Cognitive Dissonance Revisited

Chuck Akre’s firm lives inside my head. “The Art of (Not) Selling” is causing soul searching, confusion, and even a bit of anger. That anger is self directed.

For the longest time I searched for The Answer. Immersed in “value investing” books, praying to the alter of Buffett and Graham, and searching for The Formula. Here’s the problem: The Formula doesn’t exist. Only models and theories.

The past year was a good one for SCG. Given some of our large holdings, it’s remarkable that we kept pace with the index. That said, our performance was catapulted by a large position in Charter Communications, which is not a “value investment” as defined by deciles of valuation. Other meaningful contributors to performance included Apple, Netflix, and J.W. Nordstrom. Our portfolio continues to own J.W. Nordstrom and Charter as of this writing.

Going forward, the portfolio will look different from last year’s portfolio. Much of the change is attributable to our firing of a manager, which brought a substantial percentage of the portfolio “in house.” The decision to part with our previous manager was not easy, but it was the right decision. From hereafter, we completely eat what we kill.

Our strategy is to accumulate minority interests, in businesses we understand, at values that make the risk of permanent capital impairment minimal. As stated before, in the past year, the portfolio benefited from churn. Unfortunately, your manager is concerned he “learned” the wrong lessons.

Focusing on entry price has been a worthwhile pursuit. However, would it not have been better to be invested in quality companies with long runways? Sure, the entry multiples would have been higher, but the tax drag on the portfolio would be lower and we’d still own the businesses. See Charter as an example of a business that wouldn’t screen cheap but almost certainly was when we acquired our interest.

One could reasonably argue that worrying about not focusing enough on terminal values is a great “late cycle” indicator. Maybe, but also maybe not. Two quotes come to mind (thank you to @tsoh_investing on Twitter):

  • “The role of financial markets is to take money away from mediocre and underperforming companies and put it in stable, growing, high return on capital companies. Money has an almost metaphysical attraction to places where it is put to careful, good use. You can fight that trend, and invest in companies, for instance that are deeply undervalued and mismanaged – and some people are successful investing in the dregs – but very few over the long term. To use a whitewater kayaking analogy, freshwater seeks saltwater, and you can fight that if you want, but paddling upstream eventually is likely to become highly problematic.” https://microcapclub.com/2015/05/i-passed-on-berkshire-hathaway-at-97-per-share/
  • “Generally speaking, I think if you’re sure enough about a business being wonderful, it’s more important to be certain about the business being a wonderful business than it is to be certain that the price is not 10% too high … That’s a philosophy that I came slowly to. I originally was incredibly price conscious. We used to have prayer meetings before we would raise our bid an eighth. But that was a mistake. And in some cases, a huge mistake. I mean, we’ve missed things because of that.” – Warren Buffett, 1997 Shareholder Meeting, Morning Session.

In defense of our strategy, with the exception of Wells Fargo, I think it’s hard to argue our holdings are “poorly managed.” Facebook is one that many would argue should fall into that category. Personally, I might agree. However, that is a judgment call and, to the extent possible, we will invest based on fundamental truths. One of those fundamental truths is Zuckerberg built one of the biggest social networks ever and acquired two more. Thus, management is at least acceptable.

The current contemplation of whether our focus on entry price is misguided stems from a different framing of math. On one hand, it is very hard to lose when you are purchasing a $1.00 for $0.50. However, it’s also very hard to win big and IRRs will depend on how quickly the market realizes that $1.00.

On the other hand, investing is one of the few games where winners can run for a very, very long time. Importantly, strong organizations attract strong people. Those strong people tend to win. Consequently, while there is momentum in stock prices there is also business momentum. Thus, $1.00 can turn into $5.00 over time. Has a focus on entry price undervalued the momentum benefiting truly great organizations? Perhaps. To not at least contemplate that question is to remain stupid. We will not do that.

To be clear, we own our perception of good businesses. Each serves an important function in its customer’s lives. Many of these businesses are mature and cannibalizing shares. Therefore, on a per share basis, we are quite comfortable with our existing portfolio’s growth rate. Moreover, the portfolio is reasonably priced. As of this writing the Top 10 holdings, accounting for 64% of the portfolio are as follows:

Note: The weighting of the positions in this year’s portfolio are materially different from last year’s. As stated above, this is the result of firing a manager and merging the portfolios. Going forward, all major accounts are consolidated and further large changes are not anticipated.

