This is an excerpt from my “2016” letter. It will be done before I write the 2017 letter.
The Bible has 783,137 words vs. the Ten Commandments, which come in at a mere 297 words. I would probably be better off trying to live the 297 words instead of trying to understand, let alone follow what is in the other 782,840 words.
Investing runs a similar course. Investors are “worried and upset about many things, but few things are needed.”
“Because of the simpleness of the way or the easiness of it, there were many [whose returns suffered].”
I try to live by four prescriptions (I won’t call them Commandments since I have seen the movie and don’t want any of the plagues visited upon my family). There is a heavy emphasis here on “try.”
Keep it Simple:
“Human beings suffer from an inescapable desire to make everything more complex.” Buffett
Anything that is simple is not smart. The more complex thesis for an investment, the more opportunities you have to demonstrate your intelligence.
Imagine, however, that you are interviewing drivers for your transportation company. The route is very dangerous and travels along several steep cliffs through a mountain pass. You ask each man how close he could safely drive near the edge of the cliff. The first man responds, “I could drive within six inches of the edge.” The second man responds, “I could drive within two inches of the edge.” The third man responds, “I would stay as far away from the edge of the cliff as I possibly could.”
Whom would you hire?
My number one goal as your investment manager is not to lose your capital. The returns are truly secondary. I consistently (and it is always harder than it sounds) try to achieve this goal by not doing anything stupid. I have found that doing far fewer things greatly increases my chances of not doing something stupid. If you were filling out a job description for the ideal investment manager, you might list as a top priority, “Don’t do much.” I made roughly 5 large decisions this past year. I am hoping to get it down to 3 this year. We will all be better off.
Above I mentioned 5 large decisions. There were a few small decisions and I can say, without a doubt, that the results from the small decisions are either mediocre or less than satisfactory (translation: money losing). Concentration combines patience and simplicity. A hurried approach produces many actions, the sum of which cannot be considered simple given the flurry of activity. The requirement of concentration forces one to be patient for those few opportunities when one is willing to take concentrated positions. It sounds circular and I think it is.
Focus on What Matters:
Last week I saw the headline “Booker scores 70 points.” Quite the accomplishment, I thought. As a repeated victim of clickbait, my distracted self got the best of me and I read the story. It turns out that his team, the Suns, lost to the Boston Celtics (which is incidentally my favorite team since childhood).
It brought back memories of this headline: “Jordan scores 63 points against Boston Celtics in record playoff game.” This is still the most points ever scored by an NBA player in a playoff game. But, Jordan’s Bulls lost this game too.
On Booker’s game:
“Of Booker’s total points in last night’s loss, 51 came in the second half. Of those, 18 came in the game’s final four minutes—not as part of any possible furious effort to give the Suns a chance at winning, but as part of a calculated attempt to run up Booker’s scoring total. The end of the game was full of maneuvers to make sure the 20-year-old guard had the ball in his hands as often as possible, including two timeouts and an intentional foul in the last two minutes of the game alone. The Suns had been trailing by double digits for the entirety of the second half; there was no motivation here other than the chance to run up Booker’s total.”
As for Jordan’s efforts, an article about the game had this to say:
“What [Larry] Bird doesn’t mention though was that Jordan didn’t exactly put the same effort into the defensive end of the floor. If there is a knock on Jordan’s 63-point game, it’s his defense. Jordan often leaked off his man defensively to help elsewhere, and the Celtics were able to beat this regularly to get open looks. Jordan’s primary assignments shot 12-of-19, and 11 of the 19 attempts were uncontested (8-of-11). All-in-all, the Celtics scored 31 points when Jordan was the primary defender in the game, the most allowed by any player on either side.”
The wrong metric here is obviously the points of an individual player. Winning the game is the goal, at least the last time I checked.
Investing is full of metrics. I view most mispricings of businesses as situations where the market participants are overly focused on the wrong metrics. This “wrong metric” mentality works both ways. Over-valuations tend to occur when good metrics are trumpeted while ignoring the underlying decay or general crumminess of the business. Whereas, undervaluations tend to occur when certain pessimistic metrics are emphasized while missing the underlying strengths of the business. The metrics in both cases are generally near-term focused quarterly, even monthly figures.
Why do we use the wrong metrics? This is a tough question. I am not sure there is one answer. Thinking Fast and Slow is probably the best source of why we do this. However, if you don’t want to pause to go read a 350-page book in the middle of reading this letter, I will offer you a few simple suggestions.
First, companies use the “wrong” metrics a lot. And no one seems to call them on it. This reminds me of my 4-year old. I caught her sneaking M&Ms from our pantry in her little dress pockets the other day. It was cute, so I didn’t say anything the first time she did it. So, she did it again and again. Why not?
Take “Adjusted Ebitda.” Munger says you should replace Ebitda with “bullshit” each time you see it, so I assume “adjusted EBITDA” can be roughly translated as “Bullshit Squared”. Despite this obvious pile of #@&%!, nine out of the next ten earnings releases will contain either Ebitda or Adjusted Ebitda. Why stop sneaking M&Ms if no one calls you on it. This is also a variant of the “Big Lie” theory that if you continue to repeat a lie enough times, people will eventually come to believe it. The word “adjusted” appeared a whopping 113 times in Valeant’s latest earnings release.
