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Kase Capital - Short Thesis on Wingstop
Whitney Tilson's Short Thesis of Wingstop
Why Am I Short the Stock?
Valuation is absurd: 52x trailing EPS (43x NTM); 29x trailing EBITDA (24x NTM); 11x trailing revenues (10x NTM)
Same store sales growth is decelerating
An estimated half of same store sales growth in recent years has been driven by price increases, which is likely unsustainable
Little that is proprietary or unique about this business – these are chicken wing restaurants
Plenty of competitors, many much larger, with deeper pockets and better technology
Doubt Wingstop can nearly triple the number of units in the US to management’s stated goal of 2,500
Market is much more competitive and may be becoming saturated (roughly half of all chicken wing restaurants in the US have been opened the last 5 years)
Nearly 2/3 of Wingstops today are in 2 states (Texas and California) so the business and brand are largely unproven elsewhere
After 22 years and growth to over 1,000 units, company generated a mere $91 million in revenues and $15 million in net income in 2016
wingstop sales
Investor presentation boasts of phenomenal same store sales growth but note the slowing growth
In reality, Wingstop’s same store sales growth has decelerated significantly, despite increasing the pace of new unit growth
Gross margin of Wingstop’s company-owned stores has also declined significantly
Wingstop’s 2017 Guidance Indicates a Very Disappointing Year:
On the Q4 2016 call in March, management said Q1 2017 comps are negative 2.6% so far plus the cost of wings are 10% higher YoY – meaning Wingstop could report unexpectedly weak sales, margins and profits in Q1
Wingstop has issued the following guidance for 2017:
System wide unit growth of approximately 13% to 15%
Low single digit domestic same store sales growth
SG&A of between $34-35 million
Net income between $18.5-$18.8 million
Fully diluted EPS growth of 8-10%
Adjusted EBITDA growth of 13-15%
This guidance implies another 300bps of margin decline
Negative comps and plunging margins are totally inconsistent with a stock trading at such a rich valuation, so something has to give: either business metrics start to improve dramatically or the stock is likely to get cut in half (or more)
Betting on the latter (and so was Roark Capital)
Public shareholders are Wingstop’s 4th owners – and the Prior Owner has already cashed out entirely:
Founded in 1994; acquired by Gemini Group in 2003; acquired by Roark Capital in 2010; taken public in 2015
Roark specializes in franchise businesses and currently owns 16 quick/limited/full service restaurants chains – typically holds for a decade or more
In the case of Wingstop, rushed to dump its entire stake:
June 2015: IPO – 3.2 million shares sold at $19
March 2016: 6.3 million shares sold at $24
July 2016: special dividend of $2.90/share, bringing debt/EBITDA to 5.2x
August 2016: 6 million shares sold at $29.25
November 2016: all of remaining 6.8 million shares sold at $26.28
Why the rush? My guess is that Roark saw a possible fad, oversaturation, and the signs of slowing growth, so wisely took opportunity to cash out at an absurd valuation
Summary and Price Target:
Wingstop is an okay business at best and there are major signs of deterioration
Business is largely undifferentiated and faces ferocious competition from all sides
Only proved that its business and brand work in two states, yet its valuation assumes that it can scale rapidly across the US and abroad – a highly questionable proposition
Given the stock is currently priced for perfection, if I’m wrong, it has little upside – and if I’m right, look out below!
