RIP - Value Investing

The term "value investing" is one of those words where the more you think about it the weirder it becomes.  What is value after all?  It seems anything can be value investing, because value is in the eye of the beholder.

Security Analysis author Benjamin Graham made the comment in his book Intelligent Investor that

"Investment is most intelligent when it is most businesslike. It is amazing to see how many capable businessmen try to operate in Wall Street with complete disregard of all the sound principles through which they have gained success in their own undertakings. Yet every corporate security may best be viewed, in the first instance, as an ownership interest in, or a claim against, a specific business enterprise. And if a person sets out to make profits from security purchases and sales, he is embarking on a business venture of his own, which must be run in accordance with accepted business principles if it is to have a chance of success."

Let's take a step back for a few minutes.  One of the most basic rules of business, if not THE most basic rule is you sell your products for more than it costs to create or obtain them.  This is simple.  If you are going to open a ice cream shop where your cone has $.25 worth of ingredients and $.50 worth of labor and rent in it you need to sell it for $.75 if you want to stay in business.  This concept is so simple that even children understand it.  Have a child purchase an item for a few dollars and then ask to buy it off of them for less than they paid, they'll protest.  It simply makes sense.

Unfortunately this business logic doesn't extend to the stock market.  Our fictitious ice cream shop selling cones for $1.00 that cost $.75 would trades for less than the trendy ice cream shop selling the same cones with the same cost structure for $.50.  Why is this?

In the stock market there is a second dynamic at work, it's investor psychology.  It isn't just what the underlying business is doing, it's what other investors are willing to pay.  In our example investors prize trendiness and losses over profits, and so they are willing to pay more for company B.  Of course there will be stories explaining why B is better than A.  The psychology is that investors feel that since they love company B that everyone loves company B and they will always be able to sell their shares for more than they paid.

Maybe company B will make it up on volume, or they're growing, or they have a visionary ice cream scooper.  The reality is unless company B raises their prices, or figures out a way to lower their costs they will eventually end up out of business.

There is no magic to this, it's simple math.  And when you argue with math you lose, every, single, time.

Sometimes value investing is described as buying unloved companies.  The story goes that the value investor would purchase company A in our example because they aren't as trendy, or as popular.  If you extrapolate this idea you end up with the idea that a value investment is just a piece of unpopular garbage, or something no one else likes.  I think it's neither.

There is another way to view a value investor, they're an optimist.  Someone who looks at the ugly duckling and says "Hmm, they're still a duck, they can still swim, walk, fly, do duck things.  If other ducks are valued on duck things the ugly one should be as well.  And besides, beauty is fleeting, maybe those beautiful ducks will age out over time.."

Or let's take another analogy, sports.  The market values the MVP's (most valuable player) of the team.  They are popular, have great stats, and do well every game.  How could you not like the MVP?  The value investor looks at the teams that are doing poorly and works to determine which underdog has a real chance.  They're looking for the upset team, or the breakout star.  Sure that underdog might only win a game or two, but if you're gambling on single games picking the underdog will result a bigger jackpot.

The optimist isn't stupid, they don't buy what's unloved just because it's unloved.  They buy it because after evaluating the circumstances they've determined that a company has a chance.  There's a reason to be optimistic about the future when everyone else is pessimistic.

Value investing is difficult because it's hard to be optimistic when everything looks bleak.  It's easy to be a growth investor because everyone is optimistic and you're optimistic along with them.  

Unfortunately at this juncture in the market value investing is dead, completely dead.  The reason is there is almost nothing that people aren't optimistic about.  

My view on this was crystalized when I spoke to a client earlier today who specializes in small rural banks.  They said that what they're seeing is unbridled optimism about economic expansion in places that haven't been optimistic since the post World War II boom.  When optimism has crept down to the sleepiest of places it has become persuasive.

