on telling the difference between the exceptional and the everyday ($QRHC and $SIFY)

I apologize in advance for taking a moment to talk about religion but its part of my life and there's something I've been reflecting on that ties a bit into investing. So ...

... I spent the last summer running the woodworking shop at a sleepaway camp - a Jewish sleepaway camp - where I was engaged with religion pretty intensely for the first time in ~25 years. (I grew up in an observant home but there's too much good food to eat in the world; once I went off to college I started eating it).

Ritualized religion isn't my preferred version of practice - investing, music, exercise and woodworking probably top my list - but with the perspective of age / experience / worldly travels / comparative religion as my guides, I could at least re-engage with it for a few weeks, and in doing so, reflect on its meaning and meaningfulness.

I'd summarize my experience as similar to that of a visitor to Montreal eating poutine; with some interest but more an avid curiosity about why everyone else does it? All of which is to say, it's not my jam.

However, there's one short prayer that really resonated with me and I continue to think about it quite a bit. It's the last and final prayer of the Sabbath (and every Jewish holiday): "Praise God [...] who distinguishes between the holy and the everyday."

Obviously, it's a fundamental premise of all religion that such things exist that are "holy" and "not-holy", so this struck me as a foundational prayer. But at the same time, it didn't sit well with me as it it conflicts with something I've observed in my life during whatever fleeting spiritual encounters I've had - perhaps others have as well - where we are occasionally endowed with a feeling of oneness, wholeness and completeness.

In short, I was troubled by this gratitude of separation when it seems preferable to want to experience everything as "holy".

I struggled with this for awhile then eventually inverted it: What would life be like if we didn't know the difference b/t the exceptional and the everyday? This question answers itself. If we couldn't distinguish between joyous events (having a baby) and everyday events (telling that child 10-years later to clean their room, flush the toilet, wash their hands, etc.) we would lose out on a large part of our emotional selves.

... Most assuredly, and bringing this back to the subject of this blog, how different would investing be if we didn't know the difference b/t a good company and a not so good company, or a good investment and a not-so-good investment.

My initial take on this was tongue in cheek; that passive investing, which does NOT distinguish between good companies and bad companies, is - cue Dana Carvey - the work of ... Satan?! (That sorry humor aside, we should recognize that passive investing's isn't simply about avoiding the "how to pick a stock" problem as it is avoiding the "how to pick an investment manager" problem.)

It's not here for me to describe all the attributes of a good investment. I think at the very least a good business should solve a tangible problem for a customer at a price that's reasonable to pay with a quality of service that makes the customer not want to look elsewhere. (I discuss one such possible idea below.)

Whatever attributes you want to assign to a "exceptional investment" vs an "everyday investment" it is our job as investors to know the difference and be comfortable with that process so we can endure whatever happens with the stock price (ie the market telling you you're wrong) until it figures out what you've known all along^^.

Finally, in wrapping this up, lest there's any confusion, I must emphasize that while both religion and investing deal with unknowns (the future is unknowable despite what you hear on TV), the foundation of one is faith and the other is facts and if anything should be separated it should be these.

I even observe a weird irony or contradiction around this:

Investing is an outcomes based business - the outcome is everything - yet when we make an investment, we don't really know what the outcome will be b/c the future is unknowable. In absence of this foresight, we have to be supported by our facilities to reason and weigh a full set of probabilities - including failure - such that the imbalance leans heavily towards the variety of favorable outcomes that will benefit shareholders. When we believe we've found them, we should buy them in large enough numbers to be meaningful to the portfolio.

In contrast, with religion, daily faith supports its believers despite the fact that the outcome is the same for everyone. Praying harder won't change that. Investors in contrast need to be comfortable with the discomforting limits of our own certainty.

***

^^ I'm thinking here about QRHC, a stock I've been painfully buying all the way down, and had expected to buy more after what I'd anticipated would be a quarter negatively impacted by hurricanes in TX and FL. Instead 3Q became the quarter of "holy shit they just guided to 2x the EBITDA I expected" (ie $6M-$7M)

I don't put much credence in guidance b/c nobody knows the future.

I think its reasonable they will do +$6M in EBITDA at some point in the near future. But why narrow the time set to 12-consecutive months? The calendar year is an ancient concept. Even the seasonal years are changing.

So rather than excitement this guidance causes me concern. Part of this is the high expectations. If they only do $4M on the year, what would previously have been a strong step in the right direction will be considered missed expectations. That this risk was created by the aggressive guidance eats at me. This risk did not exist before.

