If God was the Only Active Investor

In active investing the investor aims to outperform an index. In passive investing the investor aims to match or track the performance of an index. 

Now imagine if God was the only active investor in a theoretical market. 

God is all knowing, so he knows all the future cash flows of all the investments available in the market. Since he is the only active investor and all other investors mimic him, all the investments in the market will be priced based on their discounted future cash flows. As such, all the investments will have exactly the same expected return. 

There are two fundamental problems with this thought exercise:

  • If God knows the future cash flows, then he’s not taking any risk. If God isn’t taking any risk, what discount factor should God use? The rate of inflation? 
  • If God is the only active investor, then who is he buying from? If God is the only investor that sets prices and all other investors are trying to mimic his returns, then all the other investors would want to buy when God buys and sell when God sells. Does this mean that no orders will be matched?

The Primacy of the Income Account

Have you ever listened to an earnings conference call or read a transcript from one of those calls? If you have, you will know that these calls usually have a question and answer session following the prepared remarks, In the Q&A sessions, sell-side analysts that cover these stocks can ask management about anything that is on their mind. 

I remember when I started following conference calls, how weird I thought the questions posed were. To me, the questions were unusually specific. It wasn’t until I realized what a sell-side analyst does, that the questions started to make sense. The analysts are simply trying to fish for inputs into their valuation models. They build these models, primarily by using discounted cash flow analysis, to come up with price targets for the stocks that they employed to cover. 

The Problem with DCF-Analysis

When you build a Discounted Cash Flow Model, you need to make a bunch of assumptions. By how much will the company grow its revenues in the next few years? How much capital expenditure will it require to maintain that growth? What is the cost of capital? Etc, etc, etc. 

DCF models can be very useful and it is imperative for business analysts to understand the possibilities as well as limitations of a DCF analysis. DCF analysis is useful when cash flows are stable and relatively predictable. DCF analysis gets difficult to use if the companies that are being analysed have extremely high growth rates or if they create value by other means than by consuming cash to generate earnings. 

Capital Allocation and Balance Sheets

The late Marty Whitman, a legendary value investor, often talked about the Primacy of the Income Account. In his opinion, analysts and other investors where too preoccupied with the income statement and earnings of companies. As a result, the wealth creation that happen through the balance sheet was often overlooked. 

I heard a great example of this the other day. I don’t remember which podcast it was, but the interviewee gave the following example:

Imagine if you had run a discounted cash flow analysis of Berkshire Hathaway shortly after Warren Buffett took over as CEO. You would have totally missed the point, since Buffett created value through capital allocation and by utilizing the balance sheet. 

A normal DCF model would nerver have captured this.

The Implied Meaning of a Market Cap

Apple is worth $2,000,000,000,000. That is a lot of money” said Anthony Pompliano on Twitter the other day. Dave Collum promptly corrected him: “priced at.” This is a very important and warranted distinction. We talk about the market capitalizations of companies all the time, but less often we think about what it actually implies. 

For Every Buyer there is a Seller

The current price of a publicly traded stock is the most recent point where the most willing seller and most eager buyer matched. So when Apple stocks ended a trading day at $498, the last buyer and seller that were matched were willing to do business for that price. For someone to buy, someone also has to sell. 

But the market price only gives us some information about the marginal sellers and buyers. One an average day, somewhere between 100 to 200 million shares of Apple stock will change hands. That’s a lot of shares. On particularly busy days, this will exceed 300 million. On a slow day, however, as little as 50 million shares will change hands. But Apple has 4.35 billion shares outstanding. So, even on the most hectic days, less than 7% of the outstanding shares will change hands.

The 7% figures is likely deceptive as high frequency trading and other forms of day trading and market making might overstate the fact that the majority of stockholders will not sell on a given day. 

Therefore, the market cap and stock price of a company will tell you where it is priced at by the market. it won’t tell you where the stock is valued at by the market.

