Insights I find valuable over time

Will be constantly updated.

New beginning

Apologies for the lack of updates recently. A lot of changes going on.

I will be leaving my current firm (US compounder, LT-focused) to join a smaller, small/micro-cap EM/Frontier fund with a personal focus around Asia. Exciting times to be involved, and the opportunity set is mouth-watering. The direction of the blog will likely tilt in that direction in the future, but it will at least still mostly be about investing!

LKQ - something I wrote up a while back

Not much juice left here. Thesis still in-play though. Since VIC 45-day window lapsed I'm posting it here.
https://www.valueinvestorsclub.com/idea/LKQ_CORP/138086

For the full write-up: https://www.dropbox.com/s/wjtepep5c759z0u/LKQ%20memo%20Feb%202016.pdf?dl=0

Investment Recommendation 

• View on the stock:  Long. Valuation came to historical low as it is being punished as a "SAAR" story alongside the OEMs and dealers but actually have little OEM-related & pricing / margin risk. Could be a good pair vs. Dealers & OEM. Beat & raise story w/ US organic growth consensus too low + capital deployment in Europe w/ strong hints of success.

• $45 / share vs. $26  as of Mid Feb 2016 the following are 2 year price targets to YE 2017

• Bull-case:  $55 / share (45% IRR, 100% up), 1 pt higher growth than base, ~25-30 bp margin expansion, 2x run-rate Net Debt / EBITDA, multiple expands to 20x PE, 12x EV/EBITDA), similar to 2013-14 level.

• Base-case: $40-45 / share (30% IRR, 60% up), US organic growth accelerates, margin towards 12%, 2x run-rate Net Debt / EBITDA, multiple remain @ 17x PE, 10.6x EV/EBITDA, in-line with historical average.

• Bear-case:  $25 / share (flat), 1.5 pt lower growth than base case, 50 bps margin decrease, 2x run-rate Net Debt / EBITDA, de-rate to 12x PE / 8x EV/EBITDA, in-line w/ crisis / other retailer / distributor.

• Nightmare-case: $20 / share (25% down), organic growth slows towards 3-4%, margin <12 1.5x="" 11x="" 7x="" auto-dealers="" average.="" de-rate="" debt="" ebitda="" ev="" hist.="" in-line="" multiple="" net="" pe="" run-rate="" span="" to="" with="">

• All cases assume 50/50 deployment of FCF to acquisition at 9-10x EBITDA / share buyback

• 2.5-to-1 risk-reward, gradual beat & raise melt-up, subject to gap-down upon litigation & accident sentiment.

• Time Horizon: 18-24 months

Some thoughts on BIDU - probably a pass for now.

I spent some time the past 2 weeks looking at BIDU. The SOTP thesis was intriguing -- The preliminary math is that assuming a 16x PE on Core Search’s FY17 results, the market implies BIDU burning cash at its projected FY2017/18 O2O run-rate for another 8 years. Put another way, the market is pricing today’s core search EPS at 16x and assuming everything else (cash, CTRIP stake, O2O cash burn + valuation) at 0. Seems nice.

However, I still decided to pass on it:

• For the stock to “work”, the core golden goose search needs to growth and accelerate. Given the cancer incident and governmental actions, it is quite likely like they miss the next quarter + continue to face skepticism on out-year growth rate. I also think that they could be over-monetizing this core business.
• While the stock implies a bid, almost oversized cash-burn for the O2O business (5-10 year peak-run-rate burn of $4 Bn / year), I find it difficult to stand behind the businesses they are plowing money into – they seem more like no-moat ventures and more of volume acquisition vehicles vs. good standalone high ROIC projects.
• The difficulty to fully understand a Chinese company and the unknown-unknown risk.

Would still like to share my thoughts. Comments welcome.

