About Me

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Avram Fisher, Founder & Portfolio Manager of Long Cast Advisers, is a former equity analyst at CSFB and BMO covering industrials and business services. He has prior experience in private equity; as a corporate governance analyst; as a writer; reporter and private investigator; and as a lifeguard and busboy (I still clear plates when my kids don't). This blog is an open book of ideas about patient investing and about starting up a small-cap focused RIA. It is part decision-diary, part investment observations and part general musings. Nothing on this blog is a solicitation for business nor a recommendation to buy or sell securities. It is simply a way to organize and share thoughts with an expanding audience of independent, patient and talented small cap investors. www.longcastadvisers.com

Friday, September 1, 2017

Why I Own Quest Resources (QRHC)

Quest Resources (QRHC) is an asset light waste services company, a waste broker. Their's is a simple business model; connect haulers and customers and provide some value therein, for a markup.

There is no lack of competition in the waste services business and the competitive advantages are few and far between, depending on vertical of expertise. This goes as well for QRHC, which is differentiated from the industry stalwarts - Waste Management, Republic Services, Clean Harbors, etc. - simply through its asset light business model.

The large companies tend to own fixed assets such as incinerators, landfills and trucks and generate a return on these assets through utilization and volume. It is in their interest to push volume into their owned assets.

QRHC takes an asset light / service only aspect to this business. They do not own trucks or landfills or incinerators, and they generate no return pushing volume into their own assets. Rather they solely help their clients manage their waste streams, whether it goes to a landfill, is diverted to recycling or to organic composting.

In short, they are agents. They sell companies with multiple locations on the service of managing their waste stream, providing information on where the waste goes, tracking volumes and how much is diverted to compost and recycling.

Concurrently, they are a hauler's outsourced sales arm. The hauler typically agrees to offer volume at some fixed price and (in an ideal world) receives in return a customer on an existing route at a high incremental margin. This creates a situation where QRHC is a "frenemy" of the hauler, at times generating volume for them, at times creating competition.

So they essentially solve three problems:

1. "one throat to choke" service for their customers who don't have to deal with multiple haulers (by way of example, my brother in law runs a large facility and says he has a list of 80 waste haulers they call on a regular basis).
2. "better information" on volumes and where it goes than what a client or competitor could / would do themselves (thought this seems like an advantage that could easily be competed away).
3. outside sales force for fixed asset owners (hauler, landfill, etc)

Here's a sample of their sales pitch to the construction vertical copied from a video of theirs ...

... nothing terribly ground breaking. It's a "blocking / tackling" business.

As with most agent / broker models, the model works on the bill / pay spread. A wide bill / pay spread + growing customer base on low fixed SG&A means all incremental gross profit flows to cash. [Consider what happens around an event like a hurricane, where demand increases and haulers likely turn away work from QRHC within the impacted region. I imagine there's a narrowing of the bill / pay spread offset by increased volume].

There is no "moat" for QRHC. There is no hidden balance sheet asset. They do not own trucks or incinerators. There is no fixed asset leverage other than SG&A scaling. And as with other brokerage businesses (real estate, insurance) and business services (staffing, construction) there are low barriers to entry in the business. These are not normally the kinds of characteristics that screen for "good investments". So what makes this an attractive investment?

In my opinion, three things ...

First, it seems like the company is at an "inflection point" where gross profits are starting to grow much faster than (and at long last in excess of) SG&A. I have observed that services companies - even those with no moats and with low barriers to entry - "work" when their revenues are large enough to support the business and when gross profits grow materially faster than a flat or declining SG&A. The "operating leverage" generated through this business can be observed across many services companies.

Second, there is a misunderstanding about forecasts for declining revenues. The company has guided to a ~$32M decline in annualized revenue, starting in the back half of 2017 and into 1H18, that arose b/c they fired a large customer (WalMart, I believe). That announcement - and likely whispers about it ahead of time - have contributed to the stock looking like a "falling knife".

What may escape investors is that the this revenue had by our estimate a 1% gross profit margin, meaning the large "headline" revenue hit is close to a ~$320k hit in gross profit. Thus, the stock market reaction - $20M in market cap going away over a $320k decline in gross profit - for a company that will do $17M in gross profit this year - seems over done.

Third, and more qualitatively, the company has been in a turnaround and has hit all its marks. In the nearly two years since the CEO took over the company, he has been consistent with articulating and implementing his plans, with the results towards profit and cash flow finally showing.

I believe there is value in the consistency between a target and actions. I'll admit that I may assign too much value to this. What is the right amount? I don't know. But I met with the CEO Ray Hatch not long after he joined the company in February 2016, and he laid out a plan to fix what he acknowledged was a terrible business and has hit all the benchmarks of the plan to date.

The plan was to ...
  • reverse split the stock to get rid of excess float
  • shrink revenues to get out of low margin contracts  
  • increase gross profit through subtraction (getting out of low margin contracts) and addition (grow new industries)
  • leverage SG&A 
... all reasonable ideas. At the time it was not an appropriate an investment. Too soon. However 1.5 years later, the financial benefits are starting to appear. There have been few surprises. The corner seems to have been turned ...

