Value Investing

Boyles Fund 4Q16 Letter To Partners – Things that Don’t Make Sense

Boyles Fund  letter to partners for the fourth quarter ended December 31, 2016. Note for regulatory reasons performance data and related info has been redacted from the letter. . But first check out our exclusive interview with Boyles on some of the hedge fund’s favorite small caps.

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2016 Hedge Fund Letters

Investing teams must take care to avoid the fate of all those cooks in the kitchen. If they can manage to actively nurture their process and relationship, the rewards may be considerable.

“We will continue to ignore political and economic forecasts, which are an expensive distraction for many investors and businessmen.” — Warren Buffett, 1994 Letter to Berkshire Hathaway Shareholders

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Creston, a smaller holding, was bought out by its largest shareholder in November. While we were cautious of this shareholder’s intentions, we had been comforted by the presence of unrelated large shareholders, whom we believed would counter such an offer. That comfort proved to be without merit. The 27% premium to the three-month average share price was much too low in our opinion—representing a valuation of approximately 10x free cash flow (which we believed to be below the firm’s earnings power). We voted against the offer. The total internal rate of return (IRR) since the inception of the idea in 2012 (prior to the Boyles launch) was 7.9%; without the impact of currency, the IRR was 14.4%. The modest outcome was impacted by the severe decline in the British Pound; the modest early outcome of an acquisition the company made; mediocre management which, while changed, was unable to generate organic growth; and as mentioned, the modest exit multiple.

Electronic Data Processing

We noted earlier in 2016 that the company was considering strategic alternatives. While we had expected a resolution prior to the end of the year, the process remains ongoing. We hope to hear of a resolution to that process in Q1 2017. Results released in December showed soft revenue with beneficial ongoing cost management efforts. Importantly, the company was able to finally dispose of a property that had been difficult to sell over the years. We believe this was a necessary precursor to a sale of the company.

Zicom Group

Current operating results have been poor due to the overall macro conditions in the marine, oil and gas, and construction industries. Crucially, the company has noted its intention to spin off a cluster of start-up investments that have been cultivated during the last five years. While progress on these investments has been frustratingly slow so far, there are early signs of significant commercial progress in several of the businesses. The company has targeted a spinoff during the next 12 to 18 months. Shares remain quite cheap in relation to tangible book value.

BrainJuicer Group

Shares performed quite well in 2016, contributing significantly to our performance during the year. The decline in the British Pound during the year provides a tailwind to reported performance, given that a substantial portion of the business is outside the UK. Growth, beyond currency impacts, also seems to have accelerated. Importantly, the company’s launch of an advertising agency called System1 Agency in 2016 seems to have progressed well. The company is adding meaningful talent investment in this business. Any success with System1 Agency would provide significant upside well beyond the base case that continues to drive our thesis, and supports the current portfolio allocation.

Echelon Financial Holdings

Shares performed poorly during 2016, as it became evident that the company’s expansion in Europe was indeed foolish. Our, and others, calls to moderate this expansion over the years we’ve owned the shares went unheeded. The sale of that business (announced during the summer) at a large discount to book remains subject only to local government approvals. Echelon shares continue to trade at a discount to tangible book value. Upside is dependent on the performance of new management in the company’s core business, and is acceptable, given that downside protection is quite formidable at recent share prices.

Hedge Funds Face Liquidation As Alpha Disappears

Things that Don’t Make Sense

“One of the key things to investing, and I think this is a life truism, is to be aware when you hear a voice in your head that says, and you usually squint your eyes or you’ll hear someone say the following words: ‘That doesn’t make sense.’ And that’s always a sign of something really powerful.” - Adam Robinson (in an interview on “The Tim Ferriss Show”)

To many people more confident about how the future will unfold than we are, 2016 may go down as a year that didn’t make much sense. The majority of so-called “experts” were wrong on things such as Brexit and the U.S. election, and wrong on how Mr. Market would respond to the results that occurred. For our part, we try not to rely too much on prediction, and instead focus our efforts on individual stock selection among businesses that can survive whatever the future has in store, at prices that give us some margin for error in case we are wrong. But the powerful lesson from studying the phrase “that doesn’t make sense” rests in the fact that it often means one of two things: 1) One’s current view of how a certain part of the world works is wrong, and it will make sense once that view is corrected (and in hindsight); or 2) There is something much bigger going on, which one does not yet understand.