Of course a retort to this post is that there are still 'cheap' companies.  There will always be companies with struggles or issues, and dying industries.  But the caveat is sometimes the market's pessimism is justified.  Industries die, companies die.  Sometimes a dying company is simply a dying company, not a value investment.  A value investment is a company that looks like it might be dying but it isn't.  Or one that the market has left for dead that is going to survive.

When I look at the market, both the public market and the private business world I see optimism everywhere.  That's a good thing, but bad for a value investor.  It's bad because there aren't things that look bad to be optimistic about.  At this point being optimistic is simply running with the pack, everyone is optimistic.  If the future optimism is warranted then everyone will do well.  Maybe we'll finally usher in that period where stocks reach the ever illusive permanently high plateau.

Given the current situation an investor has two choices.  Cheer for the star players along with everyone else, or sit on your hands and wait.  I'm more comfortable with waiting.  The good news is this, when opportunity finally arrives it will be here for a while.  The last time the market crashed there were still eye-popping bargains four years later.  You didn't have to get in right away, you could have sat on your hands for a while and still done well.

If you want to invest with the market buy something, anything really, it will go up.  For those who prefer to be optimistic in the face of pessimism there are always a few companies in little nooks and crannies, but not much else.  Maybe it's time to take a long vacation..

The blessing and curse of being public

The grass always seems greener on the other side.  Managers of public companies want to be private so they don't have to hit quarterly targets.  And strong private companies would love public capital to grow without micromanaging oversight from their VC overlords.  Even though being public is positioned as a black and white binary decision I think it's far from that, the value of being public comes from the company itself.

Let's take an example of something that is public, parks, to see why.  There are public parks and there are private parks.  In both cases a park is a piece of property that exists to benefit some party.  A park is a perfect analogy for public companies.  Parks come in all shapes and sizes, for tiny one acre plots stuck in the corner of a subdivision to the massive and well known Grand Canyon.  In the United States it's hard to travel far without encountering a park of some sort, either a large national park, or a small local township park.  Just as there are people everywhere, there are parks everywhere.

Parks vary in their quality.  The majestic National Parks are considered in a class of their own.  They're destination parks with scenic features unmatched anywhere else.  These are the large caps of the market, the companies that everyone knows that are capitalistic national treasures.  The thing with National Parks is that while they're beautiful they don't hold a monopoly on beauty.  George Washington National Forest is just as scenic as nearby Shenandoah National Park, yet one is known while the other isn't.  Likewise there are many state parks and local parks that harbor stunning attractions too.

The scenery between parks varies as does the care and quality of parks.  If you listened to Americans for long enough you'd have the impression that public parks are universally trashed and full of nepotistic park management.  This view is probably derived from that fact that most Americans visit a park exactly once a year, on the 4th of July, when they do the trashing while watching the fireworks.

For every trashed local park there are dozens of clean parks with diligent rangers.  Sometimes a park will have onerous rules to compensate for some past evils.  For example State Parks in Pennsylvania will give you a ticket if you attempt to enjoy a beer by a campfire, but in Alabama they'll sell you a beer at the ranger station.  Apparently in Alabama the local youth aren't attracted to trashing their state parks, whereas in Pennsylvania they are.  The same could be said for a company's corporate governance.  Governance varies as much as companies vary, and in almost all cases the variance is due to past issues, or perceived future issues that are unique to each company.

The similarities don't stop there either.  At the local level if a park falls into disrepair or becomes outdated often a small group of citizens will band together to get something done.  These are citizens who individually hold very little power, usually just their own vote.  They petition the government to do something with their dilapidated park.  And if nothing is done they can vote out the bums and vote in new bums with the hope these new bums can get something done.  Is this starting to sound like activist investing yet?  It isn't only local parks that can be changed due to a small group's involvement, it happens at the national level too.  Small outspoken groups can change the outcome for everyone by being persistent and loud.

Company managers act as if the metaphorical trashed park they oversea is someone else's problem instead of their own.  They neglect to mention that they looked on when someone trashed it, and that they didn't want to clean things up.  They pretend that if they were private that it wouldn't be trashed, but that's false.

