Christopher Begg of East Coast Asset Management said he realized that concentrating mispricing would likely to deliver remarkable returns after reading the statement of David Einhorn of Greenlight Capital, which was published by Value Investor Insight on March 2005.
At the time, David Einhorn revealed that he spent a lot of time on situations where mispricing might exist instead of looking at traditional metrics early on in his process.
According to Begg, as a value investor. he always focused on finding things that were cheap. However, when he reflected more on cheap versus mispricing, Begg said, “In one of your earliest issues a light bulb went off for me while reading an interview with David Einhorn of Greenlight Capital [VII, March 23, 2005]. He said that he didn’t spend a lot of time early on in his process looking at traditional valuation metrics, but instead at those situations where he thought mispricings might exist. I’d always focused as a value investor on finding things that were cheap, but the more I reflected on “cheap versus mispriced,” I realized that focusing on mispricings was more likely to drive exceptional results. That’s not at all to say cheapness doesn’t matter, but it changed my mindset profoundly on both the sourcing and due diligence processes.”
Christopher Begg on Potential sources of mispricings
Christopher Begg told Value Investor Insight (published in the August 2014 edition) that East Coast Asset Management looks for best ideas or potential sources of mispricing in three categories including compounders, transformations and workouts.
He explained that compounders are normally market leaders with high barriers to entry and high returns on capital such as MasterCard Inc (NYSE:MA) and Moody’s Corporation (NYSE:MCO).
Begg said transformations are focused on positive change with the tendency to be driven by one of any combination of three catalysts—secular, systemic and separation.
He cited the consolidation of the railroad industry as one example of secular transformation, which resulted in a significantly higher growth and profitability for top players. Begg believed that the energy industry is currently going through a secular transformation as to how the world consumes, distributes, and produce energy, which is driven by the low-cost share natural gas in North America. He suggested that NOW Inc (NYSE:DNOW) and Chicago Bridge & Iron Company N.V. (NYSE:CBI) could benefit from the secular change in the energy industry.
According to Begg, a systemic transformation is present where there is an enduring change within an organization that would drive better returns incrementally. He emphasized that a systemic transformation is not a turnaround.
Begg identified Colfax Corp (NYSE:CFX) as a good example. In 2012, Colfax caught his attention because of its transformative acquisition that brought additional industrial franchises to the company, but dragged its overall returns. According to him, the company is expected to generate meaningful and long-term improvement in profitability after it implemented its business system to its new underperforming business units. He believed that the shares of Colfax will remain attractive over the next five years.
Begg said separation—the third category of transformation is the most productive, which include demutualizations and spinoffs. He cited MasterCard Inc (NYSE:MA) and Visa Inc (NYSE:V) as examples citing the reason that both companies are becoming independent after being by a consortium of banks. NOW Inc. (NYSE:DNOW) is also an example after its separation from National-Oilwell Varco, Inc. (NYSE:NOV).
Christopher Begg on workouts
On the other hand, Begg defined workouts as traditional cheap-to-par-value ideas where his firm looks for 60-cent dollars. He explained that the stock may be cheap enough to be considered a good investment over the short-term if the market is overdoing its negativity on the prospects of the company. According to him, General Motors Company (NYSE:GM) post-bankruptcy is a good example under the workouts category. He identified the retail industry as a good place to find workouts.
When asked what Begg does after he discovers a potential stock, he stated:
We devote probably 90% of our intellectual horsepower to understanding whether the competitive moat around the business is widening or narrowing. This gets back to a general principle I find important to apply to investing, which is called dialectical materialism. It’s a way of understanding reality that basically says that everything is either growing into existence or fading out of existence.
Investors often look at the world in more of a fixed state, “this is what this business does and how it will exist in the future.”
Things are rarely so static. I would argue that less than 15% of the world’s businesses will actually be better five years from now than they are today.
In the end we’re trying to identify that small percentage of businesses we actually think are getting better.
Christopher Begg on understanding a company’s competitive moat
When Value Investor Insight asked about the breakdown of its portfolio based on the three categories Begg said it was composed of approximately 55% compounders, 40% transformation and the remaining 5% are workouts.
Begg said his firm was focused on market caps of $800 million and above and gravitates in companies beyond the start-up and initial growth phases. According to him, once his firm identified a potential idea, it devotes 90% of its research on understanding whether the competitive moat around the company’s business is narrowing or widening.
“We put every idea through a quality lens, which requires a thorough assessment of the operating economics, competitive advantage, overall market opportunity, pricing power, capital intensity and management skillset. I know quality is an over-used term, but to us, it’s all about finding businesses with superior economics that can endure,” said Begg.