A DCF analysis, even assuming favorable growth and margin increases for the next decade, yields a share price roughly half today’s level
Even at that price, stock would still be priced at more than 25x trailing EPS
This is my largest position at 3.1%
There is plenty of borrow at negligible cost
Bill Ackman's long thesis for Mondelez
Great summary of Bill Ackman's 1Q17 Letter
Mondelez
1Q17 Earnings: reported organic sales growth of 0.6%, driven by pricing growth (1.1%) and a volume decline (0.5%); all regions experienced growth with exception of North America
Despite the modest top-line growth, operating profit margins expanded significantly to 16.8%, driven primarily by a reduction in overhead costs as percentage of sales reflecting the implementation of zero-based budgeting and the rollout of global shared services
Management remains committed to its 2018 operating profit margin target of 17% to 18%
Mondelez is one of the few large-cap packaged food companies that is demonstrating both margin expansion and top-line organic growth
Over the long-term, believe that MDLZ’s categories and geographic footprint give it a significant advantage, especially in emerging markets where MDLZ’s large market shares and robust routes to market should drive accelerated growth
David Einhorn's Short Thesis on CLB
Great summary of Einhorn's SOHN Conf Presentation
Core Laboratories (CLB)
@ $113.43/share, $5B market cap and $5.2B enterprise value
Oilfield service business that helps energy companies analyze their reservoirs and increase their oil and gas recovery
Two segments: Reservoir Description and Production Enhancement
Reservoir Description: asset-light, lab-based business that analyzes reservoir rocks and fluids (71% of Revenue and 89% of EBIT in 2016)
Considered the technological leader in the field
Major oil companies rely on Core for analysis of their most complex reservoirs, where Core has earned a reputation for being best in class
Revenues and margins have been fairly stable because it specializes in multi-year projects, especially offshore and deepwater
Production Enhancement: provides tools and services related to well completion and production (29% of Revenue and 11% of EBIT in 2016)
Business sells perforating guns and charges primarily to frackers and offer well diagnostic services to E&P companies
Guns and charges are a competitive market in which Core competes against Titan, Schlumbuerger, and others
2/3+ of this segment’s revenue comes from products rather than services which makes this segment a typical commodity price-sensitive OFS
Valuation
On consensus estimates, stock trades at 35x next year’s earnings and nearly 29x 2019 estimates
Trades at a massive premium to its OFS peers – more than twice the multiple of prior peak earnings
Two reasons bulls give to justify CLB’s valuation are Core’s seemingly secular growth and its industry-leading ROIC
Core is a non-capital-intensive business; analytically, the ROIC in a non-capital-intensive business is irrelevant because you can’t reinvest your profits to grow your earnings at the stated ROIC
Core could have twice as much lab equipment without gaining any new customers – it is flawed to value the stock based on its “industry leading ROIC”
As for the secular growth, think this is a misunderstanding that dates back to 2009 and still persists today
Last cycle: when oil price briefly collapsed in 2008, revenue of most OFS companies collapsed along with it; Core’s revenue fell too but only barely and much less than others in the industry; Core managed to maintain sales and even grow margins and subsequently, revenues and margins continued to climb
Core’s stability through the down-cycle followed by growth in the recovery gave the false impression that Core is a secular growth company
Analysts began hyping the company as a secular growth story generally immune to oil price volatility and investors agreed and re-rated Core to a non-cyclical growth stock multiple
Analysts were so convinced that at year-end 2014 after oil prices had already been cut in half, still projected that Core could maintain earnings through the downturn
Analysts and their projections were wrong – a 74% decline in earnings over 2 years should have made analysts and investors reconsider the narrative but they have not; they continue to value the company as a secular grower
Right place, right time?
In reality, Core is a cyclical business whose particular product suite was less affected by the 2009 downturn than other companies in the industry
Like all OFS businesses, Core has two primary revenue drivers: price of oil and end markets where investment dollars are being spent
Reading the annual reports, Core happens to be steeped in the hottest parts of the energy market in any given year
2007: “Core will continue to emphasize execution of its time-proven strategies to produce additional growth internationally and in the natural resource plays of North America, which includes the Canadian oil sands, as well as tight-gas sand and gas-shale reservoirs”
2009: “Over the past seven years, we have focused on international crude oil developments to capitalize on our peak-oil theory… The Company has focused on international development and production-related crude oil projects almost to the exclusion of more cyclical, exploration-related activities”
2011: “Our continued focus on international crude-oil-related developments and unconventional oil from shale reservoirs enabled Core’s earnings per share growth to outpace almost all energy-related entities and industrial companies”
2012: “The Company’s laser focus on international crude oil related developments, especially those located in deepwater, continue to serve our shareholders well… Core Laboratories will continue to laser focus its attention on worldwide deepwater developments, and that will position us very well for success and growth over the next decade”