The example that Robinson used to illustrate the second point had to do with real estate investor Sam Zell noticing where Starbucks locations were opening up, and using that data point as the spark that led Zell to see the bigger force of China’s construction boom when it was still in its early stages. While we weren’t able to locate enough information to tell that story in more detail, there is another story, still in progress, that also illustrates the point: the rise of the internet, and its effect on non-internet businesses.

During the internet bubble of the late 1990s, many investors, especially in the value crowd, found themselves looking at valuations that didn’t make sense. And they were correct about the value of many of those businesses. But the bubble went on for a long time, and for many, when it seemed like valuations were as far detached from reality as they possibly could become, they just continued becoming further detached. As investors and students of how the world works, we want to see things as they are, and learn the proper lessons from the things we study. And often that means asking ourselves a second, related question—especially when we catch ourselves thinking that something doesn’t make sense. Nobel Prize-winning psychologist Danny Kahneman often asks himself this question. As described by Michael Lewis in his latest book, The Undoing Project, “...when Danny heard an illogical argument, he asked, What might that be true of?”

And to an investor focused on value investing in the late 1990s, there were plenty of illogical arguments to be found, whether it was a focus on eyeballs (webpage views) over profits, or any other metric that left one reminded of the story about a business losing money on every sale, but making it up on volume. In the internet bubble, there was more than one answer to the Kahneman question above, which aims at getting at the underlying truth of the topic at hand. One answer was psychological. Berkshire Hathaway Vice Chairman Charlie Munger has said that on several occasions, Warren Buffett has made the point that “It’s not greed that drives the world, but envy.” And envy played a big part, as people hated seeing their neighbors getting rich, and the urge to participate grew too unbearable to ignore for a large swath of people. (Munger also makes the point that envy and jealousy made two out of the Ten Commandments. That’s probably a good sign that their power shouldn’t be underestimated.)

But the internet and the way it would change business models in the future was an incredibly powerful force that people were either right to get excited about, or right to be worried about if their profits depended on a business model that could be disrupted. During the bubble, investors and the prices they were willing to pay for that future became detached from reality. But the forces pushing change continued unabated, as Moore’s Law continued to drive down the cost of computing, thus driving the cost of internet distribution closer and closer to zero.

Bill Gates, in his 1995 book The Road Ahead, wrote, “We always overestimate the change that will occur in the next two years and underestimate the change that will occur in the next ten.” And that overestimation of the short-term and underestimation of the long-term is what happened, and continues to happen, with the internet. When married with a good product, some of the businesses that ended up gathering the most eyeballs were able to reap the rewards of network effects and the winner-take-all nature of the internet to become some of the most valuable businesses in the world today. Google, which in its early days in 1998 offered to sell itself for $1 million; and Facebook, which wasn’t even launched until 2004, have completely upended the advertising industry, and are two of the most valuable (and plenty profitable) businesses in the world today.

And there’s, which was front and center during the bubble. It was trying to upend an industry much larger than that of advertising. Ironically, an investor would have actually earned a reasonable return even buying it at its peaks during the height of the bubble from 1999 to early 2000, although the hype and price then would have been hard for a value investor to justify. But while those were still the beginning days of retail on the internet, the numerous department and mall store closings announced during the last few months are prime examples of the power that the internet can wield, and as the accompanying chart from shows, the shift in customer attention has also shifted market values during the last decade.