Some thoughts on industrial gases

Spent some time going through the industrial gas space -- not exciting as I thought on the returns side – unless we are talking about a small cap in Hong Kong…

• The lifeblood of industrial production, this industry exhibits utility-like characteristics and should deliver 10-13% equity return going forward deploying capital. Not very exciting but could have idiosyncratic upside if at mid-late cycle, have management driving change / doing deals.
• Historical competitive advantage was fortified by equipment / production / transportation know-how & efficiency + localized business driven by logistics, all of which contribute to lower marginal cost per ton vs. closest competition and ensure good IRR.
• The second competitive advantage is that air is separated into not one, but many, products. The rise of demand for all types of gases and emergence of heavy-gas-users (like steel, fertilizer, etc) gave rise to the economic flywheel combining (a) sizable on-site production and (b) a dense local logistics coverage:
• Large on-site ASU is the lowest cost of production and makes rare gas economically.
• A dense local coverage allows for high co-product uptake and high wallet share. Large on-site projects allow a firm to supply to these customers at the lowest possible cost.
• High-uptake increases the on-site project’s theoretical IRR, allowing the firm to bid on on-site projects more competitively and still realize a good return.
• As overall demand grows and a firm wins more on-site projects and increases density. This leadership position strengthens.
• Given the 2 characteristics above, the local champions remained dominant through-out history – the top 4 players in any key regions never fell out of ~60-70% share. In the US in particular, the top 4 players should occupy ~90% volume share when the AL-ARG deal closes.
• Volume growth comes down to GDP+. Aside from “more stuff”, there is also using more gas for certain applications balancing out the overall mix, new applications, continued trends of outsourcing, and consolidating local distribution. The industry historically grew top-line at 4-7% clip per annum deploying capital.
• The going-forward IRR on the stock is likely 10-13%. Industry rule-of-thumb points to 15% IRR on-site projects with 300-500 bps boost if co-product monetized well. Firms like APD and PX deploy ~50% of (OCF – maint. CapEx) to these projects, yielding ~7-8% return – or 9-10% assuming maintaining 1.5-2x leverage, the rest is returned to shareholder mostly via dividend at 2-3% yield. Historical ROIC / ROIIC benchmarking bootstraps this heuristic.
• "Building on air" is a must-read for those wanting to learn the history of the industry. http://www.amazon.com/Building-Air-International-Industrial-1886-2006/dp/1107033128/ref=sr_1_1?ie=UTF8&qid=1455826095&sr=8-1&keywords=Building+on+air

Xueqiu: 为什么我反对诺亚财富的双层股权提案

Source: http://xueqiu.com/5587568451/62973317
Very well written article.

在雪球潜水3年，这不是第一次才想要写点东西，但码字的水平和速度都实在有限，所以只好一直安心做观众。

这次是真的有些想法不吐不快。

诺亚财富在12月28日发布通告，将于1月28日召开特别股东大会，投票表决公司管理层提出的修改现有公司股份投票权结构的提案。提案拟将创始人汪静波和殷哲所持有股份的投票权从普通的每股1票提升为每股4票，同时其他股东持有股份的投票权不变。如果提案通过，诺亚财富将从单层股权结构变为双层股权结构。汪静波和殷哲现有的30.5%普通股投票权将增加到63.7%，成为公司的绝对控制人。

在我有限的投资生涯中，还真不记得见过上市公司试图通过股东大会直接将内部控制人的普通投票权变为超级投票权的例子。

What I learned this year - 2015

What I learned this year - 2015

I have thought over the past few days on how to start this reflection, without making it sounding way more grandiose than it deserves – There is little doubt that this piece could inspire more cringing than nodding if I were to revisit in a few years; but some destined embarrassment aside, the chronicle of this year’s sporadic musing and labored mistakes are nonetheless necessary. For this attempt should not only help comb my scattered thoughts and share a few opinions that I feel like made me a better investor over this year, but it should also help me observe the improvement I have achieved (or lack thereof) upon reexamination.

And yes, being in New York alone during Christmas with an injury on the big toe is a catalyst too. My plan to run an 18 minute 3 mile over the next 2 months basically went out the window...

1. Sell-side's tendency to ignore capital allocation undervalues good mgmt and overvalues crap.
2. Breaking down hist. perf into components helps decipher whether future drivers is achievable.
3. Buying cheap often pre-exposes one to badCo, fight battles, and hope for catalyst & recognition, which can lead to poor returns...
4. what's more, high idea velocity and spread-out attention diminish conviction and somewhat weakens accumulation of domain knowledge.
5. ...hence while fun, quick place to learn, & v. effective, would argue upgrade to business analyst necessary to improve as an investor.
6. Mgmt quality is a must when buying quality. Mgmt that burns FCF makes a GreatCo far worse than a mediocreCo, especially given rich valuation.
7. Secular growth w/o capital is +, good venues of high ROIIC proj is +, low valuation as another venue of deployment is +. All together you get < 3
8. ...and with leveragable rev & cost base, long pathway of projs, low cost / negative cost liability, & good allocator w/ fair valuation, get married.
9. Risk to this is time consumption, price of entry, downside when wrong, and LP-base given the potential vol involved in the strategy.