Of the businesses listed above, Phillip Morris (PM) appears to be the one at greatest risk of deterioration. That said, we own the company because it sells an addictive product, has room to take prices, and is a low cost producer. Longer term, it’s plausible that PM acquires other cigarette makers (it recently tried to acquire Altria) and the volume deterioration is slower than anticipated. Phillip Morris rhymes with AB InBev (now a smaller position due to portfolio consolidation) because both entities have dominant positions, are suffering from volume declines, and benefit from raising prices.

Going forward, SCG will probably own fewer of these types of businesses and look to own businesses that are growing volumes as well. Mr. Akre makes a compelling case that it’s better to own a business that can grow its way out of a period of overvaluation. I will put more energy and focus into finding those situations.

Thank you for your continued trust. I commit to taking fewer actions in the future and finding greater long term, durable, investments. For now, our results have been satisfactory. Thus, expect at least some of the same behaviors to recur.

Realized vs. Theoretical Gains

There’s a big difference between a company I am researching and one I have actual money on the line with. Perhaps I am flawed and need to intensify my emotional state when I research. But, I think the more likely explanation is real money intensifies the analysis/emotion. It’s one thing to see a historical operational hiccup, subsequent recovery, and determine “I can live through that.” It’s quite another to live through the hiccup and wonder whether the recovery will happen.

Similarly, it’s quite easy to say “This company is way too cheap!” I strongly believed Nordstom, Inc. was too cheap in August when the stock sold off in conjunction with Macy’s results. So I bought.

But here’s the problem: Nordstom faces structural headwinds, may or may not be innovative enough to grow its business long term, and has a lot of fixed costs embedded in the business. Therefore, if things unravel at Nordstrom they could unravel quickly.

So, why did I buy? I bought because I discussed the brand with a group of women who provided me with some comfort about Nordstrom’s brand equity. Moreover, I pay enough attention to retail to know the management team is attempting to transition the company to a modern retailer (unlike Macy’s). Further, I interviewed employees that told me the culture at Nordstrom is the best in the industry. Finally, the Nordstrom family (a) owns a large block of stock, (b) tried to take it private two years ago at near 2x my purchase price, and (c) committed to returning ~$5Bn to shareholders over the next 5 years (vs. a ~$3.9Bn mkt. cap at the time). Note – Family is italicized above because I think there’s a lot more pride on the line when the store bears the name of major shareholders than there is in most situations.

The “opportunity” presented itself because Nordstrom has not executed well over the last 3 quarters. I believe Blake Nordstrom’s death (Blake was a Nordstrom family member, co-President, and largely responsible for running Nordstrom Rack) was a very difficult event for the family/organization and sometimes life gets in the way of optimal business performance. Part of my belief stems from reading about Blake. Moreover, when I spoke to investor relations the woman I spoke to choked up a bit when I offered my condolences. Given everything above, I believe the market sees a potentially broken business with headwinds and I see a business that is facing headwinds but isn’t broken (though the business quality is clearly deteriorating from what it once was).

Despite the risks, I made the bet and was ready to collect dividends, watch share repurchases reduce the dividend obligation, and collect subsequent increased dividends (dividends per share would increase as shares outstanding decreased assuming the dividend payout remained the same). I “knew” the risks I took/am taking. I understand there is a path to failure in this investment. But, at the price I purchased the equity I thought the market was emphasizing the failure potential too much and missing a lot of the good the entity has going for it.

Shortly thereafter, the stock increased almost 40%. At that point, the decision to hold became a bit more difficult. The risk of failure also felt more acute because now Mr. Market was pricing in a more rosy scenario. Importantly, risks that lived on a spreadsheet or in a writeup now actually presented potential loss of real money and the odds had changed. At this valuation, the proposed share repurchases don’t accomplish as much. Moreover, the business risks haven’t changed. That said, if Nordstrom can accomplish their goals there is still quite a bit of value in the entity. Therefore, I decided to sell half my position to reduce some portfolio risk (Nordstrom was a ~5% portfolio weight at cost).

On the other hand, my second largest position (13% current portfolio weight) is in cable companies (Charter and Comcast). These have meaningfully appreciated. However, I haven’t even considered selling either because I fundamentally believe in owning broadband infrastructure for the long term. Thus, it would take a pretty egregious price to have me sell either position at this point. NOTE – I am not saying to buy cable company stocks right now! Nothing here is investment advice.