If a company is in disrepair management often has to look only as far as the mirror to see why they're having problems.  But in the same vein, successful managers shouldn't be too quick to pat themselves on the back.  The Grand Canyon will be magnificent regardless of whatever ranger is in charge, the same is true for many large companies.  Their business runs with them or without them, not because of them.

Unfortunately there are too many managers who think that being public is the root of all of their problems.  When the problem is themselves, their company has cultural rot and needs to be changed.  Change is always possible, but it isn't easy, and executive decrying public markets are usually the same executives who want easy solutions.

Being public or private isn't a silver bullet.  Yes, there are costs associated with being public, but there are also advantages.  A public company can raise additional capital with little cost.  Whereas a private company might not have to hit quarterly targets or carry a regulatory burden, but executives might have to hit the road for month's worth of dog and pony shows to raise capital.

Be wary of when a company's management blames being public as the source of all their problems.  It's usually just a cover for their own incompetence.  But that incompetence is also an opportunity for savvy investors to initiate change.

Buy and hold is dead. Long live buy and hold.

My foray into investing was similar to most.  I found myself with a bit of extra cash and wondered "how can I earn more than 5% with this?"  Of course all of the wise and savvy people in my life such as co-workers and parents all said "invest it!" But I didn't know what that meant.  I did what any book worm would do, went to the local library, found the aisle with investment books and proceeded to check a few out.

I read all sorts of books about investment, some terrible, some interesting.  My library seemed to operate on a rolling calendar basis that was about a decade old.  That means most of the books I was checking out in 2005 were from the early to mid 1990s.  There were books on the Dogs of the Dow, and Beardstown Ladies, as well as Stocks for the Long run and many others.  The books all had a common theme, it was that savvy investors used a technique called "buy and hold."  What this meant was investors should scour the investment universe for anointed blue chip stocks, buy them at any price, and hold them forever.

The concept behind buy and hold makes sense.  You buy market leading companies, hold them, and throughout time your shares naturally appreciate.  From the end of WWII onward buy and hold was a brilliant strategy.  With the industrial hearts of Europe and Asia decimated from war the US had a natural industrial advantage.  Those blue chip stocks grew and grew and grew.  Investors would buy, hold, and re-invest their dividends for years.  Some companies even developed specialized programs where investors could invest directly with them and reinvest their dividends in partial shares at a slight discount to the market rate.  The system was focused entirely around buying these quality blue chip companies and holding them forever.

The system can't be faulted, it worked!  I know of people personally who worked for GE and other blue chip names in the 1960s-1990s who invested their entire retirement in company stock and retired a millionaire.  These weren't executives either.

Then a man named John Bogle came along and created a better buy and hold system.  Most investors were only buying blue chips, and blue chips were the main constituents of stock indexes.  This meant that at best the performance for most investors approximated an index.  The problem was that even though investors were approximating the index they were failing to match or beat its performance.  This was due to frictional trading costs, or just bad decisions.  The idea that one could buy an entire index in a mutual fund with low fees, sit back and do nothing more and earn higher returns was attractive.  From Bogle's initial concept Vanguard was born and grew into a juggernaut.

A curious twist has happened in the years since.  Index investing has overtaken buy and hold and become its own investing religion.  Along with this value investors have gone full circle.  From deriding buy and hold as an unintelligent strategy to embracing and proselytizing it.

Value investing drifted from buying companies that were disproportionally cheap to buying companies that earn above average returns that can be held forever.  Does that sound familiar?  It's buy and hold with new terms.  Instead of "blue chip" we have "compounder" and instead of "market leader" we have "high ROIC."  These compounders are discussed as being such good businesses that investors don't need to focus on the price they pay.  All one needs to do is buy them at any price and hold on for decades.  These companies will somehow grow to the sky and make everyone rich.

Is it any wonder that most funds fail to match their index?  They're back to working with a strategy where it'd be much better to buy the index.

