Circle Of Competence Issue #16
- Benton Moss
- Jun 15, 2018
- 11 min read
What are you reading this week? Drop me a line and let's connect or tweet at @competence_co. Have a great weekend!
This week, I read through the compendium (link above) of Michael Burry's quarterly letters, testimonies, interviews, and articles so wonderfully compiled by the gentlemen at Austin Value Capital (www.austinvaluecapital.com). I had previously heard of Burry's wonderful record and interesting approach to value investing, but after reading the document, I had a newfound respect for his uncanny ability to perform DEEP research.
So, let's start with a little intro. Michael Burry graduated from UCLA with a degree in economics in 1993 and went on to Vandirbilt's school of medicine. Despite studying medicine, he worked hard on his investments, often late into the night after long days during his schooling and residency. In fact, he studied so hard one night that he fell asleep during a surgery during his residency at Stanford and was promptly removed from the operating room. He left behind Stanford's neurology residency program and started his own hedge fund, Scion Capital. Interestingly, while he worked at nights on his investment theses and wrote about them on the then-budding internet forums, he drew the attention of well-known investors such as Joel Greenblatt and White Mountains Insurance CEO John Byrne (previous CEO of Geico and mentioned numerous times in Buffett's annual letters). They provided seed capital on the amount of a few million dollars for Burry to start Scion, and a budding investment legend was born.
Burry's investment record is superb. He returned roughly 21% compounded annually from 2000-2008 while the S&P 500 returned just over 3% including dividends. This period included the internet bubble bursting, during which he not only avoided losses in popular stocks but also generated significant returns. Burry was turning away money by the end of 2004.
I would describe Burry's strategy to be similar to Seth Klarman's in the sense that he hunts for value in literally any place, any industry, any company, at any time. His strategy seems to be straight out of Klarman's "Margin of Safety," likely the most well-regarded value investment strategy book ever written. He does not time markets or macroeconomic events, but invests with a large margin of safety based on underlying asset values or business fundamentals. In one of the articles in the compendium above, he describes his process more in depth. He screens for low enterprise value (market capitalization plus net debt) to EBIT (earnings before interest and taxes) multiple stocks (essentially the acquirer's multiple after depreciation and amortization) as a starting point. He starts with the lowest multiple stocks and looks for hidden assets, catalysts that will help propel the stock to a more fair value, as well as plain old dirt cheap stocks that have been thrown out by larger institutions for no fundamental reasons (spinoffs, delisting from an index, etc.). And occasionally, he will find a wonderful business at a wonderful price (what I like to call a compounder, a business that is able to reinvest profits at high rates of return on capital). So, as you can see, he was not solely a deep value investor, or a high growth high quality investor, or a special situation investor. He was all of those things, but only when the price was right.
Despite his great returns in general, his magnum opus was calling the housing bust in 2008. I would encourage people interested in the mechanics of his research and short on the subprime mortgage pools beginning in 2005/20006 to scroll through the compendium above and find his quarterly letter discussing the derivatives he used to short subprime mortgage pools (which were the riskiest of all mortgages issued in the real estate credit bubble). These types of mortgages included pay-as-you-go mortgages where people could simply choose not to pay anything on a monthly basis and interest would accrue and add to the principal. This, as Burry described it in his own words, was 'peak credit' where banks were falling all over themselves to continue issuing loans to generate fees when they sold the securitized loan portfolios to ever-more risk drunk investors. The fundamentals behind these loans, in Burry's eyes, were extremely precarious, and he essentially took a position that, if it were written down to zero after 2 years, would only destroy 10-12% of the portfolio's value. Heads, he won BIG, and tails, he didn't lose much at all.
So, how did these shorts on the subprime credit bubble work out? Well, Burry went on to make over $700M for his investors and over $100M personally from this one trade. Just as a very select few investments minted Warren Buffett's career forever (American Express, Geico, See's Candies, etc.), the same stood true for Burry's subprime credit short.
