About Me

My photo
This is written with serious investors in mind, though sometimes they're just drafts in progress. I'm a former reporter, private investigator and institutional equity analyst who digs deep to find niche undervalued and undiscovered securities. I manage money for individuals, institutions and family offices via my business Long Cast Advisers. This blog is part decision-diary, part investment observations and part general musings about Philadelphia sports. It should not be viewed as a solicitation for business or a recommendation to buy or sell securities.

Tuesday, January 26, 2016

when the process works, the patient investor sits on losses (FTLF, VRX)

Two forms of regret I most often hear when talking with investors are:

I sold too early (b/c it went up)
I held too long (b/c it went down)

Surprisingly, I rarely hear anyone say: "I wish never bought that .... ". Buying the wrong stock is like having an STD; nobody wants to admit it but if you're active as an investor (or otherwise), it's probably going to happen.

For investors who rely on research as the foundation of their work, having a checklist or process can help avoid mistakes and, when they happen, provide for an easy and effective post-mortem if the mistake is the result of a deviation from process.

However, a flawed process, or worse, a mistake that precedes process - both of which can compound mistakes - must be exceedingly hard to detect. I imagine that navigating the solution to a flawed process requires an intense degree of self-reflection and might potentially be crushing.

I'm thinking broadly of something like Valeant, where very smart investors were proven to be very wrong. I don't know Ackman or Cuniff's processes and what - if anything - went wrong with them, but as an outside observer, I think their mistake was accepting the prime fallacy that a pharma can sustain itself without R&D. In my opinion, once they accepted that, they were screwed no matter the proximate cause for the company's revaluation.

This post relates to my continuing fears of an error in process tied to a stock that - like many on the market - is underwater for the year.

Specifically this post is about Fitlife Brands (FTLF), which sells sports nutritional supplements, primarily to GNC franchise stores but also increasingly to GNC corporate stores and independent channels.

I've written about it previously and I own and like the company. The stock, like many that trade on public exchanges, is down and though we all should conduct constant due diligence on our holdings, one's focus can really narrow when sitting on steep losses.

It is the nature of capital that we should have an urge to not lose it, but if we trust our processes, it's important to fight that urge, dig down and do more research.

Keep asking that question: "What don't I know?" and then try to learn something new, because selling a stock when it's down for no other reason is sheer idiocy: If I liked it at 1x, I want more of it at 0.6x.

So the losses I'm sitting on with FTLF got me out the door for more channel checks and more due diligence and for better or worse, most of what I heard reinforced what I already knew: store mangers love the brand and it continues to sell well.

I visited five stores that were owned by various franchisees that among them own more than 20 stores, and the majority of managers I talked with all said the same things: The company is great at selling, they are great at coming up with new brands and new ideas, and their sales people are smart, personable and know the product.

Trends were mixed - some said volumes were down for the quarter other that they were up - but they all said the company was awesome and the long term trend / outlook was from their perspective positive.

I talked to two store managers who had each been in the industry for +10 years and they said the "industry" clouds felt no different than prior cycles. One said volumes were impacted by "the Dr. Oz thing" and seasonality but nothing dramatic.

Another store manager said he'd been carrying the product since they were "nothing" and that he'd seen them grow "like this" (45 degree angle with his arm) and he still sees that growth ahead.

A manager repeated something I'd heard elsewhere, that FTLF reminded him Cellucor when it was just starting out. (Cellucor is owned by Nutrabolt which rec'd a minority investment from MidOcean Partners in July 2014).

One new - marginally negative - thing I learned is that the most successful franchise in the area didn't even carry the product. 

That franchise, in a mall with predominantly Chinese stores, doesn't carry a lot of sports supplements in general and my sense was they don't have to; Chinese are big buyers of supplements. 

I didn't see that as a huge issue and it certainly made sense to me. As a side note, I had been previously informed - with some sense of awe by another store manager - that this Chinese store did $7M in annual sales, an astronomical figure compared to the $2M-$4M / year that would be expected from other stores of similar sizes. Just some color on what a GNC franchise brings in the door. 

