How to determine if the trend is your friend

This article was first published in Livewire Markets, 18 September 2019: https://www.livewiremarkets.com/wires/is-the-trend-really-your-friend

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At a recent lunch with another fund manager, I found myself engaged in a discussion about the state of the current market, ‘From your perspective, are you seeing many good opportunities?’ I asked.

‘I’m seeing good companies, but prices are toppy,’ he said, wincing before continuing. ‘More than I’d like to pay. But we’ve recently deployed more anyway.’ He shrugged his shoulders, ‘Momentum in the market is strong – the fed is decreasing rates. Despite the high prices, we wouldn’t want to miss this momentum.’

I nodded as we both acknowledged this unique investment environment of decreasing rates and high stock valuations. Yet stock prices have continued to climb steadily.

Walking back to my office I reflected, and asked myself: ‘Is now a good time to be a momentum investor, or is it time to go against the herd?’

Look at a market cycle to assess how much is left in the tank

Momentum investors have much to gain if the wave of popularity is caught early. However, be the last one to the party and you will be left with all the cleaning up. The real question is: how much more of the wave is left to catch? The solution to this contradiction can be found by understanding the long-term context.

The ratio of a company’s stock price-to-intrinsic value tells us how much the market is willing to pay for the company. It’s a useful measurement of sentiment at one point in time. There’s a clear link between sentiment (the stock price) versus fundamental value (intrinsic value).

But it doesn’t give us the full picture. To understand this contradiction, we need to see how sentiment for the stock has changed over a significant period of time – over entire market cycles. Extend the ratio of stock price-to-intrinsic value over a 15-year horizon and you’ll now gain a multi-dimensional view of just how manic-depressive Mr Market is.

As an example, here is the change in sentiment for the founder-led aerospace electronics company HEICO Corporation.

During the GFC, Mr Market was very pessimistic. He was only willing to pay 1.8x the intrinsic value of HEICO. But alas Mr Market is as fickle as they come. More recently, he has been very bullish. He’s willing to pay 4.8x intrinsic value. A large proportion of the returns have been driven solely by the company’s increasing popularity with investors.

Now we have a better view of the context. Understanding the stock price and intrinsic value over a long time period equips us to answer the following question…

The worst time to join a party

There’s an interesting observation about parties. When do they end?

Answer? They end when the alcohol runs out. Rarely do they end immediately though; good times roll on for a while longer before the sudden realisation hits the sobering crowd.

So when is the worst time to join a party?

As you’re pondering the answer, here is another view of HEICO to illustrate the point.

Although the intrinsic value of HEICO’s business has consistently increased over time, the increase in its price has far outpaced the fundamental growth of the company. HEICO is a solid and growing company, but its impressive performance has been driven primarily by sentiment and price, rather than actual business value. The price-to-intrinsic value ratio shows this.

Risk is heightened when a company’s stock price outpaces its intrinsic value for significant periods of time. As crazy as Mr Market is, one thing is certain – his enthusiasm and pessimism never last forever. The gravitational pull of a company’s fundamental value is unrelenting.

The best time to join a party is when there’s plenty of alcohol and not too many people. But tread carefully when the crowd is pumping and booze is running low. Whilst the fun may continue for a while longer yet, the risk of an abrupt ending is heightened.

A ‘reasonable’ price

Pure momentum investing focuses predominantly on the historical price movement and pays little attention to actual fundamental value. But if you want to understand if a trend is justified, the fundamentals are critical.

Armed with this insight, we can make a judgement call on what a ‘reasonable’ price would be and whether we should join the party. Some sectors run hot. Today, technology is a classic example. But a strong trend shouldn’t be a deterrent. Prices may seem exorbitant, but in the context of the company’s historical sentiment, sometimes the high price is worth paying. What may seem expensive on an absolute basis may be reasonable in the context of history. For example, the price-to-intrinsic value of Facebook was high on an absolute basis in late 2018, but was reasonable when compared to its history. It has proven to be a good entry point so far.

But there’s more for enterprising investors – the picture is still not yet complete.

A deeper level of analysis

Competition

You may have noticed my focus on individual company analysis rather than broad-based economic generalisations. We are buying slices of companies after all. Whilst we can understand the sentiment in our target company, it is also important to have context across other comparable companies. The same price-to-intrinsic value historical ratio across a few companies will give us a sense of sentiment across the sector. We’ll be able to see if there are any other reasonably priced companies.

