John Milhajevic Archives – The Rabbit Hole

Summary

Describes some of the world’s most respected investors’ proven, proprietary frameworks for finding, researching, analyzing, and implementing the best value investing opportunities

Key Takeaways

Each investor must carve out a personal way to invest in order to succeed
A share of a stock is a share in the ownership of a business
investors tend to buy after a period of good performance and withdraw after a period of bad performance, which is bad for the funds results
Those considering an investment in a hedge fund may first wish to convince themselves that their prospective fund manager can beat Buffett. Doing this on a prefee basis is hard enough; on an afterfee basis, the odds diminish considerably.
Becoming a smart asset allocator is key to managerial success
believe that our investment decisions affects the world
Losses have a perverse impact on long-term capital appreciation, 20% drop in book value requires a 25% subsequent gain in order to offset the loss
Increase in size makes it increasingly difficult to maintain same level of success
Thinking like a capital allocator is coupled with thinking like an owner. looking to the business rather than the market for return on investment
Graham-style investing starts with price of a stock. If it does not look like a bargain based on tangible metrics, Graham-style investors are not interested.
Eugene Fama and Kenneth French have found through their studies that equities with high book-to-market ratios outperform those with low ratios.
Uncovering equities that provide both asset protection on balance sheet and own businesses with high returns on capital are treasures. This is hard to find unless the business has experienced a steep near-term profit decline.
by prioritizing return of cash to shareholders, low-return businesses can assist investors in earning a strong investment return, assuming the equity purchase price was favorable.
Investors may overestimate liquidation values, as the reality of a dying business tends to hide some nasty surprises
Acceptance of discomfort can be rewarding in investing, as fearful equities frequently trade at exceptionally low valuations.
investing in asset-rich but low return business, time may be working against you. As long as management can hold on to the assets and keep reinvesting at low returns, shareholders may earn unimpressive returns despite a bargain purchase price. As result, catalysts become a relevant consideration.
Businesses trading at deep value prices are among those most likely to be creatively destroyed. It seems unwise to allocate a large portion of investable capital to any one deep value opportunity, even if it promises a large expected return
Several considerations may augment the likelihood that a Graham-style screen yields a list of market-beating investment candidates. Share re-purchases, insider buying, and cash generated through working capital shrinkage may be used as screening factors.
When we value a company based solely on readily ascertainable balance sheet values, we run the risk that those values erode over time, negatively impacting future equity value.
Many companies can be appraised most accurately by analyzing each of their distinct businesses or assets separately and then adding up those components of value to arrive at an estimate of overall enterprise or equity value.
A reason for the market’s occasional mispricing of companies with multiple sources of value may be investors’ unwillingness to value assets that differ materially from a company’s core assets.
Companies with distinct components of value often enjoy greater strategic flexibility, as they may divest a fairly valued asset to improve the balance sheet, repurchase undervalued shares, or reinvest capital in a high-return business.
Sometimes investors, in their zeal to create a sum-of-the-parts opportunity, slice a company into too many parts, creating an attractive investment thesis in theory but not in reality
We normally do not require a catalyst, but we find that situations with multiple sources of value are more prone to becoming value traps in the absence of strategic action.
It matters tremendously whether the offer is “buy one get one free” or if it is “buy ten get one free”. As shoppers we recognize the former as a more compelling offer. As investors, we often overlook this important distinction.
sum-of-the-parts opportunities come in a few different flavors, each of which demands a slightly different approach to screening. excess assets typically consist of cash and cash like assets, stakes in other businesses, real estate holdings, or a combination of these asset types.
Some hidden asset stories are so compelling that they attract quite a few smart investors, potentially eliminating both the valuation discount and the hidden nature of the assets. Investors may become patsies by failing to realize how many other smart investors have bought into the same story of hidden value.
Whenever hidden assets motivate us to consider an equity security, the question of how the assets will cease to be hidden becomes important. In this context, we are less interested in the speculative question of what will prompt other investors to see what we are seeing. rather, we focus on the economically important issue of how the value inherent in the hidden assets will accrue to us as shareholders– and when.
Buying good companies when they are cheap is invaluable advice, as demonstrated in Greenblatt’s “the Little Book That Beats the Market”.
Higher return on capital employed indicates a good business. Typically calculate capital employed as net working capital plus net fixed assets.