The other part of my concern is b/c the earnings growth that drives the guidance is from new markets, customers and industries. Whatever the business, new lines present risks. Industry expansions always worries me.

In this case, the company is ramping up its exposure to the construction waste business. Just let that sink in a minute. Does anyone associate "construction waste" with "GAAP accounting"? I do not.

Did they leave themselves wiggle room to learn this new market? I do not know. It is impossible to know how much of an adjustment period "wiggle room" exists in the guidance. Mgmt has delivered on everything else it's said it would do, but I would hate for this to be the case sticking one's neck out only to have their head cut off.

***

I have been spending a lot of time on a new idea that I think might be an exceptional investment. The company is SIFY Technologies (SIFY), an Indian "Information and Communications Technology" ICT company.

I'm attracted to the company by its recent financial performance, its valuation, its adherence to a vision laid out - and somewhat reviled - nearly seven years ago, the business acumen / success of its Chairman who I think is the strategist behind the vision, and finally its (theoretic) access to a potentially robust market for long-term technology expansion.

Here's the financial performance summary in USD.

I observe growth in revenues, stable margins, and cash flow generation over time. The company is also comparatively underlevered vs many larger ICT's likely more familiar to investors like CenturyLink (CTL) in the US or even Reliance Communications in India (NSE:RCOM) both of which have 1.6x Debt / Equity ratios.

Concurrently I observe a valuation of around 7x - 8x EBITDA.

I'm going to submit a longer write up on this for a contest on SumZero so this will simply be a brief take but allow me to at least elaborate on one aspect of this:

If it's such a good idea, why is it so cheap? I view this predominantly as a fallen / forgotten turnaround that has several strikes against it.

Before delving any deeper, the best place to start is this absolutely brilliant and prescient short report on SIFY from the VIC in February 2012. It is a must read to understand the historical background and the evolution to where they are today.

My take on reading it is ... look how far they've come! The company's investment decisions that generated ridicule back then now generate cash and profit. And yes, while they were in pretty bad shape back then, something had to change for them to remain in business. Also, back then it was trading at a 60x EBITDA while today on a total outstanding share basis (178M) they trade at a not unreasonable multiple for a growing cash flow generating company.

But then one must consider the following strikes against it ...

1. It's in India. There is a lack of proximity, knowledge and clarity to Indian investments.

2. As the short report mentioned, 5-10 years ago there were a series of insider transactions that severely diluted shareholders. People with long institutional memories will be wary.

3. It's been a pretty low ROA and ROE business.

4. DSO's are absurdly high

5. The company admits this is "Version 3" of the company.

... digging more deeply into it reveals that since the recapitalization, share count has remained pretty stable, that ROA and ROE are growing (thought still too low), that trade DSO's have been historically pretty stable, and that Versions 1 & 2 were carried out under prior management.

The briefst summary here is that I see an owner / operator business that's undergone an attractive l/t evolution finally bearing fruit. This owner / operator is Chairman Raju Vegesna who owns 85% of the company. Vegesna is a former Motorla engineer and chip designer. He has two mentions on the page "Who are the Computer Architects?" associated with developing workstation processors.

He's also founded and sold two companies ...

ServerWorks, sold to the semiconductor company Broadcom for $1.8B in January 2001. He then worked at Broadcom for two years until 2003 and apparently lead a highly successful division before he was pushed out. (Broadcom was acquired by Avago in January 2016)

ServerEngines to Emulex for $225M EV in June 2010. (Emulex was acquired by Avago in 2015).

... I think it's fair to say he's smart. There's an old article about him from 2011 that highlights his interesting background (here's the link but the website isn't secure).

I'll add more details on this in the future. As always, do your own homework.

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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, WHICH I MAY OWN.

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

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.

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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.

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.

[PS: HERE IS AN UPDATED VERSION OF THAT VERY SAME CHART ONE YEAR OUT ... 

... THEY ARE GROWING GP BUT UNFORTUNATELY CASH SG&A REMAINS TOO HIGH AND CONTINUES TO TREND WITH REVENUES. I THINK THE ISSUE IS LOUSY TECHNOLOGY; IF THEIR TECHNOLOGY WERE STRONG AND SCALABLE THIS COULD EASILY BE 10X]

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.

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

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 --

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.

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.

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.

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 -- 

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.

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?
etc
etc

... 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.