What impressed me most about Burry after reading through the compendium from Austin Value was his uncanny ability to synthesize multiple sources of data into a cohesive thesis that was often exactly how reality worked out. His ability to do DEEP research allowed him to have a very clear sense of what the value of a security or set of securities would be worth in the future. His close attention to detail coupled with a focus on margin of safety allowed him to produce one of the most illustrious hedge fund careers in recent years, propelling his net worth from around $1M in 2008 to over $300M after Scion shut down post 2008.
Thank you to Austin Value Capital for putting together such a wonderful compendium of Dr. Burry’s writing!
DEPARTMENT OF GENERAL FINANCE
This is a tragic story of the effects of regulation and economic incentives on the lives of individuals who have been affected by life threatening conditions requiring medical helicopter flights. I have always believed that as investors, it is essential to seek the highest returns available, but not at the direct expense of others. One of my checklist items when I consider investing in a stock (courtesy of Guy Spier's checklist) is if their customers are better or worse off after doing business with the company. It seems like these consumers are the victims of life-or-death extortion at the hands of these helicopter companies.
This article shows how private-equity backed medical helicopter companies seem to be using consumers as leverage against the big insurance companies and they are simply caught between a rock and a hard place. On the one hand, they have to fight the insurers to pay out more for helicopter claims, and on the other, they have massive bills to pay for an hour ride to the helicopter company.
Excellent article by Jason Zweig at the Wall Street Journal about the odd adjustments to earnings that companies are making in filings this year, all in the name of “transparency for shareholders.” The way he sees it (which, I agree with 100%), these companies don’t want to recognize certain expenses that are part of normal business operations and are becoming more commonplace as metrics for shareholders. This can be dangerously misleading for all involved. But as in most cases in financial markets, it takes awhile before the chickens come home to roost.
Wonderful philosophical piece by Ensemble Capital on the false dichotomy of growth vs. value investing. As the author (and Charlie Munger also) points out, all intelligent investing involves valuing a business and paying less than that for a margin of safety. No (sane) investor ever seeks to overpay for an investment, and every investor that purchases a security believes that they are buying a winner. Simply put, different investors have different strategies for generating returns in the stock market, and at the end of the day, investing boils down to purchasing something that is worth more than what you are paying. I encourage all investors of all backgrounds to read this.
Women are having children at their lowest rate in 30 years according to the WSJ. As economic growth has two levers - population growth and productivity growth - it seems more and more likely that future economic growth will come from productivity gains than population growth.
Good article on the parallels between the world's most successful people in various industries. My key takeaway was simply this - don't wait in line for your turn, go make it happen.
DEPARTMENT OF STARTUPS AND TECHNOLOGY
Well done summary of Mary Meeker's internet Trends presentation. She is a partner at renowned venture firm Kaufield, Perkins, and Byers and released her 30,000 foot view of the tech sector trends annually. In particular, I found it interesting that smartphone sales were slowing while online retail sales growth wasn’t just growing, but accelerating. As a corollary, physical retail continued to decline rapidly.
Interesting article from Harvard business review on why Microsoft would pay 30 times annual revenues for GitHub for strategic reasons. While I understand the logic behind the move, I also have read in other places that there could be potential developer migrations to competing platforms due to the precarious situation of having their code in the hands of a large tech company vs. an independent storage platform. This will be an interesting story to follow - and one must ask whether shareholders of Microsoft will be better off in 10 years or not? To put it into perspective, their purchase price works out to roughly $1 per share currently. From a one off deal perspective, the financials make no sense. But from a broader technology platform standpoint, it seems to make more sense that this acquisition could generate a lot more than $1 per share in value due to the services that GitHub can offer under Microsoft’s leadership.
Interesting article on OpenDoor, a new platform that helps intermediate between buyers and sellers of real estate, reducing the complexity and effort involved in a more traditionally labor/effort intensive real estate transaction. I wrote about how real estate agents were the last piece to get disrupted in the real estate industry last week after reading a piece at Slate, but OpenDoor seems to be going straight for the jugular. This will be an interesting trend to follow - who will win over consumers? The agent or the platform?