Potential growth

So far the focus has been on gaining historical context. Sometimes the momentum is justified if there are tangible growth prospects. In other words, intrinsic value is expected to grow significantly with price. In those situations, the trend may be your friend. For those that heard me speak at the AIA National Conference, I outlined my framework to assess the potential growth of a company.

Intrinsic value

Speculators focus on stock price movements only. Investors focus on the underlying true worth of a company.

As Warren Buffett says “Price is what you pay, value is what you get”.

The fundamentals of a company’s value is reflected in its Intrinsic value. Importantly, in determining a company’s intrinsic value, I’ve stripped out accounting distortions that may hide a company’s true worth.

So… Is the trend your friend?

If the fundamentals of a company are sound and the price is reasonable in the context of its history and other competitors, then the trend may indeed be an ally. Ride the wave and enjoy the party.

Price and intrinsic value may deviate for many years but price will eventually move towards intrinsic value over the long-term. Seeing the full picture is key to capturing sensible opportunities. In every party, everyone sobers eventually.

Happy compounding.

Note: HEICO has been used here as an example only, this article is not a buy or sell recommendation for any of the stocks listed.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

Lawrence Lam
Managing Director & Founder

When turnarounds work

This article was first published in Money Management, 15 August 2019: https://www.moneymanagement.com.au/features/expert-analysis/when-turnarounds-work
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Investing in corporate turnarounds is like buying a broken vintage car. Most will end up in decline, but a special few will be fixed and reward their owners handsomely. When corporate turnarounds work, they yield spectacular returns in the multiples. This is the model private equity firms employ. So can ordinary investors apply the same principles to profit from these special situations? What factors should be considered in the analysis?

Many investors shy away from turnarounds. After all, the company in consideration is usually experiencing historical decline. Think about Qantas ten years ago. From 2008 to 2010, Qantas revenues fell by $2 billion (13% decrease over the 2 years). Add to that an industrial dispute that lasted 2 years, Qantas was a very unpopular blue chip. It’s share price fell by 82% from 2007 to 2012. But we all know what has happened since then. It turned out to be the perfect window of opportunity to invest as Qantas has returned a multiple of 4x total shareholder return since then.

Corporate decline or multi bagger turnaround?

Most corporate turnarounds will not work. These companies have left it too late to adapt to changing business environment. For example, many retail companies reliant purely on foot traffic have realised too late they should have invested heavily in online sales (think J.C.  Penney).

But environmental challenges exist all the time. This is not the cause of failure. It is the inability to adapt and evolve that leads to erosion of a business model. For every J.C. Penney, there are companies like Home Depot that have continued to grow with the market.

As investors, we focus a lot on asking ourselves, “are we being too optimistic? Is this a bubble?” but we should equally consider the flipside, “are we being too pessimistic? Is the stock underpriced?” Opportunities reveal themselves only to those that investigate further.

This was why Warren Buffett invested a quarter of his assets in American Express when its share price halved in 1964. The company had been left with an immense financial obligation after being defrauded by one of its clients. The trust in the brand had been severely damaged and the company was in trouble. Despite this, the clue to the future growth of Amex was in the Oracle’s analysis. After delving deeper, Buffett concluded the fundamentals of the company were robust. Customers continued to use Amex cards and the brand was unlikely to be permanently impaired. The rest is history.

Just because a company’s share price is declining, shouldn’t mean it’s an automatic write off. The very essence of investing urges us to seek out the truth through analysis.

But most struggling companies aren’t like American Express. Many have weak underlying fundamentals. Everyday investors don’t have the ability to aggressively restructure companies like private equity firms. Does this exclude investors from participating in potentially lucrative turnarounds? What are the clues investors can use to determine if these companies will be future multi baggers?

Against the conventional wisdom of corporate boards

Clue 1:

Look for companies with a smaller-sized board with less external directors. Corporate turnarounds require rolling up of sleeves. The board’s role in getting their hands dirty has greater value than being a typical challenger/debater when crucial decisions are required. Executive directors are likely to add greater value in this respect than non-executive directors.

Conventional wisdom dictates that corporate boards should separate the role of CEO and Chair. External independent directors should be favoured. Textbooks say this governance model is how corporations maintain proper checks and balances.

This doesn’t work for turnaround situations. A core ingredient in any turnaround is the minimisation of bureaucracy. The company needs all hands on deck and all hands need to be fully aligned. Often hard decisions need to be made, and made with conviction. This is not the time for board politics; independent directors looking for their next board gig won’t help the situation. Conventional governance doesn’t work in this case because there are too many chefs in the kitchen.