2013: “The Company’s laser focus on crude-oil developments, especially those in the deepwater and unconventional tight-oil plays that are primarily in shale reservoirs, continue to serve our shareholders well, as over 80% of Core’s revenue is now derived from oil-related projects. This percentage is likely to continue to grow as development of unconventional tight-oil shale reservoirs gain traction, not only in North America, but in the UK, Russia, North Africa, the Middle East, China, and Australia, among other places”
2014-2015: “Our continued focus on worldwide crude oil related and large natural gas liquefaction projects, especially those related to the development of deepwater fields off West and East Africa, the eastern Mediterranean region and increased activity in the Gulf of Mexico”
Reading Core’s annual reports is like opening a time capsule preserving the history of energy market hype
Bill Ackman's thesis for Freddie and Fannie
Great summary of Bill Ackman's letter
Fannie Mae / Freddie Mac
Underlying earnings in their core mortgage guarantee businesses declined modestly in the first quarter, reflecting lower refinancing volumes driven by a large increase in interest rates in the 4Q16
Believe long-term earnings power will continue to grow due to 3 factors:
An increase in guarantee fees as the fees on new mortgages exceed the average fees on the existing portfolio
Growth of the total guarantee portfolio along with mortgage originations
Lower credit losses as portfolio’s credit quality continues to improve
Housing finance reform is a top priority for both the new administration and Congress
Key constituents including Steven Mnuchin have a thorough understanding of the critical role that Fannie and Freddie play in the health of the nation’s housing finance system
In contrast to vintage 2013 proposals that sought to replace Fannie and Freddie or wind them down, several proposals released over the last month, most recently a white paper from the Independent Community Bankers of America, recognize that preserving a reformed and restructured Fannie and Freddie is the only way to ensure the continued health of the secondary mortgage market, especially for a large number of community banks that are critical sources of financing for many homeowners
Bill Ackman's latest short thesis
Great summary of Bill Ackman's letter
Herbalife Short
Despite weak performance in Q1, share price has appreciated by more than 50% YTD
Due in part to HLF’s misleading portrayal of its first quarter operating performance and the company’s share repurchase program
Reported flat y-o-y constant-currency sales growth across the business
Growth in some markets (Mexico, EMEA, and China) was offset by substantial declines in others (South & Central America, North America, and Asia Pacific)
Reported significant persistent declines in South Korea, Brazil, and UK
Dramatic “pop” and “drop” reflected in HLF’s individual markets are highly characteristic of pyramid schemes, which achieved accelerated growth until a market reaches saturation, after which there is a dramatic decline in volumes as participants recognize that being a distributor is a money-losing proposition
While bullish investors have suggested that the company’s recent results show that it can manage effectively through the requirements of the FTC settlement, North American performance in the quarter does not yet reflect the impact of FTC permanent injunction
China at 20% of sales is HLF’s second largest segment after North America – while China realized 17% volume growth in Q1, management noted that there was a significant pull-forward in volume ahead of a 5% price increase in April
10-Q included significant notable changes to risk disclosures with respect to China
“Uncertainties relating to interpretation and enforcement of legislation in China governing direct selling and anti-pyramiding”
Would not be surprised to learn that HLF is under investigation by Chinese authorities, particularly in light of the recently announced Foreign Corrupt Practices investigation of HLF’s China operations by the Department of Justice and the SEC
Believe the injunctive relief imposed by the FTC is likely to weigh significantly on HLF’s financial performance in the coming quarters
Coupled with decelerating growth and substantial deterioration in many international markets, expect earnings to decline on an operational basis in 2017
Despite above issues, now trading at 17x the midpoint of management’s adjusted guidance
Currently trading at highest P/E ratio in its history as a result of recent stock price increase and its declining earnings
Great summary of Ackman's thesis on Chipotle
Great summary of Ackman's 1Q17 Letter
Chipotle
Since Steve Ells returned to the role of sole CEO in December of last year, implemented significant organizational and operational changes aimed at elevating the guest experience
Renewed focus on delivering a great guest experience has re-energized and motivated the organization, leading to better customer service scores, lower restaurant manager turnover, and improvements in many other key performance metrics
1Q17 reported results with same-store sales increasing 17.8% y-o-y
Announced in late March that it is the only national restaurant chain with no added colors, flavors or preservatives in any of its ingredients it uses to prepare its food
In December, four new independent directors joined board of directors including Pershing Square’s investment team partner Ali Namvar and advisory board member Matt Paull
Optimistic about the initiatives that CMG’s executive team has put in place to enhance the guest experience, differentiate the brand, increase sales through opportunities like mobile ordering and catering, and improve restaurant margins over the long-term
Elliott's Plan to Unlock $46B at BHP
Elliott's Plan to Unlock 50% or $46B of Value at BHP