-------------------------------------------

1.       Let’s start with the sell-side – it has a tendency to mis-model capital allocation (aka let cash build and ignore acquisition, buyback, and debt pay-down), not scrutinizing the fixed vs. variable components of the cost structure. This leads to structurally conservative estimates for great companies that scales + deploys capital well, while overvaluing crappy companies that destroy capital – especially during tough times when volumes collapse. I found identifying recent changes & differences in management’s value driver vs. the broad sell-side model a good source of alpha. Recent examples include CDNS (sell-side mis-modelling buyback & fixed cost leverage) and PTC (sell-side ignoring subscription transition).

2.       Secondly, I found it helpful to break down historical stock performance into different components – is it pricing, volume, acquisition, margin, interest/tax, share shrink, or multiples? A recent example I went through was LKQ, where it’s 20% compounded return almost exclusively driven by acquisition revenue growth, with ~7% organic growth offset by dilution and multiples contraction. This helps me think about where the future performance comes from – and in LKQ’s case, through my work I believe organic growth will accelerate over the next few years, and EU is a big, big playground for further consolidation. The performance formula in this case is in-tact, and stock should continue to work. Anytime there is a big change in that, we are probably prime for some strong periods of volatility.

3.       One can find that the bulk of a stock’s longer term performance comes from bottom-line growth on a per share basis. Rarely is multiple expansion so potent to drive multi-year performance – it’s hard to get things >50% cheap except during a liquidity crunch; and rarely is the intrinsic value growth so exponential and sizable to up-sling the stock wildly in a short period (the best companies can do 20-25% CAGR for a good few years). So while one ideally wants the double-hit from both multiples and numbers, buying a stock often comes down to a philosophical debate – would one rather buy stocks cheaply and hope for the kiss of the prince (and the crowd), or would one buy good stallions in a good price and wait to be rewarded by the company itself? How does one want to get paid?

4.       The cheap vs. quality debate is delicate – when one buys cheaply, the multiple expansion / multiple rerating, while essentially a pull-forward of future returns, does offer good, quick performance and one can do very well as long as the net is wide and eyes are keen. But here are a few drawbacks that made me increasingly selective:

a.       Buying cheap inherently has an assumption that there is almost immediate inefficiency in the pricing (duh). The thesis requires the recognition of the crowd and/or the force of the company itself. It needs a catalyst to convince investors there is outsized returns and/or can actually crystalize the value. Without the catalyst, the company will simply meander on its return path, sometimes for many years.

b.      In the case of “meandering”, very often these companies are cyclical, only earn mediocre returns given competitive pressure, experience little growth, sometimes face structural problems, and could have poor capital allocators. It’s not always the case, but the stock performance can often languish absent of a catalyst – which means the investor suffers opportunity cost vs. owning a good company that ideally always compounds the wealth at a much higher rate. Worse yet, for these companies, investors had to “fight battles” against poor management / numbers, disentangle all the hair (God forbid, has anyone looked at AMBC?), and sink a disproportionate amount of time in what I call a “low return-on-brain” endeavor.

c.       And that’s not too bad, you may say, since identifying quality businesses is even harder and when one’s wrong, one is really wrong. Totally fair point, but one must also take time into account: for such bargain hunters that fish for inefficiently priced, cheap companies, the idea velocity is often very high: catalysts typically play out within 6-12 months, and since the pool is vast and these ideas are often hairy and uncertain, one must not only spend a sufficient amount of time but also adequately diversify – which means the portfolio turn can be high and one risks tirelessly diluting the effort (some may call scratching the surface) in slivers of inefficiencies to replenish the played-out situations. Taxes, trading cost, and lack of knowledge accumulation (due to lack of depth) are all risks to this method – and there is little surprise that many investors never seem to improve after years of practice, they just never looked at businesses but instead only analyzed securities.

