One of the most frustrating things many of us encounter in our daily routines is trying to find good service professionals. Is your car making a funny sound? Who do you call? Does your refrigerator just stop refrigerating every few days — and then start again? What do you do? Most of us prefer to find someone we can absolutely trust to both figure out what is wrong and to actually solve the problem for us.
I don’t think the situation is any different for investment services. My goal with this newsletter is to share some of the insights I have gained from the day-to-day work of analyzing stocks and managing portfolios over twenty-plus years. Hopefully you will find some of these ideas helpful in navigating the investment landscape.
Personally, when I begin a search for a service professional, I usually start by asking who I know that might have a good contact. I normally prefer to find independent professionals who I feel really want to solve my problem. Many people, however, prefer to employ a large, well-recognized chain. The first section of this letter will discuss the pros and cons of size as it relates to money management firms.
Also, many of you have asked for more details about how I analyze and select stocks. In response, I am introducing a new section to Arete Insights entitled “Lessons from the Trenches.” This section will highlight Arete’s approach to stock research by discussing various tips, tricks, and analytical tools I have developed that have provided valuable incremental insights.
Finally, if you know of anyone who may be interested in reading this letter, please let me know or ask them to contact me (my contact information is at the bottom of the page) so I can put them on the distribution list. Arete offers a compelling investment value at least partly by shunning large advertising and selling expenses — I appreciate your help in keeping it that way!
Thanks and take care!
David Robertson, CFA
CEO, Portfolio Manager
. . . I say tomato
Last quarter we began a discussion about concepts that can mean very different things to different people. Quality is one such concept, and also one that is core to Arete’s mission. What makes one firm better than another? For many, size of the firm can send strong signals — for better and worse.
The conventional view is that operational risk is greater at small firms. Small firms often do not have sufficient people, systems, and resources to consistently operate their business. They are busy scrambling for assets. Things slip through the cracks. Conversely, large firms tend to be more fully staffed, better equipped, and can provide more functional expertise.
The alternative view, and one certainly borne by plenty of experience in the money management business, is that operational risk is often greater at large firms. Organizational culture, power structures, and incentives are tightly linked to firm profitability. These interests nearly always win out when in conflict with client interests. Small firms, on the other hand, often exercise far greater care in serving their clients due to personal commitment and reputation. With everything at risk, they have no other choice.
There is also a widely held view that business risk is greater at small firms. The conventional view is that small firms tend to be under-capitalized and may not be able to sustain themselves or to exploit growth opportunities. Large firms, however, often have better access to capital which allows them to slog through business downturns.
Since money management is not a capital intensive business, capital availability is far less important than for most other industries. What matters a great deal are quality organizational governance and prudent budgetary management. In these respects, small firms often fare much better because owners tend to have significant stakes in the business. Without such stakes in the business, employees at large firms tend to have greater incentive to manage their careers than to serve clients.
These thoughts were captured well by Henry Higdon of Higdon Partners, LLC. He stated at the conference, The Changing Face of the Investment Management Industry, “We see a lot of disillusionment and disenchantment with the big firms. People want to go to smaller firms. They want to work with people they trust and respect, and they want to make a difference, and the big firms don’t really provide that.”
While it is clear that there are compelling arguments for both sides, perhaps the most important insight resides with the tradeoffs involved. On one hand, large firms have more resources than small ones. On the other, clients mean everything to small firms. Which is more important?
The answer was easier forty years ago. Large firms could deploy more people to gather information and analyze results. Large firms could also afford costly computing resources to crunch the numbers. Large firms then were also tiny compared to the behemoths of today, and were not saddled with the same degree of organizational complexity and conflicts of interest. Today, much of the bias for large firms represents inertia; technology has slashed the costs of computers, telecoms, and trading thereby substantially eliminating the competitive advantages size once conferred.