Greenblatt’s use of operating income to enterprise value as the way of determining cheapness is congruent with his use of operating income to capital employed as the way of determining quality, as the effects of leverage and taxes are stripped from both calculations.
Greenblatt’s magic formula suggests that it will keep outperforming markets over time despite the fact that its success, in theory, would attract a flock of investors and therefore eliminating its prospective attractiveness.
Mr. Market makes two mistakes with some consistency: it over values high-return businesses whose returns on capital derive from explosive but ultimately transitory trends or fads. On the flip side, the market may undervalue unhyped quality businesses with sustainable high-return reinvestment opportunities.
The future is what counts in investing, and while historical data has the advantage of certainty, forward-looking estimates have the advantage of relevance.
High returns on existing capital – the capital already employed in a business – are almost meaningless without the ability to invest new capital at above-average returns. Returns on existing capital, whether high or low, are already reflected in a company’s operating income.
Business executives can distinguish themselves in two ways: business value creation and smart capital allocation
Distinguish between business performance and stock price. Better management results generally mean better business outcomes, but in terms of the stock beating the market also depends on market quotation at time of investment.
Eliminate the bad actors when it comes to finding better management, even when some are esteemed by the business establishment.
Some factors that reflect CEO attitude towards owners
1. Communication with shareholders open and honest
2. Composition of board of directors
3. What does financial leverage tell us about the management
Determinations like shareholder friendliness, alignment of interests and the ability to run a business not only involve many variables but also an element of judgment. while we cannot exactly screen for jockey stocks, we can use screens to move a step closer toward finding companies with good management
Screening for close alignment involves two proxies, stock ownership and insider buying activity.
Most capital allocators view reinvestment as a default option, giving little consideration to the alternatives.
Making a list of great capital allocators represents a continuous process of discovery and curation. Corporate executives come and go, and seemingly great managers may reveal themselves as not so great over time.
Subjective assessment of management in a one on one meeting likely adds value to the investment process, assuming the investor is aware of the biases involved and judges correctly that awareness will render inconsequential any biases.
in addition to selecting a proper focus for a meeting, investors may want to prioritize meetings likely to produce incremental, differentiated insights.
“hedgefundletters.com“
One of the best pieces of advice “Do your own work and do not trust the tips of others”. nonetheless, following the moves of super investors can be both smart and profitable, if done correctly.
Common traits of super investors, Other than remarkable returns, are clear thinking, lucid communication, a visible passion for the process of investing and surprisingly humble attitude toward success.
Even if we accept that super investors are likely to outperform the market, it is not entirely clear that copying superinvestors also leads to outperformance
The problem is not that all investors make mistakes but also that our ability to stick with an investment is diminished if we have not done the research to give ourselves a certain level of conviction in an idea.
Investors may invest in macro theme or political outcome that makes them invest in individual stocks that they may not be entirely sure about. Viewing these stock purchases as endorsements from such investors would be a mistake
Factors to track superinvestors: decide which type of investors to track, concentration of portfolio, average portfolio turnover, propensity to employ short selling, and congruence between one’s own investment approach and that of a superinvestor
Turnover is important because as outside observers we receive only delayed notice of other investors’ buy-sell activity. the higher the turnover, the higher the chance that an investors is considering selling a holding by the time we consider buying it.
Context is paramount when assessing the purchase and sale activity of superinvestors. imagine three investors, each of whom has invested five percent of their respective equity portfolios in Bank of America. It would be wrong to infer that each investor’s position has comparable significance for our purposes.
Several key developments have created opportunities for small stock investors, including an increase in the size of institutional portfolios, an escalation of compensation expectations, exclusion of small stocks from major market indices, and scant research coverage by sell-side firms.
Major shareholders have more influence on small-company CEOs than they do on their large-company counterparts, as more investment firms can credibly put small companies in play.
We find that small stocks outperform large stocks by a statistically significant margin over time. while the results differ based on the time periods examined and the definitions used, the verdict is clearly in favor of small stocks.
