“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” –Benjamin Graham
Consuming financial news has become a game of juggling conflicting spin. One media outlet throws up the headline “Apple reports record quarter” while another simultaneously reports “Shares of Apple are tumbling after iPhone disappointment”. Which is it – “An industrial recession is engulfing America”, or “US auto sales set record”? It is no wonder that the whiplash of conflicting news feeds massive volatility in stock markets.
How can investors achieve clarity amid all this chaos and confusion?
Value investing provides a time-tested remedy. Always remember that stocks are not just ticker symbols floating on a TV screen. Shares represent ownership interests in real companies, real businesses. By studying a company’s assets, profits, and growth prospects, we can calculate the true intrinsic value of the stock. When news-driven volatility creates a big gap between a stock’s price and its intrinsic value, value investors exploit the opportunity, not succumb to fear. (For less-active investors, a dollar-cost averaging strategy can create a similar benefit.)
Benjamin Graham, the great teacher and father of value investing, provided a wonderful analogy in the above quote. Over a long-enough time horizon (typically 2-3 years, though sometimes longer) the substance of a business shines through, and a stock rises to its intrinsic value.
How does this happen? Well, sometimes the market gradually comes to its senses on its own. In a short-term oriented world, the Value Investor’s long-term mindset is a key competitive advantage.
In our Partnership, we have certainly benefited from steady, wide-moat companies that compounded capital over many years. But we also acknowledge the importance of catalysts – operational, financial or macro events that help unlock the value of the business and cause the stock price to rise dramatically. Most of our successful investments over the last 8 years have resulted from one or more of these catalysts. Let’s take a look at each of these catalyst categories.
Operational catalysts involve capable managers rolling up their sleeves and improving their businesses. Given our business consulting experience, these catalysts are near and dear to us. Our Partnership’s very first investment, Hershey Candy, was based on our investigation of the company’s manufacturing and logistics transformation program. The market gave Hershey’s little credit for the expected savings. We assessed that the cost reductions were actually highly credible and would help fund an increase in its marketing budget. The realization of these savings, combined with the company’s more robust marketing strategy and price increases ahead of inflation, led to a double in its share price over a few years.
Companies that have credible operational catalysts can significantly enhance intrinsic value over time. Specifically, we anticipate some combination of the following three operational drivers for our portfolio companies:
Grow Sales: an increase in prices or sales volumes of new or existing offerings
Cut Costs: a reduction in COGS, SG&A or interest costs
KMF Advice: an improvement in capital allocation or communication strategies based on our counsel
These operational catalysts often form the core of an investment thesis. As in the example above for Hershey’s Candy, the market often misprices the operational skills even of strong management teams. We have become more active in engaging management teams, especially of our small-cap holdings. Our investment process filters out companies lacking good managers, or poorly aligned managers. That’s why we find that top executives (CEO and CFO) of our portfolio companies are quite open to our collaborative, friendly advice. In addition to business strategy, our advice tends to include helping portfolio companies with better communicating their value to shareholders, and improving their capital allocation practices to become more shareholder-friendly.
Let’s turn to the second catalyst category. Financial catalysts are actions a company takes on its capital structure to unlock value. Past successes include Apple, whose shares rose 80% over a few months after the company launched investor-friendly share repurchases and dividends. For small cap companies, a common catalyst has been a sale of the entire business at huge premiums (often nearly double) the prevailing price. Examples from our Partnership’s experience include Shaw Group, Bronco Drilling, Parlux Fragrances, and – most recently — ADT.
Many of you are probably familiar with ADT, the home security and monitoring company. While this market is highly fragmented, ADT has the dominant share in North America. The company has also been deploying new capabilities into their traditional security suite including real-time video and smartphone integration. The management team has also extended their core offering to include healthcare monitoring services for seniors and commercial offerings for small and medium business. When ADT was spun out of its parent company in 2012, it quickly went on our list of great businesses to buy if we ever got a bargain price in the market.
Fortunately, the shares fell meaningfully in the spring of 2014 after the company pulled back on its stock repurchase program to focus on developing new products and the short-term quarterly performance disappointed. Nothing was wrong with the core business, in fact, it appeared to us that management was doing all the right things to drive long-term success for the business. With the stock below $30 per share, we bought greedily believing the Private Market Value for this business was nearly twice that.
How did we come up with these bookends? At less than $30 per share, ADT was priced as if it would never grow its earnings. This seemed extremely conservative given the improvements in the service offering were leading to higher pricing, a series of cost cutting initiatives were boosting profits, and ADT’s brand could be a platform for further industry consolidation. With these considerations in mind, it was not hard to see that ADT’s true business value was likely worth $50+ per share.
After our initial purchases, the market seemed to catch onto our perspective. The rest of 2014 and early 2015 witnessed pretty strong gains in the stock as management continued to execute against its plans.
But, as the markets began to sour in late 2015 and early 2016, ADT’s stock price tumbled again. Wefound this odd since the company was actually performing better than it had been when we first bought it. So, with the market giving us another opportunity to buy more at even better prices, we added to our position.
