Global Return Asset Management commentary for the second quarter ended June 30, 2017.
Gates Capital Management's ECF Value Funds have a fantastic track record. The funds (full-name Excess Cash Flow Value Funds), which invest in an event-driven equity and credit strategy, have produced a 12.6% annualised return over the past 26 years. The funds added 7.7% overall in the second half of 2022, outperforming the 3.4% return for Read More
Year-to-date through the end of Q2 2017, we’ve generated a 7.04% net return.1 In Q2 2017 we generated a 1.32% net return and ended the quarter with over 30% of assets in Cash.
Our Q2 2017 activity includes the following:
In the letter below I breakdown a stock’s sources of return and then discuss the components of earnings growth. In the last section, I describe the methods by which I analyze prospective investments.
I would like to thank our newest partners for trusting us with their capital. Abby and I have nearly 100% of our own money invested alongside yours; hence, I’m motivated to work hard and perform well.
Please feel free to contact me if you have any questions or would like to discuss my investment strategy or risk management principles.
Our Cash Balance grew significantly during May and June because we welcomed several new partners into the fund. It would have been easy to invest their cash into our existing positions but there were several problems with doing this.
First, throughout May and June the value of our stocks increased to prices beyond where I’m a buyer. Second, the fund’s newest investors will be better served if I wait to purchase our holdings at prices that offer better risk/return ratios. And finally, Global Return’s compounded annual growth rate, which is the main metric by which I judge our success, would’ve been harmed if I invested this cash at existing stock prices. In summary, no one with a vested interest in the fund would have benefited.
Thankfully I have the greatest group of clients a fund manager could ask for and they understand why I maintained the Cash – because I’m trying to generate superior risk-adjusted returns.
Sources Of Return
My primary focus is on identifying and capturing above-average risk-adjusted returns.
For long-term fundamental investors like us, a stock has only three sources of return: its dividend, earnings growth5 and multiples expansion6.7
Another factor impacting a stock’s return is the length of time elapsed between buying and selling the stock, but this is an extrinsic factor and not a source of return.
Of these sources of return, we prefer investing in companies with earnings growth potential. There are several reasons for this:
1. Earnings growth offers the best asymmetrical risk-reward ratio
2. We can estimate the probability that the earnings growth will occur and then quantify the intrinsic value created from this growth
3. While we do derive returns from multiples expansion, we don’t make investments when the potential return is predicated on the stock’s multiples expanding. And why not? To do this is a risky proposition – the Investing Gods have never promised to restore a stock’s multiples to their previous levels or take them to new highs.
And the final reason is perhaps the most important: A company’s earnings growth is the direct result of its competitive advantages. Simultaneously, a company’s ability to survive or grow is dependent upon the durability of its competitive advantages. Therefore, because we want to invest in formidable companies with asymmetric risk/reward ratios, we seek companies with earnings growth potential.
And where does earnings growth come from?
Sources Of Earning Growth
A company’s earnings growth can come from any of these sources:
We prefer investing in companies that grow earnings from sales growth, which results from either priceincreases or market expansion.
And while we like sales growth from price increases, we favor sales growth from market expansion. This is because as a company expands its market, a portion of its profits are reinvested to further increase its sales and earnings growth. And as stated above, earnings growth is the result of a company’s competitive advantages, so each time a company reinvests its profits, it’s also fortifying and expanding its competitive advantages.
Now that you know what we’re looking for, you probably want to know how we identify it. Right?
This Is How We Do It
The human brain collects, interprets and processes tens of thousands of pieces of data all day, every day. And because we generally have the same routine every day, our brains “chunk” together our activities; think of chunking as “muscle memory”. For example, when you brush your teeth you don’t tell yourself, “Pickup your toothbrush with your left hand, then use your right hand to pickup the toothpaste,” this just happens automatically.
Our brains also chunk our work routines, but unfortunately, the consequences of chunking at work are far greater than forgetting to brush your teeth.
So what’s the solution?
Checklists And Decision Trees
At Global Return, we’ve created proprietary Checklists and Decision Trees for every aspect of our financial analysis process.
