“The person that turns over the most rocks wins the game. And that’s always been my philosophy”
- Peter Lynch
Not long ago, several members of our research team took a
scenic road trip down the Mississippi River to visit a small-cap company in
Iowa. The company is a good-sized
furniture manufacturer with a gleaming new headquarters right on the banks of
the river. As we do with many companies
we are seriously researching, we had a full afternoon of meetings scheduled
with the senior executives of the company, followed by a plant tour of the
nearby upholstered seating division.
After the usual introductions and pleasantries with the CEO
and CFO, we casually asked how often they hosted meetings with investors like
us. “You’re the first to come visit us
in five years!” was their reply. When we
hear that from a company, it tends to get us excited. It’s also not that unusual.
We get excited about unknown companies in the same way that
a beachcomber might get excited when his metal detector starts beeping over a
clump of sand. The beeping alone doesn’t
tell us what lies beneath; it could be a dime or a diamond bracelet. The simple
fact that we are one of the few to take notice is significant.
Taking notice of companies that are unknown,
under-researched, and hard to find (the nearest airport was three hours away)
isn’t all that unusual for us because those are exactly the types of
opportunities we seek. Information is a valuable commodity in investing, and
the scarcer it is the more valuable it becomes.
We believe that performing due diligence research that others are
unwilling or unable to perform is a real competitive advantage.
Investors who make the time and effort to find, research,
and invest in lesser-known companies—those who turn over more rocks, as Peter
Lynch would say—gain insights into three critical areas that we think are
significant drivers of value and, therefore, investor returns over time:
- Corporate Strategy
- Competition
- Culture
Doing the hard work of traveling to companies, interviewing
management teams, and touring facilities isn’t easy, but we believe that the
unique insights that such activities usually render to the intrepid investor
can translate into attractive returns over time.
Corporate Strategy
When doing due diligence on a public company, many investors
start by perusing the publicly-available regulatory documents of a
company. These filings (Annual Reports,
Quarterly Reports, Prospectuses, and the like) offer excellent information, and
plenty of it. It isn’t unusual for a
Fortune 500 company’s Annual Report to run several hundred pages long.
What quickly becomes apparent when reading these voluminous
filings, however, is that much of it is written by two categories of authors:
accountants and lawyers. There is
usually an abundance of accounting arcana, and what qualitative descriptions there
are of the company’s operations, reporting segments, and risk factors tend to
be heavily redacted as if they were sterilized to be only as descriptive as
required by law. Understandably, it
makes little sense for a company to go overboard on explaining the nuances of
its business and strategy in a public government filing that is accessible by
customers, competitors, and the like.
Excessive transparency could ultimately be detrimental to the company.
Investors, however, do need to know these nuances to make
intelligent, rational judgments about the strength of the company and the
sensibility of its strategy. We’ve found
that the best way to gather these insights is through direct, face-to-face
management interviews.
Management interviews should ultimately yield answers to two
important questions: does the company have a cohesive strategy? And does that strategy truly differentiate
the company from its competitors?
Amazingly, some companies do not have corporate
strategies. Quite simply, they lack an
overarching vision for their enterprise, as well as the framework to translate
vision into action. Especially among
smaller companies, there can be a tendency to simply do business the way it’s
always been done, or to seemingly run the company for the benefit of
management’s lifestyle, or to lack serious directors or shareholders who are
willing and able to hold the company accountable. We believe, that over time, this is surely a
recipe for investment disaster.
Most of the time, though, serious companies have taken the
time and effort to thoughtfully articulate where they want their company to be
in the future and what the roadmap for getting there looks like. The articulation of this vision, and more
importantly, the operating philosophy animating it, is critical to investment
success.
Is management aggressive, willing to pursue a
win-at-all-costs fight for market share?
Or are they more conservative and tactical, picking battles where the
odds of success are stacked in their favor?
Is their attention to the opportunities before them more scattershot, or
focused? Do they prioritize ethical
business practices, or is regulatory compliance of secondary concern? How do they think about creating value for
shareholders over time, and what are the metrics used to gauge this progress?
These are the questions whose answers often cannot be found
in public filings. For those companies
who do not command much attention from Wall Street, the answers to these
important questions must be ferreted out by investors willing to engage
companies on their own terms.
Competition
Corporate strategy only makes sense when viewed through the
prism of competition. A company’s
ability to generate and sustain returns on capital is largely determined by the
structure of the industry or industries in which it chooses to operate. The difference between a concentrated,
monopolistic industry and a fragmented commodity one is enormous. Engaging a management team on the issues of
competition can produce extraordinary insights for investors into both the
quality of the company itself, as well as the quality of its competitors.
Whether a CEO respects, fears, or ignores a competitor can
also be revealing. More than a few
times, we have walked away from meeting with a management team more impressed
with one of their competitors than the company itself.
Culture
While there may be external clues to a company’s culture,
such as communication style, performance track record, or outside reputation,
there is nothing like standing inside a company’s offices and facilities to
truly touch and feel its atmosphere and aura.
Even small clues like décor, employee perks, and the location of the
executive suite say a lot about how and why a company operates.
We get particularly excited about a company when we can
discern a passion or mission from within the organization. Usually the tone and tenor of this passion
begins with the CEO. Do managers and
employees appear to be simply working to collect a paycheck and accrue vacation
time? Or is there a larger purpose, a
raison d’etre, which emanates from conversations and motivates activity? This is the fuel that feeds the engines of
ingenuity, work ethic, and ultimately profitability.
It can be especially exciting to visit companies with recent
leadership changes, where an old, slow-moving culture may be giving way to
something more dynamic. Several years
ago we visited a company that had gained a reputation for infighting and
stagnation after fifteen years under a CEO who seemed to be happy to extract
his multi-million-dollar salary while the company and stock price flat-lined. After his retirement, he was replaced by an
outside CEO who was ten years his junior and brought with him a lot of passion
and energy. On his first Thanksgiving as
CEO, after purging much of the old leadership of the company, he personally
gave every employee a frozen turkey and a hug.
We were impressed.
Conclusion
We believe that there are structural reasons why most of
Wall Street does not pay much attention to smaller companies that are
out-of-the-way and out-of-favor. The
brokerage and research business is largely built on trading commissions and
advisory and banking fees. Many asset
managers are focused on gathering assets in a business where scale drives
profitability. Consequently, public
companies that are too small, too illiquid, or over-capitalized fall through
the cracks. There is little economic
incentive for large, sophisticated investors to invest in them.
And yet, there is a whole swath of these companies that are
worth paying attention to because they have defensible business models,
attractive competitive positions, and the right kind of culture to grow and
thrive over time.
By rolling up our sleeves and doing the hard work of
uncovering and understanding these companies’ strategy, competition, and
culture, we can glean important information from them and develop unique
insights that give us the opportunity to generate alpha over the long haul.
The information presented herein may incorporate Punch &
Associates’ opinions as of the date of this publication, is subject to change
without notice and should not be considered as a solicitation to buy or sell
any security. Certain information
contained herein may constitute forward-looking statements. Forward-looking statements are subject to
numerous assumptions, risks, and uncertainties, and actual results may differ
materially from those anticipated in forward-looking statements. As a practical matter, no entity is able to
accurately and consistently predict future market activities. While Punch & Associates makes reasonable
efforts to ensure information contained herein is accurate, it cannot guarantee
the accuracy of all such information.
This material should not be construed as accounting, legal, or tax
advice. Punch & Associates is not
qualified to provide legal, accounting, or tax advice, and accordingly
encourages clients and potential clients to consult their professional advisers
with respect to such matters.