Arete was founded with the mission of delivering functional excellence in money management — in other words, quality. Based on changes in technology, changes in the industry, and dynamics observed through our own experiences, we believe it is now far more important for active managers to be independent and to have skin in the game than to have a few more resources. Quality demands that size be managed to complement mission.
One of our goals with the Arete Insights newsletter is to share our insights into how the investment management business really works. Due to several requests from readers, we are creating a new section to expand upon the scope of our “Insider’s View.” “Lessons from the Trenches” will highlight our approach to stock research. Our intent is to share with you some of the tips, tricks, and other tools we have incorporated into our work that may provide you some insights into how we engage in our craft.
One of my most memorable experiences analyzing a company happened in my first job after business school. It also provided one of my most valuable lessons. My job was to analyze and model a small radio broadcasting company with about $10 million in revenues and to determine what it was worth.
Like a good bottoms-up analyst, I went about the process of analyzing the financial statements, researching the industry, and looking at comparable companies.
When it came to valuation, I used the historical financials as a foundation from which to forecast future results. I used what I believed to be reasonably conservative estimates for revenue growth and margins and ran them out for ten years in a discounted cash flow model. I calculated a weighted average cost of capital and discounted the cash flows back to present. When all was said and done, the model indicated that the company had negative value!
Not to be sidetracked, I hunkered down and tested all of my assumptions. I determined that the revenue growth rates were too conservative and that the margins, although forecast to be higher than they ever had been, could go higher yet. I still got a negative value! I pushed and pushed every assumption but to no avail.
I finally had a breakthrough when I was talking to a radio professional about the industry. The person mentioned that a radio station has value even if there are no intervening cash flows because FCC licenses have value. This is called “stick" value. The concept is very similar to that of a patent and to a zoned/entitled parcel of land. All of a sudden, things started to make sense and I was easily able to complete the valuation exercise.
This incident taught me a couple of important lessons about analysis and valuation. First, it reinforced the notion that all models are imperfect representations of reality. Each model has strengths and weaknesses depending on the specific situation. While I already knew this, I gained a much greater appreciation for the breadth and variety of special situations I had not yet encountered.
Second, it also taught me that at any point in time, there are several different possible outcomes. The future is indeterminate. As a result, analysts need to consider different scenarios and explore the implications of each. Analyzing scenarios improves as one gains experience with certain industries and types of situations. In addition, creativity can also prove useful in imagining what might happen that can affect a business model.
In my radio broadcaster exercise, my original valuation analysis was based on only one scenario, that of modest incremental improvements. As it turns out, it wasn’t even a useful scenario. Once I researched comparable “stick” values, I was able to provide a reasonable downside valuation (with limited supply, it could always be sold). Then, I could look at the more successful broadcasting companies as a guide for establishing an upper bound for profitability and valuation. Finally, I could compare the managers to others in the industry to determine where along the spectrum company profitability might fall.
There are two important takeaways from this example. First, this is exactly the kind of example I use when I work with younger analysts to help them build their skillsets. They still need to do all of the nitty-gritty work of stock analysis such as reading and studying industries, public filings, articles, research reports, financial statements, conference calls, company presentations, etc. Incorporating concepts like “stick” value, however, increase perspective and in so doing, generate incremental improvement in the conversion of analytical resources to portfolio performance.
The second important takeaway is that this exercise highlights the tradeoff between depth and breadth of analysis. Many investors benefit from the breadth of services a financial planner provides in managing the myriad financial issues associated with a comprehensive investment plan. Managing such a wide array of issues, while useful to many, makes it virtually impossible to conduct the kind of in-depth analysis that provides real insight into individual companies and securities.
This is exactly how Arete differentiates itself with individual investors. By focusing narrowly on our area of expertise, US mid cap stocks, and by continuing to do the rigorous and original analysis we have been trained to do for large institutions, we offer to individuals and small institutions the type of research and access that used to only be available to large institutions. This proposition should especially appeal to those who appreciate the value active management can provide, but want to make sure their manager knows more about it than they do.