Between Unturned Rocks and a Hard Place

The Challenge of Finding Attractive Investments in a High Risk-Low Return World

Welcome to the fourth issue of Value Situations, and the third of the regular “quick ideas” editions. In this issue, rather than highlighting a specific equity situation I discuss taking a creative approach to idea generation and how I think about finding original and actionable ideas in the current market.  

Disclaimer

Value Situations is NOT investment advice and the author is not an investment advisor.

All content on this website and in the newsletter, and all other communication and correspondence from its author, is for informational and educational purposes only and should not in any circumstances, whether express or implied, be considered to be advice of an investment, legal or any other nature.  Please carry out your own research and due diligence.

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The person that turns over the most rocks wins the game.

- Peter Lynch

You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map -- way off the map … No one will tell you about these businesses. You have to find them. 

- Warren Buffett

This is a difficult market for equity investors. Equities are hovering near all-time record highs, implying low future returns and making it extremely difficult to find attractive ideas offering above-market rates of return. Indeed it’s not just equities that are at all time highs, as almost every major asset class now appears stretched in terms of price. Howard Marks of Oaktree Capital Management sums up the current state of the market well:

We’re in an asset bubble. It’s everything. It’s not particular to high-yield bonds, or to bonds, or stocks. It’s real estate, it’s private equity, it’s everything. The way I describe it is, we’re in a low return world . . . How do you make a decent return in a low return world? The answer is: it’s hard.

Some of the pitfalls that make the current equity market such a hard place for investors include:

1. Very high stock prices generally, in anticipation of a full economic recovery post-COVID, meaning little or no margin of safety, or room for error in future corporate results

2. The mindless purchasing by index funds and ETFs of whatever stocks go up and selling of whatever docks go down, further divorcing stocks from fundamentals and preventing true price discovery

3. Record high margin debt simultaneously driving prices higher AND increasing the risk of sudden and severe market declines in the event of margin calls (see the Archegos collapse as a recent case in point)

4. Disruptive pockets of excess such as the Reddit / meme stock trading frenzy, contributing to more speculative behaviour and price distortion

5. The inflation vs. deflation question as a result of central bank “money printing” and increased public sector debt following the COVID pandemic, creating uncertainty around future economic prospects

6. Continued COVID-related uncertainty with concerns around new variants and slow vaccine roll-out adding to volatility

In my view, when the noise of the market is at its loudest (as I believe it is today) it’s best to take a step back and consider Peter Lynch and Warren Buffett’s advice above and seek out original, non-consensus ideas by turning over as many rocks as possible.

Dr. Michael Burry, of Michael Lewis’ The Big Short fame, is perhaps one of the best recent exponents of this rock-turning approach to finding new ideas. A passage from the book reproduced below illustrates how a creative, idiosyncratic approach to uncovering opportunities can work well and lead to spectacular results.

Often as not, he turned up what he called "ick" investments. In October 2001, he explained the concept in his letter to investors: "Ick investing means taking a special analytical interest in stocks that inspire a first reaction of 'ick.'"

The alarmingly named Avant! Corporation was a good example. He'd found it searching for the word "accepted" in news stories. He knew that, standing on the edge of the playing field, he needed to find unorthodox ways to tilt it to his advantage, and that usually meant finding unusual situations the world might not be fully aware of. "I wasn't searching for a news report of a scam or fraud per se," he said. "That would have been too backward-looking, and I was looking to get in front of something. I was looking for something happening in the courts that might lead to an investment thesis. An argument being accepted, a plea being accepted, a settlement being accepted by the court." A court had accepted a plea from a software company called the Avant! Corporation. Avant! had been accused of stealing from a competitor the software code that was the whole foundation of Avant!'s business. The company had $100 million in cash in the bank, was still generating $100 million a year of free cash flow--and had a market value of only $250 million! Michael Burry started digging; by the time he was done, he knew more about the Avant! Corporation than any man on earth. He was able to see that even if the executives went to jail (as they did) and the fines were paid (as they were), Avant! would be worth a lot more than the market then assumed. Most of its engineers were Chinese nationals on work visas, and thus trapped--there was no risk that anyone would quit before the lights were out. To make money on Avant!'s stock, however, he'd probably have to stomach short-term losses, as investors puked up shares in horrified response to negative publicity.

