definition be avoided. Rather, the important aspect is the certainty of the fundamental difference between consensus and value of the company for which you are trying to calculate upside potential. For me personally, this goes back to my thinking and reasoning for the name of the Liquidation Oxymoron’s and what that name implies. Or explained in a more colorful way with the help of one of my favorite quotes in investing:
“You don’t have to know a man’s exact weight to know that he’s fat.” – B. Graham
In conclusion, I will always try to calculate upside potential based on the return formula stated above. For some investment ideas this calculation exercise will be quite thorough and detailed (e.g. HEL:SAGCV, analysis not published). For some investment ideas (e.g. NASDAQ:GIGM, analysis not published) I will more or less fall back on my assessment that the company is a Liquidation Oxymoron (i.e. makes it through the exclusion process) with high certainty in regards to the current fundamental difference between consensus and value. In conclusion, I will not exclude or rank the Liquidation Oxymoron’s population based on the outcome of their return formula calculations. Rather, I will rank the investment ideas in terms of my conviction for their upside potential, i.e. most probable upside potential. In order to make such an assessment I have to take into consideration potential catalysts and other factors and characteristics for the Liquidation Oxymoron’s.
The circumstances for what a posteriori is determined as the catalysts is hard to determine and arrive at a priori. I’m not the first one to make this unsatisfactory conclusion as the following statement from 1955 will show:
Related to the statement above is his famous quote:
“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – B. Graham
Although I ascribe to the belief that value is its own catalyst there are nonetheless some circumstances and signs that I keep my eyes open for when I’m to determine my conviction for the Liquidation Oxymoron’s upside potential. Furthermore, the reason why catalysts, other than the mentioned realisation of value from Mr. Market over time, are important to take into consideration has to do with the time factor of investing. Specifically, these catalysts have the potential to unlock value in a direct and fast manner. I would argue that the time factor is an important component if one, like myself, think in terms of CAGR.
For the Liquidation Oxymoron’s I will specifically evaluate and take into consideration any signs of:
- shareholder activism.
- major asset sales, spinoffs or mergers plans.
- acquisition and/or expansion plans.
- dividend and/or share buyback plans.
- buyout or takeover plans.
- changes in management.
Note that what I have stated above is not to be considered an exhaustive list of catalysts. Rather, the evaluation of potential catalysts and their respective probabilities has to be done on an idea per idea basis since they will be highly individual and context dependent.
Other factors and characteristics
The factors and characteristics I will mention below are not to be considered “make it or break it” components for the investment ideas of the Liquidation Oxymoron population. Rather, they are factors and characteristics that have the potential to improve both the upside potential and the probability of upside potential. As you will see, non of these are original or special in any way but should in my opinion nevertheless be taken into consideration during the stock picking process:
- Small market capitalisation (preferably nano or micro cap).
- The trading of the company shares is illiquid.
- Large insider ownership and/or insider are recent net-buyers of company shares.
- Reasonable insider pay.
- Famous deep value investors on the shareholder list and/or they are recent net-buyers of company shares.
- Company has improving fundamentals (e.g. high F-score).
- Low-level of debt or high level of debt but the company is aggressively paying down debt.
- Company has historically paid dividends.
- Company has historically been net-buyers of company shares.
- Company conducts business in a stable and/or boring industry.
- Company has been active for some time (preferably more than ten years).
- Company shares are currently trading near historical lows.
- The company is not a perennial Liquidation Oxymoron (i.e. the company has historically trade above raNAV).
- A big portion of raNAV consists of cash and cash equivalents.
- Company has hidden/undervalued asset values not reflected on the balance sheet.
- Positive or low raNAV burn-rate.
- Low valuation compared to operating earnings and/or free cash flow.
Again, the list above is not to be considered an exhaustive list of factors and characteristics that should be taken into consideration during the inclusion process. The ones mentioned above I usually consider but I might retract and/or add factors and characteristics to the list in the future.
The buying- and selling process
Similar to the situation for the first post on the Investment Manifesto, this one became longer than I had expected. As a result, I will save my thoughts and ideas about the selling- and buying process for the Liquidation Oxymoron portfolio for yet another post. I promise, this will be the last part in my series of post related to the Investment Manifesto.