I am sure most millennials have heard of Fortnite (and if you haven’t, don’t worry you will). Its rise to video game dominance has been swift. However, one must ask, in the video game industry, is this a phenomenon that is going to stick and grow or just a fad game that will be replaced in 3 years? I tend to be more bullish on the video game sector as a whole vs. one off producers. This is the approach that Tencent Holdings has taken, investing in the biggest producers over the past 5 years, essentially spreading its bets. They have essentially taken a directional bet on the video game industry as a whole. Note that Tencent owns 40% of Epic Games, developer of Fortnite.
Previously known as Alipay, Ant Financial was rebranded in 2014. It was estimated back in 2016 that almost 60% of all Chinese online payments were sent through Ant Financial. That is an ENORMOUS number in terms of transactions and currency volume, which is what prompted investors to continue to pour capital into the private company.
This quote from the article says it all: “The starting point for all of this will be a mindset change, with companies seeking to measure future success by their ability to provide continuous learning options to employees.”
DEPARTMENT OF PODCASTS
For those of you who have watched "Catch Me If You Can," this is surely better than the movie. This is the absolutely incredible (and true!) story of Frank Abignale, impersonator extraordinaire, on Talks At Google. If there is one lesson I took away from this, besides marveling at Abignale's pure brilliance, it was his emphasis on loving family and country above all else. Truly inspirational and brilliant talk.
Just a fantastic discussion with Eric Cinnamond (ericcinnamond.com) on all things small cap value investing. I particularly enjoyed Eric's valuation method - not unlike the technique Buffett uses and Bruce Greenwald teaches in his famous book "Value Investing: From Graham to Buffett and Beyond." Pay close attention to how he describes his valuation techniques when analyzing companies.
I also found it very interesting that he was long 2 year treasuries given how fast their yields have increased over the past year relative to the S&P 500's dividend yield. As Jeff Gundlach recently tweeted, the 2 year yield is above the S&P dividend yield for the first time in over a decade. This means that you can either 1) get a dividend that is risky with underlying fundamentals that could deteriorate based on economic conditions or 2) buy a 2 year treasury and get the same yield with no upside but literally risk free cash flow. Highly recommend!
For anyone who is even remotely interested in what kinds of data analytics and machine learning are being applied in the asset management world, this episode is for you. Patrick O'Shaughnessy gets into the weeds with Michael Recce, the chief data scientist for Neuberger Berman. Using his data analytics research team, he is attempting to create in depth multi-layer information dashboards for every company in the investment universe. Talk about a tall task. Very interesting and at times a tad nerdy.
I thoroughly enjoyed this podcast by the previous CEO and Chairman of Dollar General. There is a lot of wisdom that gets shared in this episode, mostly on leadership, company culture and values, and family business. I highly recommend this for anyone running or thinking about running/starting a business in the retail sector!
I was most interested in the section where the interviewer questioned Mr. Turner on the implications of firing his brother during a period of financial distress due to over expansion and a large debt burden - imagine carrying that burden for the rest of you life, knowing that you had no choice but to split the family over business matters! Interestingly, his brother went on to become a large developer in the up and coming area known as "the gulch" in Nashville, Tennessee. Under Cal Turner Jr.'s leadership, Dollar General expanded to over 6,000 stores and became a multi-billion dollar franchise. Well-worth the listen!
I enjoyed this interview with Paul Thompson, and focused particularly on his methods for automating the deal generation and offer process with virtual assistants. Great episode!
DEPARTMENT OF LETTERS
Carl Icahn's June 11th Letter To SandRidge Shareholders Carl Icahn's June 14th Letter To SandRidge Shareholders
Grab some popcorn and watch the fireworks on June 19th for the vote on the board!
What are you reading this week? Drop me a line and let's connect or tweet at @competence_co. Have a great weekend!
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