So, while a spreadsheet may produce similar IRRs for those two investments, the experience of owning the assets is quite different. The obvious response to what I am writing is “Retail investors should require a higher IRR to enter positions than cable company investors since there is less business risk in a cable company.” First, I agree. But more importantly, the right behavior/stomach is necessary to realize the theoretical IRR. And, that behavior can be difficult to handicap until the asset resides in an investor’s portfolio.

Generally speaking, I’ve found assets purchased because of valuation are much more difficult to hold because there is usually some element of business risk attached to them. Consequently, my focus has morphed to higher quality businesses trading at reasonable prices. However, I can’t help but look at my perception of mispriced assets. After all, I am trying to buy more value than I am paying for.

That said, the real gains are made from holding. And holding business risk is a lot tougher than it looks on a spreadsheet. Which is probably why the opportunity exists for those that are (a) right and (b) selective on price.

Recommended Reading

https://www.nytimes.com/2019/10/23/style/nordstrom-family-department-stores.html

Know What You Own

Andrew Rangeley recently wrote about sharing his investment ideas. The full post can be found at http://yetanothervalueblog.com/2019/07/some-things-and-ideas-july-2019.html. In the post, Andrew wrote “…the longer I invest, the more I think the most important part of this job / doing the work around this job is developing the conviction to hold an investment thesis.” I couldn’t agree more.

When I started investing I would look at what other people were doing and try to back into why they owned what they owned. I still think that’s a useful, and interesting, exercise. However, you must make sure you don’t rely on the conclusion of the person you are researching. Instead, research the idea in order to determine whether that particular asset is right for your portfolio.

The world has many potential outcomes. Unless you know why you own a position how will you know when to sell? Which path of outcomes bothers you and which paths are you OK with? I guess you can follow some famous investor’s SEC filings and sell when they sell. But, if you implement that strategy I would strongly advise against checking stock prices in between filings.

What happens if you follow your favorite blogger/Twitter account into a position? How will you know if they’ve changed their minds? You probably won’t. And they probably won’t think to tell you when they exit. You have to know what you own and why.

A recent example from this blog is Ryanair (RYAAY). I highlighted RYAAY as an interesting investment idea on May 22, 2019. As a quick aside, this is a good time to remind everyone reading this post that nothing here is investment advice. Anything SCG writes about is meant to highlight interesting things to research and/or look into for learning purposes only.

Anyway, the stock traded at ~$68/sh when we wrote about it. A mere 3 months later the stock traded at ~$57/sh. A 17% “loss” in 3 months (aka -68% annualized return). Impeccable market timing! Was I concerned? Not even a little. Would I have been concerned if I followed someone else into the position? Heck yes! SCG probably would have sold.

Furthermore, I worry that someone may have followed us into the position and sold at the wrong time. I implore anyone reading this not to buy anything I write about. If it interests you then please do your own research. Develop your own conviction so you know when to worry and when not to. Otherwise, you’re just donating money to people that did their work.

Unexpected Lessons

This site’s goal is to become a resource for people interested in investments. Therefore, almost all posts will be investment specific. However, there are exceptions to the rule. Arnold Van Den Berg’s life lessons are one of those exceptions.

Last week I attended an investment event organized by MOI Global. I enjoy those events because the community of investors is a truly amazing group of people. Therefore, I was intrigued when I saw a group of people gathered around a table at a cocktail hour. I figured some investing legend was waxing poetic about the merits of his/her investments. Naturally, I went to the table.

When I got to the table I saw Arnold Van Den Berg. I liked Mr. Van Den Berg’s talk at Google so I was excited to hear what he had to say. I was mesmorized the minute I sat down.

Mr. Van Den Berg was telling stories about his parents surviving Auschwitz. The most memorable story described his father surviving death marches. A death march was a 24 hour hike through deep snow. The participants had “normal” clothes on. If someone’s knee touched the snow, the Nazis beat them. If the person didn’t get up, the Nazis killed them.

Mr. Van Den Berg said his dad survived by focusing on locking his knee the second his foot touched the ground. Why? Because that was the only way to:

  • keep his knee high enough out of the snow, and
  • support his body weight given how depleted his body was.

