Been awhile since I've written here. I've cooled on the blog to focus on my investment business, Long Cast Advisers, which continues to grow, slowly and thoughtfully. But the not-writing has left me with a hole of sorts. I like researching companies and sharing what I know with others who might be interested. Having been stuck at home with the fam basically the last two years, I can say confidently that folks around here are not interested. So I gotta put it "out there" instead.
Figured I'd start with a quick review of hits and misses over the years, what's aged well and what hasn't, etc. I went back and briefly scrolled through old posts.
What's working >> OTCM, CCRD (nee INS), QRHC and CCRN
What's worked >> (all takeouts) IVTY, ARIS, SEV and CDI
What didn't >> FHCO, PSSR, ESWW and STLY
What stings the most >> post on not buying OLED. (I generally regret most the things I don't do).
FTLF gets a special call it. I sold it long ago but kudos to Dayton Judd, who recapitalized it and transitioned into a capital light and pure play brand now generating growth in profits and book value ahead of where it was before he took over. He understood the value of the brand and put the right investments behind it to make this all happen.
Thinking about "the value of the brand and the right investments", I have stumbled on a chance to share a recent observation, which is a wide disparity in valuation multiples for small companies versus large companies that both have high ROE's.
But let me take a brief step back ... With regards to finance, every few years there's some new / old idea and even occasionally new / new idea that takes the world by storm (CDO's and MBS, REITS and MLPS, SPACs, etc.) and promise juicy returns for investors. Often they do for some period of time, and certainly enrich the facilitators of these idea, but these rarely endure.
But there's something foundational about active value investing where the less "new" the better. This is why timeless classics of investing are still relevant even if you've already heard them 1,000 times. I think adhering to the principles of value investing is what makes it so simple and pure, though one get lost at times looking at shiny new things.
That's how I found myself flipping through Chris Mayer's "100-Baggers". There are always going to be stocks that go up 100x to great fanfare ... and then crash when no one is looking. This book is largely about the durable businesses that continue to operate to plan. It's not a ground breaking book, more of a tasting menu of other great books, and that's not a critique, it's just that the attributes of durable businesses that comprise 100-baggers haven't changed that much, so drawing on the "the Outsiders" and Joel Greenblatt and Michael Mauboussin, etc. is totally appropriate.
For me it served as a simple reminder of the foundational principles of investing and one of those principles is looking for companies that have high ROEs.
It's been awhile since I've done a simple "high ROE screen" but I got it in mind and fired up Sentieo's screening to look up companies with ROE between 25% and 45% and found something kind of crazy. Based on the data kicked out by Sentieo (which is sometimes quite wonky) on average, small companies with high ROE's trade at less than half the valuation multiples of large companies with high ROE's (and I included the median to account for outliers).
But my hypothesis is that larger companies whose brands are by nature better known enjoy the premium b/c investors believe the "moat" is wider and deeper, so easier to protect the R of ROE. One thing to note from this observation; investing in small companies with high ROE's might (might!) be a value trap unless there's a pathway to larger growth.
Another thought is that from a high level, all business is "... a brand with the right investments behind it." That brand can be perceived or actual "better product quality, service, results, etc." Smaller companies are still developing those brands so there's more uncertainty to the brand value vs larger companies where the brand value is already established.
And one final thought is the value available when a small company with an established brand that has endured years of poor investments gets taken over by someone who can put the right investments behind it. Like FTLF, or maybe that yellow pages company THRYV (which I don't know enough about). It was certainly part of the thesis behind the investment in CCRN and a few others over the years.
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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.
This is a great observation!
ReplyDeleteI think there are two or three causes / implications here. I think you are right about the potential of small value traps; how many managers have you heard who think they can arbitrage the difference between the small company's relatively small multiple and the much larger multiples earned by bigger firms with similar financial returns (but scaled)? HVAC rollups come to mind ...
I think there is a fundamental aspect, as you note one factor might be that the truly large firm that can earn high returns on equity probably does have a very good moat, since the opportunity it is pursuing is clearly a desirable one. Whether it can truly protect itself is your unstated question.
But I think it goes beyond that in a fundamental sense - it is simply VERY VERY hard to scale to gargantuan size without suffering a pretty big degredation of ROE, becuase in most cases, very large firms got there through acquisitions, many of which often had worse economics than the original business (GE, anyone?). Sustaining high ROE when addressing so much business volume does really make the much larger business qualitatively BETTER.
However, there might just be a non-fundamental explanation, namely the impact of indexation / passive. We all know that large cap, and especially large cap growth, has attracted massive passive flows for the past three decades. Given the valuation-insensitive bids, in which the larger (and more expensive) a thing is, the more passive dollars it attracts, we should expect large firms to trade at significant premia to small ones.
Finally, what does this suggest about capital allocation? Well, one thing it suggests is that small firms should really look to reinvest and or acquire wisely to maintain high ROEs while increasing their size. I suppose most managements are already well incentivized to do this, since all else equal, firms with larger revenues tend to have better paid managers. But, clearly, an ability to grow the firm makes for a better situation for investors (and also, it should be said, for employees, since it gives them new work and the prospect of increased responsibilities).
Failing that, though, management might want to avoid repurchases, since they are unlikely to have the same sort of impact on valuation that is so often assumed by small value investors; we all think that if they simply buy out the less committed that the value of the stock should rise; but actually, as you observe, this might be something of a value trap mirage in which the slow reduction in the share count (unless it is very very persistent like an APT) doesn't really lead to an increase in the share price, even as EPS rises; this seems a bit odd, since in theory, the dollars are being reinvested at a low valuation, BUT probably a higher valuation than the internally generated ROE and since the company isn't growing, there is not going to be a meaningful increase in multiple. Indeed, it might lead to a shrinkage of the market cap, and certainly of the liquidity, moving the name further from the set of attractive investments.
Instead, perhaps management should consider more dividends. This doesn't increase the share price, either, of course, but it gives the individual investor more control over reallocating capital to attractive opportunities. For taxable investors, of course, this might be less interesting, but as a company investment strategy, it might make much more sense to avoid reinvesting in a small business that will always earn modest multiples in favor of something with more growth potential.
I guess that is true for investors anyway.
Thanks for this analysis, though, it makes total sense.