Chris Mittleman – Value Investing With A Private Equity Mindset

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Manual of Ideas interview with Chris Mittleman on the subject of “Value Investing With A Private Equity Mindset.”

H/T NiteBitch

Shai Dardashti, managing director of The Manual of Ideas, recently had the pleasure of sitting down for an exclusive interview with Chris Mittleman, Chief Investment Officer of Mittleman Brothers. Based in Melville, NY and with $400 million in assets under management, the firm has returned 736%, net of fees, since 2003, handily beating the S&P 500 and Russell 2000.

(The following interview has been edited for space and clarity.)

Q&A with Chris Mittleman

The Manual of Ideas: Your investment approach was recently referred to by Barron’s as applying a private equity mindset to investing in public markets. Please elaborate.

Chris Mittleman: The kind of businesses we’re targeting are the same kind of companies that private equity firms are attracted to. These are businesses that generate free cash flow on a sustained basis; free cash flows that are, if not predictable, at least somewhat repeatable, so that if I pay 10x FCF for this business today, hopefully in five years’ time, the cash flows are going to still be at some semblance of that level in a worst-case scenario.

We’re looking at a business based on, if we were to buy the whole company, what would be the cash-on-cash return we will get in year one, two, three, four? That’s what private equity does when they scout investments, but the key distinction is that we are not seeking to take control. We’re not looking at it from a real private equity point of view, but there is this aspect of it that ’s like private equity investing. Many of the companies that we’ve invested in ended up getting bought out by private equity, so you see that they’re looking for the same qualities in a business, a key difference being that they have to pay a control premium.

As an asset class, private equity has very good long-term returns, but we’ve been able to outperform that asset class, on average, over an extended period because we’re not paying that control premium.

We’re looking for the kinds of businesses where you have a fairly strong sense that the free cash flows are going to be reproducible and will hopefully grow over time, and you’re able to pay a low price relative to those cash flows. You’re not getting control, but you’re paying a much lower price than a private equity firm. Rather than pay 10x EBITDA or 15x free cash flow, we’re trying to pay substantially less. Obviously, the valuation depends on the nature of the business, but that’s how we end up outperforming the private equity asset class.

MOI: You have the benefit of liquidity, you’re not locked in…

Chris Mittleman: Public liquidity is a benefit , but not always. We have at times invested in situations where liquidity might be limited. We’re a large shareholder of Revlon. The largest shareholder is Ron Perelman who owns 78% of the stock, whereas we own ~3%, but we’re still the second-largest shareholder. Revlon is a sizable company but the float is small because of Ron Perelman’s ownership. Although Revlon has a market capitalization of nearly $2 billion, only about 20% of the stock is in the public float. It’s liquid, but it’s not so liquid that we can sell our whole position in a week. It would likely take us up to a couple of months to fully exit the position without a liquidity event, so we do tolerate some degree of illiquidity because we have a very good, long-term oriented client base.

Our client retention ratio over the course of thirteen years or so is on the order of 98%. Our clients understand the temperament and patience required to invest in a long-term oriented strategy like ours, in which we’re looking at every investment with at least a three- to five-year time horizon.

There have been some situations where an investment I thought would work out in three to five years actually took six to ten years to ultimately work out, and that ’s fine, if you’re getting the outcome you expected in the end. But you have to sometimes be willing to endure a period of time that is uncomfortably long to reap the benefits of the investment.

MOI: And that’s how you earn the result, by having patience?

Chris Mittleman: Patience is one of the most critical attributes for a long-term investor because you can be right and the market may tell you that you’re wrong, and it may tell you so for an extended period of time. It may reach the point where your sanity begins to be questioned by clients and even your colleagues. I’ve been in situations like that. There were many times where I’ve been involved in an investment, where it looks like it might not work out, and it ultimately did work out, and worked out wonderfully. Sometimes the difference between success and failure was not just about our understanding and steadfast belief in the value of a holding, but how long we were willing to wait to achieve that result.

There’s a quote by Michelangelo, “Genius is eternal patience.” But there’s another great quote by Johann Wolfgang von Goethe, “Genius is knowing when to stop.” Is genius eternal patience or is it knowing when to stop? It’s one of those two, or maybe it ’s both. But we can’t expect eternal patience. There has to be some kind of return on our investment at a point in time that ’s reasonable. But what is that point of time? That ’s a really difficult thing to say definitively. We can’t just say that if it doesn’t work out in five years, it’s wrong. Because I’ve had many investments that worked out in year six, seven, or eight. If I had sold in year five, we would not have achieved a desirable return. You really have to be capable of making these determinations about when patience is justified and when it’s cowardly self-delusion or denial.