Burry bought his first shares of Avant! in June 2001 at $12 a share. Avant!'s management then appeared on the cover of an issue of Business Week under the headline "Does Crime Pay?" The stock plunged; Burry bought more. Avant!'s management went to jail. The stock fell some more. Mike Burry kept on buying it--all the way down to $2 a share. He became Avant!'s single largest shareholder; he pressed management for changes. "With [the former CEO's] criminal aura no longer a part of operating management," he wrote to the new bosses, "Avant! has a chance to demonstrate its concern for shareholders." In August, in another e-mail, he wrote, "Avant! still makes me feel I'm sleeping with the village slut. No matter how well my needs are met, I doubt I'll ever brag about it. The 'creep' factor is off the charts. I half think that if I pushed Avant! too hard I'd end up being terrorized by the Chinese mafia." Four months later, Avant! got taken over for $22 a share. "That was a classic Mike Burry trade," says one of his investors. "It goes up by ten times but first it goes down by half."

Reading over the Avant! case, I suggest the main takeaways are as follows:

• Burry didn’t find this idea by mechanically screening for stocks based on superficial criteria such as low P/E ratios, or from reading investment bank/broker research notes

• Instead he creatively searched for an event or situation that might lead to an idea - in this case a legal settlement that would unlock value. No doubt, it was only after hours of searching news and filings that he came across the Avant! situation, which he then studied in detail

• Burry made sure he understood the situation and the potential range of outcomes, i.e. he considered the downside “What if I’m wrong?” scenario in order to conclude on the investment merits vs. risks.

• The situation was supported by clear, fundamental value with downside protection; the balance sheet and FCF provided a substantial margin of safety vs. the anomalous market cap of Avant!, which indicated it was clearly neglected or misunderstood by the market

• A catalyst was present, in that the resolution of litigation would trigger a re-rating (in this instance via acquisition), assisted by Burry’s activist stance.

I’ll admit this was a particularly hairy and complex situation given the litigation, and deserving of the “ick” label. It’s likely traditional investment managers would have been precluded from holding it given the litigation risk and the price volatility during the legal proceedings. However it was precisely because of this “ick” factor that it was overlooked and proved to be a great idea.

It’s also worth highlighting that Burry came across his Avant! idea in October 2001, a time of both heightened market excess from the dot.com bubble as well as societal and economic uncertainty in the wake of the September 11th terrorist attacks. The tech and meme stock-propelled, post-COVID market environment we face currently is perhaps not too dissimilar to the one Burry faced back in 2001.

In that light, Burry’s approach to finding an idea like Avant! is instructive for equity investors today, reflecting a differentiated process of “finding unusual situations the world might not be fully aware of.” With that in mind, I find it useful to consider what the world is definitely aware of today as a starting point to rule out consensus ideas where there is little or no investment edge to be had. The FAANGM stocks - Facebook, Amazon, Apple, Netflix, Google (listed via parent company Alphabet) and Microsoft - are all great companies and were clear winners during the pandemic, but do not represent particularly interesting investments today in my view. Combined these six companies account for ~25% of the S&P 500 and are the subject of extensive (and perhaps excessive) analyst coverage:

• Facebook – 50 analysts covering the stock

• Amazon - 47 analysts

• Apple – 42 analysts

• Netflix – 41 analysts

• Google (Alphabet) – 45 analysts

• Microsoft - 38 analysts

  Source: Koyfin data

With an average of ~44 analysts covering each name (all with considerable resources at their disposal, access to management etc. ), there really is no edge or differentiated insight to be had with these. Given such scrutiny, these stocks are unlikely to be mis-priced.

In addition, the law of large numbers and diminishing returns must also surely apply to these names – the FAANGM have a combined market cap of ~$9 trillion and so are unlikely to offer 100% upside from here, or offer asymmetric return profiles the larger they get. On that basis, I feel better opportunities probably lie elsewhere.

I believe investing is a creative as much as an analytical process, and creative thinking is required to know which rocks to look under to find interesting and actionable ideas. Some areas that I believe are fruitful for uncovering such ideas include the following:

• Niche markets or products (often overlooked) with limited or no competition, entrenched positions and/or high switching costs

• Profit warnings that reflect temporary issues that are readily fixable and do not reflect a fundamental flaw in a business model

• Structural change situations, as I’ve written about previously

• Event driven situations, such as spin-offs, transformative mergers, bankruptcy exits etc. (These tend not to correlate with the direction of the wider market, making them all the more interesting)

• Companies with little or no analyst coverage, and so are overlooked or unknown

• Lowly leveraged companies that compete against highly leveraged peers

• Companies tainted by industry association, e.g. where a company’s stock price is depressed because of a negative perception in the market regarding one or more peers

The above are just illustrative of the types of situations where mis-pricing and value can be found, and which won’t appear on any stock screens. These require active searching that often amounts to nothing, but that is the time cost of finding valuable ideas.

In conclusion, the case of Burry’s Avant! idea is a useful reminder that attractive investment opportunities can be found even in a market as hard as today’s, through creative thinking, patience and a persistent turning over of many rocks.