5.       You can probably see my now affinity to doing the work “once” and holding dearly to quality companies. This is not to say the other way is “inferior” – I started my career being an event-investor. They have important places in the portfolio given the immediate, outsized reward, are often very fun to analyze, and when carefully selected offer very good downside protection (as quality companies tend to be very expensive). It is a great place to start learning too, the broad, generalist approach and high velocity trains one to be acute observer of value. One can, however, fall into complacency and never advance to understand how business build, sustain, and defend their competitive moat to generate lasting returns – and consequently miss out on the bliss of looking beyond the next 12-24 months, remaining confident that is buttressed by webs of knowledge, and reap spectacular personal and career benefits both as a thinker and an investor. In other words, I think it’s even more fun to venture beyond just buying “cheap”.

6.       Buying quality, however, requires good management. A good team not only reduces pain and volatility the process (always beat and raise, no operating surprises, do what’s promised, attract right investor base), but also put capital in best place that rewards investors. Since doing it this way requires the company to pay us, a bad management that wastes FCF is an utter nightmare – which can manifest itself in buybacks at ridiculous multiples, CapEx & R&D projects that never grow earnings / share, and/or doing overpriced deals. I have danced with a fair share of crooks and incompetent folks to know never getting myself in those situations ever again, and Munger’s quote about “investing in a business that even a fool can run” is horribly misleading-- Business quality does not trump management when the people on top are squandering the cash.

7.       Return on incremental invested capital in this case also becomes very important. Some businesses don’t really have a means of deploying FCF into similar ROIC projects so resort to share buybacks (Moody’s, Visa, BLL, CDNS, etc), and some are forced to put money into lower ROIC / riskier projects (Such as Live Nation’s event / venue business, pharma’s drug R&D instead of M&A of proven products, or LKQ’s non-salvage parts business). To be fair, some of the best businesses have secular drivers that don’t require capital to achieve growth (and I love them, such as the flight ticket volume for SABR, the financing volume for MCO, transactional volume for V, secular share gain for MKTX, and increased allocation on wealth management products for NOAH), but to the extent that it does, the great businesses should have market-aloof ways of deploying cash at very high ROIIC (Roper, Constellation, LKQ, Kraft on acquisitions, Amazon / JD on its long-tail projects, Cable companies on their internet access, etc). Solid retail & food concepts at the roll-out phase are also fantastic in that regard (Like PSMT).

8.       Hence, whenever I found a company with secular, visible growth drivers, long pathway of capital deployment, highly leveragable revenue and cost structure, ability to finance its operations with any liability at low / zero / negative cost of carry, and a capable capital allocator, it would be a sin to pass.

9.       A few words on the risk to this method – they could be time-consuming to fully appreciate (often one-of-a-kind), are often expensive (which could lead to lower short-term returns), can be very costly when wrong (multiples & # contract = huge downside as competitive moat deteriorates), and requires a solid liability base to play given the potential volatility involved. The first 3 are easy to understand, but let me elaborate on the 4^th: one thing is that sometimes when these businesses are investing in long-tail projects with potentially excellent IRR, near-term swings of the market cannot be capitalized on via share buybacks. The second thing is that this buy-and-hold method essentially throws path-control out the window. Couple both you get periods of heightened volatility in performance – and it’s poo-poo time if equity / liability base has a knock-in feature of liquidation (“you are down 10% for the past 3 months, I’m pulling my money out”). Investing this way, and sometimes especially in long-duration DCF and/or NAV stories (like CNX and Rolls-Royce, some would argue), is truly a luxury for your typical hedge fund.

I think I went through the cons of managing money 1 way, and the pros of doing it another way; but I think the lesson this year is not a full-fledged conversion to Omaha -- Macro plays very important factors in the drivers, growth-oriented investing is still FCF-driven but really depends on sentiment, addressable market, and the adoption S-curve, technical is more-or-less a pricing reflection of underlying fundamental assumptions, and event is still one of the best ways to get non-correlated returns; rather it is a realization to keep the minds open and sharpened for other tools in the box, while appreciating the robustness of one of the oldest, yet proven ways of reaping the fruit of a growing capitalistic world.

Merry Christmas and Happy New Year.