There’s this balancing act between being stoic and an investor who’s maybe too ashamed to admit they’re wrong or in denial about being wrong. It’s a risk. If you’re so used to being right in the end, and if you’re used to your investment thesis working out in the long term, you can always lull yourself into a sense of complacency that everything will work out and that if you seem wrong today, you just wait a little while and you’ll be proven right. It can be a problem to trick yourself into believing too much in your own capabilities, if you are overly patient without being as discerning about whether it’s justified or not.

MOI: We love to ask managers about the difference between being early and being wrong…

Chris Mittleman: It’s so difficult to know because sometimes being wrong is expressed by the stock price not going up. Maybe it’s not dropping, but the stock may stay flat for a long period of time and although the business results are coming in okay, the lack of gains can be frustrating. We went through this with our investment in Icahn Enterprises. I started buying that when I was a stock broker in the mid-1990s and the company was named American Real Estate Partners. It was $9 per share with $12 of net cash on the balance sheet and another $10 per share of income-producing real estate. I watched it for a number of years thinking that it was going to be a great investment at some point.

I thought the right moment was in 1996 when they changed the charter of the company to allow Carl Icahn to invest outside of real estate. I thought that was the moment it was going to turn into a Berkshire-type situation. I started buying the company in the summer of 1996. Six years go by, and the stock was still at $9. Why is that?

Book value grew every year. They had positive net income and cash flows. But Icahn was trying to keep the stock cheap so that he could buy more of it. He wasn’t holding conference calls, he wasn’t talking to the public as he increased his stake in the business from 50% to 80% over the course of six years. It was a very frustrating time as the stock went nowhere.

Then from 2002 to 2007, the stock rose from $9 to $130 and we ended up selling at an average in the mid-$50s. The point is that, if you were to judge the success of our investment by the first six years, it was an abject failure. But if you measure success over a ten-year period, it generated a 20+% compounded annual return.

That’s an extreme example but how did I know to wait it out? Because I could see the value. This was one of those Graham and Dodd-type situations, where it wasn’t about trying to guess what the cash flow was going to be. There was both cash and real estate value piling up. It was easy to see but it was just a question of when that would be appropriately valued and reflected in the stock price. That gave me the ability to be as patient as I needed to be.

It’s not always easy and you’re not always right. Sometimes I’ve held stocks up to the end but failed miserably. I can think of a few examples in my career where I held onto a stock for three, four, five years thinking that it’s just going to take another year, and then finally realized the business is not coming back.

It really behooves you to be critical when the reason that you’re wrong is because the business is not performing as you thought it would be. Those are the hard ones to come to terms with because you don’t know. It may be a temporary setback, or a multi-year issue. These are subjective judgments that require quite a bit of forecasting and analytical work to determine if the issue is specific to this one company or to the industry as a whole. So, you try to gauge where an industry has gone or where this company is in their competitive position and that ’s not something that you can always do with supreme accuracy.

When I’ve been wrong to be patient is when there’s been a secular headwind, where I was betting on a cheap valuation. I can recall on a few occasions investing in something where I was paying ~5x EBITDA and ~5x free cash flow, and I thought that as long as this business doesn’t contract too rapidly, then I can make a good return. But usually that was wrong.

I did that with the yellow pages company RH Donnelly in 2007-2008. It was a business that had been recession resistant. I thought, this business is so cheap that I have to at least give this a shot because the free cash flow is massive. Its EBITDA margins were 40%-50% and it had a very resilient history. But that resilience was being eviscerated by the Internet, and as that “great recession” rolled through, they didn’t have the kind of resilience they had in the past because of the alternatives available for local advertising in the U.S. That was something I just didn’t appreciate. I thought that I had a contrary view. I thought my view was more likely to be right and it was just wrong. But it took me a few years to realize how wrong it was. Disappointing numbers kept coming in and finally it dawned on me, but it was too late. By then I’d lost 90% of the investment and the stock ultimately went to $0.

Sometimes your patience is misplaced. Obviously, this is part of the learning process. It’s when to be patient, when not to. When to move quickly versus waiting around. Sometimes things go so wrong so quickly that you know that your thesis was so wrong, that there’s just no point in being patient anymore.