So what's the alternative?  It's my belief that for most companies there is a price where they should be purchased, and a price where they should be sold.  No company grows at 20% forever, the math works against them.  Take a company earning $1b growing at 20%.  After 20 years of growth they're generating $38b in income.  After 30 years of growth it's $237b in income.  And 40: $1.4T, and 50: $9T, and 60: $56T.  A company that starts with $1b in income and grows at 20% a year for 50 years will be earning more than the entire GDP of the US in slightly over 50 years.  Is that realistic?

Let's also note that very few investors get on board when the company is earning $1b, they latch on after 15-20 years of growth once they have a long track record.  It's at this point that most of these companies are hitting their peak scale and growth starts to taper off.

Investors like to delude themselves and say that they know better than most what the future will hold.  That they'll only buy companies that can grown earnings 20% for the next twenty years.  Think about how crazy that is.  Let's go back 20 years.  What companies were going to take over the world?  How about Gateway Computer, they were an all-star.  They had stores, they had cool commercials, they were a popular brand.  They vanished in a string of mergers.  Maybe Apple?  Back in the late 1990s it was a lame computer manufacturer that was on the brink of death.  The weekly Best Buy ads would have them in a line-up compared to other Mac clones as well as PC's.  The Apples always had the worst specs and highest price.  No one would have guessed they'd become a dominant brand selling cell phones.  Back then Motorola was cleaning up with their StarTAC phone.  The cell phone world belonged to Motorola and Nokia.  Yet twenty years later those companies exist in name only now, a bet on them in 1997 would have ended in pain and misery.

Of course a few readers will say "Amazon and Google", which is perfect hindsight bias.  Now that they're the market leaders we all "knew" they'd be like this in the late 90s didn't we?  I remember back then AltaVista was killing it in search, same with Lycos.  Amazon was interesting if you wanted books, but that's all they sold.

There are times when the market is pricing a company too low given their future prospects, or even current prospects.  It's during those times when an investor should purchase shares.  But just as the market likes to undershoot it also likes to overshoot.  And companies that were formerly undervalued can become just as overvalued.  Instead of holding on by justifying a low cost basis it's time to cut the cord and take gains.

Holding too long can become dangerous.  I know of an investor who purchased a deeply undervalued company in the early 1980s.  They held and the stock grew by almost 100x.  His investors who cashed out at that time profited from his holding, but he continued to hold.  As of a few years ago the stock was below his cost basis from the early 80s.  The company went full cycle, from small to an all-star and back again.

If you don't know when to buy or when to sell you might be telling a similar story some day.  It's time to buy a company when they're trading at a deep discount to either their assets, earnings, or the M&A multiple of their peer companies.  The metrics on selling are different, and maybe this is what trips investors up.  When a company appreciates you need to evaluate them differently.  Look at the growth the market is pricing into the stock and estimate if that's appropriate.  Also look at the trajectory of the company's revenue and earnings and estimate if those growth rates seem appropriate.  There are times when you can buy a company at 50% of book and sell at 100% of book when nothing in the business has changed.  But more often something has changed that ignited the move, and usually what's changed is earnings so it's the earnings that need to be evaluated.

The only way to earn above average returns in the market is to do be doing something different than the market.  You can't be doing something different if you're mostly buying large constituents of the indexes and holding on.  Remember that every price has a point where they're a buy, and everything a sell.  For those of us who adhere to this the idea that most of the market is buying and holding blindly is a good thing, it means more opportunity for us.  So seize that and profit!

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Are all "Graham" stocks junk?

Have you ever walked down the street and inadvertently stepped on a piece of gum?  It's annoying.  A piece of previously enjoyed food carelessly discarded on the ground and is now stuck to your shoe.  In many ways investing in the mold of Benjamin Graham is like a sticky piece of gum on the street for most investors.  It's an idea that had merit seventy or eighty years ago, but is old fashioned and is now stuck to everyone's shoes.  Most value investors have spent a considerable amounts of time metaphorically scraping Graham's ideas from their shoes.  But amazingly there are still a few still chewing on that old gum and enjoying it, why?