-- END --

ALL RIGHTS RESERVED. COPYRIGHT LONG CAST ADVISERS.

the best investing advice I ever got

years ago, one of my oldest friends, let's call him "daniel" (himself incidentally the son of a legendary investor), was consoling me.

for what you may ask?

another friend had excluded me from some event. i was in my 20's and such things felt mortally significant.

with perspective, i now know that the negative feelings that arise from being excluded  is fairly universal among humans of any age and of most cultures. in the worst cases, it causes otherwise smart people to do horrific things. these days in the generally overvalued prvt tech markets its characterized by the acronym FOMO.

in any case, "daniel" said to me: "why do you give a shit what he thinks?"

that turns out to be the best investing advice i ever got.

the desire for acceptance is a wonderful human trait but it is one investors should reflect on. how long can we go without it and for what reasons would we pursue it?

a chip on the shoulder isn't a bad thing unless it weighs you and your portfolio down.

-- END --

compounding, after taxes and inflation, isn't as much a wonder

the 8th wonder of the world - "compounding" - is the magical return that grows on itself, over and over. it is a goal for investors, and a challenge.

yet different investors experience 15% annual returns differently and this is not well understood.

the consistent 15% return grows $100k to $1M in 17-years

the investor who experiences 3% inflation has a real 12% return and takes 20-years to achieve $1M in real terms.

the short term investor who sells their gains every year and has a marginal 28% tax rate receives a 9% after tax real compound return. 28-years later the portfolio is worth $1M.

were one to invest $100K in a store or business, how long should they expect to wait for it to return 10x capital? 28-years seems like a long time. there are many alternatives to equity in public companies that should be considered when allocating capital

the beauty of the stock market is the ease of investing in businesses. on any given day there are tens-of-thousands of businesses worldwide with public bids. wait for the right ones at the right price, buy a lot of it and expect to own it forever.

the wonder is who wouldn't want to buy businesses, that redeploy capital wisely and grow in real terms, with the eye of owning them for long periods? anything else short changes the return.

-- 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.

Sometimes a Balance Sheet is the Simplest Idea

Since this is a company in transition, the business description ("We are a vertically integrated, advanced materials provider specializing in monocrystalline sapphire for applications in optical and industrial systems...") is meaningless.

the important disclosures are the Shareholder Letter dated 2/21/17 and the new CEO announcement dated 3/16/17

I summarize below the key points from the shareholder letter ...

• decision was made to limit our focus to the smaller but growing optical and industrial segments of the sapphire market ... quickly exit the mainstream LED and mobile device segments of the sapphire market ... sell most of our plant capacity and generate cash to provide more opportunities to deliver stockholder value.
• We are actively pursuing the sale of a 134,400 square foot manufacturing and office facility in Batavia, Illinois. Also, additional land in Batavia, Illinois we acquired in March 2012, Also the sale of  a 65,000 square foot facility in Penang, Malaysia. 
• Our wafer patterning equipment in Penang was sold in the fourth quarter of 2016 for $4.5 million, and we are structuring an auction in the next 90 days to sell the polishing and fabrication equipment. Additionally, the real estate is currently on the market. 
• We are in the process of consolidating operations into our leased space in Bensenville, Illinois and Franklin Park, Illinois and vacating our largest owned facility in Batavia, Illinois. 
• planning a second auction for the excess equipment in the Batavia plant in the next 90 days ... also actively selling this property and our initial focus is to seek a buyer that is interested in both the building and infrastructure. 
• reduce overall company headcount from 220 at the end of September to 40 today, significantly reducing current and go-forward cash-burn. We have been careful to maintain the employee knowledge base in our strategic markets built over the past 15 years.
• we are actively evaluating the acquisition of profitable companies both in and outside of the sapphire market in order to accelerate growth and to utilize our substantial net loss carry-forwards. 
• Because acquisitions are being given greater consideration, the Board of Directors [has a new CEO Tim Brog] with more extensive experience in mergers and acquisitions 
• In addition to reducing costs, these changes will maximize accountability to stockholders and bring in a fresh perspective and new skill set to the executive team and the Board of Directors.
• we are beginning to see a meaningful improvement in cash flow. 

The new CEO has had prior success unlocking value in turnarounds and in monetizing NOL's through acquisitions. It is impossible to say whether he can do that again but the cost of failure is somewhat limited by the valuation relative to the balance sheet and mgmt's efforts to stem the cash burn. 

-- 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.

Year End Client Letter + Website Launch

I finally - at long last - launched my firm's website ...

www.longcastadvisers.com

... we published our 2016 "year end letter" concurrent with the website launch and that can be found on the website under the "Links & Letters" section.

