The outlook for the average investor looks pretty scary. Markets appear heavily overvalued, debt is at record levels and the political backdrop is barely stable. The result will likely be volatile and low returns for the majority.
To make decent money from here, investors will have to do something very different to the market. This is where High Impact-Low Conviction (HILC) Value Investing comes in. HILC Value Investing is perfectly suited to the volatile environment we face.
Michael Zimmerman’s Prentice Capital had an excellent year
Prentice Capital's Long/ Short Equity Fund was up 26% net for the fourth quarter, bringing its full-year return to 53.6% for 2020. In his fourth-quarter letter to investors, which was reviewed by ValueWalk, Michael Zimmerman said the development of COVID-19 vaccines, continued easy money and clarity in the election drove a risk-on environment. Q4 2020 Read More
Defining The HILC Mindset
HILC investments are stocks where:
- The probability of success is uncertain or impossible to put a timeframe on.
- The potential pay-off - in terms of a conservative assessment of intrinsic value – is very large – i.e. two- to three-hundred percent minimum.
HILC Is A Behavioural Blindspot - Here's Why
Few investors beat the market, and the only way to do so to invest with an edge: that means doing something other investors cannot or will not do.
And today, the market has a behavioural blind spot for 'HILC’ value stocks.
One of the most well documented behavioural biases is Certainty Bias. Human brains struggle with uncertainty. Intuitively we just don't like it and find it very hard to live with.
So, investors look for the illusion of certainty, or something close.
Certainty bias is made worse by the fact that today’s markets are dominated by highly educated investors, typically with postgraduate level degrees and access to more information than ever. We have been conditioned by decades of education to believe that a thesis must involve pages of careful research and evidence. Without it, there can be no investment case. ‘I dunno’ is not an acceptable answer.
In reality uncertainty is a constant. The world is full of unknowns. We cannot really be sure of anything. A low conviction mindset is much closer to the truth.
A HILC mindset embraces uncertainty and accepts unknowns. It is research-light. Low conviction allows you to change your mind and to adapt freely. You can accept being wrong. What matters is that if you are right at any point, you're going to make 200% or more.
And therein lies the paradox that makes HILC investing conceptually difficult. You might not even believe the investment case or you might not have a view on it at all! What matters is that there is a meaningful possibility of a very large pay-off. Imagine a lottery ticket for sale for $100 with a 1% chance of a million dollar jackpot. This is an amazing investment. However, the central case is still that you are highly likely to lose all your money!
To take a real example, Navios Maritime Containers is a Nasdaq-listed, small-cap container shipping company. For much of 2020, it traded on around 0.15x tangible book. This was in spite of the fact it had better financials than most shippers, and strong cash flow. The auditors helped out in the interim results when they declared the ships did not need revaluing downwards as they were bought at the bottom of the last cycle. Management (who indirectly own most of the stock) then gave you another clue by announcing a massive buyback. NMCI has risen six-fold in a few months, yet still trades below book.
In a situation like Navios, the answer does not lie in trying to predict the container shipping industry (impossible even for experts) or the spread of Covid (ditto). The answer lies in recognising that:
- There is an asymmetric skew, and
- The underlying drivers are depressed and volatile; meaning at some point they are likely to be more favourable.
Opportunities like Navios Maritime pop up because most institutional investors (who represent over 80% of the market) cannot take them. As Buffett famously quipped, ‘If you don’t know who the patsy is, you’re the patsy.’ In cases like this, we know who the patsies are.
For starters, today’s markets are dominated by ageing savers and bond refugees. For them, certainty and safety is top priority. Volatility is viewed as a problem, to such an extent that institutional risk models will usually force professionals to divest volatile or illiquid stocks.
Professionals also need to explain what they own. Clients expect to hear intelligent, reasoned and complete investment cases. They don’t pay for unknown unknowns and uncertain timeframes.
PR also matters. Most institutional managers cannot afford the career risk of a stock that might go to zero. Stocks facing litigation or regulatory risks are also a no-no. Stocks listed in Russia or Hong Kong, or that produce commodities like coal are all seen as unacceptable reputational risks, regardless of the upside. These are the very places where HILC stocks tend to pitch camp.
So HILC investing is behaviourally, conceptually and institutionally difficult. The vast majority of investors cannot do HILC, regardless of the reward opportunity.
Three Rules For Building A HILC Portfolio
HILC portfolios are not for everyone. Stocks like these tend to be small and illiquid, almost always volatile and covered in fleas – i.e. things that keep investors and clients away (litigation, scandal, troubled countries or industries). They also have failure rates – some of them will go to zero.