Introduction:
Elliott holds long economic interest in BHP of approximately 4.1% of issued shares
Despite being a leading global resources company with a portfolio of best-in-class large-scale diversified mining assets, BHP has underperformed a portfolio of comparable mineral and petroleum companies
Despite the progressive demerger of South32 in May 2015, management still cannot deliver optimal shareholder value without:
Resolving the shareholder value inefficiencies from dual-listing
Monetizing the intrinsic value of US petroleum business
Enhancing capital management to an optimal level
BHP Shareholder Value Unlock Plan is designed to address these issues with 3 key steps:
Unifying BHP’s dual-listed company structure into a single Australian-headquartered and Australian tax resident listed company
Demerging and separately listing BHP’s US petroleum business on the NYSE
Adopting a policy of consistent and value-optimized capital returns to shareholders
Analysis shows that implementation of this plan could enable management to provide shareholders with an increase in value of up to 48.6% (limited shareholders) / 51% (PLC shareholders)
Step 1: Unifying BHP into a single Australian-headquartered and Australian tax resident listed company
Following the South32 demerger, estimate that PLC now generates only 8.9% of BHP’s EBITDA but PLC accounts for 39.7% of BHP’s aggregate number of issued shares
Long-term misalignment of profits vs. shareholder base has led to a massive and continuing build-up of franking credits – totaling $9.7B or 10% of BHP’s market cap
Over the last 16 years since the completion of dual listing, PLC’s shares have traded at an average discount of 12.7% to Limited shares
Price dislocation stems from the economic asymmetry which in turn undermines the fundamental principles and objectives of the dual listing structure
Unification would:
Create a single Australian-headquartered and Australian tax resident unified BHP company which would be managed from Australia. That company could retain BHP’s current stock market listings and continue to be included within key FTSE and ASX stock indices
Put BHP’s Limited and PLC shareholders on the same footing, eliminate current trading value mismatch
Allow BHP to access the value represented by its existing massive $9.7B franking credit balance, plus future franking credits generated by the business
Significantly enhance the scope for, and optimize the impact of, BHP share buybacks – unified BHP’s management could return the substantial upcoming excess cash flow to shareholders by way of 14% discounted off-market share buybacks
Remove any need to use the Dividend Share Mechanism, thereby avoiding wastage of valuable franking credits
Help management to avoid making badly timed acquisitions paid for in cash, given the opportunity to deploy significant cash resources in value-enhancing post-unification share buybacks
Increase the scope for management to pursue appropriate acquisition opportunities using unified BHP’s own shares as consideration
Remove certain other material tax, operational and strategic inefficiencies caused by the dual listing structure
Step 2: Demerging and separately listing BHP’s US petroleum business
Based on commonly utilized valuation metrics for comparable businesses, the indicated value for BHP’s US petroleum business is $22B, which is well in excess of the current analyst consensus valuation for that business
Analysis indicates that US petroleum business has not been able to successfully contribute to shareholder value at BHP since:
It provides no meaningful diversification benefits to BHP as a whole
Lack of synergies between US petroleum business and its mining assets
Intrinsic value is being obscured by bundling it with BHP’s other assets
Demerger and separate listing of US petroleum assets on the NYSE would:
Unlock the intrinsic value of the US petroleum business and provide shareholders with access to what we believe would be a much higher market value for that business
Allow the demerged US petroleum business to be properly capitalized and pursue value-accretive strategic opportunities
Allow BHP’s management to fully focus on deriving value from BHP’s unrivalled portfolio of first-tier mineral assets
Allow BHP’s investors to tailor their own desired exposure to US energy and petroleum equities rather than being constrained by the fixed acreage composition and petroleum vs. minerals mix currently being offered by BHP
Step 3: Adopting a policy of consistent and optimized capital returns to shareholders
BHP is expected to generate $31B of excess cash flow in the next 5 years, assuming the current 50% payout ratio of net income
A clearly defined and communicated ongoing 14% discounted off-market buyback program undertaken by a unified Australian tax resident BHP which has demerged its US petroleum business would:
Enable BHP to pursue its own shares at a substantial discount, achieving an overall cost which is 5.6% lower than the price at which BHP can currently buy back its shares
Release up to 66% more franking credits to shareholders
Facilitate an initial off-market buyback of at least $6B
Within the 5 year period ending June 2022, in addition to the continuation of the current 50% payout ratio, adopting this capital return policy as part of the Value Unlock Plan could result in:
Total $33B being returned to shareholders via buybacks
29% of core BHP’s share capital being repurchased
Total EPS accretion from buybacks of 33% in respect of the shares remaining in issue after the 14% discounted buyback program
An increase in BHP’s NAV of $20B (21% of current market cap)
Our analysis indicates that implementation of the Value Unlock Plan could provide BHP shareholders with an increase in the value attributable to their shareholdings of up to 48.6% (Limited Shareholders) / 51% (PLC Shareholders).