Largest S&P 500 Single Day Drop

One of the things that has preoccupied my mind lately are the underlying differences in approach between active investing and passive investing.

Imagine the two following hypothetical money managers: One of them is an active investor. He performs bottom-up fundamental research of companies, trying to determine their “intrinsic value”.

The other investor is passive. He uses quantitative analysis in order to find factors would have lead to out performance compared to a specific benchmark (these strategies are called “smart-beta” as they are passive in nature, but still aim to outperform the benchmark).

Analytical vs Statistical Approaches

For lack of better terminology, lets say that the active investor has an analytical approach, while the passive investor has a statistical approach.

The active investor is focused on the future cash flows of the company. He is tries to understand the business model of the company he is analyzing how the company creates value. He might try to study historical transaction multiples or how similar public compare in terms of valuation ratios. But primarily, the fundamental investor is trying to analyse future events.

The quantitative investor, however, is looking at a universe of stocks. He mines datasets to find a relationship between factors and performance. He designs different strategies and uses backtesting to see how these strategies would have performed.

The Limits of History

But what is data? Data is history.

Consider the following: Suppose you ask the investors about the largest single day drop in the S&P 500. The quant tells you that the largest single daily drop of the S&P 500 occurred on October 19, 1987, when the index fell by 20.47%.

The fundamental investor, however, tells you that the largest single day drop hasn’t happened yet.

Strawman & Steelman Valuations

A strawman argument is a frequently used tactic in rhetoric and oratory debate. It’s used in business, in politics and Twitter arguments alike. It’s simple and effective. You basically pick an argument of your opponent and rephrase it in a way that makes it easy to refute. Strawman arguments are not real arguments. They don’t even have to be true. 

Peter Thiel argues that for decision making, you should really steelman your opponents arguments. If you try to find the strongest and most compelling reasons for your opponents stand, it allows you to improve your side of the argument or even discover flaws in your own reasoning. 

The same should apply to valuation. You should always try to steelman the potential risk factors that you apply to your investment thesis. 

How to find a business exit broker

So you have decided to sell your small business or company. The very first thing that crosses through the mind of most people (and rightfully so) is the question: how can I maximize the value of my exit? The key here is getting the right broker for the job. 

The task of finding the right partner to help you sell your business is no easy. There are countless examples of owners that ending up choosing the wrong broker or having a misaligned incentive structure with their broker. As a result, they fail to get the right buyer or fail to close a sale. The repercussions of choosing the wrong broker can be drastic.

However, if you choose the right intermediary for your business exit, there is a possibility of obtaining your exit goals. But how do you get to choose the right broker? Don’t panic because we have got you covered and in this article we are going to give some tips that you should apply when choosing a business exit broker. To start with, don’t try to find an exit broker on google, you might end up regretting after making huge losses. Follow the following tips and you can be sure of getting the right broker.

Look for attributes of a superstar

You just don’t hire a broker without looking for his or her attributes. A good broker that is not going to bring losses should be characterized by the following features.

Specialized experience

Experience is not just experience. When it comes to selling your business. A broker might have been in the game for more than 20 years and still not be the right choice for you. You need to go for a broker who is experienced in your line of your business. For example if you deal with electronics and you choose a broker who has been dealing with real estate for all his life, you might end up making losses no matter how talented he is. Having experience in your industry is vital.

The broker should also have some experience selling businesses and companies in your geographical market as well as within your price range. If the broker does not have this knowledge, it is very possible that his pricing and marketing efforts might fall short of your sales goals.

A verified track record 

The broker you are about to hire should be able to provide you with some reference of customers he or she have served before and they were satisfied with his efforts. If he is not willing to share this kind of information, it might be a red flag that he is not as good as he claims to be.

But when the broker gladly provides you with a list of customers who were more than satisfied to work with him it is a step towards the right direction. Follow up a few clients who were served and confirm the claims that he is a superstar. If the ones who you contact seem to agree that he is a star, then ask about his weaknesses and see if his qualities are enough to help you meet your objectives.