I know...every fund managers claim to use a “proprietary process” to conduct their investment analysis. Well we too make this claim. But unlike many, we have nearly 200 pages of information that details our process – I researched, developed, and wrote all 200 pages myself – it’s truly proprietary.
I’ll pause here because I’m assuming you have two questions, so I’ll answer them now. Yes, these 200 pages are available to current and prospective investors. And no, we don’t use all 200 pages for every prospective investment.
Below I describe how we use Checklists and Decision Trees to identify companies we want to invest in.
Here’s a simple question for you that will be very difficult to answer:
How much money will you earn (to the penny), after you pay your living expenses, retirement savings, medical costs and miscellaneous expenses three months from now?
That’s a tough question to answer, right?
Then how does a publicly traded company with, for example, $100 million in revenue and several thousand employees know how much it’s going to earn – to the penny – three months from now?
Companies accomplish this miraculous feat using U.S. GAAP, which is as malleable as silly putty. But just because U.S. GAAP is legal doesn’t mean it provides useful information about a company’s financials.
Armed with this kindergarden logic, we created 14 different Checklists to assess the quality of a company’s financial statements.
For example, some companies use Aggressive Revenue Recognition to boost sales. This would be like a commission salesman telling his wife he earned $50,000 dollars but not telling her he may never close the deal or receive the $50,000. Other companies use Balance Sheet Adjustments to improve cash flow. For example, imagine this same salesman takes a cash advance from his credit card and then tells his wife he’s generated cash from his commission paying job.
To be clear, Aggressive Revenue Recognition and Balance Sheet Adjustments aren’t illegal, but they do indicate the quality of a company’s financial statements. Over long periods of time, companies with high-quality financial statements perform better than companies with low-quality financial statements, and our Checklists help us ferret-out these companies.
We love Decision Trees because they’re a roadmap for making successful decisions. When used properly, a Decision Tree empowers the user to make informed decisions based on probable outcomes. Here’s an abridged version a Decision Trees we use to assess a company’s Competitive Advantages:
Competitive advantages are classified as either Consumer or Corporate. For brevity, I’ve omitted the Consumer category, as well as many other Types of competitive advantages and their subsequent nodes.
Here’s how to use the Decision Tree: On the top right is the node “Variable” followed by the nodes “High” and “Low”. Here, the fund manager is reminded to assess whether the company’s variable cost structure is high or low. He can then determine whether this poses a risk, and if so, quantify that risk by analyzing the company’s Degree of Operating Leverage or Degree of Total Leverage. Once complete, he can assign the appropriate node a risk/reward ratio, probability or expected result.
Every prospective investment is evaluated using our Decision Trees. Specifically, each node is given a risk/reward ratio, or probability, and the expected result(s). When complete, we simply follow the appropriate branches and calculate the risk/reward ratios, or probabilities, to determine whether to proceed with the investment.
There are multiple advantages to using Checklists and Decision Trees:
1. No two investments are exactly alike and because our brains chunk information, Checklists and Decision Trees ensure we follow a systematic process to evaluate prospective investments
2. They’re the most efficient and effective process for analyzing prospective investments
3. These tools help remove biases and opinions we may have
4. They help us calculate the probabilities of an investment
5. They’re a template that can be improved over time
In summation, I’ve listed the three sources of return a stock offers. I then outlined how a company can grow its earnings and described why we prefer investing in companies growing earnings from sales growth. In the last section, I provided two examples of the tools we use to identify investments.
I have no prognosis for what the market will do for the remainder of 2017. As stock prices decline, the sentiment of my letters will change to bullishness. I prefer declining prices because this is when our Cash is most productive – I can buy more stock with less money. It should not be ironic that declining prices offer reduced risk and increased returns, which, after all, is what every investor wants.
At the organizational level, I’m very happy with our progress. We continue adding clients to our already impressive roster and for that I’m very grateful. I also continue meeting with prospective employees and partners, please continue sending your friends to us.
Please feel free to contact me if you would like to discuss our investment or risk management strategies.
See the full PDF below.