Tag: fundamental research

Value and Growth are Joined at the Hip

Most people think Warren Buffett is a value investor but if you want to go into the particulars, one could argue that he is primarily a fundamental investor. Buffett famously said that growth and value are joined at the hip. Both are areas of fundamental analysis.

One could also argue that many business owners would not easily understand the question if you would ask if they focus more on growth or value in their capital allocations. Business owners simply allocate capital to the projects with the highest expected IRR, irrespective of any category you might want to fit it into. 

Personally, I really like the framework put forth by the late Marty Whitman. In his opinion, there are are 5 main areas of fundamental finance: 

  1. Value Investing (limited to minority positions in public co’s) 
  2. Distress Investing
  3. Control Investing
  4. Credit Analysis
  5. First and Second Stage Venture Capital Investments

Warren Buffett, as an example, has been active in all of those categories, either directly or indirectly. Henry Singleton, as well, is someone you could not classify as a value investor specifically. He just went where he thought the highest IRR was at any given time.

Peter Lynch: “I Love Volatility”

There is this great short clip on YouTube with the legendary former mutual fund manager Peter Lynch (of Magellan Funds). In the video, Lynch declares his love for volatility and explains how he approached it: 

“Volatility will occur. The markets will continue to have these ups and downs. I think that is a great opportunity, if people can understand what they own. If they don’t understand what they own mutual funds. And keep adding to it. Basically, corporate profits have grown about 8% per year, historically. So corporate profits double every nine year. The stock market ought to double every nine years.”

The operative phrase here is “if people can understand what they own”. We can also invert what Lynch is saying in the video and ask ourselves what value we can provide by understanding the assets that have a volatile price?  

The Social Value of Active Investing

There’s a fantastic podcast interview with Micheal Mauboussin on the Invest with the Best Podcast, where he talks about the value that active investors bring to the market. Mauboussin says the following: 

“Now, one of the things we’ve talked about quite a bit is, is there a role for indexing? And the answer is, absolutely yes. And I think for many people, that’s a very sensible solution. But that does not mean that the active management industry can go away. It’s not going to go away, because there are two things that it does that are still really important. One is price discovery, and again, indexing benefits from that positive externality, I think we can never lose that.” 

“Essentially the fees paid to active management subsidize the indexing industry. And the other is liquidity. And even in these environments, we see that index people don’t trade that much. And so we need liquidity if you have it. I think those are public goods, those are vital, and those will continue to play a role. So the debate should be, what percent of the assets should be active versus passive?” 

By this logic, you could also posit that as an active investor the best way for you to add value is to find areas where you can add value by pricing the securities in question (research, know-how, etc), especially in securities where (or time when) liquidity is scarce.

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.

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.” 

Copying Top Investors and Their Portfolios

When it comes to investing, being a small fish in a big pond isn’t all that bad. Consider the following:

  • All institutional investors need to file a so-called Form 13F. They basically have to tell the Securities and Exchange Commission what they are investing in. Better yet, all this information is made public. 
  • What makes an institutional investor institutional, is that fact that they have clients. An institutional investor manages and invests money on behalf of their clients. And how do they get money from others to manage? Just like any other regular company…by selling. They literally tell how they invest and how they plan to invest. 
  • Some investors, like Carl Ichan, Bill Ackman and Dan Loeb are activist investors. How do they get active? By publishing to the public detailed reports on what they think the value is of the companies that they turn active on and how they think the company needs to do in order to achieve those valuations. 

All of this information is readily available for you as an investor. Big investors with small armies of stock researchers and equity analysts are publishing research in droves and filing disclosures on their positions every day. 

All of this information is available to you for free. 

How Scuttlebutt Investing Works

The Scuttlebutt method of investing is fathered by the legendary investor Phil Fisher. Fisher is likely most known for his bestselling book Common Stocks & Uncommon Profits.

Scuttlebutt investing, as the name indicates, begins with a story or some other anecdotal data point, that triggers interest. It might be a product you love, a competitor you hate because of her competence.

How to Practice the Scuttlebutt Method

This is just the starting point, though. You have a hunch. You might be on to something, but what’s the next step? Do you check the performance of the stock price, do you download the financial statements and start crunching numbers?

If you are a Scuttlebutt Investor, your research would be very hands-on. You might visit retail locations or even manufacturing facilities. You would get feedback from customers, resellers or even competitors. You would try to understand the competitive dynamics of the market, performing the Silver Bullet Test on the people you would talk to.

Following up with Fundamental Research 

The Scuttlebutt Method is great to validate investment ideas and building an intuitive understanding of the operational and brand-related qualities of a potential investment. Nonetheless, once you have strengthened your conviction about a certain stock, what you want to do is to cross-validate your finding with a fundamental analysis of the financial statements of the company.

This will give you a clearer picture of the business model and allows you to compare your scuttlebutt data points with the overall financial and valuation picture.

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.