Connections and Networks

If a broker claims that he will be able to take your business from listing to closing alone without needing any help from anyone that is a bomb waiting to explode to your business. Excellent brokers usually have established connections with able lawyers, accountants as well as other local professionals.

Even if you are going to use your own lawyer, it is still important to confirm that the broker has good relationships with lawyers and other professionals in your locality. This will help you understand if the lawyer has been able to gain respect from them and if he has, then most certainly he is as good as he says.

Truthfulness and Trust

The most common barrier when it comes to selling your business is the pricing. Not many brokers are honest about the real worth of the business. Most of the brokers usually tell the clients what they want to hear. This can result to dragging during the sale of the business.

But a broker who is good and knows what he is doing will tell you up front the value of your business and other sensitive details of your business even though that’s not you might be wanting to hear. If the broker is that truthful and he has all the above qualities, there is a very high chance that he is going to make you profits.

Finding a Broker You can Trust

Now that you are equipped with the traits that you should look for, it is important to understand where to start your search.

Local Referrals

There is no better way of finding an excellent broker than from the local referrals. Do some research and find out whom is doing business listing in your area and then verify his or her qualifications discreetly using some of your industry contacts. Get all the information you need about him or her before considering to hire.

Legal and Financial Advice

There is a very high chance that your lawyer or accountant knows one or two brokers that are very good at their jobs. Keep them in the loop and ask them to help you identify the best broker for the job.

Online Directories

Many online directories are not very reliable but since you already know how to identify a good broker when you see one, you can look for some suggestions from online and assess a few of them before hiring one.

Chambers of Commerce

Most of the chamber of commerce and economic development offices usually possess up to date information about most of the local professional brokers included and they may be able to help you find an excellent broker. Just to protect your confidentiality, frame your questions in a general manner.

The Columbo Method of Equity Research

Remember detective Columbo? He was a phenomenal character played by Peter Falk in a 1970s TV series called…you guessed it…Columbo. Detective Columbo was a scruffy and simplistic character, dressed in his signature beige raincoat and crumpy white shirt with a loosely knotted tie.

Colombo is no normal detective series, though. As is you would expect, Columbo’s job is to solve murder mysteries. However, the episodes don’t play out with Columbo delving into each case and eventually discovering who is the murderer, in a sharp twist near the end. Columbo is a detective series without the mystery.

In the case of Columbo, each of the 69 episodes begins with the scene of the murder. So, as a viewer, you know from the beginning who the doer is. The rest of the episode is a mental wrestling match between the murderer and lieutenant Columbo.

The Colombo Technique of Investigation

In each Columbo case, the murder is committed by someone close to the victim. This allows Columbo to approach the suspect as a witness or someone who can help Colombo in piecing together the pieces of the puzzle.

To the assailant, Columbo seems totally incompetent. The scruffiness of his hair and clothing give the impression that he slept in his clothes. He constantly scratches his head and he asks the assailant for help. His questions are simplistic and make him look like he’s totally out of his dept.

But Columbo is playing a part. He’s playing dumb. The perpetrator grows confident and starts to get comfortable, even annoyed. The trap is set. In the final minutes of a Columbo episode, the perpetrator has made a mistake and Columbo wrestles him down for the tap-out.

Stock Research and Colombo 

So, how does this relate to equity analysis? In stock research, there is no crime, there is no murderer. As an analyst, you have a stock and you build your opinion based on fundamental analysis.

But therein lies the caveat. You see, it is you who is the perpetrator because once you start your analysis, you start to for opinions. You will start subjecting your mind to all forms of mental biases. You become overly optimistic. You get anchored. You will start to look for confirmation in the data.

“But that’s me, I’m paranoic. Every time I see a dead body I think it’s murdered. Can’t imagine anyone murdering themselves.”  