MOI: The private equity approach to investing—does that suggest there are certain business types that you gravitate towards?

Chris Mittleman: Private equity investors look for the same kind of durable franchises that we look for. Usually, private equity is investing with a certain amount of debt. In order to service that debt, the businesses need to have cash flows that they can count on. That’s why they’re looking for something where there is an obvious franchise value with something seemingly defensible that has strong cash flow characteristics.

We’re looking for that too, but not because we’re planning on putting leverage on. We’re not planning on changing the balance sheet. A business that can tolerate leverage usually should have some if you’re looking at an optimal capital structure. A highmargin business with steady free cash flow growth would usually do better to have a bit of leverage. The leverage also provides a bit of tax shelter. We look at the businesses that we’ve invested in over the years that had private equity-type attractions to them, and they are businesses that you see private equity firms buying and selling over time.

We owned the car rental firm Avis Budget Group. That company was in and out of private equity hands five times in less than twenty-five years. We’ve owned companies like Playtex Products, which was involved in a couple of private equity buyouts. We bought it when they came public in the 1990s. We bought it again in the 2000s. Ultimately, the company was acquired by Energizer. But it is the kind of business you can understand might be attractive for private equity. Playtex had the number two market share in tampons. They had a very good business franchise with the Banana Boat suntan lotion and also baby products.

These are market shares that were around for decades. And when you have a business like that, you can get a sense that the economics and the free cash flows are not going to drop overnight. I think we have that today in Revlon. Revlon has a fairly lackluster long-term track record in terms of their sales growth. But they have 18%-19% EBITDA margins that convert very well to free cash flow. That free cash flow is attractive to us, like it would be to a private equity firm. So, there is definitely this overlap that we often see in our companies where private equity is very interested or comes in as a buyer.

MOI: Arguably, private equity, as owners, have special tools in their toolkit. They can change the balance sheet or the strategy…

Chris Mittleman: Absolutely. That’s what they get in return for their control premium. Although not every private equity firm will take control of every investment. There’s been a trend in private equity, to take passive investments in certain situations. For example, you see these PIPE deals where a private equity firm buys a big block of convertible preferred stock with an eye towards an improvement in the business, making it worth more, but not with the intent to gain complete control.

We don’t gain control but we don’t pay for it either, so we’re paying a significant discount to intrinsic value, whereas private equity buyers are paying a much higher price that ’s often close to or at intrinsic value. When I look at private equity transactions, I always look at the purchase price valuation of the business acquired and usually what they pay is around the price at which I would be a seller. Private equity firms are generally paying close to what I consider intrinsic value.

But my sense of intrinsic value is often lower than most who might appraise the value of a business because I’m looking to be cheap and conservative in that regard.

MOI: How have experiences shaped your view on what to avoid in the future?

Chris Mittleman: When I think about the history of my mistakes (and it’s a long history), those mistakes have generally been when the investment was in a business that was ostensibly very cheap, but where you had secular headwinds, and those headwinds led to the undoing of the thesis. When I look back on the investments that I sold at a loss, they were bought at a very low valuation. But that valuation was not enough to discount fully what was to come, which was a demolition of EBITDA and free cash flow.

Another issue would be where there’s a major concentration in one product line. That would be something that I would be hesitant to do again. I had a couple of experiences where I invested in a business with revenues that were overly concentrated in one product line and that product line was ultimately usurped by something else; a better mouse trap. I would be better off avoiding those situations.

I don’t have a strong sense of what the absolute rule should be because every situation is different. Maybe some situations warrant making an exception, and maybe Apple was one of those. I thought about investing in Apple. I remember in 2002, or 2003, the stock was trading almost at net cash and I strongly considered it at that time. I thought of Sony in the 1980s and I remembered thinking about how Sony came up with this great, revolutionary product called the Walkman. And soon everyone had one. But then competitors came in with a flow of very similar devices. The profitability of that business was then severely impaired by that competition and they only had a few years of real market dominance.

I thought, what was to prevent that from happening to Apple’s iPod? And I was scared away from the consumer products company that was so focused on one or two things, and with Apple my fear proved misguided. It was one very special, revolutionary company, in which the general rule didn’t apply well. You just can’t be too dogmatic about this. You can’t be too absolute, and say, “I’ll never do this, or never do that.” You need to have an open mind for exceptional situations and I try to be open minded and not overly dogmatic about any of this.

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