The common sentiment is that Graham-esque stocks, that is stocks that trade at low valuation multiples such as a stock trading at10x earnings and 75% of book are junk and a waste of time to research.  The implicit assumption in all of this is that the market is somewhat efficient and if a business trades for a poor multiple it must have some problem that makes it deserving of the low multiple.

A company might be deserving of a low multiple because there is fraud, or they retain a management team that has decided to loot the coffers.  Although ironically fraudulent companies often earn praise and high multiples from the market until the day they fail, a la Valeant.

The stereotype of a value stock is a company producing shag carpeting run by managers wearing polyester suits with elbow pads who are wondering why sales are declining.  This can be the case sometimes, but it's more of an outlier than the norm.

I think the greater problem with Graham type stocks is they are in unattractive industries, and investors don't like to be out of step with the market.  I ran a screen for stocks trading below 75% of book value and for less than 10x earnings.  The resulting small list contained some sketchy biotech companies, a number of even sketchier Russian mining companies, as well as a few other resource and industrial companies.

These companies with depressed valuations don't appear in anyone's quarterly shareholder letter, and they aren't on WhaleWisdom.  In a perverse sense the increased socialization and ability to network with other investors via the Internet has made this problem worse.  I've heard of investors who search Twitter, Seeking Alpha and hedge fund letters for ideas.  If an idea isn't "approved" by someone well known in one of these circles it must not be worth researching.  The idea is that these high profile managers or prolific Internet posters spend all of their time reading and scouring nooks and crannies for stocks.  So they must have looked at everything already, and if they didn't buy it then it isn't worth buying.

Just because a name doesn't appear on Twitter, or in hedge fund letters, or on Seeking Alpha doesn't mean it's a bad idea, or it's not worth researching.  There are still plenty of areas that are inefficient, and stocks that are out of favor is the biggest area.

People like to be liked.  It's easy to be liked when you're doing the same thing as everyone else.  This is true for all aspects of life.  In sports-crazed cities it's difficult to cheer for an out of town team.  Groups of friends all have similar interests and views.  Political parties change direction often, but party followers keep toting the line.  The market is just a group of people too, and the market collectively likes things like any other group.  These likes and interests are echoed on TV, in letters, and in public speeches about investing.

Currently the market likes artificial intelligence, self-driving cars, automation, mail-order catalogs presented as websites (what is old is new again..Amazon the new Sears?), companies with high ROE's regardless of how they're generated, compounders and moats.  This wasn't always the case, at periods in the past the market's interests were different, and they'll change again in the future.  Yesterday's Nifty Fifty is today's IBM with investors running for the exists.

In large the market points in the correct general direction.  In the 1990s it pointed towards the Internet becoming a thing, it did become a thing.  In the 2000s it pointed towards financialization, which is still a thing.  The finer details aren't always correct, but the general direction usually is.

If a company isn't part of the cool kids club they might be able to float alongside for a while.  Maybe they'll toss a few keywords in their proxy about automation and technology innovation.  Or maybe their high ROE is good enough for a while.  But eventually those wannabes fall by the wayside.  Sentiment shifts and somehow a wannabe becomes a left behinder.  For years resource companies were the cool kids, now suddenly no one will touch them.  Airlines spent a long time in the ditch, but now they're suddenly cool again.  This is the popularity cycle at work.

One of the foundational concepts that Benjamin Graham taught was that there can be value where others don't believe it exists.  What he didn't say was "buy everything no one else likes."  He said to go poke where others aren't poking, because sometimes the baby is thrown out with the bathwater.

It's in these pools of dirty bathwater that deep value investors go searching for babies.  While the pool might be dirty the discovered baby isn't.  To beat an analogy to death.. the babies we're finding are cute and innocent, unsure of why they're laying on the street out the window in a puddle of bad water.

