Investing in the Misunderstood

Ian Cassel Blog, Educational 8 Comments

A full-time private microcap investor recently commented on our forum:

I’m quite curious how you all account and measure the relative performance of variables that can be quantified like earnings, balance sheet etc, vs intangibles like quality of management, appointments to the board etc. On balance, I put more weight on things that can’t be objectively measured.

The comment forced me to introspect a bit. First, I’d like to make a topical observation. The current market environment can play a role, at least initially, on how much qualitative you need to apply to your investing. In really good markets it’s all but impossible to find great companies trading at cheap TTM fundamentals so you have to look deeper into the qualitative. In bad markets, known great businesses can trade very cheap so you don’t really have to think that deeply into the qualitative.

Drilling down further, I’m reminded of Paul Lountzis’s top four reasons investors don’t conduct qualitative analysis:

  1. Investors don’t concentrate enough to make it worthwhile
  2. Investors don’t hold stocks long enough to make it worthwhile
  3. It’s hard
  4. It’s expensive (in person meetings, travel, etc)

An investor’s time frame (months vs years) and individual position sizing (small vs big as a % of overall portfolio) likely play a significant role in how much an investor is going to dig below the quantitative surface. If you are going to sell a company because they earned $0.01 EPS less this quarter or next quarter, then you aren’t really going to be diving into the long term sustainable qualitative factors of the business as much as someone that is truly making three to five-year investment decisions.

If your goal is to achieve maximum capital gains, then your intention with every purchase should be to hold for years. If you are going to hold for years, you need to put in the work to understand the qualitative.

For my investment style, it’s the quantitative and qualitative factors that initially attract me to the company. I need to see a fundamental reason and quality reason to be interested in an investment. Shortly after making an initial investment, the focus shifts significantly to the qualitative factors because it’s the only way to build conviction for the long-term. What makes the business special and why will it continue to be special? This is what qualitative elements answer.

If it were mostly the quantitative factors, I would never be able to hold onto something long enough to capture the big gains. What do I mean by this? If your aim to is hold a great business for a long time, you are going to have to get used to holding a business that isn’t always “cheap”. This is excruciatingly hard for many value investors who only believe cheap = value. I don’t like to use the word cheap to define value, I would rather use the word misunderstood = value.

In general, I’m looking for businesses, management teams, and opportunities that are misunderstood by the market place. Perhaps it’s the business quality that is misunderstood. Perhaps it’s the quality level of management that is misunderstood. Perhaps it’s the culture, strategy, or intellectual property. It could even be perceived negative events that have occurred, and shareholders are selling, and they are wrong. A majority of investors are focusing on the wrong thing(s). Whatever it may be, misunderstood, represents a big opportunity for investors that are willing to put in the work to piece together reality.

Misunderstood attributes often show up in the qualitative insights you uncover. They are like little colored tiles you find when researching a company. Sometimes the individual tiles mean nothing and sometimes they form a beautiful mosaic. The latter can be so exhilarating, and I’m sure many of you have had it occur at least once. You had differential insights that were spurred on by your past experiences that allowed you to see what others didn’t.

The more experience you gain the quicker you get at recognizing when you don’t need to evaluate a company. We are all impressed by our filters and how in 30 seconds an astute investor can scan an annual report and know whether the business is worthy of further diligence. We all have these pre-conceived “deal killers” built into our System 1 processes (see Thinking Fast and Slow).

Insiders own <10% of company = Bad

Insider Selling = Bad

Above Average Management Salaries = Bad

Gross Margins <50% = Bad

Revenue Growth <20% = Bad

Debt = Bad

Bad

Bad

Bad

I look at hundreds of ideas per year, and others like Brent Beshore look at thousands of ideas per year.  Our past experience affords us the ability to make quick and fast judgements, but it’s also these System 1 decisions that can shield us from misunderstood situations.

Let me give you an example:

Six years ago, I was researching a company that had many great characteristics. All but one thing, which coincidentally was the one thing that scared off many others. The CEO sold stock every month, $5,000-$6,000 per month, out of a $3 million position size. It was annoying to see this every month. I know because it annoyed me. When I met with the CEO in person, after having a couple calls, I had to ask him about it.

He told me that his father had health issues throughout his life that limited his abilities and output during his working years. He said that his father was a great person, “One of those people that should have gotten more out of life than he did”. His father didn’t have a lot of money. He was receiving assistance from the government but didn’t have anything left over after paying bills.

The CEO (son) and his wife made the decision they would honor his father by giving him some extra cash every month, so he could enjoy the sunset of his life. The CEO himself was getting paid $220,000 and had two teenage boys and stay at home wife, so he didn’t have a lot of disposable income and was all in on the company.

And this is the part I remember most because it was a great line. The CEO said, “If the choice is between me being slightly wealthier in the future or honoring my father today, I’ll choose the latter.”

The CEO told me he received a lot of complaints from investors about insider selling, but few asked him why. Most investors saw the insider selling, made a quick judgement that he was just another greedy, self-indulgent public CEO, and passed. Few dug deeper to find the truth.

