Wednesday, November 30, 2016

The Value of Turning Over More Rocks

Authored by John Carraux, CFA


“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:
  1. Corporate Strategy
  2. Competition
  3. 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 d├ęcor, 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.