This is the essence of value investing.  Looking where others aren't looking, but sifting the bad from the good.  The idea is to find companies that have been marked by the market as bad that aren't.  Since these companies aren't bad like the market suggests, their goodness will eventually shine through for investors to notice.  When this happens their price will appreciate to be in line with other similar companies, not the mis-matched peers they were previously trading with.

Like everything in life investing is a popularity contest, and Graham style investing is not popular at the moment, just like the types of stocks it uncovers.  This doesn't mean the strategy isn't profitable.  It's actually the opposite, excess returns are found outside of the main stream of popularity.  I'd wager that a set of randomly selected set of companies trading at low P/B and low P/E ratios will outperform the FANG stocks, or Tesla over the next three to five years.  But this isn't a popular notion, and no one wants to be caught writing about a no-name value stock in their quarterly letter.  And that's why this opportunity exists.

Another look at National Stock Yards

It's easy to follow a company when they release information once a year, and that information is a simple 12 page annual report.  That's the case with National Stock Yards (NSYC), a company I've owned a single share of since 2012. 

Since I last wrote about the company I've received an five additional annual reports.  That's 60 pages of reading material on this company, not much.  All of the information in those reports can be summed up in a simple statement "the more things change the more they stay the same." 

Here's the backstory.  A long time ago in a far away place there was a company that owned stockyards.  A stockyard is a place where cattle are auctioned off to buyers.  Ranchers drive their cattle by horse, or train, or truck to the stockyard at pre-determined dates when auctions are held.  Cattle buyers come and purchase the ingredients for your burgers and steaks and the ranchers return home without cattle, but with pockets full of cash.

The company was established in the 1870s in Oklahoma.  The date and place invokes images of cowboys and Indians, saloons and western movies.  Those days are long gone and the company now consists of three things, their Oklahoma stockyard that's still transacting cattle, a plot of empty land near St. Louis, and an ownership interest in a golf course.

When I last wrote about the company shares traded for $166 a share and the company earned nothing outside of real estate sales.  Last year the company reported an operating profit from their livestock operations.  For years they'd be talking about how the livestock herd in the US was decimated and that was the reason behind their losses.  In 2015 someone came up with the idea of raising prices and lo and behold they earned a profit, and volume didn't decline either!  On the back of continued price increases their livestock operations earned another profit in 2016.  And supposedly the herd is back to normal now.

The real asset isn't livestock, it's their St. Louis land.  The company owns 191 acres of empty land an "easy five minute drive to downtown St. Louis."  The land is carried at $2.9m on the books.  For years they've been chopping off small chunks and selling them for various amounts.  In 2016 the company sold 11 acres for $890,000.  The company seems to prefer to sell 10 acre lots for prices varying from $100k to the most recent $890k.

A danger with real estate valuation is extrapolating the price per acre from one sale across the entire land holding.  The company's sales history shows that not all of the land holds the same value.  On the conservative side we can assume the property is worth at least $10,000/acre, with some plots worth up to $89,000/acre. 

On the low side their 191 acres would be worth $1.91m.  This is an overly conservative value because management lets us know it is.  The property is held on the books for about $15,000 per acre.  But management notes in the report "Management estimates that the fair value of the Company's St. Louis real estate is in excess of its carrying value and demolition costs, and accordingly, the carrying value of the St. Louis real estate has not been adjusted accordingly."

Let's put the pieces together.  In 2016 the company earned $21.72 per share, and if you remove their real estate proceeds earned $13.52 per share from livestock.  Current book value is $7.7m including the St. Louis land.  If we remove that we get a book value of $4.1m for the livestock, or $94.03 per share.  The company's core business is earning 14% on its equity, a respectable return.

Stockyards aren't sexy like self-driving cars or internet advertising, so maybe their earnings only deserve a 10x multiple.  This would mean the core company is worth $135 per share.  Shares trade with a bid of $250 and an ask of $498.  Let's ignore the ask for a minute.