I’m embarrassed to say I never did buy the stock, and it’s up 1,400% since then. It’s amazing how a great business can cure a lot of ills or even overcome a few misperceived negatives, especially misunderstood ones.

I’m interested in finding businesses, management teams, and opportunities that are misunderstood by the market place. The quantitative is what might attract you to invest but it’s the qualitative that will keep you invested. Dig below the surface to truly understand the businesses you own and the people that run them. Don’t let your past experiences and fast System 1 thinking blind you to misunderstood situations. Dig deeper. Seek truth.

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Comments 8

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      Author
  1. Good topic and a great way for us to do a bit of reviewing of our own research methods. Looking over so much material tends to make us fairly robotic about what’s good and what’s bad and we tend to overlook the human side of things. Stocks I have rejected last year may have a whole new reason to revisit them this year often because of things that couldn’t be quickly quantified.

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      Author

      Thanks John. Yes, in todays world of instant access to financial data, where many people are screening for the same things and tossing companies in the trash bin for the same reasons, it’s often good sometimes to look beneath the surface a bit more.

  2. Why not just take a $6k * 12 = $72k raise in salary than selling stock. Especially since you mention the stock is up 14 times after that. Each of those $6 K payments is now worth $84 K. Was the $220 K salary already large in % terms of profits?

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      Author

      He could have certainly done that, but he felt it was best to not have shareholders paying for his other family member issues. His father passed away a couple years later.

  3. As an investor who over the years has practiced both ends of the extremes — qualitative first thirty odd years ago, and now quantitative — I’d like to offer the following thoughts.

    1. Putting aside computer algorithms based on stock price/volume relationships or other esoteric characteristics inspired by unique views of what works in the market, quantitative research is based on the bias or belief that growing companies with no or low debt, expanding margins, high returns on capital, low capital expenditure requirements, stable or improving capital turnover outperform, over time, companies with shrinking margins, excessive debt, low returns on capital, declining capital turnover, etc. All of these characteristics are measurable quantitatively.

    2. Quality companies, by definition, exhibit strong financial statement trends over time. Nevertheless, most research (what does most mean? maybe 51% or 60%, certainly not 80%, but most) I read seems to be based on the assumption that quality means “I like this company. They may not be performing all that well now, and may not have performed that well over the last few years, but I see big things in store.” To me, that’s conjecture about quality, not quality.

    3. Conjecture, emotion, bias, a belief in one’s superior analytical ability, superior intelligence, the belief that an investor can see things, trends, form out of nebulous, chaotic or simply irrelevant factors and therefore reach a superior conclusion to other investors is the enemy of the average investor. Or even the above average investor.

    4. RenTech, Renaissance Technologies, probably has the best thirty year record of any professional money manager in the US. It is over three times that of Buffett’s over the last thirty years. It shuns the press mostly, so it doesn’t get much attention. It’s approach is completely quantitative, mostly short term, highly diversified and highly leveraged. It is basically taking levered positions on a stable, low risk, low volatility portfolio. And they were up 80% in 2008. That helps.

    5. Would you rather know a little about a lot of companies? If so, it is crucial that you know a few very important things very well, and be willing to exit positions quickly if they show signs of not working out. If you’d rather know a lot about a very few companies, it is important to be non-diversified to increase position size on weakness, and take long term positions. Saying that quantitative is better than qualitative, or vice-versa, is a little like saying fly fishing is better than spinner fishing, or bass fishing is better than trout fishing. Or Chinese cooking is better than French cuisine. More relevant, which approach, qualitative or quantitative, allows a particular investor to react to adverse market conditions with a cool, rational mindset? Which mindset allows a particular investor to benefit from adverse developments as opposed to suffer from them? Avoid panic selling, avoid emotion at the market extremes. In the face of a declining security or market, buying more may be the rational decision, or cutting one’s losses. Many factors play into that decision, that are too extensive to review here, but the decision needs to be based on logic, careful thought, not emotion.

    6. At the time Buffett took his Coca-Cola position I was a qualitative analyst flying all over the country to interview former executives, directors (past and current), customers, competitors, etc. of companies of interest to my clients who were mostly acquirers or activist investors. I’d sometimes sit in bars outside factories and talk to workers when they got off shift to find the dirt. When Buffett took his initial position in Coke, it seemed illogical to me — five times book, twelve times cash flow, fifteen times earnings (a big number in those high interest rate days). When it proved to be a highly-successful investment I studied it and found that the numbers — expanding margins, shrinking asset base through sales of bottling and other lower margin business, major expansion into international markets — and it changed my investment philosophy from one of flying all over the country to talk to people about mediocre, undervalued companies to a focus on the numbers.

    Finally, I sometimes read or hear comments by highly-successful small cap investors, people who definitely know what they are doing and who think deeply about small cap investing, to the effect that quantitative investing doesn’t work in small cap. That’s always puzzled me. Their position, I think, is that the story matters more than the numbers in small cap. Obviously, small companies can be quality companies, and quality is reflected above all else in the numbers.

    1. Hey Rod. I always love reading your thought. Although I think bringing up Renaissance Technologies is a bit extreme as I don’t think a single one of us here will be able to do what James Simon is doing.

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