Thursday, October 29, 2015

The Limits of the Outsider approach to investing

Often great books, even business books, do not directly translate into actionable investing concepts. "The Outsiders" by William Thorndike is one of the best business books I have read. It details the exploits of John Malone, Henry Singleton, Buffett and others, and how they built incredibly successful businesses.

Its a series of stories that elaborate on inspiring vision and execution, but there is one problem - for sure, these outsiders were wildly successful, but how can an outside individual investor recognize these companies and managers a priori to join them on their ride? Ay, there's the rub.

The exact tactics that John Malone and many others used to build their companies - massive amount of debt, continuous M&A, buybacks, and eschewing earnings - look like many of the exact things that a defensive investor seeks to avoid.

Interestingly enough one of the questions that came up when the book came out was, nautrally, so we know the historic examples of Outsider CEOs, but what current CEOs embody that approach? One of the main examples given was Michael Pearson the Outsider CEO of Valeant.

Valeant seemed to tick all the Outsider boxes - a new CEO with an unconventional approach, shaking up a staid industry, massive debt, 9x revenue growth in the last five years, a Debt/Equity ratio of 4.8,  and one acquisition after another, each one larger than the last. Most people(*) including Thorndike tabbed this as the next Outsider.

But when I tried to apply The Outsider theory in investing, as an outside, individual, non-professional investor, I found that its not so easy. Again, the very metrics I look to avoid are the hallmarks of many Outsider approaches. In fact, John Malone even mocks the lower risk approaches

“Their philosophy is low leverage, low risk and high cash payout to their shareholders,” Malone said of Vodafone. “I prefer to grow equity value.”

Who am I to argue with Malone's approach? Of course, Malone can say that with confidence, his track record speaks for itself, but what about lesser skilled CEOs of which there are many? And again, how should we recognize a Malone up front? So what works for Malone and Singleton is probably not going to work as well for an individual investor, because the difference between Malone versus Leo Apotheker and Carly Fiorina is not always obvious at the time in terms of tactics.

Now Valeant shareholders are having to wrestle with these questions. Is this a great buying opportunity, because Philidor is totally copacetic, should they back up the truck? Or is it time to run for the exits? Either way, its potentially very expensive to find out.

Sanjay Bakshi's excellent lecture on Klein vs Kahneman distills decision making down to Klein's expert insights versus Kahneman's mistake avoidance. Individual investors already have major implicit advantages - time and patience, not sure they need more, because they can harvest satisfying returns simply from time and patience assuming they can avoid mistakes.  In my view, bravery is required to capitalize on your view of what scenario Valeant is in at present. Bravery can yield great results when you are right, but patient quality offers a better margin of safety the rest of the time.

* Well, one person did not: "Valeant is like ITT and Harold Geneen come back to life, only the guy is worse this time." - Charlie Munger (March 2015)

5 comments:

  1. Great post. Yeah way too hard to tell the Enrons from the real things in the outlier space. It's also harder in the tech space to be sure of managerial quality. Mediocre people can look very good just because they rode the right rocket; so their success isn't evidence of superior decision-making ability averaged over lots of decisions but just a small number of possible lucky decisions.

    Back in 2000 when it hard a $80bn market cap or some such I used to ask people what does JDS Uniphase do? When they'd say "optical components" I'd ask "optical components that do what?" I was living in Si Valley, all of my friends are engineers and nobody has an idea. So hard to interpret the abilities someone who has success that comes from investing, working, managing something like that.

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  2. @Daniel - thank you

    @Cormac - yep, its easy to buy into a pleasant sounding story and its hard for engineers and investors to admit when they don't know something. Add a side order of envy and presto you get dotcom darling JDSU

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  3. Very good article Gunnar. Unfortunately, it is very difficult to tell who is a true outsider or a true pretender in advance. The outsider mentality is not a clear cut recipe for success - others who have followed the same mentality in other industries have had their heads handed out to them.

    The same thing goes for the "next" Berkshire Hathaway/Warren Buffett. So far, I have been unimpressed by many "future Buffetts".



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  4. @DGI - thank you. I agree, being tabbed "the next Warren Buffett" may be more like the Sports Illustrated cover curse and in a worst case could result in owning Sears

    http://fortune.com/2012/11/21/are-these-the-new-warren-buffetts/

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