Howard Marks Memo: Lines in the Sand
Great summary of Howard Marks Memo: Lines in the Sand
How do Subscription Lines Work?
Subscription lines are bank loans extended to funds that enable them to use borrowed money, rather than LP capital, to make early investments or pay fees and expenses
In general subscription lines are 1) limited as a % of the LP’s capital commitments, 2) are secured by LP’s capital commitments, and 3) generally must be repaid in the early or middle part of the fund’s life although terms are beginning to lengthen
A $100 million fund with a subscription line might be able to buy $50 million of assets without calling LP capital but it still can’t invest more than $100 million
Bottom line is that essentially all subscription line financing does is defer LP capital calling
These lines lever LP capital but do not lever funds in the sense of allowing funds to invest more than their committed capital (different from hedge funds that use leverage to deploy more than their committed capital)
What Are the Effects?
Its use does not increase the total $ profits that the fund will earn from investments over its lifetime
Use of subscription line doesn’t alter fund’s committed capital or invested capital – either the multiple of committed capital or the multiple of invested capital is not improved
Positives:
Original purpose was to enable GPs to make investments and pay fund fees and expenses without frequent capital calls and to prevent opportunistic funds that don’t sit on large amounts of cash from missing out on opportunities requiring quick funding
With calls for LP capital postponed, reported IRR in the early years (the dollar weighted return on LP capital) will increase (assuming early profits exceed the interest and expenses on the line)
Use of borrowed money can reduce or even eliminate the deleterious impact on early returns of the so-called J-curve
J-curve results from the fact that in a fund’s early years, management fees are usually charged on total committed capital while a relatively small percentage of the capital has been put to work and the tendency of private investments to take a while to show results
Over time, fund’s IRR will retreat from its elevated early level and move down toward what it would have been if the fund hadn’t employed a subscription line
All things being equal, fund’s lifetime IRR will remain higher than it otherwise would have been
Any return the LPs earn on the uncalled capital in excess of their share of the fund’s subscription line costs will be additive to their results
Negatives:
Interest and expenses will be paid that wouldn’t have been paid if LP capital had been called instead – since fund isn’t becoming levered, payment of costs is a permanent net negative for the fund
Some LPs may actually prefer to have their capital called and earn their preferred return
Use of a subscription line in lieu of LP capital shrinks the dollar preferred return hurdle; lowering the hurdle can increase the GP’s probability of collecting incentive fees (carried interest) and cause the payment of incentive fees to the GP to begin sooner
Less disciplined or less diligent GPs may be induced to lower the standards to which they subject investments because their effective cost of capital seems so low
Some LPs seek to avoid so-called Unrelated Business Taxable Income
Since each LP commitment is an essential part of the bank’s collateral, existence of a line could conceivably complicate the process of selling an LP interest in a secondary transaction
Many banks are requiring more intrusive information of fund LPs
Impact on Fund Performance Metrics
Since a fund’s total $ profits and multiple of capital are not improved by the use of a subscription line, the increase in IRR, while pleasant, might be thought of as illusory
While valuable, neither IRR nor MOCC nor MOC, nor any other single metric, is sufficient to tell us whether the GP did a good job
High IRR certainly is desirable – but this is what a fund can show if the GP only makes 1 investment with a small fraction of the fund’s committed capital and that investment produces a substantial profit
If a $100 million fund invests $1 million in something and sells it a month later for $2 million, this would annualize to an IRR of roughly 400,000% and if that’s the only investment GP makes, that’ll be the fund’s IRR; it certainly doesn’t mean the GP did a good job and I doubt the LP who committed $10 million to the fund will be happy with $10.1 million back in the end
To understand what an IRR really says about fund performance, you have to know what % of the capital and how long the GP held onto it
Big multiple of invested capital is good but it also may have limited significance. Say the GP of a $100 million fund invests $10 million, keeps it invested for the fund’s entire 10-year life and earns an annual return of 15% on that investment – this will result in proceeds of $40 million and thus 4x MOC. That’s great but again, if this is the only investment made, LPs get a profit of $30 million (certainly not what they had in mind when they committed $100 million)
Big multiple of committed capital sounds almost perfect but it too isn’t sufficient. MOCC of 3x is good but if it took 6 years, IRR is 20% and if it took 10 years to generate the same profit, IRR is just 11.6%
In order to be able to assess fund performance, we have to know:
How much capital was committed
How much capital was invested
How long it was kept invested
How much was returned to LPs
