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

Tuesday, October 10, 2017

A Brief Thought Experiment (+ 3Q Results)

A brief thought experiment: Imagine a company that sells snow to eskimos. Now imagine it's growing and profitable and generates cash ...

... then maybe you start to rationalize it. Maybe they have a brand that's so powerful customers want to pay for something they don't need. And that brand creates a moat. Maybe its the greatest company in the world! Or not? "Climate change will kill them! Climate change will create more demand!?" You can follow any line of reasoning your mind takes.

Maybe this is a sign of brain damage but this idea has been on my mind a lot lately.

Companies whose products we don't need and are only differentiated by some perception-of-differentiation or services sold well in the man-hour impression are selling snow to eskimos. EVen outside the consumer space there are more of these than one cares to think and some may be considered excellent investments b/c they are so darn good at selling.

This is not a ground breaking observation nor a suggestion to buy a small company ahead of an eventual product or brand development or new service hire, just to recognize the power of the sales function. It's something we miss at times. Maybe an unwillingness to acknowledge that differences are matters of perception and perceptions are pliant and easily manipulated.

Which is where a good salesperson or a good sales experience comes in. I know it sounds antiquated but in less modern terms anything that eases a transaction forward - or enables a bias or emotion - is a good salesman. It is invaluable at differentiating. A "like" on the great confirmation bias machine. These are hard to generate but scale well across a network.

I'm not stupid enough to compare Jobs' Apple with a waste brokerage business or any other small services companies LCA owns, but a handful are growing their costs / expenses / expenditures towards selling / marketing / product improvement with the expectation that revenues will follow.

The market sees shrinking profitability and cash flow. Short term thinking by "the market" is part of the opportunity set for patient investors. At the right multiple, not much needs to go right. I see companies that have in the past generated returns on their investments, indicating a business where history and management show up. A long growth history in BVPS is more valuable than most recent BVPS.

If the market considered a return on investment likely or probable, these stocks would trade at higher multiples in anticipation of the eventual rebound in earnings. Neither me nor the market knows the future but we are anticipating different outcomes. 

***

Long Cast Advisers recently published it's 3Q17 letter:

"3Q17 was our eight quarter in business. Cumulative returns on accounts managed by Long Cast Advisers increased 8% in 3Q17, net of applicable fees. This was better than the various indices against which we benchmark ourselves. YTD returns through the end of 3Q17 are 21% net of fees. Since inception, we have returned a cumulative 57% net of fees, materially ahead of our benchmarks."

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ALL RIGHTS RESERVED. PAST HISTORY IS NO GUARANTEE OF PRIOR RETURNS. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS IN THE COMPANIES MENTIONED HERE. I MAY OWN POSITIONS IN T

Tuesday, October 3, 2017

On obfuscation and the cynicism of investor stupidity ($EVI)

A short seller's presentation on $EVI was published yesterday. It is a long read. IMHO readers would be better off reading EVI's just published 10-K for 2017 and for 2015 as well. Go straight to the source.

But time is short and relative. "Should I read this or that?" The report's author hacks this concept of constrained time - as do many other media - to tell us an abbreviated version of things from their perspective.

It succeeded in serving its purpose, as it often does in the info/business/complex, but failed to adequately inform, as as it also often does in the info/business/complex. We the audience should expect more lest we fall to the level of stupidity expected in its consumption.

This was a valuation / technical short dressed up as fundamental analysis with absurd allegations, self serving drivel and a misunderstanding of the industry served. It reflects a cynicism about investors' intelligence, assuming people will believe it since it comes from a source that's been reinforced by the authority shaping mechanism of the info/business/media. I don't buy it.

For example, of a main allegation, that the company is "teetering on a covenant breach":

"Per the terms of its credit agreement, EVI must maintain quarterly profitability or risk a covenant breach. Q4'17 earnings of just $0.5m means that EVI is already teetering on a covenant breach"

The record shows that in the last 5-years quarterly and 15 years annually the company has never reported a loss. The report should include that information if it considers a quarterly loss a risk.

One can argue valuation until they're blue in the face. I'll frame up the short case a bit more simply quoting my backgammon opponent of last night, himself a former aerospace analyst: "Paying 20x pro forma EBITDA for a cyclical company is insane. We're mid-cycle for godsakes! When the cycle turns, you're going to get creamed. You should sell! You're buying into the cult of personality with this CEO!"

That's the short case: Valuation on a cyclical company.

Don't believe what anyone says about laundry being non-cyclical; capital goods are cyclical. EVI is cyclical. But, the record indicates that EVI is a late cycle play, that additional exposure to maintenance CAPEX mitigates some of the extremes of the cyclicality as does current and future geographic + product diversity.

Which gets to the bigger point on why I and others are bulls despite the nose-bleed NTM valuation. Investing is a business of probabilities. I see a high probability that EVI can continue to expand its growth, within and beyond the traditional capital laundry equipment into water reuse, remediation, perhaps even chemicals (the CEO's former business) and into add'l areas serving a client base that now stretches across the US and into Mexico, Central America and the Caribbean. (PS: All those wiped out resorts will need new equipment soon).

The point is, what's important is simply the company's effectiveness at  continuing to achieve it's "buy and build" expansion in the future.

So if you believe (as I do) that this company will report $16M or $24M in EBITDA in the future, than arbitrarily narrowing the opportunity set for that growth to a 12-month time horizon "b/c that's how we value things" is meaningless.

I also believe that the CEO is a rare and unusual talent and as I commented elsewhere, shorting this thing b/c 4Q17 margins are weak is like shorting Doc Gooden in '84 after he lost two games in a row, in August.

Obviously, one should only expand their comfort zone when using knowledge and information as a guide. Unfortunately, the short report contained neither. I actually expected more.

There's no harm in waiting for another pitch elsewhere. For me, I think EVI solves the problem of allocating capital b/c it allows me to buy a well run business that should grow significantly / materially over time. When the law of larger numbers starts to catch up, that's when the multiple will shrink, but at that point I suspect this will be a more expensive stock.

-- END --

ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS. I MAY OWN POSITIONS IN THE COMPANIES MENTIONED HERE.

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

https://www.linkedin.com/in/steve-marchal-65352415/
https://www.linkedin.com/in/robert-semple-99184168/
https://pcaobus.org//Inspections/Reports/Documents/2009_Semple.pdf

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ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS. I MAY OWN POSITIONS IN THE COMPANIES MENTIONED HERE.

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.

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ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS. I MAY OWN POSITIONS IN THE COMPANIES MENTIONED HERE.

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 --

ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS. I MAY OWN POSITIONS IN THE COMPANIES MENTIONED HERE.

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 --

ALL RIGHTS RESERVED. THIS IS NOT A SOLICITATION FOR BUSINESS NOR A RECOMMENDATION TO BUY OR SELL SECURITIES. I HAVE NO ASSURANCES THAT INFORMATION IS CORRECT NOR DO I HAVE ANY OBLIGATION TO UPDATE READERS ON ANY CHANGES TO AN INVESTMENT THESIS. I MAY OWN POSITIONS IN THE COMPANIES MENTIONED HERE.