 Surprising research

Clue 2:

Companies that implement ways to grow themselves out of decline are more likely to be multi bagger turnarounds, as opposed to those that reactively cost-cut when times get tough.

Fixing a broken vintage car isn’t easy. It requires correct diagnosis of the issues and then applying the right actions. Most of the time CEOs aren’t focused on the correct areas. Research has shown that turnaround strategies focused on building and growing are significantly more effective than those on cost-cutting[1]. It requires greater courage to launch new products or increase research and development spend in the face of decline. Most CEOs are reluctant to take career risk with this approach when conventional cost-cutting exercises like downsizing can yield immediate short-term improvements.

The right person to lead the turnaround

Clue 3:

Founders are more likely to lead a successful turnaround of their companies.

Crucial to any successful turnaround is a CEO who is resourceful, creative and an adept capital allocator. There’s a certain type that fit this mold well, those founders our fund is very familiar with.

The benefits of investing in founder-led companies are well-known. This is our fund’s specialty. It also happens to be underestimated by many investors. Founders who remain long-term managers and owners of their companies are the best candidates to lead a successful turnaround. Captains of their own leaking boat are highly motivated to repair it permanently rather than jump ship. The Corporate Governance International Review found there to be historically a 24% greater likelihood of success when founders led a corporate turnaround[2].

There are many examples of these types of leaders, the well-known ones are of course Steve Jobs and Howard Schultz. The resurrection of Apple and Starbucks can only be attributed to the brilliant impact of these founders and the heart they had in their business.

A little-known Belgian with the midas touch

Clue 4:

Look for close alignment between board, management and ownership. This is often represented by economic interest or voting rights. Being joined at the hip pocket is a wonderful thing. Strong leaders who stand to gain as much as owners is a strong clue for the likely success of a turnaround.

One media-shy businessman has had an incredible track record of rebuilding companies. Luc Tack hails from a small country town in Belgium called Deinze. I confess that our admiration for Luc’s abilities is biased. Our fund is invested alongside him and we stand to benefit from his nous.

The son of an operator of a small flax factory, it was 1979 when young Luc saw an opportunity in the growing Belgian furniture market. But it wasn’t selling furniture itself, that was far too competitive for Luc. The real opportunity was in supplying the wood instead. So the 21-year old flew to the United States, secured a wood supplier and founded a company called Oostrowood.

As he later recalls, his long-term business mindset came from his mother who always said to him, “do not cackle, lay eggs”, and laying eggs he did.

By the nineties, Oostrowood had transformed itself into a wooden flooring company and Luc began moving into an equally unsexy industry – textiles. Weaving mill companies Ter Molst and Oostrotex were eggs laid in the nineties that would later prove crucial to Luc’s future success.

On the back of the success of his diverse businesses, in the early 2000s Luc took majority control of a struggling weaving loom manufacturer called Picanol. It was 2009 and the quiet entrepreneur pumped 15 million euro into the then-ailing company that was on the verge of bankruptcy. No one else believed in the company at the time. It was a neglected manufacturing business riddled with internal division and hadn’t adapted to the changing market.

His first objective as CEO was to turn a profit. He announced that for as long as the company made losses, he would not pay himself a salary. He suffered for only one year. Since his tenure, the company has increased its revenues by 2.5x and almost tripled its net profit.

To this day, Luc Tack sets himself a measly salary of 100,000 euro each year. His focus remains firmly on laying eggs.

In closing

Investors can make a lot of money from corporate turnarounds and have lower risk as prices are depressed. The clues above help you to see whether a company has the heart, stomach and brains necessary to change their fortunes. Sometimes things aren’t as dire as we think.

Happy compounding.

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that uncovers the best founder-led companies in the world. We invest in unique, overlooked companies in markets and industries beyond most managers’ reach. We are a different type of global fund – for more articles and information about us, visit www.lumenaryinvest.com

[1] Abebe MA, Tangpong C. Founder‐CEOs and corporate turnaround among declining firms. Corp Govern Int Rev. 2018;26:45–57. https://doi.org/10.1111/corg.12216

[2] Abebe MA, Tangpong C. Founder‐CEOs and corporate turnaround among declining firms. Corp Govern Int Rev. 2018;26:45–57. https://doi.org/10.1111/corg.12216

Lawrence Lam
Managing Director & Founder