Boyles Fund

We bring all of this up to stress the importance of the internet and technology to almost all businesses. While the changes during the last 20 years have been massive, there is still much to come and much to think about, both from an opportunity perspective as well as a risk-management perspective. As technologist Kevin Kelly wrote in his most recent book, The Inevitable, “In terms of the internet, nothing has happened yet! The internet is still at the beginning of its beginning.” While we don’t expect to be considering the purchase of any of the major technology companies mentioned above—absent another 2008-like market decline—there are profitable businesses that will benefit from the tailwind technology will provide. Indeed, some of them are run by management teams we admire that have carved out smaller, growing niches; we’d love to own them at a fair price. We were able to make investments in two of them during the early 2016 market decline: one in decent size (BrainJuicer) and one (Tucows) in which, when it was raining gold, we unfortunately brought our thimble.

“Big opportunities come infrequently. When it’s raining gold, reach for a bucket, not a thimble.” - Warren Buffett, 2009 Letter to Shareholders

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Cooks in the KitchenWe are often asked about the impact of operating an investment program with multiple decision makers. Even Mr. Buffett and Mr. Munger have questioned the efficacy of investment committees in the management of portfolios. We’d hesitate to put co-managers in the same category as a committee, but it is an important topic.

We are the first to admit that there are frictions in addition to the benefits of the model we have at Boyles. Boyles operates with two managers, each equally responsible for finding ideas, conducting diligence, and making decisions. We do not apportion pieces of the portfolio to either manager. Each is expected to be fully conversant about ideas under examination or in the portfolio. We’ve been operating in this manner for 10 years now. That longevity tends to help.

The biggest difficulty when it comes to such a model is that not every person similarly interprets a given set of facts or places the same weight on particular facts when analyzing an investment. This is perhaps no different from any other situation in life, and it remains true even when co-managers share an investment philosophy. It is true at Boyles. While it is rare that facts themselves are in dispute, this friction can either be a source of destructive and counterproductive strain; or what Linda Hill, a professor at Harvard University, has described positively as “creative abrasion.” After studying Pixar’s success with team-based creative development, which has led to a number of blockbuster animated movie productions, she identified three cores to the success: creative abrasion, creative agility, and creative resolution. In a 2015 TED presentation, she stated:

“Creative abrasion is about being able to create a marketplace of ideas through debate and discourse. In innovative organizations, they amplify differences, they don’t minimize them. Creative abrasion is not about brainstorming, where people suspend their judgement. No, they know how to have very heated but constructive arguments to create a portfolio of alternatives. Individuals in innovative organizations learn how to inquire, they learn how to actively listen, but guess what? They also learn how to advocate for their point of view. They understand that innovation rarely happens unless you have both diversity and conflict.

“Creative agility is about being able to test and refine that portfolio of ideas through quick pursuit, reflection, and adjustment. It’s about discovery-driven learning where you act, as opposed to plan, your way to the future. It’s about design thinking where you have that interesting combination of the scientific method and the artistic process. It’s about running a series of experiments, and not a series of pilots. Experiments are usually about learning. When you get a negative outcome, you’re still really learning something that you need to know. Pilots are often
about being right. When they don’t work, someone or something is to blame.

“The final capability is creative resolution. This is about doing decision making in a way that you can actually combine even opposing ideas to reconfigure them in new combinations to produce a solution that is new and useful. When you look at innovative organizations, they never go along to get along. They don’t compromise. They don’t let one group or one individual dominate, even if it’s the boss, even if it’s the expert. Instead, they have developed a rather patient and more inclusive decision making process that allows for ‘both/and’ solutions to arise and not simply ‘either/or’ solutions.”

We believe that Professor Hill’s thoughts on creative abrasion, agility (if you substitute ideas and investments for experiments and pilots), and resolution are particularly useful when thinking about how we operate a co-manager model. When each of the three are calibrated correctly, the team-based model can beat the single-manager model. However, for each of Hill’s concepts to work in the investment business, we believe there are a few necessary ingredients, including:

  •  Cohesion of investment style
  • Open conversation about evolution of investment philosophy
  • Willingness to accept critique on ideas and diligence process
  • Trust that the other party is living up to their responsibilities
  • Open communication about interpretation of facts
  • Sufficient time operating under these conditions
  • Genuine acceptance that outcomes are joint outcomes

It is a constant process, and the relationship requires work, but in the end we believe it can lead to superior outcomes.


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