– Lieutenant Columbo

As an analyst, you have to put on your mental raincoat and find your inner Columbo. You have to take a step back and start to ask yourself the simple question. The overly naive and borderline stupid questions. You have to confront yourself and find start to look for loopholes in your story.

Just One More Thing…

Lieutenant Columbo bombards his suspects with questions. He’s relentless. He keeps coming back with a question. He’s apologetic, he excuses himself. He just can’t help himself, he says. But he keeps coming back for “just one more thing.” 

Discount to Net Asset Value | Protect Your Downside

One way to value a stock, especially those of companies that own various subsidiaries or a portfolio of assets, is by analysing the company’s discount (or surplus) to Net Asset Value.

Conglomerate Discount – The Case of Exor

We recently took a close look at Exor N.V., the holding company that controls such publicly traded companies as Fiat Chrysler Automobiles, Ferrari and CNH Industries. Conglomerates like Exor are interesting to analyse as they tend to trade a steep discount on the mark-to-market Net Asset Values (or market-adjusted book value).

In the case of Exor, the company trades at about a 30% discount on the market value of assets on the balance sheet. 

Point of Maximum Pessimism – The Case of Dundee Corporation

If you are a Contrarian Investor, you are trying to go where other investors feel extremely uncomfortable to be. You are trying to go where others are running to the exits, but at the same time, you don’t want to be too early. 

One of those situations is materializing at a Canadian Asset Management Company called Dundee Corporation. After a series of unfortunate events (and decisions), the market capitalization of Dundee is gone from about a billion dollars to about $74 million. 

The company trades at a steep discount to book value, but for good reason. The company has been haemorrhaging money as failed investments have sucked up cash and destroyed shareholders’ capital. 

But investors may have overreacted. Even though the company is taking drastic steps to turn the business around, Dundee’s stock is trading at about a 70% discount to book value. If the company manages to stop the bleeding, a significant re-rating might be in the cards. 

The Fundamentals are in the Footnotes

The whole point of fundamental research or value investing or whatever you want to call it is to get an edge by looking a little deeper than others are looking. This is why you won’t get very far by using stock screeners.

Stock Research on Onverstock.com 

We recently published a stock report on the Fundamental Finance Playbook about Overstock.com. The article is a deep dive into the current status of the company’s online retail business. We try to figure out if the business is, in fact, in a turnaround as management claims, or if the company is at risk of running out of cash.

Previously, the management had stated that they were trying to sell the online retail business but so far nothing has materialized. During our research phase we noticed that during the last quarter, consulting fees on the corporate level had increased significantly. By corporate level, we mean not connected to the operations of the online retail business nor the blockchain ventures.

Overstock engaged Guggenheim in 2018 to explore strategic options for the retail business and find possible buyers. If the consulting expenses are mostly in the “Other” business segment and neither in the retail operations nor the tZero operations, it is plausible that Overstock is already in advance negotiations with potential buyers through Guggenheim.

What that indicated to us, was that there was a possibility that Overstock was already working with Guggenheim Securities, the company that Overstock employed to find buyers, on advanced negotiations with possible buyers. These kinds of transactions usually require heavy due diligence, so it would be quite plausible that costs would ramp up like this.

Two Potential Acquirers 

A week after we published, Patrick Byrne, Chairman and CEO of Overstock said in an interview with CNN that the company was in negotiations with two potential acquirers. It remains to be seen if anything materializes from this, but it goes to show that sometimes the fundamental facts are buried in the footnotes.

Stock Report | OTC Markets (OTCM)

OTC Markets (OTCM) is an American Financial market providing price and liquidity information for Over-The-Counter securities. The company was founded in 1913 as the National Quotation Bureau since the company has changed many names. The company operates in the Financial Services space.

Business Segments

The company primarily provides 3 services:

OTCQX

OTCQX is the trading platform that connects clients to broker-dealers, providing liquidity and execution solutions.