One fund with a higher IRR didn’t necessarily outperform another – and, provocatively, a fund that used a subscription line and came in with a high IRR may not have done as good a job as one that didn’t use a line and reported a lower IRR
Use of subscription lines sheds considerable doubt on the significance of IRR and when IRR becomes suspect, anyone waiting to evaluate fund results has no choice but to put greater emphasis on the multiple of capital
Bigger Questions
Suppose the fund makes $5 million of investments against an LP’s $10 million commitment – borrowing $5 million on the line – and there’s a financial crisis (or investment simply turns out to be a big loser) and investments decline in value to $2 million. Suppose the line comes due, the fund calls $5 million from the LP with which to repay it, and the LP concludes to NOT put up $5 million to secure investments now worth $2 million. Instead, it defaults on the capital call, potentially limiting the fund’s ability to repay the line and/or make further investments, and thereby possibly harming the remaining LPs (this is an extreme hypothetical)
Increasing use of subscription lines is altering the pattern of drawdowns and distributions. Going years without seeing much capital called could convince an LP that calls have become less likely. Suppose that, in response, rather than set aside capital equal to its commitments, the LP puts it into other investments
This kind of behavior can result in the LP becoming levered
Suppose a financial crisis brings large losses to fund investments in general – if the LP made excess commitments, it could suffer levered losses and be forced to liquidate in a bad market
It’s mostly during crises that weaknesses are exposed, things that are supposed to happen fail to do so, and unanticipated consequences and linkages manifest themselves
The key to financial security – individual or societal – doesn’t lie in counting on things to work in good times or on average. Rather, it consists of figuring out what can go wrong in bad times, and of only doing things that will prove survivable even if they materialize
Howard Marks: Truth About Investing
Great summary of Howard Marks' Presentation: The Truth About Investing
Most investors can’t see the macro future better than anyone else. Thus trying to predict the future won’t make them successful investors.
Nevertheless, most investors act as if they can see the future. Either they think they can, or they think they have to pretend they can. That’s dangerous if it turns out they can’t, as is usually the case.
Once in a while someone receives widespread attention for having made a startlingly accurate forecast. It usually turns out to have been luck and thus can’t be repeated.
One of the main reasons for this is the enormous influence of randomness. Events often fail to materialize as they should. Improbable things happen all the time, and things that are likely fail to happen. Investors who made seemingly logical decisions lose money, and others profit from unforeseeable windfalls. Nothing is more common than investors who were “right for the wrong reason” and vice versa.
Investors would be wise to accept that they can’t see the macro future and restrict themselves to doing things that are within their power. These include gaining insight regarding companies, industries and securities; controlling emotion; and behaving in a contrarian and counter-cyclical manner.
While we can’t see where we’re going, we ought to have a good sense for where we are. It’s possible to enhance investment results by making tactical decisions suited to the market climate. The most important is the choice between aggressiveness and defensiveness. These decisions can be made on the basis of observations regarding current conditions; they don’t require guesswork about the future.
Superior results don’t come from buying high quality assets, but from buying assets – regardless of quality – for less than they’re worth. It’s essential to understand the difference between buying good things and buying things well.
A low purchase price not only creates the potential for gain; it also limits downside risk. The bigger the discount from fair value, the greater the “margin of safety” an investment provides.
Sometimes there are plentiful opportunities for unusual return with less-than-commensurate risk, and sometimes opportunities are few and risky. It’s important to wait patiently for the former. When there’s nothing clever to do, it’s a mistake to try to be clever.
The price of a security at a given point in time reflects the consensus of investors regarding its value. The big gains arise when the consensus turns out to have underestimated reality. To be able to take advantage of such divergences, you have to think in a way that departs from the consensus; you have to think different and better. This goal can be described as “second-level thinking” or “variant perception.”
Superior performance doesn’t come from being right, but from being more right than the consensus. You can be right about something and perform just average if everyone else is right, too. Or you can be wrong and outperform if everyone else is more wrong.
Any time you think you know something others don’t, you should examine the basis for that belief. “Does everyone know that?” “Why should I be privy to exceptional information or insight?” “Am I certain I’m right and everyone else is wrong; mightn’t it be the opposite?” If it’s the result of advice from someone else, you must ask, “Why would anyone give me potentially profitable information?”