Even if small caps as a group stop outperforming large caps, the differential between top and bottom performers should continue to be greater in the case of smaller stocks, providing opportunities for research-driven investors.
While underfollowed situations generally offer fertile ground for research-driven investors, it is not always necessary that many people analyze an investment for pricing inefficiency to be eliminated.
In small cap arena, moving beyond quantitative screens is valuable because few professionals are willing to start at A and work through Z in their appraisal of qualitative value drivers of small companies.
Small company executives are also generally more forthcoming than are corporate executives whose ability to communicate spontaneously has been lawyered into oblivion. Ask a small company CEO how business is going and you might get an answer.
one well-known drawback of small stock investing is the, at times, severely constrained trading liquidity of smaller companies. Wider bid-ask spreads, greater market impact, and perhaps greater trading commissions conspire to make entering and exiting the equity of small companies a costly affair.
Many of the best small stock opportunities elude discovery by quantitative screens. the reasons include rapid change in company fundamentals, the disproportionate impact of management quality on value, and the tendency of small companies to lump nonrecurring items into financial reports.
we may uncover hidden inflection points by scouring the small-cap landscape for companies with two or more businesses, one of which is typically a large, declining legacy business. if the other business is a profitable growth business, we may have found a compelling opportunity.
Special situations encompass equities whose near to medium term stock price performance is largely independent of the performance of equity markets.
the flood of talent and capital has taken some areas of special situation investing from obscurity to popularity, reducing prospective investment returns.
the more obscure a market niche, the higher the likelihood that diligent investors will generate market beating returns.
in markets that exhibit informational inefficiency, rewards may accrue to those who make the effort to obtain timely, accurate and relevant information.
Analytical inefficiencies may play an even greater role in driving outperformance in special situations. While information is generally available to investors willing to dig for it, many market participants struggle to overcome the analytical hurdles.
Investing rules, as distinct from laws, need to be broken occasionally in the pursuit of investment excellence. In this context, rules include the financial formulas we have memorized along the ways.
Some insights can be gained only if we launch the process of inquiry at the relevant point in time. If we do so, we may enrich the process with new insights at a later date, but if we fail to launch the process, we may never capture the available insights.
Special situations are one of the few investment areas in which it makes sense to pay at least as much attention to the time component of annualized return as to the absolute return expected in a particular situation.
Special situations crystallize the meaning of value. In a liquidation, value is determined solely by when and how much cash we will receive in exchange for the cash we give up today. When no terminal value remains, we cannot base the investment thesis on what other investors might pay for a business.
In the absence of identifiable drivers of inefficiency, the probability may be higher that our appraisal of value contains an oversight or flaw. If we can identify a non-fundamental factor that explains the low valuation, we gain confidence in an estimate of value that differs from the market price.
Passive returns to investing in leveraged equities reveal little about the merits of such an approach. On the other hand, the all-but-certain wide dispersion of returns strikes us as crucial.
It would be difficult to overstate the importance of judgment in this area. Even if all investors possessed comprehensive data on equity stubs, their investment decisions, and outcomes, would differ materially.
We need to be careful not to overreach when our judgment turns out to be correct. The payoffs in equity stubs may exert an intoxicating effect on the successful investor.
Do to the lopsided payoff in leveraged equities, the probability of winning on any one investment may be well under 50 percent. The low batting average increases the size of the sample required to estimate the ex ante likelihood of success with any confidence.
It helps to commit our investment theses to paper, and then test and refine them over time. In leveraged equities, experience can be an investor’s key asset, it interpreted properly. We add this qualification because a danger exists that we overlearn.
The tendency of investors to think about the likely outcome rather than the range of possible outcomes represents a key stumbling block to success in leveraged equities.
Assuming we wish to wade into treacherous but potentially rewarding equity stubs, one of the key considerations in each situation is the ownership of the debt on a company’s books.
We distinguish between two types of equity stubs for screening purposes: first, we look for companies that have been designed as equity stubs, namely, private equity type investments available in the public market. Second, we target companies that have become equity stubs due to some kind of stumble.

What I got out of it

Good overview of where to look for and how to look for value investments