The Negative Art of Investing

If your family is anything like mine, there will be a ping-pong tournament over the holidays.  Here is how to win….and these ideas may (or may not) apply to investing.

First, don’t try to spin the ball.  Second, don’t try to hit the corners and finally, the ball getting over the net with only 1cm to spare is not the goal….

We all probably have that uncle or nephew, who thinks they are going to hit each and every corner following their dramatic gravity-defying spin serve.  Additionally, this person will repeatedly attempt to perform a volleyball-esque spike each time the ball bounces slightly higher than normal.

Instead, just hit the ball back over the net in the middle of the board, over and over…and viola, you will probably win a lot of the games, maybe even the elusive Sugar Bowl that the matriarch of the family has promised the victor.

Ping pong is mainly a game of not losing.  Tennis calls it unforced errors.  Investors call it capital loss.  This sounds simple and logical, but the moment you step up to the ping pong table, you will probably look to copy your uncle who is spinning the ball and aiming for the corners….and you will lose.

If I were to write a 10 chapter book on investing, the first 9 would include a discussion of things not to do.  This is not sexy, but it is probably better advice than the next 50 books chalked full of things you should do to invest.  

I really believe this, and if I wrote only what I wanted, I would probably write 100:1 ratio of things not to do vs. things to do (John encourages me to be more positive).

First, let’s start with something easy: comparables.  The deplorable comparables.  This is a mainstay of the financial world.  There was probably a father long ago who explained to his son that the son’s future wife (in an arranged marriage) would be “comparable” to the woman the son actually wanted to marry.  This young man’s disappointment, upon meeting his betrothed,  has continued down through the ages.

Why are comparables bad?

Let’s pick an industry, say generic pharmaceuticals.  A modern day investor will pull up a list of the 15 companies within this category on his or her Bloomberg terminal, check briefly on the LTM (last twelve months) Ebitda (or some other earnings measure) and compare where Valeant is “trading” to Teva’s valuation.  Valeant might be a 12x Ebitda and Teva might be at 10x Ebitda. The analyst will diligently compile a list, focusing in on the undervalued companies in the group and then seek to explain why this discount is or is not warranted.  

However, this process is backwards and focuses first on where the stock “should” trade, instead of first understanding the underlying business.  But…this is just the first step, you might respond.  Sure, but how many of us plan to exercise at the “end of the day.”  This may come as a surprise to you, but things that are pushed off often don’t get done well or even at all.  Such is the case with comparables.  With an initial focus on where the company should trade given its “comparables” people are reluctant to shift their anchor away from this initial valuation.  

These are two great examples of comparables arguments for the valuation of a company (in this case, Brookdale Senior Living).   The first presentation can be found here and the second letter here.

The most recent letter to the board of BKD (which may produce a great return–I have no idea) lists various transactions and then indicates what BKD “should” be trade at given these comparables.  

There is zero discussion of the underlying business of BKD.  What is the reputation of the local operators in the communities where the facilities are located?  Do they make centralized buying decisions?   Are the local operators compensated on the occupancy rates and/or acuity of the underlying patients?  Have the ancillary services been utilized fully across the full spectrum of their properties?  How has capital expenditure projections differed from actual expenditures over the past 2 years and why?  I am 99% sure Land and Building Investment Management could not answer these questions.  However, these are the things that should drive value over time.  Since the original letter to the Board in 2015, the value of BKD has fallen roughly 65%.  I have no clue where it will go in the next year, but I do know that Land and Buildings is focusing on the wrong drivers of long term value.

Here is an excerpt from the letter (full letter can be found here).

Sell the Company’s owned real estate and distribute proceeds to shareholders

It is time for Brookdale’s Board of Directors to take affirmative action to maximize the value of Brookdale for all shareholders, sell the $7 billion-plus owned senior housing portfolio, and distribute the proceeds to shareholders. Based on three senior housing sales transactions in November 2016, all over $1 billion, applying a cap rate of 6.25%, Brookdale’s owned real estate is worth in excess of $21 net per share.

NorthStar Realty Finance (NYSE: NRF) sold a non-controlling stake in over $2 billion worth of senior housing at an estimated low-to-mid 5’s cap rate to Taikang Insurance Group, a large Chinese financial services company

Welltower (NYSE: HCN) sold $1.2 billion of non-core, lower quality senior housing assets at a 6.3% NOI cap rate

HCP (NYSE: HCP) sold $1.125 billion of below average quality Brookdale senior housing assets at a 6.5% NOI cap rate principally to Blackstone

The significant institutional demand and high valuations for senior housing real estate are due to the attractive long-term demographic demand profile and high historical NOI growth. The three transactions completed last month transferred assets approaching the size of Brookdale’s owned real estate and as a result provide a compelling justification for the applicable 6.25% cap rate at which the Company can obtain $21.50 per share in a divestiture of BKD’s owned real estate.

The analysis of a business should not focus on what valuation the company should trade at, but instead on how much you are willing to pay for the future cash flows of a business given your understanding of the durability of those future cash flows (which includes both longevity and growth potential of those cash flows).  The short term focus on where something should trade and how an “activist” can nudge the company to get it to trade in line with its comparables is merely the investing version of aiming for the corners in ping pong.  

Because it is the holidays, I will add one more Don’t.  This is a oldie, but goodie from Charlie.  From the horse’s mouth:

Usually, I don’t use formal projections. I don’t let people do them for me because I don’t like throwing up on the desk, but I see them made in a very foolish way all the time, and many people believe in them, no matter how foolish they are. It’s an effective sales technique in America to put a foolish projection on a desk.

And if you’re an investment banker, it’s an art form. I don’t read their projections either. Once Warren and I bought a company and the seller had a big study done by an investment banker, it was about this thick. We just turned it over as if it were a diseased carcass. He said, “We paid $2 million for that.” I said, “We don’t use them. Never look at them.”

What follows is a projection from a well-regarding investment bank in the middle of 2012.  I am researching the company and hope to write it up within the next week or two.  The first is taken from the “pitch book” in 2012 and the second table is the actual numbers (2016 fiscal year is already complete for this company).

You can ignore 2012 because that was a half-year, but below are the actual results of the company, revenue and operating income from 2013-2016.  Missed it by a mile is an understatement.  Of note, this company did zero acquisitions during this time period and spent less on capex than projected.

2013 2014 2015 2016
Revenue $671 $759 $863 $951
EBIT $329 $430 $528 $614


2016 revenue was 90% greater than projections and EBIT was a whopping 256% off from the projections (to the upside).  Sadly, I spent 10 minutes reading through the pitchbook.  I will do better in the future.

__________________________

Matt Brice is the portfolio manager of The Sova Group, LLC, an investment firm that manages separate accounts for clients. Matt can be reached at matt@thesovagroup.com. 

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