The market, and by market I mean some savvy buyer who's looking at the same material I am, believes the company's remaining real estate is worth $115 per share.  That puts the implied value of the St. Louis land at about $5m, or about 72% above carrying cost.  A $5m land valuation assumes acres are sold at an average price of $26,000.

Is this a reasonable valuation?  Maybe?  The math behind a $250 per share valuation seems sound, but it's interesting that there's a seller who is only happy to let them go at $498 per share.  A $498 per share value implies the non-operating assets are worth $8.3m.

What's great is that you can reduce National Stock Yard's valuation down to two variables, the value of their core business, and the value of their real estate.  Maybe the core business is worth 15x earnings.  If they were a compounder or outsider investors would be trampling each other to pay 30x earnings.  But instead it's a bunch of cowboys selling cattle in dusty Oklahoma warehouses.  Likewise the St. Louis land could be worth a small fortune, or maybe not.  That's up to the investor to decide.

It's also worth pondering that to most investors this is a dead company.  And the narrative is dead companies are dead money.  But it's worth pointing out that I purchased this for $166 a share in November of 2012 and there is an active bid at $250.  That's a 50% gain in about 4.5 years. The company has paid a sizable dividend per year, $20 per share the last two years.  I think I've received $60-70 in dividends bumping the return from 50% in 4.5 years to an 86% return in 4.5 years, or about 20% a year.  That's not bad for something left for dead!

You'll note that I never discussed the golf course outside of a mention at the top of the post.  It's because the company holds it at $0, and we don't know anything about it.  I consider it bit of a valuation bonus.  Maybe the golf course is worth an additional $10-20 per share.  If it isn't it doesn't change anything with the main thesis.

The investment outlook is as certain in 2017 as it was in 2012 for the company.  If the company's core business remains stable and they can sell their remaining St. Louis land then maybe shares really are worth $500 a share.  Until then I'll continue to hold my single share and watch from the sidelines.

Disclosure: I own a share

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Why growth can be a killer

It's as if we're wired for growth.  "Growth is good." "If you're not growing you're dying." Everyone wants to be growing, personally, physically, mentally.  Businesses are no different.  Growing companies are rewarded a high multiple and low growth companies are rewarded low multiples.  But is growth always good?

Growth in businesses is exciting.  When a company is growing it's lively, employees are excited, customers are excited, there is momentum.  It is fun to be a part of something growing.

The problem with growth is that it's hard to manage well.  Humans seem to make the best decisions when they can assess the inputs, thoughtfully consider those inputs and make a decision.  When a company is in the midst of rapid growth management doesn't have the opportunity to make thought out decisions.  People need to be hired yesterday, customers are ordering things that don't exist yet, it's all hands on deck all the time.

Some of the excited from working at a growing company comes from the fact that no two days are the same.  There are always new challenges.  The reason for this is because the workplace is chaotic and employees don't have fixed roles yet.  No two days are the same because on Monday you might be solving an engineering problem, and on Tuesday you're helping to pack boxes in the warehouse.  When a problem comes up everyone huddles to figure out how to tackle it.  Unfortunately playing whack-a-mole with problems isn't efficient, or sustainable way to conduct business.

Companies are successful when they can introspect, identify why they are successful and systematize their success.  This systematization is the process that turns a start-up into something sustainable.  It's also the point where most of the initial cowboy (or cowgirl) employees leave because a company has becoming "too corporate."

Companies are typically started by people who are willing to do anything at any time to get a job done.  These are people who enjoy challenges and thrive in chaos.  They are the people who are willing to try new things, but usually aren't very structured, they can't be.  As a company grows it needs to become organized and organization doesn't come from the initial employees.  It comes from new hires with experience in structured environments.  These new hires usher in the second phase in a company's lifecycle.  The sustainable corporate phase.  Success is systematized and becomes sustainable.

Growth can kill companies when they refuse to systematize their processes and become corporate.  This could be because a company's Founder doesn't want to lose their start-up culture.  Or it could be that the initial management team doesn't know that it needs to systematize. 