His father attributed his survival on his ability to singularly focus on that task. His ability to focus was driven by his will to survive. And, his will to survive existed because of his family. Regardless of his circumstances, he focused on his wife and children.

Throughout his time at Auschwitz Mr. Van Den Berg’s father would see young, able bodied men come into the camp. Almost all of them withered away within 6 months. Arnold’s father said many of them lost the will to live because they didn’t have a larger purpose. Once they lost the will to live, death was inevitable.

I tried to absorb everything I could from Mr. Van Den Berg. Some lessons include:

  • When your life is more important than your principles, you sacrifice your principles. When your principles are more important than your life, you sacrifice your life. Mr. Van Den Berg is alive today because a young woman valued her principles enough to risk her life in order to smuggle him out of Amsterdam.
  • Never underestimate the power of the subconscious mind.
  • Focus is key to success.
  • Never give up. Whatever failure brought you to the point where you’re considering giving up also took you closer to success.
  • In order to be successful you must:
    • (a) be totally honest with yourself,
    • (b) repeat the actions necessary to become who you want to be,
    • (c) do good (the universe rewards those that legitimately add value),
    • (d) believe in yourself and your life direction.

Some of this advice may sound like self help BS. But, it’s coming from a man that grew up with a father and mother that survived the Holocaust. Moreover, he survived being in an orphanage while his parents were in Auschwitz. He lost 39 family members over that period. Therefore, I think his perspective on life is one worth taking seriously.

This post isn’t going to help anyone outperform the market. It won’t bring anyone back from sizing a position too big or making some analytical mistake. But, hopefully it keeps the world in perspective and helps someone realize how lucky they are. There’s a lot to be grateful for. Take a moment, remember that, call your loved ones, then get back to trying to outperform.

Recommended Reading/Viewing:

Mr. Van Den Berg at Google

https://www.barnesandnoble.com/w/think-and-grow-rich-napoleon-hill/1116671906#/

https://www.barnesandnoble.com/w/mans-search-for-meaning-with-new-foreward-viktor-e-frankl/1028813627#/ – Haven’t read this but @jerrycap recommended it and his book choices are pretty solid.

FB, AAPL, GOOG – SHAME

The spirit of Henry Singleton cried a little this earnings season. If you don’t know who he is see https://25iq.com/2014/11/08/a-dozen-things-ive-learned-from-henry-singleton-about-value-investing-venture-capital/. In short, he was one of the best capital allocators of all time. He issued shares when Mr. Market loved his company and bought them back when Mr. Market didn’t like his company. Dr. Singleton didn’t care about Mr. Market’s opinion. He used Mr. Market to his advantage.

Today, corporate share buybacks are all over the news. On December 21, 2018 Barron’s ran an article about corporate buybacks setting a record in 2018. https://www.barrons.com/articles/2018-record-stock-buybacks-51545361596. This excerpt was particularly exciting for long term oriented investors:

Why? Because in December there was carnage in the market. Everyone was selling everything indiscriminately. The selling offered up some very interesting opportunities in certain companies. That’s when management teams should pounce.

So what did Facebook, Apple, and Google all do with their cash hoards at that time? Nothing. At least nothing meaningful. And that is a disgraceful outcome given the amount of talent that is at these companies. In retrospect, it’s pretty clear that December was not a fundamentally driven sell off. It was fear based (though Apple actually had a meaningful slowdown in China).

Moreover, these companies had internal data that showed they were healthy. The CFOs knew the businesses were not deteriorating like the stock price. That is the exact time a corporate finance department should increase their buying activity. Especially in a cash generative company! Instead, they sat on their hands.

And that lack of action demonstrates why corporations, in aggregate, are not very good at share repurchases. Corporate buybacks decrease share count and shares historically tend to increase in price. So, for the long term investor buybacks at most prices are better than nothing. But, buybacks have immense potential power and even today’s best companies don’t understand how (or are too scared) to use them properly.

In the interest of disclosure, SCG reduced its cash position from 33% in October to just under 20% by the end of December. This isn’t a promotional statement. In fact, it’s way too early to determine whether that was the right long term decision. But, why in the world were the best companies not meaningfully deploying capital when SCG was? The answer lies in the institutional imperative. And that is a sad realization considering who those companies supposedly employ.