To build an effective HILC portfolio, you need to follow at least three rules:
- Diversify like crazy and have a hard limit on how much you will commit to any one idea.
Because most of these ideas are volatile and some could fail, you need far more diversification than normal. Currently I have 98 stocks. If you like to average down or build positions over time, you also need a hard limit, to avoid committing too much to any one idea.
- Use a massive margin of safety.
Some ideas will fail, while others may take several years to work out. For this reason, I’d suggest a minimum 70% margin of safety on top of any conservative estimate of intrinsic value. That means, when you are right there’s at least a 200% gain to offset those headwinds.
- Check financial strength thoroughly.
HILC investing is effectively buying a warrant on change – the litigation will be settled, or the cycle will return, etc.
However, given the uncertainty and unknowns, it is impossible to predict when that change will happen, and there may be more bumps on the way. Thus, strong or at least reasonable financials are crucial to ensure the company can get through.
Real-Life Examples Of HILC Investing
Here are some historic examples of successful HILC investing. For full disclosure I have owned or do own all of the stocks mentioned:
US Healthcare (2010). The introduction of Obamacare created considerable uncertainty around the future of US healthcare. While there was a lot of uncertainty as to the detail, it was clear that any universal healthcare proposal would require compromise, take time to implement and involve most of these businesses. It was possible to buy cash generative healthcare franchises on P/Es of 4 or 5. Many of these (such as Humana and Amedisys) have risen nearly tenfold since then.
US For Profit Education (2013-2016). The US for-profit education sector was given a justifiably rough ride under the Obama administration, with myriad regulatory scandals. Of the four stocks I owned in the sector, one went to zero (ITT educational services), one returned 50% after being acquired by private equity (Apollo), Career education generated a 300% gain, and UTI did 400%.
Iron Ore Miners (2015). When commodity prices collapsed in 2015, the consensus was that iron ore would never recover. This was in spite of trading deep into its cost curve. Iron ore has quadrupled since then. I bought a basket of global stocks generating returns anywhere from 300% (BHP) to 4000% (NRW holdings – an Aussie mining services provider). However, one of those stocks went to zero (Sundance Resources). You did not need to know everything about the iron ore market, which has proven impossible, even for experts to predict. What mattered is that it is always volatile and was very depressed, with capex at lower levels than at any time in over a century.
These examples illustrate the eclectic nature of HILC investing. HILC investing involves analysing highly uncertain situations. What matters is that they are depressed and likely to recover at some point, with several hundred percent gains when they do. Crucially, HILC stocks are volatile and do not always work out. That is why diversification and financial strength matter.
Even after the run-up in many HILC stocks, there are still plenty kicking about.
Oil Services companies with decent balance sheets are a particularly rich hunting ground. Activity is currently more depressed than at any time and valuations are often extreme.
Thermal Coal also looks interesting. Again, things are incredibly depressed with much of the cost curve underwater. Financial stress combined with Climate-related reluctance to invest is setting up a classic supply crunch in what is a massively operational geared industry. While demand is falling in Europe and America, it continues to grow globally, driven by Asia. Australia has the lowest cost coal miners, but the US is the swing producer if global supply gets tight.
Asian construction and property companies. While the near-term outlook may look tough, there are many listed Asian construction and property development stocks with net cash balance sheets and family ownership trading at 0.2x-0.3x Book. I find some of the foundation works companies particularly attractive. When stimulus-funded construction returns, these moribund family businesses, trading at a fifth of replacement cost will boom.
All these examples face enormous uncertainty, have highly volatile drivers that are currently depressed, and extreme valuations, meaning potentially huge upside. I would not put more than 1% of my money into any one of them, but collectively, they can make a formidable portfolio.
Unleash Your Incredible HILC!
HILC investing involves building a broad portfolio of deep value stocks facing uncertainty but with potential returns of greater than 200%.
It is a perfect way to mine today’s institutional and behavioural blind-spots. HILC works because most investors cannot do it.
Building an effective HILC portfolio means diversifying widely, buying only when the margin of safety is enormous, and thoroughly checking financial strength. Be patient, accept uncertainty, and be prepared for a bumpy ride!
In today’s overvalued markets, HILC is the perfect way to exploit the volatility we face, as markets and industries cycle between panic and exuberance. With quality franchises, growth stocks and early stage concepts all trading at extreme levels, from here, HILC value investing is the only way left to generate great returns.
About the Author
Andrew Hunt is a global deep value investor and author of “Better Value Investing: A Simple Guide to Improving your Results as a Value Investor.”