Over the last few decades, investors’ timeframes have shrunk. They’ve become obsessed with quarterly returns. In fact, technology now enables them to become distracted by returns on a daily basis, and even minute-by-minute. Thus one way to gain an advantage is by ignoring the “noise” created by the manic swings of others and focusing on the things that matter in the long term.
It isn’t the inability to see the future that cripples most efforts at investment. More often it’s emotion. Investors swing like a pendulum – between greed and fear; euphoria and depression; credulousness and skepticism; and risk tolerance and risk aversion. Usually they swing in the wrong direction, warming to things after they rise and shunning them after they fall.
Most investors behave pro-cyclically, to their own detriment. When economic indicators, corporate earnings and asset prices have been rising, people become more optimistic and buy at cyclical highs. Likewise, their pessimism grows when the reverse is true, causing them to sell (and certainly to not buy) at cyclical lows. It’s essential to act counter-cyclically.
Cyclical ups and downs don’t go on forever. But at the extremes, most investors act as if they will. This is a big part of the reason for bubbles and crashes. 3 stages to a bull market: 1) when a few forward-looking people begin to believe things will get better; 2) when most investors realize improvement is actually underway; 3) when everyone concludes that things can only get better forever
It’s important to practice “contrarian” behavior and do the opposite of what others do at the extremes. For example, the markets are riskiest when there’s a widespread belief that there’s no risk, since this makes investors feel it’s safe to do risky things. Thus we must sell when others are emboldened (and buy when they’re afraid).
The efficient market hypothesis holds that thanks to the combined efforts of thousands of intelligent, informed and motivated investors, the market price of each asset accurately reflects its underlying or intrinsic value. Thus market prices are fair, and if you pay the market price, you can expect to earn a risk-adjusted return that’s fair relative to all other assets – no more and no less. This is the reason for the assertion that “you can’t beat the market.” While not all markets are efficient the concept of market efficiency must not be ignored. In more-developed markets, efficiency reduces the frequency and magnitude of opportunities to out-think the consensus and identify mispricings or “inefficiencies.”
In the search for market inefficiencies, it helps to get to a market early, before it becomes understood, popular and respectable. There’s nothing like playing in an “easy game” – an inefficient asset class – where the other investors are few in number, ill-informed or biased negatively. That’s far easier than trying to be the smartest person in a game that everyone understands and is eager to play.
In investing, the behavior of the participants alters the landscape; this is what George Soros calls “reflexivity.” Thus markets should be expected to become more efficient over time. When investors who bought early show big gains, others will rush in and bid things up. It makes no sense to assume a market that offered bargains in the past will always do so in the future.
To be a successful investor, you have to have a philosophy and process you believe in and can stick to, even under pressure. Since no approach will allow you to profit from all types of opportunities or in all environments, you have to be willing to not participate in everything that goes up, only the things that fit your approach. To be a disciplined investor, you have to be able to stand by and watch as other people make money in things you passed on.
Every investment approach will run into environments for which it is ill-suited. That means even the best of investors will have periods of poor performance. Even if you’re correct in identifying a divergence of popular opinion from eventual reality, it can take a long time for price to converge with value, and it can require something that serves as a catalyst. In order to be able to stick with an approach or decision until it proves out, investors have to be able to weather periods when the results are embarrassing. This can be very difficult.
Those who invest the money of others, rather than their own, have to worry about losing their jobs or their clients. Fear of embarrassing performance can make them excessively risk-averse and cause them to over-diversify and shy away from bold commitments.
To succeed you have to survive, and in particular that means avoiding selling out at market bottoms. It’s not enough to survive “on average”; you have to survive on the worst days. Selling out at the bottom – and thus failing to participate in the subsequent recovery – is the cardinal sin of investing. The ability to persevere requires consistent adherence to a well-thought-out approach; control over emotion; and a portfolio built to withstand declines.
Risk is an inescapable part of investing. You shouldn’t expect to make money without bearing risk. Any approach, strategy or investment that promises substantial gain without risk is simply too good to be true.
But you also shouldn’t expect to make money just for bearing risk. Many people believe riskier investments produce higher returns, and thus the way to make more money is to take more risk. That can’t be right.