Eventually the chaotic fire fighting becomes unsustainable and a company collapses under its own weight.  Unfortunately the collapse is sudden and unexpected.  There isn't always a specific reason for the collapse.  But the underlying reason is always the same.  The chaos became unmanageable and obligations went unfulfilled.

The corollary to growing too fast are companies with little growth that never seem to die.  These low growth companies are some of the stalwarts of value investing.  Just like growth is lauded no growth is despised.  Who wants to work for a company that grows at 3% a year?  Even worse, who wants to invest in such a slow-poke?

The perception around low growth companies is fascinating.  Even though most are exhibiting some absolute level of growth, even if small, investors see these as "dying" companies.  They are dying in the eyes of the market because they're not growing fast.

Just as it's difficult to systematize a fast growing company it's hard to take a systematized low growth company and turn on the growth spigot.  Low growth companies are set in their ways.  Their ways are often successful in generating consistent returns, but not consistently high returns.  Some of this could be due to their products or market, or it could be that the company doesn't know what needs to be changed to generate increased growth.

In the book Security Analysis the author Benjamin Graham discusses buying stocks and encourages the reader to look at a company's past growth history.  He states that if a company had experience with growth or high earnings in the past then management is familiar with what it took to get there, even if they aren't experiencing it currently.  This is preferable to a company that has never had more than middling growth.  The implication is that the management team doesn't know what's necessary to create conditions that generate growth.

The world of venture capital investing is filled with carcasses of companies that grew fast and failed.  Most of the companies didn't fail because customers didn't like their products, or there wasn't market demand, or they couldn't generate revenue.  They failed because they grew too fast.  Their growth was unmanageable and they grew their way to failure.

Venture capitalists are hoping to leech onto a company that can mitigate the growth landmines.  They are looking to find companies that grow fast, but also figure out how to become corporate and sustainable.

Investors in public markets should avoid high straight line growth and instead favor companies with moderate, but sustainable growth.  High paced growth is exciting for a while, but when the bottom falls out shares crash and investors become bewildered wondering "how could this happen?"

A company with sustainable growth can retain excitement from growing.  But without out of control growth the investor stands more of a chance that they'll be able to enjoy the fruit of their growth investment.  If you're in the market for growth don't be a moth attracted to the flame from a rocket investment.  Rather look for sustainable growth identifiable by a management team that is corporate and has systematized their success.  

Podcast interview plus a new investing system course

Planet Microcap Podcast

I recently had the chance to be interviewed by Robert Kraft on the Planet Microcap Podcast.  We had a great conversation that ranged from investing in microcaps, to bank investing, and some background on how I got started.

You can listen below:

If you have a chance listen to some of the other podcasts from Planet Microcap.  There are some interesting guests worth listening to.

My Investing System Course

I have quite the back catalog of content on this blog.  Scattered throughout old posts are theories on how I look at investments and how I find new ideas.  I know a few brave souls have dove into the more than 1,000 pages of material and read from start to finish.  But most of you don't have that much time to go trawling through pages of posts to find what you're looking for.

One question I'm asked over and over is "How do you find investments?" and "How do you evaluate investments?"  In one sense finding an oddball investment is like finding my posts on how I do it.  You start with a lot of content and begin to dig...  We decided to short-circuit the digging step and provide all of this in a simple email newsletter.

If you sign up for the course you'll receive one email a day on the following topics:

  • Day 1: Where to hunt oddballs (Is screening dead?)
  • Day 2: Assets and book value (Where 50 cent dollars hide)
  • Day 3: Earnings (Growth isn’t everything)
  • Day 4: Management: (Roach motel avoidance 101)
  • Day 5: Catalysts (Who needs em?)
  • Day 6: Activism (Can anyone go activist these days?)
  • Day 7: Portfolio Management and When to Sell (The system I use to manage 50+ positions)
You can sign up below: