A New Book and a New Idea ($IVTY, $MDT)

I recently received a gift in the mail, a copy of this out of print book by former CIA intelligence analyst, Richards Heuer. The book is influenced by Kahneman and Tversky but framed primarily around the decision making part of analysis and not just the analysis of decision making.

It is a dense read with fewer "cognitive party tricks" than the pages of so many other popular books on the subject, but it's fascinating, even as I'm only halfway through it.

Since I've recently sold some positions and also have some new clients, I have the "high class problem" of having capital to put to work. So the book arrived just as I'm searching for new ideas and as a result, the aspect of the book that's come into sharpest focus is the relative nature of observations and its relationship to decision making.

We all know that colors have a relative nature, changing depending on the background. And we all know there is a relative nature to sound, to speed, to taste, to time, etc.

Concurrently, the book also introduced to me the concept of "bounded rationality", which describes our tendency to frame things in a specific way, then solve for the problem within that arbitrary frame. For example, my wife often poses questions at me along the lines of  "would you rather do this or that?" as if those are the only two options available, and without articulating the problem she's trying to solve. (I'll acknowledge the difficulty of being married to an over-analytical spouse when all she wants to do is go out for dinner).

Reflecting on these aspects of decision making is critical for the obvious reason that ours is a decision making business and few people do it well consistently. Though the first year of my firm provides a good start, consistency is measured in years not months, and I still have a lot to prove.

Furthermore, the returns we put up isn't some theoretical experience; I have a fiduciary obligation and professional responsibility to grow my client's capital and avoid losses on their hard earned money. It's important to get it right and I better not screw it up!

So with these new insights into the relative nature of observations, it comes to mind that the search I've been conducting for new ideas may be rife with biases I'd never before considered. Here I am reading Q's and K's, learning about businesses, screening, modelling, reading, reviewing ... and saying "no" over and over ... and up percolates an emotional experience, let's call it "frustration", about not finding good ideas.

Frustration can lead to impatience ... and then perhaps the relative nature of observations takes over ... and I'm suddenly comparing the next idea to the last idea instead of to an objective benchmark. Each idea is independent of the other - and I should be more eager to preserve cash for the right idea than rush into the wrong one - but what if I'm suddenly framing them relative to each other and thus distorting the analysis?

The problem with all this is twofold: First, the potential lack of awareness that fatigue and relativity can drive decisions. Second, because most of the stocks I tend to buy are lonely trades where validation can be incredibly delayed, I might not know whether I'm "right or wrong" about a stock for months, if not years. I'd rather hold cash than be wrong ... but I'd like to not miss opportunities to be right.

All of a sudden the obvious and well discussed theories behind deep value investing are crystalized: If you buy companies for less than its asset value, you don't have to worry so much about the future. It's an easy philosophy on paper but less so in practice, because some "deep value" businesses absolutely suck and the good ones don't trade for below their asset values for long. Value, as we all know, is infrequently obvious.

This all calls to mind something Howard Marks wrote about "the future":

"It would be convenient to say that adherence to value investing permits investors to avoid conjecture about the future and that growth investing consists only of conjecture about the future, but that would be a considerable exaggeration. After all, establishing the current value of a business requires an opinion regarding its future, and that in turn must take into account the likely macro-economic environment, competitive developments and technological advances. Even a promising net- net investment can be doomed if the company’s assets are squandered on money- losing operations or unwise acquisitions.

There’s no bright-line distinction between value and growth; both require us to deal with the future. Value investors think about the company’s potential for growth, and the “growth at a reasonable price” school pays explicit homage to value. It’s all a matter of degree. However, I think it can fairly be said that growth investing is about the future, whereas value investing emphasizes current day considerations but can’t escape dealing with the future."

The future, the fact that nobody knows it, and the risks associated with its possible outcomes are important considerations in all investments. One I've been considering - Invuity - which makes lighted surgical equipment for the operating room, recently sold off b/c of weaker than expected guidance for 2017 (the near future), but I think it may represent a compelling long term opportunity.

At $6.00, Invuity (ticker: IVTY) has a $100M market cap and is trading at ~2.5x 2017 sales guidance of $40M-$42M, a future that implies 35% topline growth. This is - I believe - a “capitulation price” for a company innovating in an overlooked and undervalued area of the surgical equipment market and in an industry where stocks tend to trade in the range of 2x-10x sales.

The company’s core product is an engineered piece of plastic that delivers cool bright light with a wide field and few shadows directly into the cavity of a surgical "field". This piece of plastic – for simplicity sake let’s just call it a widget for now – either clips onto a reusable retractor that the company sells or is built into the company’s version of ubiquitous operating room tools like "yankauers" and "bovies".

The company has two types of sales; a "capital" sale - an expensive piece of reusable equipment - and a "disposable" sale (ie recurring) via the handheld equipment and clip on widget. These products together improve visualization - a surgeon’s ability to see - in non-laproscopic / non-robotic procedures.

The company currently markets these products into four narrow verticals: Breast oncology, orthopedic surgeries, thoracic and spine procedures. Some procedures like "nipple sparing masectomies" and "anterior hip arthroplasties" are particularly well suited for the device as they are fairly technical and involve smaller incisions for open surgery, making "visualization" difficult.

These procedures benefit the patients via less scarring and/or faster recovery times so the concurrence of the new procedure's acceptance and the improved equipment may help grow their use and thus demand for the equipment, etc. (Note that despite the negative bias towards the anterior approach in this link, it acknowledges speedier recovery for the anterior approach as well as the greater difficulty with visualization).

B/c of the NSM procedure the company has had the greatest traction with breast oncology - about 40% of sales - but has under-penetrated the more lucrative spine and orthopedic procedures.

This is still a small company - not just in market cap but in actual size - selling just a few products into a few narrow verticals. At 3Q16, the most recent quarter, the company had 65 salespeople, many of them with the company for less than a year, selling into 700 accounts. Small, yes, but on a relative basis, compared with last year, this reflects 25% growth in salespeople, 50% growth in accounts, and a 63% increase in procedures per quarter, to 26,000 from 16,000 in 3Q15.

In 1H17, the company will launch one new product - the “PhotonBlade” - a lighted version of Medtronic’s PEAK PlasmaBlade, which will have the "light widget" built in and a tip that causes less scarring. The company believes this product will allow the company to further penetrate breast oncology and spine market.

It is worth noting here that IVTY’s head of R&D, Paul Davison, was the head of R&D at PEAK Surgical, before it was acquired by Medtronic in 2011. At the time of the 2011 acquisition, PEAK had $20M in sales and was acquired for a 6x sales multiple.

So what don't we know?

I have talked to a number of doctor's about the product for qualitative background. One, whom I respect and admire greatly, insists on caution with the investment. "They're not the first to try to do this," he says. "There've been people trying to come up with better lights on surgical tools for more than 30-years."

My response: "That's proof it's a problem searching for a solution."

Several other doctors I talked with expressed enthusiasm for the product; "Tt would be awesome if it did what they say it does" but they all universally blanched at the price.

And price is an issue. The company charges a huge 10x premium for their lighted product. Their disposable yankauers and bovies as well as the clip on widgets (called “waveguides”) cost $250 to $300 compared to non-lighted versions of the same products, which cost under $25.

In a market with thin margins for hospitals and risk that ACA will disappear, it seems ridiculous to think hospitals will pay this much for disposable plastic. The product pricing is the first of many obvious reasons why this company fails.

Yet, despite the premium and all the other obvious reasons, the company is on track to sell $24M of these disposable plastic products in '16 (and $8M in reusable products that the widgets clip into), all at +70% gross profit margins. And these are pure cost to the hospital; there is no CPT code that allows the hospital to get reimbursed for its use.

The reasons for the company's potential success are less obvious. Again, this investment depends on a future. But experience indicates that it takes time – and costs money - to introduce a new premium product to the market and for the market to adopt it. It takes time for a salesperson to “mature” and an account to “mature”. It takes time for doctors to see the light and press a hospital Value Analysis Committee to buy for them a premium priced piece of equipment.

And yes, the costs of selling currently exceed the revenues, but perhaps there is overlooked promise in the early operating evidence, particularly with the recurring revenue disposable widgets and most particularly at 3Q16, where the ratio of incremental sales to incremental marketing spend reached an inflection point and increased to 48%.

Management expects to keep sales staff flat into 2017 and focus on going “deeper” into existing accounts and were this to happen, we would see continued revenue scaling and then perhaps we are just now seeing the inflection and impact of more salespeople and more accounts on revenues.

Yet, the market is most skeptical as signs of success are improving. That skepticism, which underlies the low multiple, is driven by a variety of issues I'll lay out below:

1. The proximate issue with the recent decline in the stock price was a guidance shortfall. On the 3Q16 earnings call, mgmt guided to 35% topline growth in 2017 down from expectations of 50% growth, and this led to the stock’s capitulation. The stock was trading towards $13 heading into the quarter and hit $4.50 on the earnings release.

The 3Q16 sell-off reflected the market’s focus on the weak guidance. Through the lens of a DCF model, such a response makes total sense: If T+1 income is lower, the whole valuation declines. But from a qualitative perspective, there should be no point in investing in this company at any price – regardless of what the DCF says - nor under any circumstance without the belief that IVTY’s usefulness to its customers will grow over time, along with its sales and eventually profits.

What drives long term growth of a company – qualitatively - is a problem identified and solved at a price the customer can afford. We see evidence in the operations that the company’s illumination products are indeed solving a problem and they are generating traction on the valuable recurring revenue side of the business. But ...

2. Price seems to be a major issue.

A former employee I talked with said cost is the single biggest obstacle with "going deeper". This person said as they "get deeper" into accounts and sell more into each hospital, eventually the invoices roll up to the CFO who pushes back.

In addition, every doctor I talked with - bar none - expressed shock at the cost.

The company says the better lighting enables doctors to perform surgeries faster and therefore do 1-2 more per day. A response I got from another doctor was polite laughter: "If I were to make a list of items that slows down my [thoracic] surgeries, lighting would be like item 1,700."

The company also said interestingly, "when we show up on the CFO's desk, it means we're doing something right." Reminds me of the old saying: "Salesmanship begins when the customer says no."

3. In addition to being high priced, there's no CPT code for the product, so hospitals don't get reimbursed for their use. And hospitals aren't rolling in cash to spend on expensive equipment.

4. And recently there seems to be a lot of salesperson turnover.

5. And surgical procedures are supposedly moving away from open towards laproscopic and robotic

My response on these four items is that these issues are not "new". 

A brief look at a scuttlebutt message board for pharma sales reps shows people talking about the high product pricing, employee turnover, competition, etc. since at least 2014. In the interim, sales have grown from $14M to $32M. 

Meanwhile, the cost / benefit analysis of robotic surgeries doesn't appear to be compelling (though as long as insurance covers it, hospitals will do it). 

More broadly, product price is a solvable problem. They can continue down the path of a $250-$300 ASP, scratching for sales within the four narrow verticals and with the new product expected to come out in 1H17, they can offer bundled pricing. 

Or, they can lower prices. These products are cheap to make and if the product is desired, the potential for ubiquitous access across all hospital channels at a lower price is an attractive investment option, though even more attractive at the higher price. 

6. Ultimately though, the skepticism is bound - like life itself - by the limits of time. The company is unprofitable, running at losses of $40M in 2016 on sales of $32M and gross profit margins +70%. It also has $14.5M of outstanding debt at 12.5% interest, held by Healthcare Royalty Partners, a medspace investment firm that also owns 5% of the stock. And although the company has $34M in net cash on the balance sheet, it is still cash flow negative so at some point, there will be a future dilution event.

This is no walk in the park, but startups with losses and debt are not unusual, and this isn't the first rodeo for the management team - lead by CEO Phil Sawyer and CFO Jim Mackaness - who have prior experience running growth distribution businesses.

Nobody knows the future, but at ~2x 2017 sales, the stock market appears skeptical about the prospects due to losses, debt, the recent guidance shortfall, and issues that are not new.

That skepticism overlooks what appears to be some traction in the recurring revenue business and the traction is new, the evidence of success is new, the favorable relationship between the sales and cost curves are new and trending in the right direction.

Sure, my biases and frustrations, hubris about my successes, shame about my losses, all may have contributed to this idea floating up to a level of thinking that ... maybe it's totally irrational. A yankauer for $250? A plastic widget with some special light? Hospitals spending money on stuff they don't get reimbursed for?

Maybe I've talked myself into a bad idea ... but when the market is already valuing this as a bad idea ... and the evidence suggests that its not failing ... it seems to offer a favorable possibility for those armed with information and an uncommon perspective.

 - END –


Two recent activist situations that are more compelling than ARIS: CDI and SEV

I wrote earlier this week about the absurd activist situation at ARIS, a company whose share price is up 20% last 52 weeks (about 2x the S&P); up from a market value of $20M in 2012 to nearly $100M today (about 30% CAGR) and has concurrently grown bvps over the same per by ~10% CAGR. In short, it is not the most obvious target for change.

Consider in contrast two companies where activist are more appropriately getting involved and that might be worth keeping an eye on: CDI and SEV.


On its best day this company - part temp placement, part perm placement, part "body shop" project work in the construction / oil & gas / aerospace / IT industries - dreams of being a combination of Jacobs Engineering and Booz Allen.

But it wakes up everyday with a stale brand in need of a refresh, due primarily to the neglect of an absent board that has generated fees for itself and its agents while destroying value for shareholders.

Compounding the neglect is an unusual ownership structure; 25% of the company is owned by the  "Garrison Trust", which itself is managed and owned by the board. It is the governance equivalent of chaining the kids (is shareholders) to the radiator so the parents can go out and play.

Family services is finally coming, under the name Radoff and Schechter, who have most recently sent this spot on letter to the board. If it doesn't wake them up, I'm sure there are a few more letters coming. Radoff and Schechter - the activists - have been on an absolute tear ripping new holes into a most neglectful bunch.

To be frank, I wrote negatively about CDI at the end of Sept when it was trading below the value of its working capital + PP&E - l/t liabilities. It was then a wonderful opportunity for deep value investors as it is now trading at 1.6x that asset value.

Beauty, they say, is in the eye of the beholder. I do not see beauty b/c I do not see a pathway to success. The brand is stale. The work is undifferentiated. The company may benefit under the l/t turnaround plan by the "interim" CEO who has experience managing growth at stale brands, but how "interim" is he and what value does the company add that others cant such that there is a wide and probable pathway to success?

The "deep value" investor doesn't truck with possible future pathways, they only need look at the value vs the balance sheet and have done well buying the stock at a discount to that value.


Speaking of possible futures and pathetic boards, here's one that may have both.

Sevcon makes motor controllers for electric vehicles. In the most simplest terms, their product sits between an electric power source and a motor, and allows them to talk to each other. (Consider a switch that sits between a power source and a motor, but is simply either on or off. A motor controller in contrast is a complicated switch that can manage a variety of parameters around the power, the heat, the torque, etc. and constantly manages the power going back and forth, under a variety of conditions).

Some companies like Tesla make their own motor controllers specific to their motors. SEV makes one that is programmable across different electric power sources and motors. An EE told me they are like DOS or LINUX of motor controllers, compared to other companies that make motor controllers equivalent to MACs, easier to program but with fewer parameters.

The value of SEV is they can modify / customize their software to solve for specific problems around drive trains and / or accessories. Their simpler, older generation products, were used in simple EV's like golf carts, electric motorcycles*, and in industrial equipment - scissor lifts, fork lifts, heavy machinery - a business now in steep decline.

* Just a note that Brammo - the electric motorcycle company - was acquired by Polaris in 2015, specifically for its drive train, which included a Sevcon controller. The "holy grail" for Polaris isn't an electric motorcycle - though it is trying to rejuvenate the Victory brand with that purpose in mind - but rather a drive train for an electric ATV, the better to quietly transport hunters through the great outdoors.

Meanwhile, the holy grail for Sevcon - and potentially investors - is moving up the value scale from smaller vehicles to larger 4-wheel vehicles, a business they stumbled onto a few years ago.

They are currently developing controllers for a handful of OEM's that could deliver a stream of future royalty payments if the products under development go into production and are successful with the consumer market.

From the last conf call ...

"We have more projects in the pipeline than never before and we expect the customer enthusiasm for Sevcon solutions will continue. We currently has five major projects in the development phase of the pipeline having added an extension to one of the four projects we mentioned last quarter. We expect two to go into production in 2017, one in 2019 and then two in 2020."

"With the addition of the new content for the high performance sports car manufacturer we expect total production revenue from these projects to be approximately $206 million over the five to seven year production life. This is up from a 166 million that we projected on last quarter’s call. We’ll then be adding on revenues for spares in the 5 to 10 years following completion of production."

... as I once learned: "buy in the order cycle, sell into the delivery cycle." This company appears deep in the order cycle and again, the possibility of a pathway to success. Nobody knows the future.

But back to the present, and back to the board of directors, it's a laughing stock, especially for a high tech company with potential growth ahead.

Someone is finally trying to change that.

One thing that makes this board so ridiculous is that the current chairman of the board actually lists in his bio (ie his achievements) funds that failed under or around his watch,  companies that went bankrupt around his watch, and a firm that was invested in a ponzi scheme around his watch.

He might not be the provocateur that causes problems but he sure carries them around like the stink on cheese. A more proactive board can instill top down changes, drive accountability, set targets, increase the RPM of the growth engine of a company. The slate of potential candidates proposed to replace the board could enlarge the possibilities of future success.

Nobody knows the future but in both these cases, someone is trying to improve the odds for success and that could bode well for investors.

-- END --


ARIS: F1Q17 Results and the Most Absurd Proxy Battle Ever ($ARIS, $EBAY)

I've been a fan and stockholder of ARIS since it traded in the mid $3 range and I continue to like the company. I think the mgmt team is unusually strong in a sub $100M market cap company, I think the company still has room to grow in its variety of verticals and finally I think the business sells for a more than reasonable multiple such that a long term investment could benefit from the two attributes of growth and multiple expansion.

Despite these attributes, some impatient investor is challenging the company to sell itself. It is one of the most absurd proxy battles I've ever seen for a company so small. Absurd for so many reasons, but primarily in the waste of money and energy; there have been 15 DEF filings since the antagonist went after them in late October.

The information also directs investors in many cases to the wrong information - notably in this page of his presentation filing - which focuses on Net Income and not FCF. Because ARIS capitalizes its software development, Net Income includes significant depreciation. Back that out and there's quite material divergence b/t Income and Cash Flow. What do you think is more important?

(these are TTM figures)

I don't think the antagonist has a chance of winning the proxy battle - I certainly hope he doesn't, I want this to continue to compound indefinitely - so I think this is simply a drain on the company and shareholders like me who appreciate the value of compounding growth over the long term, and are not focused on the day to day changes in the stock price.

Its the compounding of growth and the benefit to returns that I aim to write briefly about here.

A week or two back, the company reported F1Q17 results. The company reported $12M in sales and $2M in EBITDA, reflecting a 17.6% EBITDA margin. By my account, these results reflect 29% ROE and 18% ROA.

(these are quarterly figures)

On a trailing 12-mos basis, the company has reported $48M in sales and $8.6M in EBITDA. With 18M shares out and $3M in net debt, this reflects a 12x multiple on trailing results. Everyone should decide for themselves what's cheap and what's not, but it seems an attractive valuation to me for a company consistently growing profits and FCF and reinvesting FCF at high returns such that topline and returns are growing consistently.

However, results do not reflect the Auction123 acquisition that closed a day after quarter end. According to the press release that accompanied the purchase, that acquisition adds ~$4M / year revenues.

And then these tidbits from the conference call:

On the $10.5M acquisition ... "From a multiple perspective, we paid 7.2 times the trailing 12-month EBITDA for Auction123 at closing. If the first two-year earn out is paid [$1.5M] and considered part of the transaction then we paid 8.2 times the trailing 12-month EBITDA." >> This implies ~$1.4M in trailing EBITDA, or about 35% EBITDA margins. Is it reasonable to think those margins are sustainable? It's in the same ball park as EBAY's margins so ... why not? 

On the balance sheet post the acquisition close: "... our transaction closed on November 1, 2016, we had about $16.8 million of total debt which is just under two times our trailing 12 months EBITDA, and cash and cash equivalents of approximately $3.3 million or a net debt of $13.5 million." >> On this basis, adding the acquired EBITDA and adjusting the net debt, this is now trading for 11x trailing EV / EBITDA. 

And finally thinking about year end, "... as we look ahead and consider our expected cash flow and debt payment schedule, we anticipate by our fiscal year end on July 31, 2017, our cash balance will be back above $5 million and our net debt will be below $10 million." >> this implies, assuming zero growth, that the company is trading at 10x FY17 EBITDA. 

On a comparable basis, the peer group multiple is about 15x. When it comes down to it, that discounted multiple is really what this whole proxy battle is about from the get go.

It feels a bit lonely talking about this company. I've not seen any evidence or read any information anywhere that this is a bad business. I'm not deterred by the debt as the mgmt team has been a terrific steward of it and is now operating in an environment where the pent up energy of millions of entrepreneurs is about to be unleashed (so much tongue in cheek, I just threw up a little).

I think the evidence suggests this is a good business trading for 10x next year's EBITDA, as good businesses sometimes do, and its generating cash and reinvesting it at high rates. The question is, do you sell now and lose the benefit of a quality mgmt team allocating capital wisely or allow the company to continue to generate cash and grow, and generate cash and grow, and generate cash and grow, etc.

To me, the opportunity for the patient investor is to buy more, and wait patiently.

-- END --


Brief Advice on Interviewing Management

I worked earlier in my career as a writer and reporter so I have some experience interviewing people, a skill that comes in handy when assessing management.

These are three short rules to interviewing management that I learned in my early 20's. It's very basic but essential so as to not waste anyone's time:

1. Ask open ended questions. The inverted way of saying this is: Do not EVER ask "yes" or "no" questions. We all do it. Get in the habit of not doing it, by whatever means necessary. The corollary to that is ...

2. Do not ask leading questions. It traps yourself in your own presumptuousness.

3. Silence is your friend. Don't fall prey to the knee jerk reaction of filling empty space and as much as you can, do NOT finish their answers. Invite them to continue to expound on whatever they are talking about.

I recently read somewhere a suggestion to not interview mgmt b/c it creates biases. I find that a mgmt interview puts qualitative skin around the financial bones so I try to be aware of flattery ("Oh, great question" etc) and all the other bullshit people put forward when they talk to me.

One of the ways I try to avoid those biases is by asking myself ...

"how often do you think they repeat this narrative? do they actually believe it or are they just used to saying it? how can I get them off this narrative and get them to talk about things on the 2nd level"

... insincerity is the enemy of revelation.

Management is such a critical component in the long term success / failure of small companies that not understanding their motivations, their perspective and their imaginations leaves too much to the whipsaw of quarterly results, about which, sometimes even they have no control. But they are responsible for the long term operational maneuverings of a company, and that is the essential key to a company's long term growth and profitability and an investors ability to compound wealth repeatedly.

We all have our own truths, in life and in business, and investing is simply a way to handicap them, to quantify them, to wager on them. I don't profess to know more than anyone nor to have answers about everything. But I have a bit of experience interviewing people and I just wanted to share one tool that I think is essential to learning more about an investment.

-- END --


EMH and the "CON" in Consensus

Anyone who spends time in business meetings, or on boards, or in any engagement with other people (including even sitting around a table and deciding what to have for dinner), probably recognizes that the efficiency of a meeting - ie the achievement through consensus of an optimal outcome - often declines as more people are involved.

And yet, one of the basic tenets of the efficient market hypothesis is that when it comes to market prices, a larger cohort achieves the most efficiency since the price aggregates information "dispersed amongst individuals within a society." (Recall that "efficient" in EMH isn't fitter / happier / more productive but is more a form of "consensus").

But why should a wider and larger base of participants yield more "efficient" results in the stock market, when so much evidence in other avenues of life exists to the contrary? Perhaps we should think more productively about how often - and where - its likely to be wrong. I think that's a muscle investors regularly exercise.


The trouble with "consensus" - in a meeting and in the stock market - is that people are often anchored on the last comment, or the last stock price, or "what everyone else is doing" - and they mistake these data points as "sources of information" when actually they're forms of biases.

I recall reading once how the last thing Buffett looks at when analyzing a business is its price and chart, preferring to read all other filings first in order to make his own unbiased assessment divorced from the anchoring phenomenon.

It's a useful parable on how to not use consensus. Another is William Goldman's famous saying: "Nobody knows nothing." I say that to myself all the time.


The trend towards passive indexing - a massive trend - is supported by three things:

1. Efficient market hypothesis. If you can't beat the market, why bother trying?
2. Active management returns, which "on average" underperforms the market
3. The difficulty of identifying skilled asset managers who consistently outperform the market over long periods.

So the consequence of taking the EMH as fact has trillions of dollars in consequences.

So does the "headline story" about poor returns of active investors.

Just as a reminder for a moment; investing is a zero sum game. There are two parties to every trade, a buyer and a seller. Reason therefore dictates that in aggregate, the average of all active investors, after fees, should underperform the market, roughly by the delta of fees.

Now, investors who want to follow a benchmark with the most undifferentiated and readily available solution can and should pursue the lowest cost index funds available to them. Anything else - anyone steered to a higher cost model - is a con job.

But investors who want a differentiated solution - who want an experience apart from and are willing to accept results that are different from the market - should either spend time learning how to invest or find someone with experience and skills who can do it for them.

The difficulty of finding that person, the difficulty of separating luck from skill, salespeople from super investors, wheat from chaff, etc. is the third and perhaps largest foundation of the trend towards passive investing.

It's so difficult even for institutions to identify high quality investment managers, and doubly so for individuals.

All in, you have this easy solution (passive investing) that solves / avoids the problem of having to find good managers yet still supports Wall Street's desire to separate you from your money. It plugs perfectly into the rubric of the industry as it already exists.


But here's where I think EMH and the passive trend have it all wrong and where the opportunity for good investors grows everyday: Finding high quality capital allocators is the only job within the entire investment ecosystem. I take an almost ideological view on this and I think its where investing shares at least as much with the practices of other art (and ethics) as it does with finance and accounting.

As a steward of capital seeking to invest in publicly traded companies I look for executives who allocate capital wisely. These CEO's and CFO's in turn look for managers who can manage capital (staff, equipment, etc) effectively. They in turn prize employees that convert their labor productively, and on and on.

It's the capital equivalent of turtles all the way down.

But since passive investing disabuses the notion that anyone can outperform the market, and EMH says that prices are all accurate, the conclusion is to ignore the search for better capital allocators and simply spread your bets and diversify.

Which is why the price for capital allocators is going down.

But the value of finding good capital allocators - from the CEO down to the line worker, from the endowment to the startup investment manager, from the QB to the special teams coach - is not going away. And for those who desire exceptional outcomes, it never will.

Over time, we who search for good capital allocators will get better at it while the competitive field diminishes.


I was going to write more about a specific idea I've been working on, but I'm still drawing information on it so I'll close with a brief comment on investing with incomplete information.

The other day I wrote about an inference drawn from one company to learn something incremental about another company. It helped to lock in gains and avoid losses for my clients and since a penny saved is a penny earned, I feel it justified my 1% fee.

The opposite of those inferences is acknowledging and valuing incomplete information when making investment decisions, and compensating for that with price and portfolio positioning.

I think good stockpickers, even when they dig down for that 3rd, 4th or nth piece of information, acknowledge the limits of what they know.

For this reason, I am cautious of detailed checklists, b/c it risks creating a false impression that on completing it, we'll have certainty. There never is certainly. I prefer a broad functionary checklist at the top of which I write in big letters: "What don't I know?"

Even as we dig a bit deeper and contextualize financial data with qualitative information, there are always going to be unknowns and surprises.

There's a value to what we don't know. I believe for "good investments" - and by that I mean investments in companies managed by "quality capital allocators" - time and patience is the best way to manage and offsets the risks of the unknowns. It seems an important concept that EMH totally ignores.

-- END --


FTLF and An Investment Manager's Responsibility to Their Clients

On November 1, I sent an email to a friend ...

"I have concerns about FTLF 3Q and shorter term traders should likely lock in gains"

... and I sold shares for clients. The genesis of the caution was my review of GNC's 3Q16 10Q, which stated ...

"[GNC's] Domestic franchise revenue decreased $2.4 million to $85.8 million in the current quarter compared with $88.2 million in the prior year quarter primarily due to lower wholesale sales associated with lower retail same store sales of our franchisees as well as the earlier timing of our annual franchise convention, which resulted in $6.3 million of lower sales in the current quarter as compared with the prior year quarter."

... if GNC domestic franchise sales were impacted by the timing of the convention at the end of June, it made me wonder how much of FTLF's astounding $8.7M in 2Q16 sales were pulled forward as a result of the convention.

So I looked at the timing of the convention in prior years and it didn't take long to see a trend ...

... hard to know precisely how much the "convention bump" impacts sales, but I know that 1Q tends to be the seasonally strongest (b/c of new year's resolutions) and it tapers from there. So I just combined 2Q & 3Q together to get a sense of the typical two-quarter figure relative to seasonally peak 1Q sales.

I saw that in a "normal" year (whatever that means) 2Q + 3Q sales ~ 1.6x to 1.8x of 1Q sales. I used those multiples to back into a presumed 3Q16 sales figure in FTLF and at the high end, it inferred $5M in 3Q16 sales.

My stomach dropped at that moment, about as much as the stock dropped when FTLF preannounced 3Q16 sales of $5.3M.

This being the first time such a "surprise" has happened while managing outside money, it got me wondering about how much information of this information I should share. I decided to do nothing, but it seemed like there was no right answer.

Ideas are the lifeblood of an investment manager. It is their passion, their purse and their intellectual capital. That I have been sharing some of them freely has been a function of my own interest in having an open diary into my thoughts, growth and maturation as an investment adviser managing outside capital.

But as I've grown my AUM and client base - and having just struggled with this uncomfortable situation - maybe it is time to rethink that model and morph towards something different, either a paid subscription / advisory or simply quarterly and annual letters for clients, as others investment mgrs do.

I'm not sure how this will change aspects of what I write about in the future, but over time, all things evolve and I imagine this blog will as well so as to avoid this situation in the future.

Either way, my sole commitment - my fiduciary responsibility - will always be first and foremost to my clients.

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All rights reserved. This blog is not a solicitation for business nor a recommendation to buy or sell securities. This blog is for entertainment purposes only. I am under no obligation to provide any updates on any position I write about here.

On the short term activist shaking the ARIS tree

It is an interesting observation that when one types the word "SEVEN" into google search function, it autofills "Seven Deadly Sins" a reflection I suppose on the frequency with which the people check for behavioral affirmations.

In a way, the stock market has a similar effect. Every tick in the market can be a behavioral affirmation of one kind or another that can heighten the tension between greed and charity, or diligence and sloth.

I write here however, of the tension between "wrath" (less formally known as "impatience") and its more virtuous partner "patience". I find the latter to be a stellar principle for sound investing but it can be so difficult in practice that even those who speak of "long-term value-oriented investments" find it hard to back up with actions.

This all comes to mind because of the impatience recently expressed by the investor filing a DFAN14A with the SEC on ARI Network Services (ARIS), indicating a desire to solicit the sale of the company, an action that strikes me less as the endeavor of an activist than an expression of impatience and idiocy.

What we know about ARIS need not be rehashed because I've written about it elsewhere, but I'll summarize in three bullets:
  • It is an $85M market cap company whose CEO Roy Oliver, since taking the reins in 2008, has grown shareholder equity 33% CAGR. 
  • In stewardship with his capable CFO Bill Nurthen, who joined the company in 2013, Oliver now runs a cash flow generating business that has reinvested in high return acquisitions, an attribute of a "compounding" company
  • By increasing the availability of and access to debt, the company should be able to continue to fund what has hitherto been a successful acquisition strategy into the future.
In my ~15 years in institutional finance, I've rarely seen such strong capabilities in companies above $10B market cap and here I am a shareholder of one that is still below $100M, and with a potentially long runway of growth ahead.

Taken all in, I believe the C-suite team is unusually strong and capable for a company so small (though they are not perfect). 

Yet, were the company to sell, we would lose our ownership rights to the company just as the going-got-good and we would lose the benefits of investing in a C-suite team that has performed so admirably. To break up the band, so to speak, seems premature; to nip such success in the bud seems stupid. 

Obviously, once a company has gone public it is in principle already sold; shareholders are the owners and the executives are the managers.

This missive is therefore addressed to my fellow owners who like me can see the long road ahead under present management, who don't want to pay taxes on their growth in capital to date and who know how hard it is to find well run companies that can compound growth over time, for what are well run companies but good mgmt teams allocating capital - labor, time and financial - wisely?

When we find them good companies well managed, we should hold onto them for long periods b/c they are few and far between.

I imagine all shareholders know as much as I do and see the same attributes as I see in ARIS,  but what do we know about the owner advocating for the sale? I aim here to briefly fill in that gap based on available information so we can judge for ourselves whether his suggestions reflect temperance or gluttony.

This appears to be the third activist endeavor for the owner ...

1. AdCare Health (ADK). Period of activism: 2013 until Present (he is now on the board).

Initial statement from April 2013 says he owns 750k shares at $4.01.

In July 2013 he's advocating they sell the real estate to generate $4 / share cash that they pay as a dividend to shareholders and that the remaining business would be worth $9 / share. In August 2013 he says they should split into a REIT and an operating company. July 2014, the company announces it will end operations and convert into a holding company that would make it attractive to be acquired by a REIT. In November 2015, the Vice Chair has fraud charges filed against him. (I can't keep up!).

ADK now sells for under $2 and is the subject of an activist campaign by Echo Lake Capital / Ephraim Fields. Value investors appear to like the opportunity from the NOL's and the property.

2. Resonant Inc (RESN).

Initial statement of ownership of 300,000 shares in Feb 2015 at $15.47.

Continued to buy through the spring of 2015 such that ownership stake reflects 700,000 shares and the stock is trading at $4.75. In February 2016 he's given a board seat with the stock at $1.80. As of 4/27/16 he owns 1.035M shares.

3. ARI Network Services (ARIS)

1M shares bought b/t October and December 2014 @ $3.67 / share. In December 2015 files letter that company should seek potential sale. In Oct 2016, files proxy that company should consider a sale and that he is nominating himself and some investment banker to the board.

... I dare not speak ill of other investors for it is undoubtedly a function of hubris to think that one is smarter than another.

We all see in companies values - the more divergent the value the greater the opportunity - and I hope the value this investor sees in the shares he owns can be realized. I know nothing about two of them. However, I have experienced two things in life that I can say with certainty:

1. People tend to repeat their patterns of behaviors. Conclusion: Someone who has a prior history of buying small cap companies, getting on the board and overseeing value destruction is likely to do that again. We should aim to keep those with a frequency of such behaviors from coming to near to managing the capital that investors, company employees and managers have worked so hard to produce.

2. When my children ask for things they've done nothing to deserve, I say "no". Conclusion: When your unsolicited proxy arrives, shareholders should do the same here.

-- END --


The Half Truths Told About Passive Accounts, And the Whole Truth on Concentrated Patient Investing

Peter Thiel apparently likes to ask an interview question: "Tell me something that's true, that almost nobody agrees with you on."

I prefer the question "Tell me something that's false that everyone believes" and as I've grown older I've gained more confidence in those things that come to mind.

At the top of that list right now is the idea of diversification, (followed closely by Vikings not actually wearing horns on their helmets).

Diversification makes sense b/c it follows the common principle, "don't put all your eggs in one basket".

Ironically however, that principle conflicts with every single one of life's most important decisions; who you marry, what you do as a career, who you work with, etc.

In all the major commitments in life, we by nature put all your eggs in one basket.

I think everyone would do well practicing at least once in awhile putting all their eggs into one basket so they better understand the inputs to and tolerate the consequences of those actions.

Anything else is laziness.


This relates to the half truth that we should invest our savings in the market through a diversified basket of low cost index funds as an alternative to buying and selecting individual businesses for investment.

The whole truth is that when asset returns are correlated the presumed benefits of diversification disappear, so why is it better than individual stock selection?


I reckon most people don't think about the markets as individual companies. I reckon they think about it more like a flock of starlings in murmuration but those of us who analyze individual companies are like ornithologists who can pick out individual birds.

When you dig deeper into "the market" and look at its components it becomes apparent that sometimes "the market" is really just a few stocks overweighted in an index, impacting the whole.


There are a lot of ways to invest in the stock market beyond undifferentiated passive investing. I buy and hold small companies for long periods and limit my portfolio to a handful of what I think are terrific businesses trading at reasonable prices (or better still, unreasonably low prices).

There are plenty of other people who do what I do up and down the market cap spectrum (ie large and small companies) and then there are others who buy bankruptcies, debt, risk / arb, options. There's no lack of variety of investors. Some are more consistent and successfull than others.

Regardless of who those people are, I think I speak for all of them -

every single investor that buys individual securities 

- that the underlying trend towards blanket diversification reflects two forms of laziness - intellectual and professional - that has become nearly universally accepted but is just plain wrong.

By intellectual laziness I mean the inherent incongruency that we should prefer market exposure with market risk over business exposure with business risk.

A well researched, thoroughly analyzed, cash flow generating, under-levered and growing business acquired inexpensively should - at any point in time - be a safer investment than a basket of companies arbitrarily selected by their size or industry or valuation, especially when that basket overlaps so many others. And if properly selected it can generate a more meaningful return than that basket.

But finding those companies takes time and effort and its stressful and difficult and it gets in the way of making money that comes from accumulating assets, which is how all money managers get paid regardless of performance.

By professional laziness I mean the things that happen when people ...

1) accept intellectual laziness and call it a service.

2) do what everyone else does and call it "unique" or "proprietary"

3) take vast sums of money from endowments, pension funds, retirement funds, government entities, etc and put it into instruments that behave like index funds simply b/c it's too hard to allocate them otherwise, and with no consideration of or responsibility for those whose retirement depends on the wise allocation of said capital.

... the alternative in all cases involves work that is difficult and differentiated but could be more meaningful to clients; identifying a handful of undervalued securities and owning them.


I've been investing personally since the late-1990's, starting with 10 to 100 share lots when it was easy and you could read Buffett at night and still buy www.something.com during the day and be up 10x the next and none of it made sense, but it was fun.

The investing structure of Graham and Buffett resonated with me nonetheless and I fell in love with it, slowly transitioning from my prior work as a writer / reporter to institutional research (with stints as a PI and in PE in between) then working for nearly 15 years on the sell side (with an MBA squeezed in) covering mostly industrials and services related companies up until I was laid off in 2012.

Here's a small collection of books I used to teach myself about investing ...

... I have a whole other shelf of text books from my MBA plus it's incredible what's available online now (and at the library).


Ironically, b/c I worked on the sell side, I had little time to spend thinking about my own investments and b/c of Eliot Spitzer I couldn't own the stocks I covered, so my personal accounts (I managed three) were fairly haphazard.

I had three primary accounts: One mostly held companies where friends of ours worked (a quasi Lynchian approach), one was concentrated in micro caps I'd read about in trade journals or found on screens, and one was diversified with large companies.

I tracked returns extensively on Quicken on an early generation Macbook but i gave that up when i started working in the industry. It was okay for me that some stocks went up more than others went down.

When I was let go, and looking for work on the buying side, I figured I should start reflecting on my personal returns. I could only go back as far as the end of 2007 since E*Trade only kept returns for a certain period and here's what I did over that time period.

Nothing earth shattering ... but it dawned on me that owning a handful of random micro-caps in concentrated positions for long periods led to 2x outperformance of the major indices, and with a pretty a low correlation.

What if I just focused on that area of the market, not buying "random micro caps that sounded interesting" but fully understanding the businesses, the managers and executives, the customers, analyzing these tiny companies as I'd analyzed mid- and large-cap companies in my coverage sector, and making big bets in the best ones I could find, while saying "no" a whole lot more?

I decided that's my business, not just b/c of the outperformance over an arbitrary time period, but b/c I liked finding gems overlooked by others and most importantly b/c it would be easier to compound a small sum of money in smaller companies than it would be in larger companies.

Since that time, noting the end dates for the other two accounts which have been moved, that small cap concentrated account is up 18% CAGR. It seems to validate the thesis.

The downside of focus on small caps, which I've talked about with a few institutional PM's who run small cap funds, is that the strategy maxes out at a certain AUM, which caps compensation.

That's fine. That's why so few people do it. It is good enough for now to experience the ego gratification of investing in deliciously inexpensive well run company employing great people doing interesting work satisfying the needs of hungry customers, and doing it with integrity for myself, my clients and the companies I own.


This the most differentiated approach to investing requires patience. It is sometimes quick and exciting, sometimes slow and frustrating, but its always enervating and enlightening way engage the world around me.

The opposite end of the investing is the most undifferentiated mass marketed passive movement. They will charge you the least fees but you get the mass strategy. Someday this institutional passive investing will resemble the equivalent of cheap protein, including i fear, even the slaughterhouse.

-- END --


A Brief Description of the Kinds of Stocks I'm Wary Of

Here's one type at least: The "heroic / satanic savior"

That's where "BNI's" (ie "brand name investors") with terrific financial backgrounds but no industry experience swoop-in heroically with the imprimatur of "financial stewardship" ... and destroy value.

I speak specifically in this case on $CDI, now trading near net / net valuation, but there are so many examples I've seen where this happens. 

In this case, some ex-Eddie Lampert / Sears / Lehman folks joined the company in Oct 2014, and since that time, shareholder equity is down 25% and total debt is up 10-fold.

I imagine their compensation reflects the skills required to achieve such a distinction. In fact the word "compensation" shows up a quite astounding 385 times in the most recent proxy statement, though you'd have to scroll to page 24 to see the actual discussion on executive compensation (by that point, they've already mentioned the term 107 times).

From there on, you'd see there a quite intense amount of description of a comp plan that focuses on "shareholder value," which is mentioned only eight times in the report. (Perhaps a new investment analysis is the ratio of "compensation" to "shareholder value" in the proxy statement).

As for what drives "shareholder value": The company believes "... that if CDI consistently attains or exceeds its target levels of operating profit and RONA, shareholder value will increase over the long term. Our targets are intended to be challenging, yet realistic and achievable at the time they are established."

Since RONA excludes goodwill, that comp plan essentially incentivizes management to lever up and make acquisitions in order to grow operating profit. You can imagine that's the plan. Scorpions gonna do what scorpions do.

But this is a business where the assets walk out the door every night and I can cite many more levered acquisitions in the people business that have not worked than those that have. (My experiences are in the investment banking world where it never works).

Still, the horse is out of the barn. They've already made their first purchase paying $35M cash for "EdgeRock Technologies" a company that supplies project managers for ERP rollouts. Plus, they have a new $100M credit facility to borrow for future transactions and given that they're under levered relative to other staffing firms, they have plenty of borrowing capacity available.

But if they can't maintain or grow the operations, it potentially leaves long term investors holding the proverbial bag.

Staffing is not a complicated business: manage your bill / pay spread, keep overhead as low as possible, and hire high energy, terrific salespeople. But it is also a brutal business characterized by:

- Cyclicality. Staffed employees are first in and first out.
- Low barriers to entry. All you need is an internet connection.
- Incredible competitiveness
- Disintermediated by technology

This is the second staffing company I've looked at recently trading at or near net / net valuation ($HSON is the other one) where some BNI's have come in to "turn it around" ... and they haven't.

The good news is, these are just two of the tens of thousands of companies that  trade everyday in the public market, with a bid on all of them.

If I wanted to own a services rollup, I'd be more keen on companies run by managers with a rabid dog mentality towards selling and collecting vs financial mgmt. I'm just not the type of deep value investor that can step in front of a business unless success is paved with operating excellence.

-- END -- 


A Comparison b/t C&I loan growth and the ratio of multi family to single family housing permits

Been looking at a lighting company that gets half its revenues from multi-family residential new construction.

Though a different company than TAYD, both are exposed in some way to institutional or commercial construction.

This chart shows changes in C&I loan growth (commercial and industrial loans) - the blue area graph - via FRB layered on top of housing permit data, specifically, the ratio of multifamily permits (five or more units) to single family permits.

I think the takeaway is that multi family construction permits really ramp relative to single family later in a cycle, and that there was a period of under building of multi-family units during the housing bubble.

My sense is that business is passed the peak, at least for the current cycle (yes Virginia, there is a business cycle, no matter how skewed it may be by interest rate policy).

Or maybe slowing C&I loan growth is from uncertainty about future policy and rates, due to the election.

I'm not a macro-investor I just love comparing things.

-- END --


Happy Birthday Vanguard (I got you a Spotify account as a gift!)

This morning, the Marketplace Morning Report  had a story on Vanguard's 40th birthday and a piece on revenue growth in music streaming. 

It dawned on me that Spotify and Vanguard shared similar dynamics - they are both disruptive innovations - and if that's the case, then it follows that stock pickers are the equivalent of hifi-enthusiasts in an ETF-dominated world; a shrinking community of music perfectionists that think they do it "better" than everyone else. 

Through the lens of convenience, "better" isn't about sound quality and imaging but about pervasiveness and availability. 

There are countless places we've accepted - for the sake of convenience - "lower quality experiences" in our lives. That's a key aspect of disruptive innovation that Vanguard brought to the investment world (the program starts at 3:40)

Vanguard's innovation? At a time when people were trying to beat the market with exceptional results, Vanguard offered a way to be ... unexceptional ... and now its S&P 500 mutual fund and Total Stock Markets Fund are the two largest funds in the country. 

What an incredible experience for the average person who doesn't follow the markets, who doesn't know how to tell a good investment from a bad investment - or even a good investment manager from a bad one - and who has no financial education to not have to make a decision and concurrently be freed from the bonds of snake oil salesmen with the ease and convenience of buying something that's simply good enough. 

What - if anything - are those people missing? And what can I learn from this as a startup RIA focused on small cap investing? 

I don't think people know what they're missing. Many treat their investment and retirement savings with little thought - and much hope - probably b/c they don't know how to think about it, or they've never entertained the notion of "I can invest." So they outsource it.

On the latter - what can I learn? - how do I reach people who don't know what they're missing? I guess I could start a fund and focus on the small market of other hifi enthusiasts who don't want to listen to a compressed version of Eine Alpensinfonie or won't watch "Lawrence of Arabia" on a cellphone. 

I'm passionate about trying to reach a wider audience to help them understand the choices they face, provide some education and service, and, potentially, deliver returns on capital that exceed the market, with less risk, less tumult, and also while avoiding companies whose missions are opposed by my clients. (When you own the S&P, you own companies that build guns, burns coal, promote addictions, etc. Why should someone opposed to those endeavors accept them in their investment portfolios?)

To anyone who thinks investing is hard, I tell them that picking stocks is just a concentrated form of the same decisions people make all the time: what shoes to wear, what fruit to buy, what to eat for dinner. Once you lay out the parameters, it's easier to make a decision. Not easy, but easier.

As an avid investor, I balance the difficulty of decision making with the alternative, and I can't fathom why someone would want to risk capital on an undifferentiated mass of companies whose value - on whole - tracks GDP growth +/- people's attitudes (ie multiples). Why would I want to outsource mine and my clients' capital to other people's attitudes when knowledge and experience can do better? Instead, I prefer to make decisions, and as few as possible. 

Finally, I firmly believe that we lose things when we accept unexceptional, in the investment world and in the real world. 

What we lose in the process of making undifferentiated investments, is, I think a key point in that Sanford Bernstein piece from awhile back, that if we're no longer allocating capital to its best and highest use but simply spreading it around, we disrupt price signals and outsource returns simply to a function of interest rates and money supply. 

And in the personal world, there maybe even worse consequences. Music, art, movies, conversations with people, travel, real adventures - not 3D replicas - these experiences create emotions. Video games create emotions too, that's why they're so much fun. But when we dial down the experiences to a virtual one, I think we limit our emotional selves. We can't possibly experience the same catharsis at a 160 kbps bit rate as we do in real life. 

In both the investment world and the world around us, when the effort at reproduction isn't towards replicating the best experience but only about convenience and accessibility - yeah, it's good enough - something is lost. We shrink the world to a bunch of correlated experiences, rather than expand it to a variety of global ones. 

-- END -- 


$EVI Acquisition: Brief Readthrough on WSD Deal + 8x ProForma Valuation

I first wrote about EVI here when I believed it to be the kind of well run company that I wanted to own forever; niche business that generates cash, functions in a kind of protected duopoly and doesn't dilute shareholders. I had behind me decades of financial statements as evidence that the business was a lock box for cash. It was a $16M mkt cap company.

Then, Henry Nahmad acquired a controlling interest in the company and he was pretty upfront that nothing / everything would change.

He'd keep the core business roughly the same but roll up the industry the way his uncle / father rolled up the HVAC industry ~40 years ago to create $WSO. Not a bad pedigree; WSO has returned +12,000% over the last 30 years.

And then nothing happened ...

... until the first week of Labor Day 2016 when the company announced its first deal to acquire Western State Design, a primarily West Coast distributor of industrial and coin/op laundry equipment, for $28M. WSD was privately held and owned by Dennis Mack and Tom Marks. With this first deal done, Nahmad can now be judged on his actions not his pedigree. 

This is a short summary of my reading on the deal.

Price / Structure / Value 

The deal has a headline $28M purchase price split between $18M in cash and $10M in stock. But there's more to the story than the headline ...

The $18M in cash comes from 1.29M shares sold to Nahmad's investment vehicle Symmetric LLC in a PIPE @ $4.65 / share (the close price before the deal closed) + $12M from a newly announced credit facility. The total size of the credit facility is $20M.

Of this cash, $15.2M is paid at the close and $2.8M will be escrowed until 18-mos after deal; this appears to be related to and contingent on collection of AR's at the time of the deal

The purchase price includes 2.04M shares of stock worth $10M based on the average closing price of the stock for the 10-days prior to the Asset Purchase Agreement. Mssrs Mack and Marks - the sellers - will own just south of 20% of the combined company after the deal.

+/- what appears to be standard working capital adjustments from the baseline $4.8M working capital at time of the deal.

Western State Design did $60M in sales last year vs $30M for the core EVI. The company, it should be noted, is tripling in size. Operationally, WSD appears to be more heavily weighted towards coin op than the commercial laundry equipment / boilers that EVI distributes. Also, there appears to be no overlap in regions as WSD is mostly out West and EVI in Florida / Caribbean / Central America.

WSD has more gov't contract / federal work than EVI and apparently has security clearances related to that work that will be transferred in the deal; (what kind of security clearance is required to do laundry?). Very little information is available though it at they are at least savvy enough to protest an award (FWIW).

Based on WSD's $60M sales figure and assuming roughly the same EBITDA margins as the core business, EVI is acquiring a company twice its size at 5x-6x EBITDA.

Before the deal EVI was trading at ~$4 / share or ~10x trailing EBITDA. Proforma it appears to be trading for ~8x proforma EBITDA.

The $12M in borrowings to fund the deal is part of a larger $20M credit facility with Wells Fargo, so they have access to an additional $8M in borrowings. Perhaps other deals are pending as well ... 

A bit about Western Design and its owners / sellers, Dennis Mack and Tom Marks

Mack and Marks are co-owners of the firm. Not much information available about them, strangely enough in this day and age of social media. Would like to learn more and probably will have a chance to meet them at the shareholder meeting in Nov, as they will both become execs of the company and at least one will serve on the board.

In the standard non-compete provision, there is a carve out for a business run by Dennis Mack: "The foregoing prohibition shall not apply to the involvement in any manner by Dennis Mack with respect to Associated Laundry Management, a commercial laundry  in Reno, Nevada." Maybe he has a lab underneath it.

Another irrelevent tidbit: EVI is not acquiring the facility of WSD's headquarters on Tripaldi Way in Hayward, CA, but rather signing a new lease with the existing landlord. That existing landlord is TylerTown LLC, an entity created in 2012 by the controller of WSD, Marianne Lenci, so like EVI itself, WSD pays rents to its CEO.

It's not an unusual situation - lots of companies do this - and its critical for investors who tend to dismiss such things as "inside dealing" to reflect and consider what's actually important information in making an investment decisions. I don't think this is.

Why am I scraping the Department of State filings to get information on this company? B/c I can't really find anything else material.

But as a sense of what kind of managers are Mssrs Marks and Mack, I found this interesting. In 2010 they had plans to develop on spec a "state-of-the-art commercial laundry for sale or lease to an operator, the company says. The building site encompasses 3.87 acres and includes a 14,000-square-foot enclosed service yard. It is strategically located for effective distribution throughout Northern California."

The risks for building on spec were somewhat offset by their ability to get funding from a state issued bond on the deal.

The point is, we know our new fellow shareholders and managers have a nose for opportunity. And they were willing to take 35% of their comp in stock. This reinforces that assumption and provides some affirmative bias that as with already existing shareholders, they see long term opportunity in the business.

-- END --


The Bias of Other Shareholders

When the esteemed fashion / style photographer Bill Cunningham died, the WSJ's Ralph Gardner Jr (a colleague from my first job out of college) wrote a piece with a hed / subhed ...

"Bill Cunningham Leaves a Social Void
The late photographer’s presence at an event told you it was worth attending"

... which struck me as a great analog to an activity popular among many investors, which is to look at what other are doing as a way to confirm that the event they're attending stock they're buying is worth owning.

If you're like me, you probably like to know who the fellow owners are and what other good investors are doing. But even while I peek at owners, I remind myself that a company's ownership composition has absolutely no bearing - zero - on its future cash flows, which is the ultimate arbiter of value.

Yet every quarter there's a flurry of time and effort analyzing 13F filings. It is the 3rd biggest waste of time for a practice "generally accepted" among investors. (The 2nd biggest is reading most sell side notes and the 1st is watching business channels).

At least this tweet, which compiles recent 13F filings has the self awareness that yes, it is probably useless. And yet, like a car accident, it's hard not to peak.

Investing is a most personal enterprise, and in some cases a most lonely one. Stop caring what everyone else is doing! Its fine to find comfort in fellow owners and to know what others are doing, but chasing stocks that other's own is a perversion of what makes investing so interesting.

A far better use of time for investors is finding people who disagree with you, a structural advantage for investors who are married.

Remember that the strike zone isn't the same for all hitters. Figure out an investment style that makes most sense to you, find businesses that fit that style, and be okay not giving a hoot what others are doing. You should be good to go.

-- END --


How to not chase a stock ($TAYD)

While doing work on my last post, I came across Taylor Devices $TAYD on a screen for companies that - similar to $ARIS - have been generating cash and reinvesting it at high rates.

$TAYD is a $61M mkt cap / $55M EV company that makes products that solves problems caused by recoil, sway and / or vibration. These are generally called "dampers" or "shock absorbers" or "snubbers" and they make all kinds of them for two general types of applications: Construction and Aerospace / Defense.

In the construction side of the business, which is now about 60% of revenues, their dampers - including fluid viscous dampers - offset the sway of buildings, bridges and other structures where wind and / or earthquakes effect such things. One of the most recent / high profile applications is in the 432 Park Ave residential tower that blights rises over the NYC skyline like an oligarch's middle finger a tall reed of grass in the center of Manhattan.

On the aerospace / defense side the company sells components of military equipment to stabilize or isolate weapons and radars, personnel or equipment, like on the seats of naval craft or in the hold of the space shuttle.

An interesting tidbit around the history of the company is that it has deep roots providing fluid viscous dampers for the military (ie in the housing of MX missile silos so they would survive a nuclear blast) and then transitioned into the construction side after the end of the cold war, as per this short quote from an article in the January 2008 issue of the Journal of Structural Engineering:

"A major reason for the relatively rapid pace of implementation of viscous fluid dampers is their long history of successful application in the military. Shortly after the Cold War ended in 1990, the technology behind the type of fluid damper that is most commonly used today (i.e., dampers with fluidic control orifices) was declassified and made available for civilian use ( Lee and Taylor 2001). Applying the well-developed fluid damping technology to civil structures was relatively straightforward to the extent that, within a short time after the first research projects were completed on the application of fluid dampers to a steelframed building (Constantinou and Symans 1993a) and an isolated bridge structure ( Tsopelas et al. 1994), such dampers were specified for a civilian project; the base-isolated Arrowhead Regional Medical Center in Colton, Calif. Asher et al. 1996."

In short, this is a business with a long history making a high value product in an unusual niche; just the kind I like to invest in.

Through FY2015 ending May 31, 2015, the company sold $31M worth of these products generating profit of $2.2M, reflecting a net profit margin of 7.1%, impressive.

Even more impressive is that through the first 9-mos of fiscal 2016, the company generated $27M in sales - nearly matching the prior year with a quarter to spare - with net income margins above 10% for 1Q and 2Q and ~14% for 3Q. (The FY16 year end has closed but company won't report until August).

And most impressive of all is that 10-years ago, this company was levered 3x EBITDA, had $86K in the bank and did 1/2 the revenues as they do today, with 92 employees ($130k / emp). Today, they have $7M in net cash, twice the revenues and a stock trading at 3x backlog, with only 112 employees ($275k sales / emp).

How the company turned around its business was a function - like all success stories - of many things happening at once but a few things stand out:
1. wider acceptance and regulatory approval of fluid viscous dampers in earthquake prone areas
2. expanded production facilities with better equipment that improved turn times
3. larger production facilities to accommodate larger products
4. better tax management, (ie lower tax rate), which means IMHO that mgmt is actively working hard to generate higher returns.

Some of the improvement is structural but some benefits from a cyclical real estate / infrastructure tailwind. Such is the nature of all industrial businesses.

And it is the nature of the stock market - especially in smaller niches of the market - to occasionally be imperfect on valuing stocks. To mine eyes, after digging into the company's business and financials, the valuation appears to reflect a mistake by the market, erring towards a rather common mistake of a stock responding to earnings growth rather than the order book.

In short, the stock appears to be violating the old adage regarding investing in industrial long-cycle businesses to "buy in the order cycle / sell into the delivery cycle".

It does not take long for an investor to observe that backlog is declining, avg project sizes are declining, and that book to bill ratio is 0.5x, meaning the company is burning backlog at twice the rate they are bringing in new business.

For those more inclined to visual displays of data, here is a graph of TAYD's backlog activity layered on top of sales activity. It is quite easy to see how the two generally move in the same direction sales lagged one period.

Here is a graph of TAYD's sales and net income. Again, quite easy to infer a relationship between the two, except in the most recent period.

Why would it be that Net Income would suddenly diverge from declining sales? I'd hazard a guess that on large fixed price projects the company can harvest awards on completion, as is the case with many construction related businesses.  And with backlog coming down, one can infer that several large projects have recently completed.

Here is a graph of TAYD's Net Income layered over "price to backlog" a valuation methodology typically used for companies that generate income off of backlog. You can see how investors reward the company with a higher multiple during periods of strong earnings

And finally, here's a chart of the median quarterly price of the stock layered on backlog.

It is certainly possible that the market knows about some orders on the horizon that will boost backlog or potentially future opportunities for sustained margin expansion.

It is possible that the company has been "re-rated higher" b/c of its prior capacity expansion, with another capacity expansion currently under way, that will enable the company to build even larger product and capture more share of the market.

But it is not possible for the company to generate strong results without strong orders, and the orders of late have been lagging.

At $60M market cap, this remains, to the wider market, an "undiscovered gem" and perhaps even a good idea for a long term investment. I don't yet understand enough the competitive landscape to make that decision. But I do know that if the pull of orders tugs earnings down, and momentum buyers flee, there will likely be another bite at this apple at lower prices for patient investors.

-- END --


$ARIS: Generating FCF and reinvesting it at high rates ...

This post is a look at the financials of ARIS, a company I've written about before and have followed for awhile. It's been throwing out tremendous amounts of cash and reinvesting it at high rates, a characteristic typical of a kind of investment known as "compounders".

The last 1.5 years - and most notably the last half - have shown quite spectacular results, with FCF returns on equity of +17% and FCF margins of 16%.

Using a screen, we compare the company's recent results to other stocks listed on the major US exchanges both with limited mkt caps (under $1B) and unlimited and find it to be in rare company.

Whether or not those results can be sustained is obviously most important. At $70M mkt cap it's still not in "orbit" so to speak. Over the next 2-4 quarters perhaps, investments in the business to meet growing demand, reduce churn and lower turn time will likley negatively impact margins so that's a near term headwind to sustaining current rates of return.

But if those investments ultimately return what the current business is doing - or more - it's possible to consider that this company is doing something unusual and special as it appears that it might be.

In my effort to learn more, I am seeking out knowledgeable folks with experience in small dealer markets (1-10 doors) or dealer services markets in the areas that ARIS serves: powersports, RV's, medical equipment, marine and wheel / tire. Please ping me if you or someone you know fits that bill so we can be connected for a brief chat.


I like it where ideas converge as recently happened here in the last two weeks ...

First I reconnected with an old friend who runs Greenlea Lane Capital and shared some ideas with him. I know few investors as focused, disciplined and patient as he and I treasure his time and counsel. Were he older, I'd perhaps call him wise but that's a sobriquet for the old and an epithet for the young, and he is young and his success to date hopefully precedes a long career ahead.

He solely seeks out compounders and while I own companies for a handful of reasons I shared with him one that I've previously written about here - $ARIS - that seemed like it fit that bill, meaning that it generates cash and reinvests it at high rates of return.

ARIS is a small software / technology company that serves the dealer markets, primarily for powersports (motorcycles and ATV's), RVs, wheel / tire and home medical equipment.

While many dealer services companies serve the back office, ARIS goes to the consumer facing side, developing websites (~50% of sales) and offering eCatalogues (~35% of sales) so that dealers with 1-10 doors can be online, showing, selling and managing product. At $4.15 it sports a $74M mkt cap / $80M EV trading at 14x TTM EBITDA, neither terribly cheap nor terribly expensive, but a discount to peers.

That idea turned the conversation towards another more mature and well known compounder - $CSU.TO - which is also a software company serving vertical markets, and got me revisiting Mark Leonard's brilliant shareholder letters, notably the most recent one about high performing conglomerates.

Independent of all this, but around the same time, someone directed me to Base Hit Investing's post on ROIIC, another great read by John Huber. The nut of that piece is how to calculate and - more importantly, internalize and understand the meaning of - returns on invested capital.

Between those concurrent events, I decided to dive more deeply into $ARIS to see how it stacks up financially against more well known compounders and to get a sense if maybe it has an opportunity to be something special.

I am a shareholder - and I don't know the future - but their recent cash flow generation has been lights out and maybe that bears out the possibility that this company could be something special. I definitely see something in the results and quality of mgmt that is unusual in a company so small.

I'll start with most recent results ...

... The 17% topline growth is ~5% organic with the rest from three acquisitions last year that enabled the company to more deeply enter the wheel / tire services space ...

TCS Technologies (Sept 2014). A dealer services company in the wheel / tire vertical that not only does websites but has an integrated point of sale / integrated inventory management piece.

TASCO Software (April 2015). Also in the wheel / tire vertical with more business mgmt / back office related offerings.

DCi (July 2015). eCatalogue in the wheel / tire / auto after market space.

... if all this sounds boring and uninteresting ("websites?"), when you look online at products for sale, you are likely looking at a picture / price / sku sourced from some kind of catalogue. In short, eCatalogues are an essential part of the infrastructure of internet commerce.

Small dealers who don't own entire catalogues essentially rent them from a company like ARIS. It is a competitive business for sure - there is no end to small companies doing it - but it is scalable, low touch, high return and - with enough subscriptions - a cash flow engine.

For ARIS, this cash flow engine has generated low dd / mid-teen FCF margins for the last 1.5 years. 

Prior to 2015, the company was working its way through an acquisition of a distressed company (50below) that created a short term blip but enabled them to substantially grow their websites business. In that case, the acquired subscribers had already paid the target company, which squandered the cash, meaning ARIS essentially acquired the liability of having to provide a service to the subscriber, but not the cash. But that is all in the past.

What is in the future?

Even as the catalogue business churns out cash the websites business is like the yin to the catalogue yan; high touch - it takes time to get a dealer website set up - and high churn - they lose about 15% of sales / year when customers jump ship to competitors or close their doors.

Just to reiterate, 15% organic growth every year is churned away. That means every basis point reduction in churn is an increase in organic growth. Reducing churn is therefore something the company is focused on though some churn is structural to the business, a factor investors should consider quite carefully.

On the most recent conf call, mgmt indicated a number of investments to speed website turnaround, reduce churn and meet growing demand. Having too much work is what I call a "high class problem" but its a problem nonetheless and the investments will be headwinds to margins.

About these investments, in their words ...

1. General investments in the business:

"As we look ahead to Q4, I want to make a few points. First, we had another quarter of strong sales bookings. This means we will continue to apply resources into translating those bookings into revenue as quickly as possible. And as such, I suspect that will continue to impact the gross margin in a way similar to what we experienced in Q3 [ie down to the high 70% / low 80% range]. 

"The flipside of that is that we are aiming to maintain organic growth rates in Q4 similar to what we experienced in Q3. Second, as I noted previously, our profit performance in the first nine months of the year has exceeded our expectations. We anticipated that there would be some investments in Q3 that would prevent us from improving upon our Q2 performance. 

"While we did make some of those investments and still improved upon our performance, some of those investments did not hit in Q3 from a timing perspective and as a result will likely materialize in Q4. These investments include, among other things, our ongoing investment in our India office, consulting fees to upgrade and optimize our data centers and the rollout and go live of our enterprise wide CRM system."

2. Platform upgrades to websites and eCatalogue:

"We have several active projects including extending and improving our core website lead gen and e-commerce platform, developing a new next-generation version of that product, and developing the next generation of our core eCatalog technology. 

"The first item extending and improving our [existing] platform is pretty obvious and has resulted in a substantial increase, in some cases a triple digit increase in leads to our dealers. These improvements have resulted in strong new bookings this year and improved churn. We remain committed to building and delivering the best platform for lead generation and e-commerce in the markets we serve. [The existing platform is internally called "endeavor" and has been around for +10 years]

"The second item is a total rewrite of that platform ... The re-write is internally code named Domino, and Domino is a product that will openly replace Endeavor. It'll be our platform for the future. It is written to be a responsive design platform. It will be much, much faster. It actually will drive much more leads. It has a tremendous amount of flexibility to be able to appeal the different vertical markets as we continue to import medical data and the entire data and other types of data. And it also is going to have significant impact on our cost structure to deliver and maintain new customers.

"... We will start porting dealers over August or September, so we will begin porting dealers over to Domino and that process will take a minimum of 12 months, it might take a little bit longer than that, but that migration effort is not going to be incremental to our cost structure today. We've had a plan to do that for a long time, and we will be porting those guys over to Domino and eventually we will retire and cut down Endeavor and all the data center that goes along with it."

"In terms of eCatalog, we have spent the last year developing the next generation publishing tools that we expect to dramatically reduce the amount of time it takes our OEM customers and our internal teams to create new content and update older content. What previously took days or weeks will now take seconds or minutes with this new platform. We developed this as a global solution from day one and designed it for use in the markets we serve as well as any other market where the equipment is complex and requires repair."

3. Opening an office in New Delhi

"We continue to build out capacity in the US and India to lower our backlog and cost structure. While our overall numbers for the quarter were quite good, our revenues would have been even higher had we been able to deliver all customers in under 30 days which is our target.

"As we discussed in the last call, one of those initiatives resulted in opening an office in New Delhi, India. Almost a year ago we assigned a senior operation resource to investigate building additional capacity in India, we conducted a comprehensive review of the options and hired a VP General Manager in November and have continued to add staff. We now have an operations team up and running in India, the leader of that team was trained in our Duluth office for three weeks and one of our senior US resources is in New Delhi now completing that team’s training. We expect this team to start working on our backlog in the next few weeks.

The nut of these investments means on the plus side, they are investing in their business to upgrade their platform and reduce churn ...

... but on the negative side, near term margin impact and with the distraction of platform upgrades and ERP / CRM systems rollouts, I'm sure we've all seen how that can get off the rails pretty quickly. Again, things investors need to consider.

How the company manages the transition will be critical to the next years results and that's really the most important thing, despite prior year results that have been exceptionally impressive. I have been focusing on how to gain insight and comfort with these changes and if anyone has networks into dealer services software that I could chat with for 15 minutes, that would be most helpful. 

Back to recent results, here is a summary of TTM figures ...

... growth, margin expansion and FCF generation.

Putting it all together with some balance sheet data gives a sense of returns on capital ...

... 17% FCF return on equity and 12% return on total cap seem impressive to me.

As BHI discussed in his post, some use in the return denominator Total Capital less Goodwill & Intang (53% on TTM FCF) and others just use Tang Capital (89% return on TTM FCF). I don't think it's appropriate to exclude goodwill / intang for acquisitive companies b/c it is an essential element of deployed capital, even as it just sits there.

I've seen a table recently that showed how an index of "compounders" generates FCF return on equity in the 19% range vs the MSCI index in the 14% range, so ARIS is somewhere between the two.

Are these exceptional results?

I try not to get bogged down in parsing return numbers so finely. What matters to me is consistent and long term growth in BVPS and cash flow generation as proof that mgmt is adding value.

In ARIS case, a lot of the growth is through acquisition and in the past they've definitely overused stock for acqs, but at 17M shares outstanding it hasn't been inappropriate given the need to expand liquidity and especially when at one point there were paying as high as 14% interest on debt. Based on a prior correspondence with the company, I believe they will be much more parsimonious with using stock for future acqs.

As for how they compare to other companies, I created a screen to see who else might fit the bill. (I think I shared a version of it on screener.co called "Companites that look like ARIS"). I used the following parameters that shared the same recent dynamics as ARIS ...

TTM Rev Growth > 20% 
( total revenue(i) + total revenue(i-1) + total revenue(i-2) + total revenue(i-3) ) / ( total revenue(i-4) + total revenue(i-5) + total revenue(i-6) + total revenue(i-7) ) > 1.2

TTM EBITDA / Total Cap > 15% / 14% / 13% for last three quarters
( ebitda(i) + ebitda(i-1) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I) + Total Stockholder Equity(I) ) > 0.15

( ebitda(i-4) + ebitda(i-1) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I-1) + Total Stockholder Equity(I-1) ) > 0.14

( ebitda(i-4) + ebitda(i-5) + ebitda(i-2) + ebitda(i-3) ) / ( Total Debt(I-2) + Total Stockholder Equity(I-2) ) > 0.13

built in parameter

FCF margin > 20% / 10% for last two quarters
( Total Operating Cash Flow(I) - Capital Expenditures(I) ) / total revenue(i) > 0.16

( Total Operating Cash Flow(I-1) - Capital Expenditures(I-1) ) / total revenue(i-1) > 0.1

** note that in my model, I appropriately calculate free cash flow net of capitalized software development, but screener doesn't have that parameter, so the comp margins are higher ** 

... and there are 13 US-listed companies not based in China with $1M > mkt caps > $1B. If you look at the screen you won't see ARIS there - strangely enough - and when I looked at the raw financial data noticed it didn't match the Q. This of course begs a whole host of other questions ... but that age old complain "until I can afford to get FactSet, its all I got to work with here".

Casting a wider net, when I lower the rev growth rate hurdle to 10%, raise the valuation hurdle to 20x and expand the market cap to $500B (also a shared screen "All cap blog screen"), the list grows to ~125 companies with a list of compounders that will be much more familiar to investors, topped by GOOG:, GILD, RAI, PYPL and ORLY to name a few.

That is good company to keep.

-- END -- 


The robot selling investments; brief thoughts on a trend

Summary bullet points:

  • No one likes being sold to. Poor selling - especially of financial products - feels condescending and judgmental. 
  • And in an environment where a generic Financial Adviser at a generic bank charges 1% to do essentially the same thing as a robot, it makes sense to choose the lower priced, self directed option. 
  • Robo-investing painlessly resolves the conflict a lot of people feel about investing, that they should know more about the market but they've never found that foothold on which to engage it. The various online robo-options provide non-judgmental, non-condescending ways of allowing people to engage the markets. 
    • But is it the best option? An undifferentiated approach to investing is now the most popular but it is not necessarily right for everyone. It reflects a misreading of academic studies as well as the lazy (and greedy) aspects of the mutual fund industry, which has become good at aggregating AUM yet can't possibly allocate it efficiently in an active style. This "race to the bottom" of AUM aggregation - not robo-investing - is hurting the industry. 
    • Selling differentiated aspects of active investing without compromising integrity or returns on capital seems the best and most attractive option to me as I try to grow a nascent asset management business. 

    I recently attended an event where a lobbyist spoke for three minutes of prolonged insincere, smarmy-ness, and towards the tail end - concluding with an awkward introduction to the event's organizer - I had this revelation: No one likes being sold to.

    It got me reflecting on the generational shift in attitudes around selling and how much the avoidance of salespeople and "being sold to" might factor into shopping online.

    Personally, I still enjoy the occasional face to face shopping experiences and the guided journey towards a better product. But online shopping is such a better alternative.

    Ironically, the entire online experience is made possible by constant shuk-like efforts to sell me stuff I just bought. Despite the ubiquity of those efforts (not on this blog, mind you), the intrusiveness is algorithmic and therefore feels impersonal and "just sort of there", like billboards in the city.

    I imagine the current batch of 20-somethings - the first generation to grow up exclusively with online shopping - is super experienced with the self-driven, yelp driven, review driven process whose independence makes the dopamine rush at its completion that much more of an accomplishment.

    Concurrently, I think every generation has their enlightenment, and if my experience in my 20's is any guide, it involves some recognition that whatever we've learned up until that point is propaganda and hypocrisy, and there's ample room for improvement to make things a bit better, more honest and real.

    With that frame of reference, I'm conflicted about the trend in "robo-investing", the simple, self guided, asset allocation method of online investing targeting today's 20-somethings.

    On one hand, of course they're investing online. The only people surprised by this are traditional financial advisers.

    On the other hand, I have a hard time understanding why the same person who might spend 20-minutes trying to find the right restaurant, glasses or sweater, might spend less time buying the least differentiated product with likely larger sums of money and more limited information.

    I struggle with this "dichotomy" (whatever that means).

    I have this nascent business - an investment management firm - focused on well-researched, patient ownership of terrific small businesses trading for discounts to my sense of what they're worth, and with enough integrity to avoid companies that despoil the environment and drop bombs on people's heads, (ie the roughly 30% of the S&P tied to energy, commodities, dirty power, and aerospace / defense).

    And I'm trying to come up with a good questionnaire to help clients better establish an awareness of how they think about money and investing so they can better understand themselves (what's more important than that?) and also so I can better understand if it makes sense for us to work together.

    So here I am exploring various ways of framing surveys to engage people in their attitudes about investing, when a friend suggested I was overthinking this and perhaps I should check out how a robo-investor establishes suitability.

    On Wealthfront I was asked TWO questions, quoted directly below ...

    1. When deciding how to invest your money, which do you care about more?
    Maximing gains
    Minimizing losses
    Both equally

    2. The global stock market is often volatile. If your entire investment portfolio lost 10% of its value in a month during a market decline, what would you do?
    Sell all
    Sell some
    Keep all
    Buy more

    ... and based on those two questions I was given a portfolio of Vanguard ETF's.

    In an environment where a generic Financial Adviser at a generic bank charges 1% to do essentially the same thing, I can see how it makes sense to use the robo-adviser. Undifferentiated AUM aggregation is a race to the bottom.

    And in an environment where a shady salesperson might ask only one question for appropriateness: "Do you want to invest? Perfect, I have the right product for you" the robot is certainly a better option (and the client won't feel dirty).

    And somewhere in the middle is the traditional FA who might unconsciously talk down to clients: "I know it's hard to understand, let me do this for you."

    In all of these worlds, I can also see how the robo-option painlessly resolves the conflict a lot of people feel about investing, that they should know more about the market - they hear about it everywhere - but they've never found that foothold on which to engage it. These robots - like online ads - provide a non-judgmental, non-condescending way of selling.

    But I also think: "Wow, Wall Street has gotten really good at separating people from their money."

    Because on one hand, if you want an undifferentiated approach, of course you should just take the cheapest alternative. But on the other hand, why should anyone accept an undifferentiated approach?

    We've taken these academic studies about how a long held passive index fund will outperform the "average active investor after fees" and turned it into an undisciplined mantra, as if its a solution to everyone's needs. Average the shady salesperson racing for AUM against an honest investor with sound judgment, and after fees you'll probably return below the market. 

    But find someone knowledgeable, trustworthy and good at this, and you might, for not much more money, become a shareholder in terrific business that you're proud to own, and some might turn out to be great returns on capital. 

    I'm framing this from my own bias as an active investor, where index ETFs seem like the investment analogy of a glory hole; it gets the job done at the lowest cost possible, just don't ask what's on the other side. (For the super-rich, secretive hedge funds fill the same void and at much higher costs, because the rich person's burden is the need to pay more).

    If you do ask what's on the other side, you'll find that it's a mass of businesses, and businesses within businesses, some too big to fail, others too big to succeed, which overall should grow at or near GDP, and whose value depends largely on interest rates and the comparative value of alternatives.

    This is "the market" - mentioned every 15 minutes on the radio, etc. in the form of "The Dow" or "The S&P" - and the huge propaganda machine that says we should invest in it absorbs people into doing things they wouldn't normally do, like wagering their retirement and savings on it, day in and day out.

    I think due to misinterpreted studies, people think the markets are less risky than individual businesses so they throw their retirement savings and 401k's and money at them. I can't wrap my head around that. Would you rather own a handful of things you know, want and like, or bags full of random things, including those that aren't necessarily good for you, that pollute, that despoil, that kill?

    I'd prefer to invest in actual businesses I (and my clients) won't feel dirty owning and that can provide meaningful returns on capital over time, no matter what "the market" does.

    There are lots of people out there investing this way. Like some of them, I aim to be an open book, a guided journey through investments and analysis, providing clients with exposure to individual businesses that generally aren't in the indexes, that are well managed, generate cash, seem inexpensive and over time could grow materially faster than GDP so that perhaps at some point - if things work out and the value is realized - ownership in these businesses can compound capital faster than the market. 

    And I do this without exposure to companies that drop bombs on people's heads or despoil the environment b/c my clients capital should have as much integrity as they do.

    It makes so much more sense to me than the undifferentiated approach. Maybe I just need to find the right robot to sell it?

    -- END --


    $WELX: An investment in Beatles history and nostalgia

    As readers of this blog know, owning stock makes you a part owner of a business. This is why owning shares in tiny $7.8M market cap pink sheet listed company Winland Electronics (WELX) makes shareholders part owner of Beatles history and nostalgia.

    I'll explain ...  

    WELX has a day job selling remote sensing equipment used to monitor (track, log and alert) temperature, humidity, water leaks and power changes within buildings. Their products include the WaterBug, TempAlert, PowerAlert and top of the line, EnviroAlert800-ip, which has inputs for up to 12 sensors and requires a subscription to a cloud based monitoring service, their entry into IoT.

    Here's the product catalog

    I've seen these products in the closets / mechanical rooms of rental buildings, but they are also in commercial refrigerators, food or pharma plants and other industrial processing that requires certain environmental monitoring. They are not fancy like the Nest but work out of the box. 

    There's a lot to like about that tiny little business though its not for every investor; revenues are highly concentrated and at 4x book, etc. it's trading at nosebleed valuations.

    The valuation reflects (obviously) a desire by some to own the stock for among other reasons that the company has transitioned from a manufacturer, to an asset light model, and some expect even possibly to an investment vehicle for its two Co-Chairmen: Thomas Braziel and Matthew Houk.

    You've probably not heard of them but they've had some success investing, Thomas through his firm BE Capital and Matthew through his work at Horizon Asset Management.

    Houk, one would presume, is good at what he does since his boss at Horizon, Murray Stahl, acquired 15% of WELX in late 2014, which is another reason for the valuation, given Stahl's fame as a "guru" in the investment world.

    In short, this is really about putting money on two young jockeys (so to speak), and alongside Stahl.

    A lesson I learned a long time ago is that if you have a chance to meet a CEO or Chairman and you find them to be terrific capital allocators with high integrity and great ideas on long term shareholder value, sometimes its best to just make an investment in them and let them do their thing, even if "that thing" is not totally known ahead of time.

    Some might say this is investing with your eyes closed, misunderstanding everything you see, b/c another lesson I learned even longer ago is not to blindly follow what you read online or promises you hear from someone with an angle. Saying "no" a lot - A LOT - and the ability to separate the "A" ideas from the rest is the hallmark of the best investors.

    But unless you're building something yourself, investing is ultimately about entrusting your capital with the best capital allocators you can find, whether its a coffeeshop owner (entrusting them to build the right space that attracts customers), an industrial company (entrusting mgmt to anticipate the right product mix), etc., and at a price and with the right concentration so that the inevitable blips and bumps don't hurt you.

    The problem of course is how to find good capital allocators. I think my brief experience as a PI helps with that, though I might be overstating its benefits.

    In any case, the "investing in a jockey" theme isn't some new ground breaking idea. I doubt most people understand at all what's going on at Berkshire but a few own BRK b/c Mssrs Buffett and Munger are "terrific capital allocators with high integrity and great ideas on long term shareholder value." It is why I own WELX.

    The aspect of being a part owner of Beatles history came later and is just the sugar in my coffee. 


    Many museums don't have budgets to put on one-off special shows so companies like Exhibits Development Group (EDG) create shows, sell them as a turnkey solution and - if the shows are successful and desirable - keep selling it over and over, presumably collecting some % of ticket sales.

    Its an easy model to comprehend; build the exhibit and resell it over and over. The incremental cost after the first show is ostensibly zero, the rent in theory is zero since the museums host, the material is probably part of someone else's collection, insurance might even be carried by the museum. The point is, in theory its a tremendous business that requires little capital and if things go well, generates cash.

    One new show that EDG is putting on is a collection of Beatles memorabilia titled "The Magical History Tour", whose world premiere was at the Pacific National Exhibition, in Vancouver, BC in August 2015 and just opened at the Ford Museum in Dearborn, MI to good reviews. Other venues to host the exhibit include the Chicago History Museum, Chicago, IL; Putnam Museum of History & Science, Quad Cities, IA; and Minnesota History Center, St. Paul, MN.

    To put on this show, created an entity called EDG-PMA LLC, reflecting the partnership between EDG and Peter Miniaci & Associates, the group of four Beatles collectors who supplied items for the show.

    WELX, through an investment vehicle I'll explain below, currently owns 14% of an investment in this LLC but it won't be long 'til more belongs to them b/c - if everything works out - that investment will eventually convert into a 25% stake.

    Here's how the investment was put together: Two investment groups - WELX and FRMO Corp - created an investment vehicle called Northumberland with initial investments of $200K and $1M, respectively and owned proportionally. Thus, WELX owns 17% of Northumberland and FRMO Corp. owns the rest.  

    Northumberland invested this $1.2M to EDG-PMA LLC. It looks like a loan but acts like a convertible preferred equity. In return for the loan investment, EDG will pay interest at an irregular dividend of 10% and once the loan  the investment is repaid - this is key - Northumberland will own 30% of the LLC putting on the show.

    Furthermore, when the investment converts to equity, WELX will end up owning 83.33% of Northumberland meaning it will own 25% of the LLC. (30% * 83.33% = 25%). I reckon its set up this way to utilize WELX's NOL's, so the profit they take might equal the profit they make without sharing it with the taxman (rim shot).

    The Beatles I hear, are pretty popular and if this ownership continues indefinitely and the show can continue, it should generate solid cash flow for as long as the LLC has access to the pieces in the show.

    Obviously, all investment carries risk as does this one, and of course, if you really want to own Paul McCartney's pick or George Harrison's notebook, eBay or other venues might be most appropriate. The value of Beatles memorabilia might even be enhanced as a result of the new show, which I hear is worth a visit if you're passing through Dearborn.

    Full text of the investment language follows.

    "On Friday, July 10, 2015, the Company completed an investment of $200,000 in Northumberland IX LLC (“Northumberland”), an entity formed with another third party [FRMO Corp] to invest a total of $1.2 million in EDG-PMA, LLC (“EDG-PMA”), itself an entity formed in cooperation with Exhibits Development Group, LLC (“EDG”) to develop, design, construct, market, place, own, and operate a traveling museum exhibition presently known as The Magical History Tour: A Beatles Memorabilia Exhibition. 

    "Northumberland’s investment in EDG-PMA is effectively structured as convertible preferred equity. 

    "The convertible preferred equity pays an irregular preferred dividend at a rate of 10 percent per annum on any outstanding principal balance and is immediately convertible into 30 percent of EDG-PMA common equity upon repayment of Northumberland’s $1.2 million principal amount, the timing of such repayment being dependent on the distributable cash flow of EDG-PMA." 

    "Until repayment of Northumberland’s $1.2 million principal amount, the convertible preferred equity is entitled to the entirety of EDG-PMA distributable cash flow. Prior to the repayment of principal, the Company’s interest in Northumberland is proportionate to its $200,000 investment. Following the repayment of principal, the Company’s interest in Northumberland shall be 83.33 percent." 

    -- END --

    This is not a solicitation for business or a recommendation to buy the stock just something unusual about a stock that I thought readers would appreciate. It is based on public filings but I can't vouch for the accuracy of those filings or of this blog post.. This "safe harbor" statement is meant to cover my ass and to remind readers they are responsible for their own research and investment decisions. At the time of this writing, I own some of the stock. All investing carries risk particularly small cap equities and that risk includes the potential for a total loss of capital.

    Kicking around a new idea: $PSSR Inexpensive and Independent Airspace Technology Company

    Summary bullet points:

    • $PSSR is a micro-cap with long operating history in aerospace technology and improving balance sheet.
    • Book of business is growing with recurring revenue subscriptions and the tailwind of long term industry trends.
    • Trading at inexpensive 5x EBITDA despite visibility into continued revenue growth.

    In a recent article in the WSJ about a successful test using blockchains (ie bitcoin technology) to record transactions in the credit default swap market, I read the following quote ...

    "Some may be reluctant to make changes that threaten their own market share or introduce new complexity to current systems that have been tested and refined over the years."

    ... and it struck me as something that could have been written about any industry, at any point in time in history.

    This post is about technological change in the aerospace industry, NextGEN, and a tiny company called PASSUR Aerospace (PSSR) that until 15 years ago had a niche in "old technology" but is evolving with the "new technology" and could have an opportunity - given its established space in the industry, its slate of solutions that support NextGEN and recent hires - to grow revenues, maintain margins and thereby expand ROE and ROA back towards double digits.

    The "old technology" is locating airplanes on a map, once essential, soon to be ubiquitous. The "new technology" is helping their customers - airlines, airports and ATC's - analyze, understand and make sense of enormous amounts of information to make better, faster and more efficient decisions around airspace and airport operations; scheduling, on the ground asset management, and routing.

    Many larger companies are focused on using algorithms to provide better information for these customers. PSSR says its competitive advantage is +20 years of data analysis tracking its own and other information for more accurate predictive software.

    I see another advantage as the stickiness of real estate in the enterprise, in the airport and ATC - the company has been there for more than 30 years - combined with finding solutions for airline customers that actually improves efficiency (a member of the board Kurt Ekert says he was formerly a sr employee at Continental Airlines when he found the company as a customer and fell in love with the product).

    If ...the industry continues to modernize and evolve, if ... the product continues to improve and if ... the company continues to focus on meeting needs of existing customers, the stock could be attractive - revenues have grown recently and deferred revenues (a measure of subscriptions) imply continued growth - while the current valuation of of 5x trailing EBITDA seems to discount much in the way of a positive outcome.

    I don't make price targets or predictions but I can imagine a future where continued and consistent steady growth and cash flow justify a higher valuation off of a larger pool of profit, while the balance sheet continues to delever, implying the potential perhaps for material growth to shareholders. Or not?  I am still trying to learn more; continued study and patience will be key.

    PASSUR was founded in 1967 and has been publicly traded for more than three decades.

    For most of this time, it operated under the awful / awesome name “Megadata” until 2008, when it changed its name eponymously to the pronunciation of the acronym of its heritage product, “Passive Secondary Surveillance Radar”.

    Underlying PSSR – the acronym – are fixed radar sites – currently 185 in all - the largest passive commercial radar network in the world - at or near airports mostly in the US but also in Europe and Asia - that provide faster and more accurate position updates to airline operations control and ATC's. (These are the spinning radars that are used as establishing shots in movies, typically followed by skidding wheels on the runway).

    The company once sold the machines, then sold the information from the machines as a subscription service. This fixed asset - and the service from it - gave PASSUR its name in the industry for solving the problem of locating an airplane and putting it on a map. As an example of this legacy, after the 1996 crash of TWA Flight 800, its radar network helped establish the precise location of the airplane at the moment it exploded and also the locations of other airplanes in the vicinity that might have witnessed it.

    For several decades that legacy business was niche, yet essential and unique in busy airspaces. But new technology - notably ADS-B - is disrupting that position. By 2020 all airplanes flying in US airspace are required to have ADS-B - whether or not this actually happens is unknown - but it would make passive secondary surveillance radar a redundancy.

    However PSSR is evolving ... and this brings us to NextGEN 

    If you read the newspapers you've heard of NextGEN, perhaps as a bloated and expensive, FAA program; a failure; a plodding success; an over-promised and under-delivered program to - depending on your viewpoint - upgrade airspace technology to improve efficiency and safety in US airspace; or to simply force all the air traffic controllers out of work.

    But NextGEN's over riding ambition is to modernize the US aviation system "... to improve the operational performance of the national airspace system."

    Because of the collaborative nature of the US airspace, the benefits of any modernization at one airport or in one airplane isn't effective unless surrounding regional airports and airplanes using those airports also upgrade.

    In the simplest least complicated explanation of NextGen, it is an effort by the FAA to "quarterback" the collaboration required between the primary agents in the industry ...

    Airlines (ie operators)
    Air Traffic Control Towers

    ... in order to modernize the US airspace.

    The whole plan unfolds in a tough politicized environment where there is reluctance to change "... or introduce new complexity to current systems that have been tested and refined over the years" as per the introductory quote.

    Big contracts. Government agencies. Modernization. It's all very complicated, long term and likely to benefit the large industry players, right?

    The RTCA (Radio Technical Commission for Aeronautics) is an industry advisory committee used by the FAA as a "Public-Private Partnership venue for developing consensus among diverse, competing interests on critical aviation modernization issues in an increasingly global enterprise."

    And here - among many places - is where PASSUR plays a part; despite their small size they are trusted, independent and known in the industry, so they have a seat at the table helping to develop, implement and track NextGEN priorities as well as participate in opportunities to improve operating efficiencies in the industry.

    Furthermore, their "last generation" technology isn't so last generation; they continue to roll out new SSR systems at airports, as backups and redundancies.

    And finally, they have been generating meaningful - and it seems recurring - revenue growth helping airlines and airports use the enormous quantities of data available to airlines from a variety of sources to solve one of three general problems that occur primarily when weather disrupts flights ...

    Better ETA’s and ETD’s to airlines improve on time performance and better prepare for arrivals and departures.

    Better on-the-ground airport information (ie “surface management”) to improve – among other things - turnaround times and on-ground performance.

    Better air-traffic management to safely accommodate increased overall capacity in the airspace and airports.

    ... in predictable environments these things on their own are not terribly complex but throw in diversions associated (most frequently) with poor weather and non-linear problems around availability of runways, gates, crew time, surface equipment, etc. begin to escalate.

    This is where PSSR's service / solution / revenue generation comes in. The company integrates its own sources (PSSR) with other available data sources (ADS-B, ASDE-X, Mode S, En Route Radar, Airline OOOI data, ACARS, fleet databases, etc) as a data feed to flight and airspace information, then runs the data through its own algorithms and uses it to provide better analysis for predictions and performance, which ultimately supports better decision making by its customers.

    It sells services and software systems via subscriptions that provide more efficiency in various aspects of the airline industry. Large material customers include $LUV and $JBLU in their most congested regions that experience weather.

    I hate to rely on cliches and jargon but this where I'll throw out the term "big data" with a link to an HBR article about how PSSR - and Sears Holding (lol) - are using "big data" to improve operations. (take it FWIW, I felt I had to reference the article).

    A key question here when we reflect on the world of big data is why aren't other people doing it, why is PSSR still independent, why aren't revenues higher, etc? 

    On the face of it, having better resources to solve these problems sounds like a “no-brainer”. However, based on our research and our understanding of the industry, there are headwinds to customer adoption of both solutions.

    On ETA / ETD, it’s not generally seen as a complicated problem where the benefits of shrinking the ETA / ATA gap is seen as critical. When a plane leaves late it can fly faster, weather remains an acceptable excuse for delays and with the exception of the most congested airports, “good enough is good enough”.

    On on-ground performance and turnaround times, the biggest factor is planing and deplaning customers. A subscription service that improves on ground performance without improving that process does not appear to be a problem customers feel need solving

    And finally, reference the quote at the beginning of this post. A source I spoke with at a competing company who said the PANYNJ, which manages some of the busiest airspace in the world, is a huge obstacle to investment in new technology for reasons as simple as "turf battles".

    In light of these obstacles, the answer to selling a customer a solution to a problem they don’t feel they have and in a crowded and competitive field is to increase and improve selling and marketing function. PSSR is doing this, it appears with early initial success albeit with some degradation of margins (EBITDA margins now 28% down from the mid- 30% range; we'll get to this in a minute).

    But the investment thesis that underlies the opportunity for material long term gains is that there will be an evolution in how these problems are viewed by the customers.

    We have seen examples in other markets and industries where marginal improvements were deemed unimportant and unnecessary until eventually they became essential and ubiquitous.

    That is the path to a maximal and exciting return. For the patient investor, if that evolution occurs and customers are willing to pay, there could be material gains. In the meantime, you're getting some solid "blocking and tackling" at a low multiple.

    We see a company growing revenues and backlog, this as a decent cash flow generating growing business trading for a low multiple at today’s prices.

    Revenue and Subscription (aka backlog) Growth
    The evidence demonstrates that since losing contracts in 2012/2013, quarterly revenues have been growing through 1Q16 (quarter ending 1/31/16) with pronounced sequential and y/y over growth over the last four quarters. The company indicated the "lost contract" was not a recurring revenue "core" program but a one-off for DHS.

    This chart tells the current growth story (revenues) as well as the future growth through two balance sheet items that capture the equivalent of “backlog” (ie subscriptions); they are deferred revenue netted against accounts receivables. Higher levels of subscriptions should lead to continued higher levels of revenues over the next 12-months leading to potential growth acceleration.

    Balance Sheet Improvement 
    When we think about a business and its all-in consistency, we look for companies with good balance sheet management as reflected in growth in shareholder equity. Here the improvement since 2012 has been slow and steady . The bulk of improvement prior to that came via a partial recapitalization / debt to equity conversion in 2012. The company’s primary shareholder GS Beckwith Gilbert owns 4M shares (53%) and is also the note holder on the $3.5M in outstanding debt.

    High EBITDA Margins, but Investments in SG&A a Headwind
    Until recently, EBITDA has largely kept pace with the growth in revenues. However, new hires in the last 12 months have absorbed a greater share of expenses.

    The new hires that impact SG&A include back office talent as well as customer facing talent:

    David Brukman, CTO.
    David Henderson, CFO
    Leo Prusak. Former FAA Deputy Director to head airport operations
    Bob Junge, formerly head of JFK airport operations, to sell airport solutions
    Howie King, formerly of competitor Saab Sensis, to be a director in business development

    Other evangelists for the product include …

    Jim Barry, CEO
    Tom White, head of product
    Chris Maccarone, airline performance

    The impact of these new hires might be evident in future revenue growth but it is certainly evident in current SG&A which at 1Q16 had increased 38% to $1.6M; it is as high as its ever been and is now up to 48% of revenues, up from the 38% average in the prior five years.

    The question of course is, can the revenues scale these new hires? The evidence from recent revenue and subscription growth is that it is on the way.

    Current competitors that sell “data driven” solutions tied to weather diversions, on ground performance and operations systems management include SAAB Sensis, Navtech (an airspace technology company recently acquired by Airbus) and IBM / weather channel, but none are as narrow and focused as PSSR.

    The risk associated with competition should include the question: "When does google get into this space"? In some respects, though the degrees of complexity are different, the evolution of NextGen is not materially different from the evolution towards self driving cars. Many of us already use devices for routing, ETA management, etc when driving. I would argue its easier to penetrate the automobile since there's no "gatekeeper" (or union) advocating obstacles to automated driving the way there is keeping it out of the ATC or cockpit.

    To this aspect, I see the company's legacy through the lens of that initial quote as a benefit. The company's real estate in the cockpit, ATC, and operating control room has value; the company is trusted and present. Best of all, they have been evolving slowly and successfully in the right direction.

    As I've dug into this industry, I've been surprised with how "old fashioned" it is. On the front end, the customer interface seems to have leapt forward with ticket ordering and boarding pass apps and the evidence shows that overall safety has improved as well.

    However, on the back end, based on what I've learned, many companies continue to operate inefficiently - and more critically - airports, municipal authorities and ATC's are as well. As someone told me recently, "the air traffic control system in this country is so antiquated, it would scare the shit out of you if you knew about it."

    Because airlines, airports and ATC's are all partners in the industry ecosystem, the full benefits of an improvement by one agent - an airline say - in on time arrival might not result in faster turnarounds if the airport or ATC doesn't improve efficiency and a gate isn't available. Again, this is the reason for NextGEN.

    It makes for an interesting investment quandry, because the situation can go on indefinitely. Ultimately however, my investment thesis is driven by the view that while improvements in efficiency can be overlooked and ignored eventually they became essential and ubiquitous. And in the meantime, you're getting a company that has a long history of quality management,

    There are obvious risks with investing in general, nano-cap specifically and in particular companies - like this one - with ownership concentrated in the hands of one person.

    Beckwith Gilbert owns ~53% of the equity of the company (4.1M shares) plus the $3.5M note paying 6% interest. He is by many accounts committed to the success of the company and was willing to stand by when it had financial difficulties but it is unclear he is committed to returning shareholder value and that's made me cautious on this position in my portfolio.

    Two issues specifically give me pause:

    1. His compensation. Mr Gilbert is paid  $300k / year for his role as the Chairman, which is as much as the CEO, Jim Barry, who does most of the heavy lifting. I have no view on what Mr Gilbert does to earn his compensation but it is in addition to the interest he receives on his $3.5M in debt to the company. Viewing that $300k comp as a form of interest expense on the debt, the implied rate on the debt is closer to 16%, which is well in excess of junk yields.

    At face value, perhaps it should be viewed as an indication of the speculativeness of the investment with as high a degree of risk as a junk bond.

    2. A comment to me about his goals for the company. I recently attended the shareholder meeting and followed up with questions after digesting what I'd learned. A final question of mine, which I like to know from all executives of all my investments, is what are the goals for company, or in short: "why"? Why be in business? Why do this? Often its just lip service but sometimes there's a commitment to customers, to employees, to shareholders, etc.

    In this case, when asked why they're still independent (given that some have rolled up and been acquired) his answer was along the lines of "b/c it's more fun to be independent and take on the big boys."

    And when I asked about the long term goals for the company, where they expected to be, etc. there was no comment beyond "having fun".

    I don't think that's untrue - there is something refreshing about that - but what does it mean for shareholders and maybe even about the employees who don't have the same financial independence as he has.

    I think its much more fun to have winning investments. 

    ADS-B. Automatic Dependent Surveillance - Broadcast

    ASDE-X. Airport Surface Detection Equipment, Model X

    ERAM. En Route Automation Modernization.

    TAMR. Terminal Automation Modernization and Replacement. "The TAMR program is upgrading air traffic control systems at terminal radar approach control (TRACON) facilities across the national air space (NAS) with the Standard Terminal Automation Replacement System (STARS) platform."

    TRACON. Terminal Radar Approach Control

    STARS. Standard Terminal Automation Replacement System

    -- END --


    "In a word: Good. In two words: Not good" Reviewing $FTLF and $FHCO

    A friend of mine recently told me this terrific joke ...  

    Two old mates run into each other.
    "How are you?" says one
    "In a word: good. In two words: not good." 

    ... incongruency, surprise and some revelation of truth are key sources of humor according to Freud - they certainly make the joke work.

    They are all key elements of investing as well.

    Responding to the inevitable surprises of investing with an even keel, without emotion, by revisiting assumptions and figuring out the important lessons to takeaway are among the essential elements of patient investing.

    This post is about recent surprises regarding stocks I've written about: $FTLF in its recently filed 10K and $FHCO with its recently announced merger with Aspen Park Pharmaceutical.


    There are many moving parts to $FTLF and the summary thesis, which I laid out in an earlier post, is as follows:

    FTLF makes branded sports nutritional supplements
    They sell primarily (+90% of revenues) brand exclusive products to GNC franchise stores
    They are "in" ~900 of GNC's ~1,000 franchise stores.
    Previously, they sold direct to these locations
    At year end 2014 GNC notified them that they were no longer able to sell direct and would be required to sell through the GNC wholesale channel
    Franchisees stocked up on inventory; sales expanded, then collapsed and 2015 was a year of slowly returning to prior levels.
    The company just anniversaried the year's disruption from this channel change (a good thing; comps are easy), but the change brings with it the following negative issues ...
    GNC is now an intermediary and has more control on price. Sales are discounted ~15%. Some of that is made up via lower shipping costs and the disappearance of transaction fees offset by higher DSO's. Furthermore, a primary benefit of direct sales to franchises was the opportunity to offer a copycat product at a lower price to the consumer and a higher margin to the franchisee. Franchisees we've spoken with said this remains true but at lower levels (ie its still a higher margin product, but not as much).
    ... the three big tailwinds for the company are 1) y/y comps are easy so we should dd organic growth all year, 2) they recently acquired a poorly run competitor but with a product that consumers and stores like so overall topline should be quite dramatic ~50% y/y and 3) best of all, over the next three years, GNC is transitioning 1,000 corporate stores to franchise stores meaning - at face value - shelf space for their core customer and core business is about to double. I say "at face value" b/c this is a brutal competitive business with incredible competition for shelf space. It is fought franchise by franchise and store by store by sales rep educating the local salesforce on the value of the product.

    $FTLF filed its' 10K 4/15 and it came with good news and bad news. I'll start with the negative surprises ...

    Inventory expanded to $4.8M meaning turns were below the 4-6 targeted range.
    The sales discount through the GNC Corporate distribution model widened to 15% from 10%
    The option to acquire 600,000 shares issued it IFIT's former CEO Stephen Adele expired unexercised.
    After deducting one time merger costs, EBITDA margins for the year were 5%

    ... all of this raises doubts about my $30M sales / 10% EBITDA margin expectations that had been the foundational thesis to the stock.

    It wasn't all bad news - organic sales growth was ~20% - and I had expected 4Q to be messy with management "kitchen sinking" all kinds of costs post merger, but the inventory figure had me concerned enough to wake up the next morning in a sweat.

    I subsequently talked with the CFO and I got a pretty narrative along the lines of ... "the past was bad b/c of XYZ but the future is wonderful" ... which didn't answer anything about the inventory, nor the wider than expected sales discount, nor the margins, nor the possibility of management conflict since their largest shareholder is the former CEO of the company they just acquired and whose business was managed E.N.T.I.R.E.L.Y differently (and incredibly poorly, to boot).

    If I had $1 for every time a mgmt team provided a narrative answer instead of a substantive one to simple business questions, I wouldn't have to work anymore and certainly I wouldn't wake up in a sweat thinking: "there's got to be better ways to make money than investing in nano-caps."

    But patient investing is about navigating those surprises.

    Are the inventory issues temporary or terminal? 

    High inventory can mean stocking ahead of sales, the timing of shipments, acquiring raw materials before a cost increase or any number of things that aren't just "good" or "bad". Too soon to say.

    Are these new risks or symptoms of risks I am already aware of? 

    GNC is the price setter, no doubt, and now that FTLF must sell through the corp distribution system, they exist solely for GNC's interest in providing alternative product to its franchisees. This was known ahead of time.

    Also, this is a brutally competitive business.

    The future opportunity remains driven by GNC's re-franchising strategy - converting 200 stores this year and 1,000 over the next three years from GNC corporate to GNC franchise stores - as well as getting iSatori products on more shelves in independent stores.

    If there's one underlying thing FTLF does it's, it's good at getting product on shelves profitably and living on its own cash flow. I've seen no evidence (yet) to dispute that assumption.

    What can I do to learn more so that I don't have to rely on a mgmt narrative with an obvious agenda? 

    The only thing I can think of is to revisit the channel checks. When I was a kid we used to visit every home furnishings store b/t home and our destination b/c of the family curtain business. We'll be visiting a few GNC franchise stores enroute to Colonial Williamsburg on our next vacation. (I doubt they have NDS products in Ye Olde Farmacy).

    The good news on FTLF is they report 1Q16 in less than a month, it's typically their strongest quarter and it will provide a better sense of performance than the kitchen sinked messy year end.

    Part of patient investing is waiting, learning, researching, checking (and re-checking) assumptions and not throwing in the towel b/c of one bad quarter that you had a sense ahead of time would be bad. If they can penetrate the new franchise stores the way they penetrated the existing ones, core revenues would double over three years + the added benefit of the iSatori product = potential for significant upside.


    In my +20 years as an investor, the bulk as a professional analyst, I have never had a "WTF!" moment like I had reading the $FHCO merger press release. Pairing a cash flow generating value company with a speculative pre-clinical phase pharmaceutical company is a deal that makes so little sense - it is so incongruous - that as Freud predicted, you almost have to laugh. And no doubt there are plenty of jokes to make.

    I have written about $FHCO a few times on this blog. I bought the stock the first time in the ~$4 range after the dividend was cancelled. I sold it for a loss in the ~$2.50 range when I fully understood that the product was an irrelevant joke and then management was not much better.

    I bought it back in the ~$1.35 range after the prior CEO was fired and OB Parrish resumed his leadership. The thinking then was that he'd lost so much money over the last two years, and the stock was so cheap, he would do the right thing to restore the value by simply using the copious cash flow to buy back shares and get the product on consumer shelves.

    I sold a bunch of the shares north of $2 when Bares showed they'd unloaded their stock but I own enough to remain an active observer.

    And I observe that FHCO, which manufactures and sells the female condom, and generates +95% of sales from developing world NGO's, will merge with Aspen Park Pharmaceuticals, a company run by two urologists / serial entrepreneurs with lousy records of value creation.

    APP has new formulations of existing drugs in preclinical and clinical phases for prostate cancer and hypogonadism (ie low testosterone) and a consumer product called Preboost "a disposable, pre-moistened wipe that uses a safe, highly effective topical anesthetic ... Slightly desensitizing the penis slows down a man’s sexual response without interfering with pleasure or orgasm."

    It is my belief - a product of my imagination based on many conversations with OB Parrish before and after the deal - that the entirety of the deal is OB Parrish's hope - no doubt sold to him - that the guy who got Preboost on the shelves can also get the FC2 on the shelves, and the oncology drugs are just icing on the cake, if they pan out (and in the development phase oncology world, who really knows?).

    I came to this conclusion in this order ...

    1. I wondered if OB Parrish lost his mind.
    2. I wondered how many people thought OB had lost his mind when he invested in a small company that had acquired rights for the female condom
    3. I reflected on his patience in refining and bringing his product to market
    4. And on his unusual relationship with the product, which, for reasons that are unclear to me, he sort of withholds from the consumer market.
    5. And finally it dawned on me that this guy is playing the "long game" and - while we don't know what's in his head - to him this must represent something "heroic"
    6. However, it's not something someone does with a strong hand so maybe it's also a bit of an admission of what I've learned, that his product is a bit of joke, a novelty like preboost and he sees the writing on the wall, that at the end of the day the FDA will down-classify the female condom and he'll be left with nothing.

    But who knows what will happen? The deal needs a super majority to pass and it seems possible he won't have the votes.

    Unlike with $FTLF I have a very limited pathway to learning more. The key here is understanding the value of the development drugs at APP ...

    delayed release Tamulosin
    MSS-722 for secondary hypogonadism
    APP-944 for male hot flashes

    ... and I tend to avoid med-tech / pharma for the speculativeness of their products and b/c I don't have enough sources to make informed decisions. But I do have a few folks I can talk with and as I learn anything material from the urologists and other folks I intend to speak with, I will post it here.

    With $FHCO, I don't yet have an opinion one way or the other and therefore see no reason to make a decision either way. But it is a strange situation. I have low expectations but plenty of patience.

    -- END --


    Hinkie's "Letter to Shareholders" and the Hubris of Intellect ($FHCO, $BRK)

    Summary Bullets:

    • Sam Hinkie, the 76er's GM quit, leaving behind a 13-page resignation letter that reads like a shareholder letter. 

    • As an investor, Philly sports fan and former writer, it's an irritating read for a number of reasons: 1) its the kind of thing that smart people do trying to sound smart, which I call "the hubris of intellect"; 2) it's a totally derivative style, unoriginal and in someone else's voice; and 3) to storm off in a huff b/c he was asked to share power with "a basketball mind" is the kind of ego driven emotional behavior that all the great investors seek to avoid.

    • Hinkie's strategy to lose in order to accumulate assets was quite wild. His abrupt resignation means he'll never have a chance to allocate the bulk of the assets he collected from losing. Therefore we'll never be able to judge the success of his path. 
    • Instead we'll have to judge  him only on his record; they won 47 out of a total of 242 games under his leadership, a 0.24 winning percentage. The cognitive dissonance of his "smart sounding letter" is lost on someone who doesn't follow sports. 

    Sam Hinkie, the 76er's GM resigned Wednesday with a 13-page resignation letter that reflects the convergence of my two great passions: Investing and Philly sports. The entire piece reads like a letter to shareholders, opening with a reference to Atul Gawande and an admission by the author that "Reading investor letters has long been one of my [guilty pleasures]."

    Still on the first page, he quotes Warren Buffett.

    By the second page he's quoting Seth Klarman as well as Charlie Munger's two step process for decision making:

    1. First, what are the factors that really govern the interests involved, rationally considered?
    2. Second, what are the subconscious influences where the brain at a subconscious level is automatically doing these things—which by and large are useful, but which often malfunctions?"

    A Buffett quote / reference shows up again on page 4: "Warren Buffett in the late 80s on this topic: “In any sort of a contest—financial, mental, or physical—it’s an enormous advantage to have opponents who have been taught that it's useless to even try.” Ask who wants to trade for an in-his-prime Kevin Garnett and 30 hands will go up. Ask who planned for it three or four years in advance and Danny Ainge is nearly alone."

    Followed by Howard Marks:

    "Howard Marks describes this as a necessary condition of great performance: you have to be nonconsensus and right. Both. That means you have to find some way to have a differentiated viewpoint from the masses. And it needs to be right. Anything less won’t work."

    Let me remind you, this is the resignation letter of a basketball GM. Red Auerbach is barely mentioned.

    On page six he quotes TED-talker Tim Urban ("one of tomorrow's polymaths").

    By page 7 he's writing about disruption and quotes Max Planck: “A new scientific truth does not triumph by convincing its opponents and making them see the light, but rather because its opponents eventually die.”

    He even throws in the word "zugzwang" somewhere towards the end.

    The cognitive dissonance of this letter might be lost on someone who doesn't follow sports but the record shows that over the last three seasons the 76ers have won just 47 games out of a total of 242 played. That's a 0.24 winning percentage. They are dying, not their opponents.

    So there's an inherent incongruity here that resolves itself to what I call "the nauseating hubris of intellect". Because even while Sam Hinkie quotes smart people, indicates a practice of and reverence for incredible investors, he built a team that has one of the worst three year records in the history of professional sports.

    To his credit, and as Hinkie's letter points out, the team was successful at achieving its plan of losing in order to acquire assets. When Hinkie was named GM, he inherited a bad team with few good options and the goal was to acquire future assets for long term success by losing a lot in the short term, getting high draft picks and drafting good young players with "upside."

    So the record doesn't tell the whole story and looking at it alone isn't fair to Hinkie.

    But his resignation itself tells another story. Although changes in the executive suite resulted in his having to share power with more traditional basketball minds, his leaving now, near the moment when he'd harvest the results of his three years of tanking, sounds like ego and emotion acting over wisdom. That is distinctly un-Buffett, un-Klarman and un-Marks.

    Everyone wants to compare themselves to the greats but when we look in the mirror, unless we have the record to show a comparison, we can't. The best we can do without such a record is humbly ask ourselves what we are doing to pursue and reveal truths, first about ourselves and then about the world around us. "To seek the truth and knowing it give the light" is the one thread that binds all great minds, people and art.

    I'm not sure what truth if any Hinkie has revealed in his tenure or his departure except that it's unlikely anyone will try this extreme case of tanking again.

    Outside of the "future assets" it remains unclear how well Hinkie did as a talent evaluator - drafting "good young players with upside" - since it takes at least three years to evaluate talent and none of the first round players they've drafted or acquired over the least three years have played for that long or are still on the team. (An example of Hinkie's work is with Michael Carter Williams, drafted in 2013 #11, named Rookie of the Year, and then traded for future draft picks that they will harvest this year).

    And although they have successfully acquired draft picks, what is done with the picks, how they are coached, how the practice is implemented, etc. all factors into the equation. Hinkie won't be around to conclude what he started.

    If he had any success at all, it's in setting the team up for the future. As he states in the letter, and I include his underlines for emphasis:

    "In the upcoming May draft lottery, we have what will likely be the best ever odds to get the #1 overall pick (nearly 30%), a roughly 50/50 chance at a top-2 pick (the highest ever), and a roughly 50/50 chance at two top-5 picks, which would be the best lottery night haul ever. That same bounce of a ping pong ball (almost a flip of a coin) will determine if we have three first round picks this year (unusual) or four (unprecedented). That's this year. Or this quarter, if you will.

    If you were to estimate the value of those firsts and the ones to follow, from this point forward we have essentially two NBA teams’ worth of first round pick value plus the third most second round picks in the league."

    The whole thing is funny to me almost in the way it would be funny to be a passenger on a jet plane flown by someone who says "I studied from the great pilots, except I never learned how to land."


    It's also funny to me in context of yesterday's merger announcement by $FHCO.

    It is one of the strangest, surprising-est and most bizarre capital allocation decisions I've ever seen in that it combines a one-product company owned primarily by value investors who are attracted to a balance sheet and cash flow, with Aspen Park Pharmaceuticals, a bio-tech company that owns patents / has rights to some prostate-cancer drugs, new formulations of existing drugs and also has a consumer product "Preboost" that uses a topical anesthetic wipe to alleviate premature ejaculation.

    I reckon the pairing makes sense in that it combines an unusual and irrelevant male consumer product with an unusual and irrelevant female consumer product.

    I can further imagine the CEO of FHCO being sold on the merger idea simply with the promise that as a combined company, the marketing genius behind Preboost would bring the FC2 to consumers.

    I've written about $FHCO in the past and have long thought that its CEO and Chairman OB Parrish has too much of a beloved view of his product, and in an unconsciously patronizing way. As I've learned talking to social workers and other professionals in the sex work community, the FC2 is a joke with likely no consumer market outside of novelties, but even the novelty market at a certain price has an investment thesis (eg $BRK owns Oriental Trading).

    Why a product that received FDA approval in 2009 isn't already on the shelves has been a mystery to me for years, particularly if the company fumbles its market lead if FDA re-classifies the device. Parrish told me once - with no irony - of seeing the FC2 on the shelf of a corner store in an upmarket section of San Francisco selling for $15 / pack  (nearly 5x retail price) and the grocer telling him that its used by gay men off label for anal sex.

    Yet, he didn't seem to appreciate what that meant about supply / demand and what could happen to sales if only they would get their product on the shelves in a variety of cities with large gay populations.

    Needless to say, I should have stopped trusting the CEO, himself sitting on losses, to make wise and sound capital allocation decisions with the belief that I could go along for the ride, which has now taken a very strange and unusual turn.

    I read the current move as a hail mary by someone near retirement age and sees this as his best way to turn a weak hand into a potential high return.

    When I asked him why he didn't just sell half the company and buy powerball tickets and he laughed. I presume he thinks a bio-tech has greater opportunity for success than a lottery ticket. Time will tell. If there's a lesson in both these stories it's to invest with managers who can fly the plane and also land it.

    -- END --