QRHC has shrunk - and will continue to shrink - its revenue in order to get out of low margin contracts. The "shrinkage" will accelerate in 2H17 as management has guided to a steep decline in revenues  down 20% vs 1H17, as they exit customer contracts. This infers that they will exit 2017 with a run rate $135M in annual revenues.

They are growing gross profit margin and gross profit dollars. Despite the 20% decline in revenues, the company expects only a 2% decline in gross profit 2H17 vs 1H17. This implies ~180bps of margin expansion 2H17 vs 1H17, as well as GP dollar growth of +15% y/y 2H17 vs 2H16, and full year GP$ growth of close to 20%. This is addition by subtraction.

Once they lap these declining revenues, they expect to benefit from the addition of new verticals and industries served, notably the construction markets. Should see revenue growth in a year.

Here is a brief chart of Sales, Gross Profit and Cash SG&A (SG&A less stock based comp) from 1Q15 to 4Q17E. This graph tells the simple story of efforts to date: Shrink revenues, grow gross profits, keep SG&A flat to down.

Maybe it's still too soon, but the valuation seems attractive to this investor when one considers the benefits of a sound and experienced management team running a simple turnaround business for cash, profit and growth.

That said, and for the benefit of those (doubters) who avoid low moat / low barrier to entry companies, I include here an unedited pre-summer draft of this note when I initially sat down to write it, so that the reader may compare if the idea seems consistent with their expectations >>

"At the current $2.90 it has a $44M mkt cap and by virtue of the roughly $6M in net debt, a $50M enterprise value. This represents a multiple of 0.3x trailing twelve month revenues and 3.4x trailing twelve month gross profits."

<< "serves you right" those moat seekers / barrier investors might say, b/c obviously the stock is much cheaper now, trading for less than half  this value than when I first sat down to write this.

The stock now trades at ~$1.40 / share, implying a $22M mkt cap / $27M EV company, or 1.7x EV / Gross Profit. It is the same business model as before though certainly cheaper.

Let's say the decline in the stock from $2.90 to today is due to the revenue guidance. It might seem material that ~$32M in revenues are going away but if you back out the numbers, and realize it's a 1% GP margin hit, I say: "Sayonara". Keep in mind as well that this decline in revenue is consistent with what management long signaled to investors.

Let's say investors who sold this b/c of the decline in revenues, value it on revenues. It traded at 0.3x TTM revenues at 1Q17. Now it trades at 0.2x against the base runrate $135M, with easy comps / growth ahead. If you believe "the right multiple" is 0.3x, this "should" trade at $1.85.

But this is not about next quarters / next years numbers and the right multiple. And in reality, the stock's decline can be due to many things, a forced seller, someone with information I don't have, etc.

I see a company in the hands of an experienced executive in an industry that is not shrinking (waste is not going away) where changes over the last two years have lead to / are leading to a pathway for cash flow generation and growth, and the market doesn't seem to be assigning much value to this current and future opportunity.

It seems to me that the patient investor has an opportunity to buy something that is under appreciated and unloved with a fairly wide and predictable pathway towards growing profitability, such that over the course of the next few years one could benefit from earnings growth and multiple expansion.

It seems reasonable to this investor to buy at around ~5x expected EBITDA a company that once it laps the easy comps, can grow revenues double digits and grow EBITDA margins to the mid-single digits.

It might not be the greatest investment in the world, but when you can invest with a management team that articulates a plan, implements it wisely, can be acquired inexpensively, is generating cash and can point to a wide pathway for potential profitability and cash flow generation, that seems a good idea. In short, QRHC solves the problem of finding good companies to own at an inexpensive price, at least for this long term investor.

A few notes ...

Mitchell Saltz is Chairman and a principle shareholder. He owns  owns 5.7M shares / 37% of the company as of most recent proxy. "Mr. Saltz founded Saf-T-Hammer in 1987, which developed and marketed firearm safety and security products designed to prevent the unauthorized access to firearms, which acquired Smith & Wesson Corp. from Tomkins, PLC in May 2001 and changed its name to American Outdoor Brands Corporation."

There is a lot of overlap between the boards of these two companies ...

... I don't know much about these folks. There are some shareholder lawsuits against them stemming from 2010 / Smith & Wesson overstating guidance. Did that have merit? I don't know.

Also of note, CEO Ray Hatch has prior experience at Oakleaf, a similar asset light business that Waste Management acquired in 2011 for $425M, or 0.7x revenues. I believe this prior experience to be a materially positive indicator.

However, when you look at old $WM filings, you see this from their 2012 10K ...

"For the year ended December 31, 2011, subsequent to the acquisition date, Oakleaf recognized revenues of $265 million and net income of less than $1 million, which are included in our Consolidated Statement of Operations. For the year ended December 31, 2012, Oakleaf recognized revenues of $617 million and net losses of $29 million, which are included in the Consolidated Statement of Operations."

... which begs a question about profitability.