I expect that I'll continue to post here about ideas and such, though not entirely certain how I'll balance that approach. As always appreciate your input, interest and comments.

-- 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.

... And out of the Blue, I was Quoted in the NYT

Maybe it's a slow news day and not much going on, but I was quoted in the NYT the other day about the Park Slope Food Coop and its recent controversy surrounding the pension for its employees.

What the NYT actually quoted was a line from one of three letters I'd written to the board and the coop newspaper. The letters were about the poor returns in the pension fund and the need for the fund to articulate and disclose its investment process and strategy, as well as concerns over management, transparency and governance.

The quote in the NYT was specifically about one of the two trustees of the pension, George Haywood, a former Lehman partner who'd started his own investment mgmt firm many years ago.

He was also a coop member who since the 1990's managed the pension as part of his workshift (all members of the coop have to work 2 hours, 45 minutes / month). Under his mgmt, returns were under whelming.

I thought it would be fun to include links to the full letters and where applicable call out portions that are relevant and important to investors in general.

I conclude as well with a personal letter I wrote to George Haywood's lawyer, Gary M., with the hope that he would forward it along.

So as to not bury the lede, not long after I wrote the private letter to George, and after years of questionable management of the coop pension with potential violations of ERISA laws, Haywood quit the coop and was named a director at Fannie Mae.

***

LETTER 1, from September 1, 2016, was written in reference to three things ...

1) erroneously reported information about the coop revenues and gross profit
2) a graphic about the pension performance that was wrong,
3) a graphic depicting the impact of a pension shortfall illustrated as cheese on a pizza and coffee beans

... at the time, the issues with poor returns on the pension were just coming to light. I'd hoped these paragraphs - the last three of the letter - would resonate most with readers:

"I get that many people have limited experience with financial presentations but everyone—from infants to addicts—knows how to make decisions about preferences. The business of investment management is quite simply a concentrated version of the types of decisions made by everyone, all the time, such as what fruit, shoes or glasses to buy, etc.

The point is, it’s far better to present such information fully and with appropriate context than to promote the continued infantilization of people’s attitudes about finance with pizza pies and coffee beans.

The idea that “it’s too complicated, leave it to us” is a part of the fabric of institutional finance that unnecessarily enriches a few at the expense of many, due simply to ignorance and complacency. Every opportunity to break that cycle should be taken."

***

LETTER 2, September 29, 2016. At this point, a small but loud faction is pushing the pension to go all passive. Obviously, that's viewed as "most prudent" these days. I was just asking for someone to please articulate investment strategy. This is the full letter.

"To the Editor: 

I have been following the debate regarding the pension plan and its investment performance with a little concern and a lot of bemusement.

My concern is primarily around the unnecessary risk created by the managers of the plan for maintaining a concentrated investment portfolio without disclosing an investment plan or strategy. If the pension trustees would articulate its process and how each investment fits into that process, it could better assess the reasons for its underperformance, i.e. whether it’s from a flawed process or a flawed execution, and adjust as necessary.

My bemusement is from learning that the co-trustee of the plan, George Haywood, is a high-profile beltway-insider, with close ties to President Obama. I am curious why and how we have a relationship with him? It certainly isn’t because there’s a dearth of financial acumen in New York City and it smells like the kind of relationship where the due diligence begins and ends with “you should invest with so and so, s/he’s very good.”

Giving money without proper oversight to someone held in high regard by others but who cannot articulate reasons for success or failure is a terrible way to do business. We wouldn’t buy cheese, produce, vegetables or proteins that way. Nobody should invest that way."

***

LETTER 3, November 10, 2016, was written after I attended a general meeting, where I learned two things ...

1) the short list of highly speculative companies the coop owned
2) how little most coop members understood about the pension in general

... it was one last plea for them to define the investment process and strategy (believing that they actually had one).

"To the Editor

The goal of managing a pension of any size is to match future cash needs with future cash flows.

Presently, more than 1/3 of the Coop’s assets are obligated against those future needs, which are funded by Coop sales and by the investment performance of the plan.

As detailed in last night’s meeting, the plan invests in companies that are not about future cash flows but about a bonanza or bust payoff; it buys speculative stocks at a low price and hopes the price will grow if a future event happens.

However, no one knows the future. If they did, and knew with certainty that the bonanza would happen, these stocks would already trade at higher prices. The uncertainty keeps VirnetX trading at a fraction of the value of its now six-year old patent infringement lawsuit against AAPL, etc. These unknowns exist for all companies.

