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.
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
Quick Portfolio Updates
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.
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.
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.
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