We do know - without a doubt - that this is a low margin business. The thesis for our investment is that this should be cash profitable in the 4% to 6% EBITDA range and with little CAPEX this is therefore trading around a 10% FCF yield at the base run rate revenue, even higher when you think about where it could be going in the hands of an experienced executive in the waste brokerage space.

But on the face of it, it looks like this "experienced executive" has never run a profitable business.

Or maybe he has? We have to deal with assumptions here but let's say Oakleaf was a 4% EBITDA margins. That's $25M EBITDA. So you'd need to see ~$50M in D&A in the first year of a $425M acquisition to have a negative $25M in net income. Given amortization of intangibles, that doesn't seem far fetched, but it's something to consider.

Finally, you can't consider an agent business without considering the risks that technology disintermediates the agent. Meet Rubicon Global, "the Uber of the waste industry". It has a $500M valuation. Oh wait, it has an $800M valuation. It even has Leonardo DiCaprio as an early investor!

I'm not going to whistle past the grave of technology, even as I make fun of the valuation et al, but there are many examples where an agent model exists alongside a technology model. I think the near term issue is less associated with the technology eating everything than with the likelihood that this private company can sustain losses for far longer than Quest can, meaning it can sign up clients at negative margins.

On the flip side, consider what would happen if Quest made an app and became the Lyft of waste management?

Quest Resource Holdings
Headquarters: The Colony, Texas
Incorporated: Nevada
Auditor: Semple, Marchal & Cooper, LLP
Phoenix, Arizona


-- END -- 


Monday, August 28, 2017

2Q17 Investor Letter

Long Cast Advisers posted its 2Q17 Investor Letter yesterday. "2Q17 was our sixth quarter in business. Cumulative returns on accounts managed by Long Cast Advisers increased 2% in 2Q17, net of applicable fees. Since inception, we have returned a cumulative 45% net of fees, materially ahead of our benchmarks."

If you'd like to receive it in the future, you can sign up for it on my firm's website

Thursday, August 24, 2017

Checking in on PSSR

A little more than a year ago I wrote about PSSR, which continues to generate cash and again trades for what seems to be a low valuation, below 6x EV / EBITDA, a 5% FCF yield, exposure to commercial airline, airport on time arrival and FAA technology budgets.

If someone impatient is selling, they're likely turned off by the recent decline in revenues and EBITDA, which have fallen off peak levels even as deferred revenues, which is an indicator of future revenues, has returned to near peak levels.

The company's quarterly statements indicate there's been a non-renewal impacting current earnings. But are these temporary or terminal issues?

In this case, the data indicate that even with Revenues and EBITDA declining - an expected outcome given a non-renewal - Deferred Revenues has grown back towards peak levels. To justify a strong a return on the stock at current levels, we would need to see Deferred Revenues continue to achieve new highs in the coming quarters. They are not there yet.

Our expectation for greater sales is buoyed by increased spending on sales personnel. The company has added former airline / FAA talent to market the product. If these are good hires then they will convert their expenses into sales and earnings.

However, SG&A spend is now up to 55% of revenues. The "normal" level is in the mid-40% range. Back of the envelope, they need to generate at +10% sales growth just to get back to "normal" and probably to justify their return on their SG&A spend and an investor's return on the stock.

No doubt, this is a competitive space and PSSR is a small player. Over the last year, I've talked with a handful of sources in the industry who work for larger competitors that offer a wider array of solutions (Navtech, now owned by Airbus; Jeppesen, owned by Boeing; IBM). None have heard of the company and most stressed the biggest issues facing all operators in the business - long order cycles and the industry's reluctance for technological change - as major headwinds, though one person thought PSSR's role as a big data warehouse with industry level information was qualitatively a positive differentiator.

It is possible that the company's marketing spend, which has propelled SG&A to new highs even as Revenue and EBITDA dip, is as good as torched cash. But deferred revenue growth indicates otherwise and furthermore increased marketing spend by rational actors is the kind of indicator that patient investors observe for signs that weigh the odds in favor of future growth.

A sale might also provide an exit for investors that does not charge our hopes. This is the same company whose Chairman (and largest shareholder) blithely told me two years ago that he's never sold because "it's more fun to compete with the big guys." He will have to prove this spirit for outside shareholders.

-- END --


Tuesday, August 22, 2017

Letter to ARIS Management on Pending Deal

I've written a handful of draft letters to the Board, but as the vote on the deal approaches (8/28), I've grown resigned to its reality and decided to write directly to management, to thank them for their work over the years.

The ARIS CEO / CFO team were among the highest quality I've encountered in my years of institutional finance and it wholly sucks that we public investors can no longer access their expertise. I'd hoped to own this company for far longer and with more value creation. It is a risk of public ownership for such assets to be taken.

Among the issues that really burns is how the whole proxy seemed an exercise in "mansplaining" that this idea to sell was actually a good one for investors. It spoke often (16 times) of the effort to "explore alternatives" but in the end it seems an impatient Board made the decision to sell then sought the highest price it could get at the moment, alternatives be damned.

It is rare to see - perhaps even antithetical to ego and hubris - a group of men get together, put in work and effort, and decide that "not doing" is the best solution, but unless operations are changing for the worse in ways we do not know, then "not doing" seemed the best course.

The compounding benefits of generating cash and re-investing it at high rates creates explosive value over time. I don't know why the Board decided they were short on it.


Roy / Bill -

This is likely my last opportunity to communicate with you as a public shareholder and I'd like to use it - primarily, but not exclusively - as an opportunity to express gratitude for the way you've run your business, for the enlightening conversations and interactions I've enjoyed since becoming a shareholder in 2013 and of course for the return on investment I experienced over that time.

Not everything you did was perfect - no one should ever expect that - but you've done a remarkable job adjusting and learning from mistakes, adapting as necessary, not shying away from difficult decisions that others likely would have avoided and especially for always explaining your reasons when they were not obvious.

All of this is to say that in my nearly 15 years as an institutional analyst on "Wall Street" you are among the most extraordinary executive teams I've ever encountered, a belief that is not diminished by the pending sale.

However, I do object to the sale, for the following four reasons:

1. The valuation multiple is too low. The Board is selling an extraordinary company at a slight premium to a "median multiple". That is absurd. They should have used the Cox / DealerTrack acquisition as a starting point to negotiations and if they couldn't get the appropriate multiple for this extraordinary asset, they should have walked away.

2. Your projections are too low. Your EBITDA this year and next is understated. Investments in India haven't yet come to fruition. Auction123 hasn't matured. No credit is given to your ability to generate cash flow and reallocate it towards high return acquisitions.

3. The deal reeks of impatience. I know you and Board believed your stock wasn't trading at "the right multiple" but selling it at the wrong multiple doesn't fix that, it only makes the mispricing permanent to public shareholders. This affront is multiplied by the fact that this sale is taking place just as the market was starting to value the company more prudently, something the Board completely discounted.

4. Finally, you are rare and unusual assets. This deal doesn't compensate us for the difficult task of having to find another "Roy and Bill".

Though it is most unfortunate that we public shareowners will no longer be able participate in the compounding effect of your managerial prowess, there is nothing I can do about it now. I can simply take away from this experience an example of what quality leadership, cash flow generation, capital allocation and engagement with shareholders is supposed to look like.

Sincerely ....

-- END --


Sunday, June 4, 2017

Lessons from the other side (IZEA)

Not everyone invests, but assuredly we all die. As ubiquitous as death is, it's pretty hard to imagine what happens at the end of our existence. No one has ever reported back. It is a known unknown.

In the absence of information, there are some pretty well established narratives: Heaven. Hell. Enlightenment. Rebirth. Etc. Each one is supported by authority shaping mechanisms. Religion, ritual, et al.

I realize many of these narratives were invented to control our children (I would tell them anything to get them to eat their vegetables) since ...

"men may construe things after their fashion,
Clean from the purpose of the things themselves"
-- Cicero, in Julius Caesar

... but at the heart these stories solve the problem of "not knowing" the what and why of our human experience. It is as if the human instinct to explain mysteries with narratives is so strong that even those divorced from evidence satisfy our palate.

What does this have to do with investing?

Well, investing is about future and the future is unknowable (no one has ever reported back). To the wise investor, the future is probabilistic, to the unwise it is as certain as death.

The point is that investors should be aware of the narratives all around them, about stocks, about the economy, about business and investing. Grasping for a narrative is as natural as a heartbeat and nearly as involuntary, but we should be wary when they are not supported by evidence. Faith is not a sound investment thesis.


I've been thinking about death - and the places where capital goes to die - following my recent investment in IZEA. It is an uncharacteristic investment for me for a number of reasons, but at the heart was a failure of process and an absence of discipline.

It is not my effort to describe here how I got got myself into a situation where I own shares of a terrible company. I was struggling with a problem and I found the wrong solution. Learning is a step function; in this case, I tripped on it.

I'm writing here instead to share what I've learned so maybe others can benefit from this experience. For the expense I've paid (on paper), I deserve a PhD. Here's a summary of the doctoral thesis ...

1. People talk about waiting for your pitch but the baseball analogy fails when you swing at the wrong pitch. Letting pitches go by = "the ones that got away" but swinging at the wrong pitch destroys capital, reputations and investment companies. It can take away your ability to get up for another at bat. This is especially true for a concentrated investor.

2. When you realize you've made a mistake admit it and move on. Moving on however doesn't mean making a second mistake. Two wrongs don't make a right. Rather, go back to process and discipline and try to find a way out. Part of what I've done to try to right this wrong follows at the end of this post.

3. Don't lose clients' capital. There have been nights when I'm cutting up cucumber snacks for my two kids, after coaching two baseball practices and while reviewing their homework, and navigating dinner time, and they whine to me about video game time and what a terrible dad I am, and I look at the knife ... and remind myself of a fairly basic rule at the center of parenting: don't kill your children. It's the same with client capital. Just don't lose it.

The permanent loss of client's capital is like killing your children.

4. Start with the cash flow statement. I come from the sell side where most of the focus is on revenues and margin. When I left the sell side and started thinking like an investor, I quickly gravitated towards the balance sheet and thinking about how a company can grow assets faster than liabilities. Now I see the utter simplicity of starting with the annual cash flow statement when building a historical model.

It doesn't mean a blanket avoidance of cash burning companies; early stage companies or those in turnaround are going to burn cash for some period of time. But there has to be a pathway towards a company existing on its own cash flow.

Also, cash generating companies that show poor accounting earnings can make terrific investments, while the opposite isn't so true (they can make good shorts).

5. Checklists. I've long been skeptical of checklists b/c I believe they create a false sense of security, as if checked boxes assure a return. They don't. Furthermore, I think checklists when overly detailed filter out ideas that could be profitable under highly probable situations.

Still, this experience has lead me to three very basic questions that I will answer before making any future investments ...

a. will the company exist in three year? (why / why not?)

b. has the company created shareholder value (ie grown BVPS) over the last three years? (why / why not / what's changing?)

c. will the company grow shareholder value over the next three years (why / why not / what's changing) and does it have the balance sheet to support this growth?

... that's pretty much it as a starting rubric for analyzing companies. These three questions alone should help weed out companies so you can avoid the mistake I made with IZEA.


The problem with mistakes is that they offset the investments you get right. This is obvious. I observe a less obvious trend that across many endeavors (the game of tennis comes to mind), those who endure and excel do so not with flashy victories but simply by limiting mistakes.

So what am I doing to get out of this mistake? For the cost of a few stamps and my time, I've written two letters to management ...

Letter 1. A simple polite basic ask and a fairly boring letter.

Letter 2. After getting a bs response from letter #1, I briefly laid out just how bad this company has performed over the last seven years and how perverse director incentives may encourage them to continue making bad decisions.

... I've also been in touch with other shareholders who may pursue their own agenda related to the incongruency between comments and guidance from the 4Q16 conf call and comments and guidance on the 1Q17 conf call, just six weeks later.

None of what I'm doing assures a return on capital but rushing to sell only compounds the mistake of rushing to buy, and if there's a rational, reasonable and possible alternative I should pursue that first.

The financial statements indicate this is a company with many flaws and history indicates that the pathway it has pursued to date is not one that will unlock value for shareholders, (even as it has created some for its customers and clients and the directors who get paid $50k / year).

I made a mistake to join this company on its pathway. Before I turn around and find my way back to a more familiar place, I need to at least try to bend the judgment of those who manage the business to draw their focus on preserving the capital they and I have already invested into it.

-- END --


Wednesday, April 26, 2017

1Q17 Letter + Thoughts on Steel Pulse

Long Cast Advisers posted its 1Q17 Investor Letter yesterday. "1Q17 was our sixth quarter in business. Cumulative returns on accounts managed by Long Cast Advisers increased 10% in 1Q17, net of applicable fees. Since inception, we have returned a cumulative 42% net of fees, materially ahead of our benchmarks."

If you'd like to receive it in the future, you can sign up for it on my firm's website


On a side note, I've been listening lately to Steel Pulse, the reggae band from Birmingham, UK, which got me wondering about their evolution and sound. To me there's something here about music, investment analysis (especially in the small cap arena) and starting a business.

i started with their first album, Handsworth Revolution (1978). i dug it hard and in the diligence of a discographic adventure, i moved on, in order, first to the offbeat and unusual "Tribute to the Martyrs" (whose album cover is an African version of Mt Rushmore); to "Reggae Fever" where a disco sound starts to take shape; to "True Democracy" a more traditional collection; to "Earth Crisis"; and ending painfully with "Babylon the Bandit", their sixth album, which won them the Grammy Award in 1986.

at this point i stopped the endeavor and went back to their first album, which i think gets better the more you listen to it, the mark of a good album.

yet, i'm confronted with this dissonance b/t their great first album and lousy award winning sixth album, which seems a mashup of 1980's theme music, part soundtrack to Beverly Hills Cop, part vomit on the bottom of Vans.

obviously this is a matter of personal taste and mine evidently lean towards the more traditional reggae. but it really gets me thinking about why the market would undervalue an incredible 1970's first new album and overvalue a crappy 1980's 6th album, if anyone "appreciated them when they were small", if people thought "they sounded like all the rest" (I don't think they do) and what it says about decisions, investing in start ups / small caps and longevity in any creative pursuit including investing.

>> what we can say about the band ...

they are masters of the traditional reggae sound paired with a desire and willingness to explore new, different and unusual boundaries

their willingness to take risks enabled them to move into new ideas and boundaries

the varied sound allowed the band to appeal to a wide audience (more sales / more success)

did they go "where the art took them" or did success lead them to be surrounded by people who overproduced the sound?

it must be difficult managing the evolution of a changing team dynamic, where band members come and go

big change in drugs b/t the 1970's and 1980's

>> what we can say about the audience ...

in 1978 the market was saturated with the traditional reggae sound

consumers sometimes put trust and faith in established brands and overlook what's new

the Grammy could have been awarded for their "body of work"

Maybe it's naive to think that an unknown band should be "discovered" and rewarded in its first year.

I can't let go of this feeling - perhaps b/c I'm a startup in my first year and everything looks like a nail to me - but this resonates with my raw efforts to start a business (though hopefully by sixth year will be as good as my first); my efforts to stand out in a crowded field with low barriers to entry; my awe at the perseverance of artists even as their tastes invariably shift; the inability to know the future and where our art will take us; the follies of awards; the magic of an endeavor; the daily absurdity of betting on future outcomes even as people and tastes change; an idea of betterment that exists in our minds converted to music / writing / art / investment analysis; and if / how / when any entrepreneurs or artists' efforts will translate into material success.

-- END -- 


Tuesday, April 4, 2017

On the Epidemic of "Buy Low Cost Index Funds"

We residents of NYC and its environs regularly pay 3x the retail price of a pint of beer to drink it in a bar vs at home. There's nothing complicated with pouring oneself a beer at home so it begs the question: What do we get for this markup?

Bar owners require compensation for their rent and overhead, but they succeed solving problems for clients not themselves. To my mind, bars solve the problem of a scarcity of places where one can legally drink in public and the prohibition against talking at the library. I'm sure there are others as well. This is why we outsource the pour.

Choosing between bars is as easy as knowing the difference between cheap and expensive bars; Yankees / Giants / Rangers / Knicks bars or Mets / Jets / Islanders / Nets bars; hipster bars, Wall Street bars, sports bars, UK pub-type bars, Russian style vodka houses, gay bars, lesbian bars, Irish bars, tourist bars, after work bars (including those that cater to those working night shifts and therefore open at 10AM), etc.

In short, with bars, you pay up, but know what you pay for and it is easy to comparison shop. One thing I can say for certain is that I've never seen anyone standing outside a bar exhorting everyone to "only buy the low cost drinks".


This post is about ...

the difficulty to comparison shop between ETF products;

the inability for the majority of people who don't work in finance to know what they're actually paying for when it comes to ETF's / index funds;

and how those people who want as little risk as possible are sold ETF's / index funds as the "low risk / low fee alternative" but actually face wildly overlooked risk that could be potentially disruptive to their savings.

... The assumption that anyone at anytime can buy an index fund and hold it forever as a solution to their savings / investment goals is as crazy as inviting a random person into their house to replace a water heater.

ETF's are a convenient - perhaps too convenient - solution to a most difficult problem of how to find and identify good investment managers. The ETF solution? Don't even bother! I'm a little biased here, but I think hiring an investment mgr can / should be done the same way one finds a doctor, lawyer, accountant, plumber, mechanic, etc. and the effort is a worthwhile alternative - even to the modest saver - to blindly buying and holding ETF's.


How finsvcs are different and how performance is woefully misunderstood 

Like other industries, there is generally an "information asymmetry" in finsvcs by virtue of the fact that an unknowledgeable client pursues the expertise of a knowledgeable professional, the same as when most people hire an accountant, plumber, doctor, contractor or mechanic, etc.

In most of these cases, an expert is hired to solve a specific problem and so there is match between what is provided and what is experienced. This expert is generally found by word of mouth, referrals, prior experience, marketing, price or convenience.

Also, like other industries - services and otherwise - there are multiple price points for the consumer to consider. And finally, like other industries where competition, low barriers to entry and a mechanized option exist, prices are coming down.

However, finsvcs differs from these other industries in three ways ...

1. In most industries, everyone sort of knows what value is offered at different price points ("leather heated seats" or "a knowledgeable helpful person on the other end of the phone") but not so much in finsvcs.

2. With a plumber or mechanic, accountant or even doctor, the engagement ends when the problem is solved. In finsvcs, the engagement goes on indefinitely.

3. In finsvcs I see a difference between the value the service provider thinks they provide and the value the client thinks they get.

... in all three of these cases, the difference between what is experienced in other industries and what is experienced to the finsvcs consumer generally resolves to "performance".

"Performance" however is woefully misunderstood. I'll get more to this later but suffice to say, since "avg performance after fees" always lags "avg performance excluding fees", we're living in this supposedly rational effort to simply "reduce fees." This has led us to this strange place that's poorly resolved with the oft repeated mantra "just buy low cost index funds."

I agree on the need for fee reduction, but needless to say, I believe the mantra to "just buy low cost index funds" is more of an epidemic than a trend and reflects further efforts by Wall Street to compel ignorance through propaganda while separating people from their money.


Comparison shopping is easy in the grocery store but hard for ETF investors 

It is perhaps an imperfect analogy but I see investors as grocery shoppers and often vice versa. The investment decision in my opinion is just a super refined version of the same kind of decisions that millions of supermarket shoppers make everyday.

And how do shoppers and investors make decisions? By inspecting the product. Both investors and shoppers are able to make informed decisions on products b/c regulations - "Section 13 or 15(d) of the Securities Exchange Act of 1934" and the 1966 Fair Packaging and Labeling Act - that require accurate and honest labels about the products inside.

I have no doubt that the learning curve to reading labels on SEC documents is a little steeper and longer than the learning curve for supermarket labels and therefore the group that does one is narrower than the group that does the other.

Yet, in both scenarios the consumer who is adept at reading the labels can make an educated decision that justifies their choice and potentially adds value to the experience they seek. It calls to mind the old Syms slogan "An Educated Consumer is our Best Customer".

So what labels are read by the massive number of Americans savers who have entrusted trillions in savings to ETF's and index funds?

In an environment where even the Oracle of Omaha says ...

"Both large and small investors should stick with low-cost index funds."

... what labels can "large and small investors" read to learn about the past and / or potential future performance of the fund? The answer is in the ETF prospectus, and they are light on relevant details.


The finsvcs industry probably doesn't want better ETF labels or for you to know their valuations

I come from the school of thought that when you buy a stock you become a part owner in the company's future cash flows, and that the stock's performance - over time and when acquired at a reasonable valuation - should approximate the company's cash return on total capital.

So I invest in a company's performance - it's collection of assets + / - mgmts ability to solve the variety of problems faced every day, etc. - with the expectation that over time, and with patience, if I'm right on the company's operating performance, eventually the stock performance will follow. I try to buy a good operating company at an inexpensive price and grow my capital as the company grows.

I am able to do this b/c of information available to me about the company via its "labels" (ie its 10Q's and K's), which, when properly analyzed, can indicate at the very least it's historic performance at generating a cash return on total capital.

Flip to an ETF label - its prospectus - and it seems devoid of information that would seem meaningful under this rubric. All you get are lists of the companies and their weightings.

Now this can be informative, but not along the lines of determining the aggregate present value of future cash flows of the contents of its portfolio.

Informative more along the lines of knowing that ~6% of the Vanguard Social Index funds is wtd to energy / mining companies, which should be meaningful to the investor who owns it in the effort to implement an SRI strategy (whoops!).

It seems to me these prospectuses would be more helpful if they included information on some independent variable like the RoTC of the the stocks in the index and for the entire portfolio, or other information that is essential to stock investors, such as sales growth, cash flows, earnings growth, etc. for each company and in aggregate.

That way investors would at least have a guide of knowing how much they're paying dollarwise for these independent variables. Those variables ultimately define the fundamental performance of the underlying companies.

Unfortunately, the big effort in finsvcs industry right now isn't about better product labeling on the most popular product of all time, but about the "fiduciary rule", which is a fight about whose interests should come first in the customer relationship.

I have a hard time holding these two ideas in my head without getting back to my earlier conviction that the mantra "buy low cost index funds" is an effort by Wall Street to compel ignorance through propaganda while separating people from their money.

Because if they are fighting against putting client interests first, they probably aren't.


Explaining ETF's to my kids 

My kids - two boys, 10 & 12 - have started getting interested in investing. I've been trying to figure out how to approach it with them in a constructive way that also dissuades them from pursuing it as a career choice, and I decided we would start simply by picking a few of the 1,000 largest stocks (still) posted daily in the WSJ along with a few index funds.

But what are index funds? My kids heard the phrase but don't know what it means, so we talked about it.

I gave them the analogy of a deck of cards. With a single stock, they can buy one card in the deck, and they would get a cut of / or / pay part of the cost of the kiddie whenever that card was played and won / lost. Which card would they want to own? The Aces, they said.

If everyone wants the Ace, its price goes up, then which card do you want? K, Q, etc. Can't even the lowly Deuce win a hand? etc.

The alternative, I suggested, would be to take a 1/52nd slice of every card in the deck, and create a new card that is equal portion of every card in the deck. That, I said, is like an index fund on the deck.

They said: "But then, if all the cards are used in a hand, don't the winners offset the losers?" And "Not every hand has every card so just a few cards will be played most often" And "The more hands played the more money the casino makes"

I'm starting to realize that even though they barely do a single thing I ask of them, at least they aren't stupid.


The goal of investing isn't to own ETF's or stocks

The goal of investing is a return on capital in excess of the rate of inflation without bearing the burden of "excessive" risk. I put "excessive" in quotes b/c there are a lot of different kinds of risk and it can mean different things to different people at different times of their lives and depending on their needs.

The benefit of ETF's is that they offer broad exposure to the market at a low cost with the ease - to both the buyer and the producer - of not having to understand (or disclose) what each company in the portfolio is doing. But keep in mind, "broad exposure to the market" isn't a goal in and of itself; the goal is the return on capital, etc ...

ETF's don't promise the return on capital part, they just promise the elimination of single company risk the same way any diversified portfolio does. If you compare an ETF or index fund to any diversified portfolio, one could safely say that ETF's are better and cheaper than alternatives at achieving this low risk return on capital goal, etc. This is an important attribute.

Through this lens, if you think about the problem an ETF solves, then you think about the problem a diversified portfolio solves, and you eventually get to theories on CAPM and the efficient frontier, etc.

And what problem do those theories solve? The problem - essentially - of how to judge and define a good investment mgr. It is - and remains - a ridiculously hard problem to solve. Endowments have a hard time doing it. Institutions have a hard time doing it. It would be nearly impossible for the average person to do it. So, from CAPM, to efficient market hypothesis, and all the way down to ETF's, the theory boils down to, "don't even bother trying".

The point is that ultimately, with ETF's you're just getting a ridiculously inelegant solution to the supremely difficult problem of how one should actually go about identifying good investment managers who can consistently generate a return on capital faster than the rate of inflation, and with limited risk.

And yet ... something is missing here. B/c when 99% of the world thinks about ETF's they're really just thinking about two things: Fees and Performance.


It should be easier to know what you're paying for

As it currently stands, Fees and Performance (along with some generic title) are essentially the only labels ETF investors look at. In a simplified world narrowed down to just those two things, and where one of them - performance - generally looks the same across asset classes, the mantra to "buy low cost index funds" makes a whole lot more sense.

The trouble with this "two label" solution isn't just the opacity. As an industry we woefully misinterpret performance.

As we know it, performance is the change in the market value in a stock. But the price of a stock isn't information about a company, it's simply information about how "the market" values that company, day to day, quarter to quarter, etc. The "voting machine" at work. Stock price performance ignores the the critical information regarding some underlying independent variable about the operations of the company, like earnings, revenue growth, FCF Return on Total Capital (or something).

If people look at performance to buy funds, and they are only buying funds with good performance, then they are purchasing something that has already increased in price. Whether or not this is a good idea is hard to say - not enough information - but there is no doubt that buying something for the sole reason that it's gone up on in price isn't remotely related to a good capital allocation decision.

Let's say there were a better "standard label" for index funds and frankly for hedge funds and investment managers of all stripes as well. Not just Fees and Performance but information that would enable investors to choose whether they want to pay more or less for that independent variable. This would help them choose between products.

I'm not talking marketing.

I'm talking better labels on the portfolio that enabled shoppers to really compare / contrast products - say the aggregate FCF Return on Total Capital of all the companies in the fund and the valuation multiple on it ($x for every % in RoTC) - and it could be compared to the aggregate and valuation multiple of the benchmark, then customers would know better what they were paying for.

Whatever metric, it would at least incorporate one of the more important attributes of capital allocation, which is price paid for some independent variable.

This could (and ostensibly should) be calculated for any portfolio. With this improved "label", shoppers would have better information to choose b/t products. It would certainly be better than the most bullshit of labels imaginable, the Morningstar "five star rating".

I'm not saying this is a perfect solution. I'm sure if I'd pull back the layers on this idea, there would be multiple methods of gaming the system (and no doubt in this business, someone is always gaming the system), but it is a simple opportunity to add reasonable, fundamental and easy to understand information that would enable consumers have more insight into what they're buying.


There is plenty of room for a differentiated strategy 

An important question you rarely hear is; "are you willing to accept different performance than the market? It might be better it might be worse, but I assure you it won't be the same." Why bother asking it?

We know for a fully loaded 30 basis points investors can get some undifferentiated market return. This means that anything paid above that - 100bps for a financial adviser or 2% / 20% for a hedge fund - implies that there is some "other service" offered for the incremental costs.

What are those other costs?

Here I am, starting my own investment mgmt business ("the food truck version of a hedge fund"), trying to figure out how to get traction with "folks who look like us" ($50k to $5M to invest), and many of them say, "we'll stick with low cost index funds".

Meanwhile, the larger and more sophisticated investors I know stick with name brand expensive hedge funds. (And what is a brand really but another "authority shaping mechanism").

So I ask myself a whole lot of questions ...

How do I sell?
What's the right target and pace of growth?
How long should it take me to get to $10M, $20M or $50M AUM?
What steps do I need to take to have functional substantive conversations with family offices / endowments?
How long is a sales cycle?

... Conventional wisdom says that performance is a big part of AUM growth but I think the evidence suggests that scale supports AUM gathering at least as much, if not more than, performance. I even venture to observe that scale drives AUM growth while performance chases it away, but that might just sound fancy and mean nothing.

But what justifies fees? This gets back to the unoriginal question above. I think "stewardship of capital" broadly defines the endeavor, which broadly speaking is some combination of ...

don't lose it
grow it
kick out some income
help me make decisions / help take care of it for me
i trust you (and a host of other emotional content around money)

... none of that is worth anything to anyone who isn't willing to accept a differentiated return.

The point of mentioning all this is that it would be so much easier if I could compare and contrast my portfolio with benchmarks, not in terms of "performance" but in terms of maybe price / aggregate RoTC of stocks in the portfolio or price / aggregate revenue growth or / aggregate book value, etc. It would be neat of I could do this (on Interactive Brokers I can't even get real time quotes anymore without paying $1,464 / year).

Everyone says fees is a friction in finance but I think the real friction is the inability to tell critical and meaningful differences b/t products. Meanwhile, instead we're all just told "just buy the lowest cost one" as if we all should just eat spam for dinner.

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