I give you the following quote from Valeant’s most recent earnings conference call:
“With respect to the definition of adjusted EBITDA, as I said, we’re trending towards a, I’ll call it, middle of the fairway. I think that the items that we add back, and I did tick them off, are the ones that are most often used by companies in arriving at a definition of adjusted EBITDA. It is perhaps a little bit shrunk down from what we might have seen based on our prior definitions, but it’s not hugely different.
I think what’s really important, at least for us internally, is that we’ve implemented policies and procedures to ensure that any item that is going to be an add back, to arrive at adjusted EBITDA, is subject to a lot of scrutiny, and importantly, control. Not to say that it wasn’t before, but it is to say we put in place procedures that Joe’s used to, I’m used to, Sam Eldessouky, who is our Chief Accounting Officer, are used to, to maintain control over those items.”
This is corporate speak for “The previous management was clearly cooking the books.” But, and this is how outrageous the state of affairs has become, the CFO goes on to say, basically, “You can trust our adjusted Ebitda numbers because our add backs are normal.” Huh?
Companies repeat misleading metrics, analysts regurgitate these same numbers and eventually, the market participants just give in and go along.
I spoke with another fund manager a few months back regarding my Taro write-up and the first thing he did was pull up the “comps” for Taro and started to rattle off the “comps” Ebitda numbers in relation to Taro’s. I told him I didn’t know what Taro’s Ebitda was. I don’t think he was impressed.
The second situation I have seen where “wrong metrics” mentality takes over is when individual analysts do a significant amount of work (“proprietary work”) to come up with variant metrics. The endowment effect takes over as these individuals become more attached to the information they have sourced without giving a full answer to the question of whether this information matters. Back to Valeant, one large investor famously cited a conference call he had arranged with 15 leading dermatologists (notice the exclusivity here) wherein he learned that the dermatologists were still going to prescribe Valeant drugs. However, if he would have walked into any Kroger or Costco pharmacy and spoken with a pharmacist for a few minutes, he would have realized how difficult it was to obtain Valeant drugs through “normal” channels and how reliant on Philidor Valeant actually was. This investor continued to cite the “mere” 7% EBITDA impact from Philidor’s closure as a reason for doubling down. I think if he would have spoken with individuals farther down the distribution channel, he would have realized this 7% was clearly an “adjusted” number.
This same phenomenon is present with detailed discounted cash flow calculations wherein analysts rely heavily on precise calculations.
To return to Valeant (I don’t see any reason to look up different examples when there is so much great material here), here is a snippet from one investor’s slide during a conference call defending Valeant after the revelations of Philidor came out:
The 2020 “cash EPS” figure of $22 has a precise feel to it since it offers an upside potential of 62%, 89% or 116% at the then current price. I am sure a lot of numbers went into a lot of different excel cells in order to produce this 2020 EPS figure of $22, but this is certainly the wrong metric.
On the flip side, let’s look at some situations where certain pessimistic metrics distracted market participants from the underlying strength of the business.
This past fall a short report came out regarding National Beverage. The focus of the report was on various governance issues and allegations of manipulated sales. However, the report completely ignored a few key metrics. Manipulation of revenues typically occurs when companies are trying to prop up their share price, either for insider sales or acquisitions. However, the founder of National Beverage hadn’t sold a share in years (or ever as far back as I bothered to look).
Secondly, the capital allocation policy was dividends, which require actual cash (and in turn actual sales). The founder was still a 75% owner, so his decision to return cash to shareholders via dividend was an odd choice given the accusations. Along these same lines, the company showed a large cash position on their balance sheet, which is typically the easiest to check for auditor, and therefore the hardest to fake. Additionally, talking to a few “stockers” at Whole Foods and Target would confirm their dislike of LaCroix: the “velocity” of their sales creates a lot of work for them. The short report was obviously a little fear mongering, but its focus on the wrong metrics was head-scratching. The stock is up roughly 100% since the short report less than 9 months ago.
Last February the financial press was up in arms about the slowdown in Apple’s revenue. The market participants decided to ignore the longer life cycle of the iPhone as the key factor behind the short-term revenue dip. The attention should have been on whether people were leaving the Apple ecosystem, which I do not believe was the case. The brand loyalty, ease of use and value-added nature of Apple’s ecosystem keep people within the fold even if they wait an extra year or two to upgrade to the next iteration of the iPhone. Apple’s stock is up over 50% since that February low.
This past August, Verisign encountered some short-term hiccups when people were either abandoning the stock because of near term no revenue growth (due to a one-time previous year Chinese surge and therefore lower revenue year over year) or potential problems with the transfer of the governance of the “The Internet” to ICANN, an international non-profit. I honestly don’t know which was the cause. The transition went off smoothly and Verisign continues to print money with a great business model–one that rhymes with Monopoly.
Typically the overly pessimistic metrics are fairly short-term and fail to see how strong the underlying business will continue to be going forward. John Huber, whom I consider the best investor in Fuquay Varina, North Carolina, has called this idea, “time arbitrage” or the ability to look beyond one quarter or a single year’s results and see how the business will be doing in 3-5 years. I agree. Nothing to add.
In most investments, the variables involved are countless, but only a few matter. Figure out what matters, focus on getting that right and ignore the rest.
I have made it past the first page, which was my original goal. However, I can’t possibility emphasize simplicity and proceed to write a 20-page letter. The End.
Matt Brice is the portfolio manager of The Sova Group, LLC. Matt can be reached at email@example.com.