Consistently generating strong returns from the share market is difficult. Cognitive biases lead us to believe that we are “above average” investors. The reality is that returns generated by the majority of even “experienced” investors are modest. Invariably a small minority outperforms the rest, and by a significant amount.
The odds are stacked against the average investor, and in no small part due to the overconfidence that seems endemic to share markets. It is practically impossible to properly digest and apply all available information in share prices. In truth, for most investors it is in large part luck that plays a significant role in them coming up with investment ideas and seeing things turn out as expected.
In the long run, I believe it is how an investor understands and manages risk that determines how well he or she does in generating consistent results.
In this note I discuss a framework that can help skew the odds back in your favour.
Although we’re “value investors”, our investments are not, nor should they be, based purely on valuation. Value is just one of the determinants of investment outcomes that could be collectively termed “redundancies” to denote an excess capacity or capability to protect against or take advantage of future events, good or bad. Broadly speaking, the redundancies that can improve your investing odds include:
– Balance sheet flexibility owing to very low or no gearing
– Skillful management that act in the interests of all shareholders
– ‘Best of breed’ business operations
– Capacity for sales growth, and (last but not least)
– Discount to intrinsic value
Together, and to varying degrees, these factors will interact to determine your success, so it is a good idea to select investments with in-built redundancy in each. In other words, an ideal investment is a company with access to more cash than it needs, a more than capable manager who can exploit opportunities, above average operations in an industry with room for the company to expand (via industry growth and/or market share), and a share price below a conservatively derived intrinsic value.
Remember, the share market is risky, but to a great extent you are controlling your risk.
Intrinsic value is subjective and therefore the most difficult to determine, though redundancy is this respect lies in the conservatism of cashflow forecasts. On this point I should highlight that sell side analyst forecasts tend to be inherently overly-optimistic. The following chart by the RBA illustrates this as a long series of mostly downward-sloping earnings revisions. I find there’s also a tendency among analysts to put less emphasis on risks than forecasting, which is understandable because they don’t manage money. Credibility aside, they don’t lose when things turn out worse than expected.
Figure 1. MSCI Australia Forecast Earnings Per Share
Source. Thomson Reuters
Returning to the five factors, what can undo an otherwise well-conceived investment is when a lack of capacity in one of them is ignored. For example, highly-leveraged yet well-managed, fast growing and ostensibly inexpensive businesses should do very well in the absence of any ‘speed bumps’. But in a downturn high debt levels will often weigh heavily on outcomes. The GFC was challenging across the board, but it compounded the downside of many good-but-leveraged businesses. A mirroring scenario is when a poor capital allocator destroys the potential of what, on other fronts, appeared to be an attractive investment.
The point is these factors can effectively cancel each other out in ways that can’t be adequately accounted for in discount rates or cashflow forecasts, hence why a sound selection framework naturally extends beyond valuation. Some people use checklists or scoring systems to restrict potential investments to a certain criteria. In the same vein and perhaps due to my engineering background, I find it useful to conceptualise investments as a system, and key elements that determine payoffs in terms of redundancies.
HFA’s Holdings is a good case study. HFA is the parent of Lighthouse Investment Partners, a US long-short multi-strategy hedge fund manager.
Despite navigating the GFC relatively well in terms of fund performance HFA’s share price collapsed due to capital flight across the industry and strong concerns around HFA’s stretched balance sheet at the time. In 2009 net debt was $100m and net debt to equity was 144%.
Within 12 months of acquiring Lighthouse for a total consideration of US$~700m the company wrote down A$600m of intangibles, mostly goodwill, and reported a US$570m loss for 2009.
However, Light House’s steady returns at low volatility attracted solid inflows in the years following, and Assets Under Management and Advice (AUMA) recovered from a low of US$5bn in 2008 US$8.5bn now.
Throughout HFA remained highly cash generative and increased operating cash flows from US$12m in 2012 to almost US$30m now on the higher AUMA.
Figure 2. HFA Reported Earnings and Cash from Operating Activities
Source. Company reports
Meanwhile the company gradually paid down its debt from internal cash flows and (eventually) put its balance sheet in a net cash position.
Figure 3. HFA Net Cash Position
Source. Company reports
It now has $US27m cash and no debt. This can fund growth investments and/or capital management, both of which could be highly value accretive. While definitely strengthening, in our view the share price hasn’t caught up to its much-improved position.
Ultimately stock picking is an exercise in identifying asymmetries. If the downside is protected against permanent capital loss, discounts to value can deliver outstanding results even in absence of any significant positive catalysts. While such opportunities are rare, your odds of finding them are markedly improved by looking in those parts of the market where inefficiency reigns, such as the under-researched small cap (sub $500m market cap) segments or in sold-off, out of favour industries.
To clarify, I’m not advocating restricting your universe by category. All companies in all market segments are potential candidates for investment. I believe that the likelihood of finding good ideas is higher when there is less competition among investors and structurally this is in smaller companies. Although this year we have seen increasing investor demand for quality mid and small caps due to the lack of growth in the top end, we don’t see the small cap universe falling into the same ‘risk equals reward’ paradigm the top end seems locked in. We believe the structural inefficiencies are very likely to persist because large fund managers, which support sell-side reseach operations, are challenged by lower levels of liquidity.
For this reason individuals and smaller investors have a better chance of finding an edge in the small caps. I recently came across an inisghtful video of Warren Buffett responding to a member from his audience who asked how he would invest if he had $10m. He said he would certainly be inclined to look among classic ‘Graham’ stocks – those trading at low ratios of enterprise value (market cap plus debt less cash) to free cash flow or those trading below working capital (asset plays) – and “would do far greater percentage-wise if I were working with small sums”. To me this highlights that there are far more opportunities to make a meaningful difference to your portfolio in those market segments with structurally less competition.