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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

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.

2 comments:

  1. Great article, thank you for sharing...

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  2. IZEA published a letter to shareholders yesterday ...

    https://www.sec.gov/Archives/edgar/data/1495231/000149523117000059/izeaproxy2017supplement.htm

    ... which the CEO sent to me and I'm sure many other's who've reached out to him as well. I responded:

    Ted -

    I agree with most of what you wrote in the letter but - forgive me for the eye roll - it resonates with me as when my kids say they're going to clean their room or do their homework or come up for dinner in five minutes.

    WE NEED EVIDENCE ... of a commitment to "sustainable profitability" and that you're making "the right decisions to build value for your shareholders."

    Evidence comes in the form of making really difficult decisions like laying off your friends and long time employees or asking them to take paycuts or work fewer hours a week.

    Evidence on the financial statements comes in a material sequential decline in G&A every quarter until its back below $2M / quarter, without inhibiting sales productivity.

    I know its draconian but it gets back to the one notion I disagree with in your letter: "... we also will not put ourselves in a position where a transaction is forced or otherwise doesn’t make sense."

    Once you've restricted your ability to "think long term" aren't you already there? You're at this point where your decisions have to be based on immediate returns, so you may have to say no to customers and no to great ideas. You have neither the cash nor the credibility to do otherwise.

    Wouldn't you rather keep saying yes? I'd think a buyer would give you that opportunity, which the public markets have restricted to the potential detriment of your platform, customers and employees.

    Talk is cheap and I'm sure you're aware that most people don't change their behavior so I think it's fair to ask for evidence. I'd suggest - short of a sale - that you find ways to demonstrate evidence with a press release at the end of every month showing monthly reductions in head count and / or G&A + growth in monthly sales / sales productivity.

    I'm hoping you can work your way through this. If you can, you'll grow wings and transform from an "entrepreneur" into a CEO. If you can't, you'll at least know what your weaknesses are and to better compensate for them in the future.

    Sincerely ... etc.

    I'm a "trust, but verify" investor

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