But the short summary is the channel checks reinforced most of what I already knew. 

So I've revisited my model as well. 

iSatori (IFIT) at the time it was acquired by FTLF was more distressed than anticipated b/c of poor balance sheet management by the prior exec team (reinforcing the opportunities to be managed by FTLF's excellent management team) leading to a lower share ratio in the acquisition.

By my math, FTLF issued 1.8M shares to acquire IFIT then repurchased 600k shares (I'm guessing at $1.50 / share) back from Stephen Adele, IFIT's prior CEO. 

So I estimate post deal FTLF has 10M shares outstanding and a slight net cash position. I maintain they can continue to do $30M sales / $3M EBITDA year one as a combined company. At current prices its trading at 4x EBITDA, which I think is an incredibly attractive price for something that has no impact from China, commodities, energy, f/x, etc.

On top of the overall market turbulence, FTLF has one specific headwind also previously disclosed and also related to the deal: IFIT's largest shareholder Russell Cleveland has about 460k shares he wants to sell and the company has the right of first refusal on the price.

This could lead to some turbulence in the near term, b/c I would bet the seller wants to get the most money he can and the buyer wants to pay the lowest reasonable price and I can imagine the seller using some leverage ala "I will dump every share on the market at $0.90 before I sell you my shares below $1.40" and them telling him to go ahead (for some reason I imagine this dialogue taking place with french accents).

This is a temporary non-operating issue overhanging the stock that should be resolved in short order, is not a surprise and maybe it's an opportunity to lower my cost basis.

Big picture is the CFO and CEO have a history of running this business profitably and with cash flow generation - even when growth has slowed in the past - I see no reason my thesis should change. In short, the stewards whom I entrusted my capital with continue to run the business with the same strategic aplomb as they've done before and as I expected.

Yet, with Valeant in periphery, I can't help but wondering if - even as I check every check in my process - have I accepted a prime fallacy that obviates the process?

I have two thoughts on what that might be ...

1) The supplement industry has intrinsic value.

I accepted the hypothesis that this is a large mature industry with ~$3B in sales that isn't going away overnight. There's room for innovation such that new brands are accepted and in some ways, it isn't much different from other consumer products (ie pop soda, for example) that aren't really good for you but are consumed in mass.

2) The company's push model advantage is sustainable.

Most of FTLF sales go through GNC franchises. GNC makes it's money selling wholesale to franchises and is expanding its franchise system so on its face, this points to more doors for FTLF. But  it makes FTLF that much more reliant on the GNC channel.

I had initially thought to hedge FTLF with a short against GNC in order to offset the risk of this situation - in retrospect it would have been the right call - but it seemed absurd to hedge a microcap with a short against a midcap. Maybe next time it won't be so absurd.

More broadly, internet sales of sports nutritional supplements is the elephant in the room. FTLF's model is to save on sales / promotional spend and push at the store level. But that won't work where the internet disintermediates the push channel. And that means it might need to spend on S&M, which would impact profitability / cash flow / etc.

... These are the questions that make investing hard and their answers, or how I choose to answer, will help me succeed or fail quickly in my business and more broadly help define my process.

Even as I sit on losses, I have to rely on my process or the emotional toll of price signals will be overwhelming. I want to avoid that.

I think my process is working. I still think is a very well run business - run for profitability and cash flow - with future opportunities for growth and margin expansion, going though some very specific turbulence regarding post acquisition shares (a temporary issue), some industry overhang (as it has done before) as well as some systemic issues that rains on all stocks.

Relying on a process doesn't make sitting on losses any more fun but it makes it bearable and its something a patient investor needs to accept, even perhaps as an opportunity to lower their cost basis.

-- END --


Friday, January 22, 2016

recent advice to a young investor; "klarman and burry don't give a shit about you"

I received an email from a young investor telling me he'd closed out of a common position we both held and had briefly shared research on over the last year.

