Investment Selection Process – Getting To Zero by Tom Macpherson, Dorfman Value Investments
“Any time you manage other people’s money, risk management should be defined as preventing the permanent impairment of capital. Nothing can be riskier to an equity investor than losing all your money. Anybody who loses sight of this is – quite frankly – both a terrible fiduciary steward and value investor” — Duncan Farquhar
In an article on Gurufocus (found here), an investment writer who uses the pen name The Science of Hitting discussed the difficulty in adding to your position after Mr. Market plays havoc on the stock’s price and valuation. Making the decision to double down is tough for several reasons. First, is there something the markets know that you don’t know? Has your research been thorough enough to fully support our thesis? Second, allocating additional capital to the investment reduces your ability and flexibility as you move from cash. You have essentially lost a potential opportunity to invest in additional holdings. As an investment manager you have to be concerned about the latter (the “Opportunity Risk”) as much as the former (“Downside Risk”). When a holding drops considerably in my portfolio, I focus on both the drop (should we invest more?) and the risk that my capital could be permanently impaired.
David Einhorn Buys Three New Stocks: These Are The Names And Theses (Q3 Letter)
David Einhorn's Greenlight Capital funds returned 5.9% in the third quarter of 2020, compared to a gain of 8.9% for the S&P 500 in the same period. This year has been particularly challenging for value investors. Growth stocks have surged as value has struggled. For Greenlight, one of Wall Street's most established value-focused investment funds, Read More
As Mr. Farquhar points out, managing other peoples’ money requires me to be both a wise financial steward and prudent investor. To achieve this, I think one of the first goals in investing is to protect to the ultimate downside – that unfortunate point when you know your investment has either suffered such losses it requires herculean efforts to get back to even or – worse – bankruptcy and the total impairment of capital.
Investment Selection Process – Getting to Zero
A key component in the investment selection process is creating models that get your investment to exactly that place – broken, impaired, bankrupt. As a means of achieving this, I like to test each model, estimate, and assumption and find a way to reach a zero valuation. Put more simply, I want to know how this investment opportunity’s capital can be permanently impaired.
I think this process is helpful in a couple of ways. First, I’ve found it more likely than not that my investments drop in price after my initial purchase. In this case we are in the dilemma discussed in the Gurufocus article. By knowing what it will take to permanently impair our investment thesis, I am far more comfortable in making the decision to purchase additional shares or not. Second, breaking an investment thesis is as important as building one. I’ve found that I’m far more receptive to data for having taken both sides. Cognitive dissonance is less, the impacts of ego and bias are reduced, and I see the company’s actions in a far different light. I think both of these reasons make me a far better investor in the long term.
After I’ve gotten comfortable with a possible investment, I will generally deconstruct the business case and pressure test them in five (5) ways: revenue, credit/debt, management, competitive moat, and regulatory. The goal in each is to find what events and/or assumptions are required to break the business in terms of strategy, operations, and financial performance.
A Macro Cardio Event – Revenue Collapses: I generally base this model on the economy having another event similar to the 2008-2009 recession. What impact would 10%, 25%, 50%, and even 75% reduction in revenue do to our valuation? What percent of the company’s customer base would need to stop buying? What events would be necessary to make that happen? I am surprised sometimes by the ease with which I can see these conditions develop. A great example of this has been natural resources. Whether in the oil industry or rare earths, we have seen some companies lose 50% of their revenue in roughly 6 months.
Cut Off the Oxygen – Credit Markets I’ve written previously about how little thought we give to the credit markets until they don’t operate efficiently. Much like cutting off oxygen, it can get your attention real quick when it’s not available. I have a tendency to test this field in two ways. First, what happens if the company’s weighted average cost of capital (WACC) is raised by 100%? Or 500%? Second, I test what happens to the company’s operations if credit was no longer available. Could the company still function? Would it still be a going concern? Don’t think this matters? During the 2007/2008 Great Recession, it was a frequently heard complaint that credit couldn’t be found on any terms.
Temporary Insanity – The Fallibility of Management: Finding management who are successful long-term allocators of capital is tough. What’s even tougher is waking up and reading your management has announced an M&A deal of a catastrophic nature. Since 80% of all deals destroy capital, it’s not far-fetched to see your investment’s team making such a move. Here I create models based on both dilution and addition of debt. What impact will a deal that dilutes by 25% have on long-term returns? If the company takes on $2B in debt what impact does this have on the financial assumptions I have previously made?
The Competitive Moat is Filled: Before investing I will look for the impact competition might have in reducing returns, margins, or market share. In particular I look to measure the impact of any pricing or “commoditization” of the company’s offerings. At what point does competition begin to affect returns on equity and capital? Force increased R&D spending? Squeeze gross and net margins? All of these will be tested – along with assumptions – to hypothetically break the investment’s competitive moat.
The Government Decides to Help: In today’s market environment, the regulatory stretch of both state and Federal government is wide and deep. In analyzing risk, another component I test to extreme is the chance that regulators get more involved in our investment’s business model. Here I test for pricing impact, compliance costs, or regulatory approvals.
I’ve written frequently about the idea that outperformance is really more about not losing than swinging for the fences. Nothing can devastate long-term returns than an investment that permanently impairs your capital. Just like a tech investor in 2000 or financials investor in 2007-2009, you will find how difficult it is to recover from catastrophic losses. I think the best way to manage risk against such events is to make them happen before you invest. By “getting to zero” before you invest a dime, I think you can both improve your investment returns and be a better financial steward of your – or your investors’ – capital.