OTCQB

OTCQB is the new reporting and market data compiling service. It grants access to various channels like Bloomberg, Thomson Reuters, etc.

OTC Pink

This is the corporate services pack, which helps companies to better engage and inform investors.

OTCIQ

Apart from these primary services, OTCM provides a service to other businesses called OTCIQ. OTCIQ serves as an investor relation portal for the company to monitor security market activity and transmit information to investors.

Management

The top brass of OTCM is highly qualified and rich with experience. The CEO, president and director, Cromwell Coulson took over in 1997 when the private company was nothing more than a publisher of quotations. Coulson and his team have transformed OTC into a publicly-traded company, operating in 3 markets and seeing an annual trading volume of just under $200 billion. 

CFO, Bea Ordonez, has over 20 years of experience in the financial services segment; she is also a member of the Institute of Chartered Accountants in England and Wales. Jason Paltrowitz, Executive Vice president of Corporate Services, has served had held management positions in renowned companies like JP Morgan Chase and BNY Mellon. 

The company’s management is more than qualified and has a great track record; OTCM has not received any warnings or penalties for non-compliance with rules and regulations in the past few years.

Market Statistics

  • Simple day moving averages 50 days: 33.72
  • Simple day moving averages 200 days: 32.1
  • 52 week Range: 25.37 – 40
  • Lifetime high: 39.95

Valuations and Competitors

  • P/E – 25.32
  • EPS- 1.36
  • NOA- $13,972
  • NOPAT- $16,148.19
  • RNOA- 1.15

Business Model

OTCM lacks any direct competitors, and therefore enjoys an almost monopolistic operation. This makes it hard to determine the exact value of the business is the lack of comparison with other publicly traded stocks. News Corp-owned MarketWatch is a close rival of OTCM in the news and press segment. Both companies publish investor reports and function in the financial service space.

However, News Corp currently trading at 12.6 has been in losses for the past 2 years. Its share has shed nearly 22% over the past year and hence can’t be considered as a comparison. On the Exchange side of things, OTCM would be dealing with the likes of NYSE and Nasdaq. Both of these exchanges are considerably beyond OTCM’s reach as of now. Hence OTCM enjoys a niche that is unlikely to change in the near future. This while making OTCM harder to value could also be seen as the advantage of the business having a unique business model.

Key Financials

(all $ figures are in thousands) 

  • EBIT: $19,645 (up 7.32% from 18,304, in 2017)
  • Net income from operations: $16,237 (up 28.8% from 12,599, in 2017)
  • Cash and Cash Equivalents: $28,813 (up 21.66% from 23,683)
  • Total Assets: $41,649 (up 14.6% from 36,317)
  • Total liabilities: $25,240 (up 12% from 22,526)
  • Net cash from operating activities: $22,590
  • Net cash from financial activities: -$15,882

Operating expenses for the company have grown at a steady rate signalling a steady expansion in the business. Net income from operations grew by 19.2% from 2016 to 2017. In 2018 it’s up 28.8%. However, that’s not the whole story because of a one-off item in the company’s gross revenue. In 2018 there was a one-off licensing deal with Bloomberg LP contributing to 10% of gross revenue from licensing, amounting to $2,338.

The model of the company allows it to be heavy on cash almost at all times. Therefore the cash and cash equivalents are larger than all other assets combined. Both the Cash and cash equivalents and the Total assets have increased. The total asset growth is faster than the total liability growth and there has been a sharp spike in the other liabilities item. 

This is causing the growth rate difference between the 2 to seem close however this will not repeat in the next quarter causing the difference highlighted more clearly. One of the most important items to notice in the balance sheet of the company is that its short and long term debt is 0. Being debt-free is always a big positive for any company.

The net cash from investments has been low, signalling that profits are simply being reinvested in the core business. However, the company has stated that it would make further acquisitions in FY 2019. The financing activity in question has been dividend payout and the operating profit has increased by nearly 37% from the previous year.