Knowing how the trustees define a good company and what has been their “batting average” on selecting the right ones would be incredibly helpful in gauging their effectiveness, far better than simply quarterly or annual returns.

If the trustees have a good process for selecting the right companies, and a track record for doing it well, then it’s just a matter of following that process and practicing patience. But if they can’t define the process, then we have no information, just the emotional whipsaw of the stock market.

Joe, who is one trustee, is an incredible asset to the Coop and he does so much with his heart in the right place and concern for all the stakeholders but—I speak here as a professional investment manager—I fear he is at the edge of his competence when it comes to investing. (Search “krill oil boom” and you’ll know what I’m talking about). That is not a good place to be with other people’s money and a terrible place to be for someone acting as a fiduciary.

George, the other trustee, and supposedly a capable and experienced biotech investor, should be able to explain and articulate his stock selection methods, process and expectations. That he hasn’t is completely unfair to Joe, who is left to explain why he “believes” these companies “will be great”, absent any fact, like a politician in an election cycle. It is also unfair to the stakeholders in the plan, and the Coop itself, for whom he creates risk.

The alternative approach pitched by Hessney is the widely accepted process of the moment. I’ve never been one for widely accepted processes and I believe there are better solutions for investing capital. But without a well thought out and well articulated investment policy statement that defines the processes by which the trustees make their selections, they are creating risk to the Coop. 

Randomness is a most unjust way to treat our capital and our employees."

***

Then I gave up writing letters to the board.

But I wrote one last letter to George Haywood via his lawyer Gary M. whose name & address I found on his SEC filings. I was told it was forwarded along.

The letter had two purposes ...

1) I wanted to meet him. He's not the typical coop member.
2) I got a sense that George didn't really know what was going on, and that the other trustee stubbornly wasn't asking for his help.

... here's portions of that letter.

Dear Gary –

I write to you in your capacity as George Haywood’s attorney on SEC filings to request that you please facilitate an introduction between us and also to relay information that I believe is important so that he can help a mutual associate.

The genesis of this letter is that we are both members of the Park Slope Food Coop. I realize this is a tenuous – perhaps absurd - connection for an introduction but it also the basis for the more critical information described below.

About the introduction ... Last November I started my own investment management firm, Long Cast Advisers, which makes concentrated investments in well researched small / micro-cap securities. We apply the same fundamental analysis I used while working for 15 years as a sell side analyst. With just a year under our belt returns are +25%. We are off to a good start.

I would like an introduction to ask for his advice and counsel on building an investment management firm. I have always found it helpful - and an enormous privilege - talking with experts like him who have experience and success in areas that interest and engage me. I would be most grateful for that opportunity.

About the information to be relayed ... Mr Haywood is one of two trustees on the PSFC pension plan. The plan, which is invested in many of the same companies as Mr Haywood, has been underperforming the major indices for the last two years.

Some members of the coop have engaged in an organized effort to highlight the underperformance, increase the plan’s disclosure and consider a change in strategy. (I am not a member of this group, though I agree that more transparency is always a good thing).

...

The key factor here is managing the task of a fiduciary while limiting risk. Based on what little I know about the plan, it appears that there is insufficient oversight in its administration, in the management of its assets, in the nature of its investments, and in its underwhelming performance. With an organized group planning to highlight these risks in order to implement its agenda, I fear a negative impact on the coop and perhaps even the trustees of the plan.

I have suggested to Joe several times that the plan should have a detailed policy statement that explains why and how it makes investment decisions so that in the absence of returns, the stakeholders can at least be assured that it is following a proven strategy, is invested wisely and always with prudent due diligence.

I have also told Joe that the plan should have quarterly or semi-annual letters discussing the why’s and how’s of performance with a look towards future expectations, the kind of memo that every Hedge Fund or Investment Manager worth their salt shares with clients. I would imagine Mr. Haywood already makes these available to his clients.

I am certain others with more experience in this area could provide additional counsel on how to better manage these risks, both seen and unseen.

I’m not sure how much of this has gotten to Mr. Haywood. Perhaps I am speaking out of line but I would rather be wrong for the right reasons than allow incaution to prevail. Mr. Haywood should know what is going on and I urge him help Joe so he is not alone in dealing with this. It is sad and unfair for Joe to work so hard for the coop with his heart in the right place to be discredited on this account.

George never responded to my request for advice and counsel on starting an investment mgmt firm but as mentioned, he's left behind a mess at the coop pension to become a director at FNMA.

-- END --

ALL RIGHTS RESERVED