He wrote to me, on why he sold: "I may be making a mistake down the road, but I could not get over the some of the risks surrounding broker/dealer requirements to keep the stock listed. This was a large position in my account, so the risks seemed magnified."

I am not one to judge. people sell for all kinds of reasons. he seemed like a nice kid who'd done some digging and we shared an interest in offbeat names. And I think he sent the email from a good place; he was sharing, and that's nice.

but i didn't know what to do with the information, and so i was bothered by the email. I still can't put my finger on it. i ended up quibbling with my wife, who'd texted me like 30 seconds later about dinner (that was assuredly not the right response).

a lot has changed with the company in the last year - it de-registered in April and hired a new, young (but experienced) CEO at year end - but nothing that initiates action now.

maybe if it were a reason i'd understood, it would have given me an opportunity to learn, think, review, or discover a new angle on the investment prism. instead, it felt like an affront. I don't know why? i know it wasn't intended that way. i think I didn't know what to do with the information.

i should have just deleted it, but i hastily penned him the response below. he politely and gracefully acknowledged it when he could've told me something else ... but when i reread it, i think it's pretty good advice for kids starting out as investors wall street, so i decided to post it here:


I appreciate that you told me you sold, though it was unnecessary and it has no impact on me.

But I'm writing here very much in reaction to something that's bugging me ...

you write on your SZ profile that you're fans of Mike Burry and Seth Klarman
And that you're a deep value investor
And that you read margin of safety

... And all I got to say is: "talk is cheap."

You've sold a stock you've held for maybe a year for a reason that makes absolutely no sense and based on this information - all the info I've got - you're not only failing on the long term deep value front but you're also not honestly reflecting on what you're doing and why. your reason for selling makes no sense to me.

lookit, I know nothing about you. maybe this is way off base. maybe i'm just a voice in the mist, but you might want to seriously take a long hard look at this experience, figure out for yourself with honest self critique what went wrong, what you can learn from it and how it might effect you going forward.

there's a lot of things we can do with our lives time beyond investing. whatever it is, if it comes from deep inside, from a place of passion and obsession and love, then you're in the right place. and I urge you b/c you're young, take your time and figure out what that is, and do not stop until you get there. it's worth the effort.

seth klarman and mike burry don't give a shit about you. Plus I bet there have been many days when they wish they were someone else. If you're putting them on a pedestal b/c they're rich and successful, then you're doing it for the wrong reason. [And] if they're your heroes b/c they did extra work to make sure they were right and stuck to their guns when everyone else said they were wrong, then you've just failed your test.

that's my best effort to be like "good luck, kid"

/ Avi"

... and I meant that, the good luck part, figuring it out and all that.

it takes a lot of practice learning to do anything and investing is no different. but learning means making mistakes. so beginners should start small and take time figuring out their tolerance for pain and risk and then use that as a guide to the questions they need to keep asking.

the way i see it, the more you know, the better you can establish an appropriate price for a stock, understand why it doesn't trade at your price and figure out what it will take to get there:

who are the customers?
why do they pay for it?
what would make them change their behavior?
how does the company make money on this?

and then with more practice and observations, you might start to see patterns emerge where your research leads you places you didn't know, b/c you kept an open mind, and you asked more questions and dug for more research.

or it takes you to a place where you find other people investing in the same things and you are suddenly a victim of confirmation bias: "oh they're doing it, so i feel better." sometimes it's better to seek out people who disagree with you.

finally, there are so many angles to investing. but having a good post mortem is a great tool. keep a collection of your investment decisions (this is mine, here) and then reflect later on what went right and what went wrong. it can be very helpful in scaling the learning curve.

improvement is not automatic and no one is an expert in everything but if you love this, and carve out a place for yourself, and can maintain the intellectual honesty to reflect back on what's going right and wrong, then it just gets back to the theme that underlies this blog: patience.

it's tough - as someone just told me - when you commit capital to an idea that does nothing. capital is the air we breathe and our great passion requires a lot of it. start small, be patient, don't go bust and if investing it lights a fire for you, you'll find endless opportunities to learn.

- END -