Apparently, we were not the only ones to recognize the bargain. A few weeks later, the private equity firm Apollo Asset Management announced a bid to take the company private for $42/share, a healthy 55% premium to its price. While this buyout price provides an excellent profit to our Partnership, we believe this is a win-win deal since Apollo will likely realize further benefits by accelerating ADT’s turnaround.
Given our Partners know we may hold a position for 3-5 years to realize the full value of our investments, getting much of those gains in less than 2 years was a fine outcome. We were happy to let this catalyst help monetize our value so we could redeploy the proceeds into other bargains the market was offering us.
The ADT buyout was just another reminder that a stock should be viewed as a fractional ownership interest in a real business. By understanding the business, its industry, its competitors, and its management’s tendencies we can then begin analyzing the company’s assets, cash-generating power, and growth prospects. With this in hand, we can calculate the company’s intrinsic value, the true worth of the stock.
Looking ahead, we see three specific financial catalysts that will impact our portfolio companies:
Buybacks: the repurchase of undervalued shares or bonds by company management
Asset Sales: a strategic sale or disposition of undervalued or unrecognized assets
Debt Placement: the sale of new debt to fund initiatives that reduce costs or grow sales
Each of these will either enhance the value of the companies we own over time or help accelerate the convergence of today’s market price with our estimate of the business’ intrinsic value per share.
Moving on, Macro catalysts are economic trends that influence a company. We have conviction that spendthrift governments and aggressive central banks will ultimately stoke inflation, and have positioned the portfolio to benefit handsomely from this. In the 2008-2012 time period, we invested with a similar thesis specifically in Japanese Real-Estate Investment Trusts (REITs) as it became clear Japanese central bankers were committed to combating deflation by turning on the printing presses of “quantitative easing”. The recovery of Japan’s real estate market from a long deflationary slump resulted in large gains in the stock prices of Japanese REITs we held patiently in the portfolio for several years. While the recent collapse in commodity prices has generated deflationary pressures around the world, we believe the combination of an eventual commodity price recovery and the cocktail of easy central bank policies will stoke inflation in the U.S. as well.
Global markets have been powerfully influenced by macro-economic forces. In the last few years, these have included an implosion in commodity prices, abnormally low interest rates, and a very strong U.S. dollar. Most Value Investors rightly focus on micro-economic factors. But even strict “bottoms-up” investors will need to factor in such extreme macroeconomic conditions into their investment assumptions and scenarios.
A recent history of interest rates reveals today’s rate environment (represented by a chart of the 10-year U.S. Treasury in the chart above) has been manipulated to an all-time extreme. While rates have fluctuated greatly over the past 60 years, the long term trend for short term rates has been between 4-6%.How many of you remember buying a 1- or 2-year CD that yielded 5%? It used to be a common experience. Not so much anymore.
No, in an effort to shore up the big banks and stimulate the economy after the financial crisis, the Federal Reserve has suppressed interest rates to near 0% for the last 7 years. There is a lot of banter as to what will happen when rates fully normalize. If the Federal Reserve Governors can manage the reversion back to the long-term trend without losing control, then all will be wine and roses. But we have spent a lot of time positioning the portfolio for a potential outcome that does not work out as well – namely that rates rise faster than folks can imagine and inflation eats away at savings, pensions and fixed incomes in a way that few can fathom.
In addition to the extreme lows in interest rates, currency exchange rates present another set of extremes. The last two years have also seen the value of the U.S. Dollar rise dramatically even past the “flight to safety” levels seen during the financial crisis when everyone sold everything and bought dollars to park their cash.
As illustrated in the figure above, there is a long-term inverse correlation between the Dollar and hard asset prices. As the Dollar goes up, commodity prices tend to go down, and vice versa. If the Dollar Index returned to levels closer to the range seen over the past 10 years, this would be a strong catalyst for hard asset prices.
So there are a number of extremes currently in the market place – low interest rates, dollar strength and hard asset price weakness. As long-term contrarians, we find it often works out well to exploit market extremes with investments that benefit when the extreme normalizes.
Therefore, we have positioned our portfolio to benefit from three specific macro catalysts over the
Rising Prices: an increase in commodity, real estate and shipping price levels
Weaker Dollar: a decline in the dollar versus other major foreign currencies
Rising Rates: an increase in U.S. interest rates back towards historical average levels
The news cycle has churned up huge volatility in the last few months. Yet at the same time, we are very pleased to see many of our portfolio holdings achieving our anticipated catalysts. As earnings reports trickle in, the share prices for several companies in our portfolio have reacted positively to one or more of the catalysts above. While we keep our eyes steadfast on the long-term, these catalysts are pleasing indicators of progress that help us keep our eyes on the prize. We encourage all investors to do the same.
Jonathon Fite co-authored this article.
Arvind Mallik and Jonathon Fite are the Managing Partners of KMF Investments, a Texas-based pure payfor- performance hedge fund. Jonathon is also an adjunct professor with the College of Business at the University of North Texas. This column is provided for general interest only and should not be construed as a solicitation or as personal investment advice. Comments may be sent to [email protected].