On Performance, Returns and Finding Ideas

A flooded basement isn't just a confrontation with nature but a reckoning with all the shit stored down there. Here's a long kept advert in the now repaired basement from the Sept 21, 2001 issue of WSJ. I kept it for sentimental reasons since GE was the first company I covered on the sell side as an associate at CSFB. My boss, Mike Regan's, advice on approaching the analysis of a behemoth like GE was priceless: "Imagine it like a grocery store," he advised, "this aisle has turbines ... that aisle has appliances. Keep it simple." 

Back then the company was very much admired and respected and nobody seemed to blink at the fact that GE Capital was the biggest single driver of operating profit. The GECS segment - the bank - did it all: Consumer loans. Industrial product loans and leasing. Transportation finance. Mortgages. Insurance. Re-insurance. And it owned the Montgomery Ward BK claim.  

Though I spent most of my time on appliances and HVAC and related products (compressors, motors, etc), and contributed little to this report, I was given co-author credit with Michael Mauboussin on this piece "Wanna Be GE". Parts of the report didn't age well (ie lauding Enron and GE) but the analysis of value creation and the failings of accounting to track those inputs in a knowledge and service economy remain timeless. He's been in at it awhile and is a true professional. 

Also found this clip of Pete Rose in the basement, which I don't remember ever having. I'm a Philly sports fan but those Reds were something special: Rose, Bench, Morgan, Foster, Seaver ... now I'm dipping into the internet...  Dave Concepción, César Gerónimo and Ken Griffey, Sr.. ... that starting eight "played 88 games together during the 1975 and 1976 seasons, losing only 19." (Wikipedia) Impressive! Pete Rose belongs in the HoF. 

I didn't write this with intention of revisiting old things in a box, but to share my YE'22 letter and include below a portion that didn't make it into the final piece; I prefer to keep the letters short and this struck me as "off topic". It is an observation on returns and performance that is both "duh" - obvious, everyone knows it - but I think worth noting. 

Time Weighted Returns (TWR) is an industry standard and is generally the “headline number” reported by investment firms. But TWR is an awfully flawed figure b/c it's a function of percent returns regardless of size or timing. Therefore, it can be skewed by the fat tail of one good (or bad) investment at any point in a fund’s life. 

As a result, TWR doesn't offer information on consistency, and I don’t mean “consistent returns”, but the consistent selection and weighting of companies that increase in value and the concurrent consistent avoidance of those that don’t. Without that consistent capability, clients are unlikely to generate returns that match the fund's overall performance. And if they're not generating those returns, what's the point? 

An extreme illustration. Let’s say you daytrade $100 to $200 (100% return) and your friend who is an even better day trader and ends up with $1,000 (900% return). Now you both realize you’re onto something and since you want to generate wealth, you start a fund and “market” those returns … and then put all the money you raise into the S&P TR ETF. 

Let’s compare 2016 to 2022 returns between these two funds and the S&P, all years showing the same returns except in the first year replace the +12% (see table below) with 100% and 900%, respectively, with subsequent years tracking the S&P. By the end of ‘22, the S&P time weighted return would be +12% CAGR while you and your friend would show gross TWR +21% and +52% collecting fees on undifferentiated results. 

This isn't "scandalous", it's a rough example of how TWR works; one bonanza can move the "performance needle" for long periods. Given the way it works and its importance, consider how it influences PM behavior? Some PM's swing for the fences - it's certainly a strategy with small amounts of money that one can afford to lose - and it can result in massive TWR. However, that TWR won't reflect the expected return for the "next client" wooed by yesterday's high returns, a problem in this what-have-you-done-for-me-lately business. 

I'm not a swing for the fences investor so much as "buy good companies at a value price" and I think a better indicator of performance is "median client return". Maybe something to ask a portfolio manager if you're seeking one out. 

Speaking of seeking out portfolio managers, I was recently at a meeting with a potential client and they asked how I find ideas. I threw out a bunch of "idea generating activities" - screening, reading through industry lists, talking with other investors, staring at a wall - but concluded with an uncomfortable truth about this business, that a lot of it is random. The potential client ultimately said no, so let me share from experience, that "so much of it is random" isn't a granular enough answer for an outside allocator to base an opinion, even if it's foundationally true 8(  

Now I find myself going through a list of companies presenting at a conference, and I'm trying to figure out which ones to meet with, so I thought I'd document a bit of how I winnow this all down. 

First cut: Sort list by EV and start with smaller companies since that's what I focus on. Many of them are already recognizable to me since I do this all the time  

For something that is new to me or "seems interesting" (totally qualitative), I'll jump over to an excel template I created awhile back that shows four years of quarterly results and a dozen of annual.  It has a summary P&L, B/S and CF statement so I can take a quick look at the progression of growth, margins and cash flow, the latter b/c (to quote that aforementioned Mauboussin report): "Value for any financial asset equals the present value of future free cash flows. Free cash flow is the difference between a company’s inflows (sales) and its outflows (operating expenses and investments). It does not matter what accounting standards a company chooses—cash is cash." 

As I'm looking at this data, I'm trying to consider the context - macro environment, industry situation, some independent variable - that drove the data, and I'm generating things to look for in the financial statements and their footnotes. Ultimately, I'm looking for "what's changing now". 

One of cheats at the single company analysis is to look at tangible book value per share (ie book value excluding goodwill and intangibles). I think it's a Joel Greenblatt-ism or one of those gurus and it makes sense to me as a proxy for value creation over time. 

Here are some examples of TBV: CCRD has created tremendous over the years.   

Here's RELL. Not much going on with TBV but something is changing with returns ... 

... which is even more obvious in the trailing quarterly results and seems sustainably driven by companies replacing combustion with regenerative electronics, lead acid batteries with ultra capacitors, etc. 

Here's another company where the data shows none of the attributes I mentioned above. It's a cyclical construction company with a pretty fetid history of value creation. Yet, I'm looking deeply into it b/c I think it could soon experience a cyclical tailwind. I'm very familiar with the industry and the time to buy is when things look worst ... 

... finally, here's Plus 500 which trades in London. It has all the "data driven attributes" (no acquisitions, so TBV doesn't apply) but it seems almost too good to be true. One reason to be cautious! 

A key thing to note is that these financials are just the starting to point. Anyone can look at data; what's actually going on at the company? Learning is an endless function and buying shares is just a step in the road to a higher education, which keeps going until you find a higher IRR idea to replace it with.

Ultimately investing is a decision making business and decision making is hard. One's investment decisions rest on the decisions of the CEO's, whose decisions rest on those of their operating managers, etc. down to the line worker or coder or customer service provider. It's like an infinite regression, the asset allocation version of "turtles all the way down." I just keep looking for better ideas and when I find something I think I like, I rely on skepticism to enable more questions, more learning and more avenues of research. 

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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. THIS IS NOT FINANCIAL ADVICE. 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, WHICH I MAY OWN.