There’s a very popular graphic that purports to show the relationship between risk and return:
risk return
Most people interpret it to mean “riskier assets produce higher returns” or “the way to make more money is to take more risk.” These are traps into which most investors fall, especially in times when things are going well and risk taking is being rewarded. It’s true that investments that seem riskier must appear to offer higher returns in order to attract capital. But if risky investments could be counted on to produce high returns, they wouldn’t be risky.
risk return 2
As risk increases, the expected return rises; the range of possible outcomes becomes wider; and the worst outcome worsens and ultimately becomes negative. This is the way to think about the risk/return relationship.
Controlling risk is just as important as identifying opportunities for return. For most people a desirable approach strikes a balance between offense and defense.
Risk has to be dealt with, but not through quantification. Theory accepts volatility as the indicator of risk, largely because data on volatility is quantitative and machinable. But people in the real world don’t worry about volatility or demand a premium return to bear it; what they care about is the likelihood of losing money. Because that likelihood can’t be quantified, risk is best handled by experienced experts applying subjective, qualitative judgment that is superior.
Investing can’t be reduced to an algorithm or a mechanical process. Few people have demonstrated the ability to excel for long via “quant” investing. Superior results generally require insight, judgment and intuition.
To ascertain whether a manager has above average skill, it’s essential to observe performance over many years and in bad markets as well as good. Short-term outperformance and short-term underperformance are “impostors” that say very little about the skill of a manager. Randomness can cause a weak manager to show good performance for a year or two, but good long-term records are likely to be the result of skill. Absent testing in tough times, aggressive risk-taking in an environment that turns out to be salutary can easily be mistaken for investment skill.
In order to deserve “incentive fees” – a share of the profits – managers have to be truly exceptional. Exceptional managers are the exception, not the rule.
Good results will bring a manager more money to manage. If inflows are allowed to go unchecked, eventually more money will bring bad performance. Increased assets under management can shorten the list of potential investments large enough to make an impact; erode a manager’s ability to be selective and agile; and encourage “style drift,” under which a manager strays into strategies beyond his core competence in an effort to put money to work.
Not everyone can beat the market averages. By definition, the average investor does average (before fees and transaction costs).
Expenses play a crucial part in determining the success of an investment program. Whatever the gross results, management fees and transaction costs will subtract from them. After expenses, then, the average investor lags the market averages.
By investing passively in a low-cost “index fund” that mirrors a market average, you can be sure to capture the return of the average. People err, however, when they think of such funds as being low-risk. Index funds eliminate the risk of underperforming the market average, but not the risk inherent in the average itself.
Expectations should be reasonable. Aiming for too high a return will either require excessive risk bearing or guarantee disappointment … or both.
No one should expect investing to be easy.
Positioning for Trump Presidency: Summary of David Einhorn's 4Q16 Letter: Positioning for Trump Presidency
- In light of Trump presidency, thoughts on current positioning:
- Long a variety of low-multiple, tax-paying, US value stocks: most benefit to companies that have profits on which to pay taxes (AMERCO, CC, Dillard’s, and DSW)
- Long AAPL: to benefit from repatriation of foreign cash and tax reform
- Long GM: more jobs, higher income, and higher wages to drive demand for consumer durables; also falls under low-multiple, tax-paying US value stock category
- Short “bubble baskets”: mostly don’t have profits (no tax benefits) and accelerating economy should allow investors to find growth without needing to pay nosebleed prices for a narrow group of profitless top-line growth stocks (Netflix)
- Short oil frackers: economies still don’t work when all investment and corporate costs are taken into account; “drill-baby-drill” attitude is likely to lead to additional mal-investment which will lead to lower prices and deeper losses; generally not cash tax payers
- Short CAT (and a few other similar industrial cyclicals that have moved much higher post-election): CAT sells machines that are used in infrastructure but this is only a small part; CAT’s biggest segments are mining and energy; just completed once-in-a-generation boom in iron ore mine development and horizontal drilling which means we can produce more oil with fewer rigs; even in infrastructure boom, CAT closed the year at 33x forward earnings
- Continue to own gold; there has been a knee-jerk decline in gold since the election, as investors presume that higher short-term rates are good for the dollar and bad for gold; great economic, geopolitical, and policy uncertainties, wider budget deficits, and possibility of inflation problem all support gold
Great summary of activist letter sent to EQT Board to merge with Range Resources...
https://investoralmanac.com/2017/01/05/activist-pushes-eqt-on-a-merger-with-antero-or-range/