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How High School and Mean Reversion Can Teach Us About Investing in the Stock Market

High school is a pivotal time of growth, learning, and self-discovery. It’s a place where we develop critical skills, forge lifelong friendships, and prepare for our futures. Beyond its immediate educational purposes, high school also offers valuable lessons applicable to the stock market, particularly the concept of mean reversion.

Understanding Mean Reversion

Mean reversion is a financial theory suggesting that asset prices and historical returns eventually revert to their long-term average or mean. This concept is crucial for market-beating success. Just as in high school, where academically excelling students may eventually regress to the average, stock prices exhibit similar behavior over time.

Mean reversion suggests that asset prices and returns tend to move back towards their long-term average or mean over time. This concept implies that periods of above-average performance are often followed by a decline, while periods of below-average performance may precede a recovery. In financial markets, mean reversion affects the valuation of stocks, bonds, and other assets, influencing investment strategies and risk assessments. For example, consider a stock that experiences a sharp increase in price due to a series of strong earnings reports and market enthusiasm. If the company’s growth slows down or market sentiment shifts, the stock price might decline, reverting to its historical average. This reversion process reflects the natural tendency of markets to correct overvaluation or undervaluation, aligning prices more closely with their intrinsic value over the long term.

Mean reversion plays an important role in the success of stock picking, as it can significantly influence the valuation of investments over time. If you invest in an undervalued company that eventually achieves average or above-average results, mean reversion can aid your success by leading to a revaluation of the stock at a higher price, thus providing substantial returns. Conversely, if you invest in a highly above-average company whose performance subsequently declines towards mediocrity, mean reversion can work against you. In this scenario, the shares may be revalued at a much lower price, resulting in potential losses. Therefore, understanding and anticipating mean reversion is essential for making informed investment decisions and optimizing portfolio performance.

Honors Students vs. Struggling Students: A Market Analogy

Imagine comparing an honors student to a struggling student. The honors student represents a richly valued company with a strong track record of success, while the struggling student symbolizes a distressed company facing challenges. If you had to invest in a portion of their future success, you would likely find a better bargain in the struggling student. Despite the honors student’s history of high achievement, they are more prone to revert to the average as they progress through life, mirroring the trajectory of a richly valued company that might not sustain its exceptional performance indefinitely.

Consider two students: one is an honors student who goes to a prestigious college, and the other is a struggling student who excels in hands-on work. While the honors student appears to have the potential for higher earnings, this isn’t always the case. As their lives progress, the honors student enrolls in an expensive college. Despite receiving some scholarships, they incur significant debt to obtain their degree. After graduation, they secure a regular office job, dealing with corporate management and still paying off their debt.

On the other hand, the struggling student, upon graduation, enters a trade school to become a plumber or electrician. After completing their apprenticeship and working for a few years with experts, they manage to save money and start their own trade business. Their initial higher income from the in-demand trade, coupled with low debt due to the absence of student loans and a modest lifestyle, positions them favorably. This student becomes a business owner with a highly useful skill in an environment where there is a shortage of skilled tradespeople.

Meanwhile, the honors student is stuck in a corporate office job. They can’t afford to quit due to their debt obligations, and they face an oversaturated job market filled with graduates possessing similar degrees and skill sets. This scenario illustrates how initial appearances can be deceiving and how different paths can lead to varied outcomes. The struggling student’s practical skills and financial prudence lead to a prosperous business, while the honors student grapples with debt and limited career advancement in a crowded job market.

This scenario is analogous to the dynamics between richly valued companies and distressed companies in the stock market. Distressed companies are often viewed as unsuccessful, allowing investors to purchase their shares at a bargain price. In contrast, richly valued companies are seen as successful and are bought at a premium price. If a distressed company implements necessary changes and starts generating attractive returns on its capital, the phenomenon of multiple expansion—wherein the market assigns a higher price-to-earnings ratio to the company due to improved prospects—can significantly boost the returns for investors who bought shares at the distressed price. On the other hand, richly valued companies might face increased competition, which can erode their attractive returns. Additionally, changes in the industry sector may drive their performance back to the average, leading to reduced returns for investors who purchased shares at a premium. This highlights the potential benefits of investing in undervalued companies poised for recovery versus the risks associated with investing in already successful companies that may struggle to maintain their high valuations.

Investment Strategy Insights

When considering investments, the honors student and struggling student analogy reveals key strategic insights:

Richly Valued Companies (Honors Students):

   – These companies have a stellar track record and command high valuations.

   – They are often seen as safer bets due to their proven success.

   – However, they are more likely to experience mean reversion, where their exceptional performance may not be sustainable in the long run.

   – Investing in these companies at their peak might lead to lower returns as they revert to average market performance.

 Distressed Companies (Struggling Students):

   – These companies are undervalued and face significant challenges.

   – Investing in them appears riskier, but they have greater potential for substantial gains if they turn around.

   – If these companies manage to improve and revert to the mean, the initial low investment price can yield significant returns.

   – This strategy capitalizes on the potential for mean reversion, where distressed companies can outperform expectations.

Recognizing Outliers and Risks

In every scenario, outliers exist. Outstanding individuals, such as exceptionally gifted students or highly successful companies, tend to stand out and command high valuations. These entities are often marked by lofty growth expectations and a proven track record. Conversely, struggling students or distressed companies might exhibit clear signs of failure, similar to companies burdened by overleverage and poor management decisions that erode shareholder value.

Although, just like the scenario with the struggling student, distressed companies have the potential to be guided in the right direction. Activist investing in a distressed company can be compared to getting a tutor for a struggling student. By providing the time, attention, and focused assistance they need, both the student and the company can improve in areas where they are deficient. This targeted support can help move the student (or company) toward success. Activist investors play a crucial role in market efficiency by identifying distressed companies and actively working to improve their operations, management, and strategic direction. This intervention is similar to how a tutor can sit down with a struggling student and give extra attention to the curriculum they are failing to understand. In both scenarios, having someone provide extra attention and guidance in areas of improvement can significantly increase the chances of future success.

On the other hand, some companies and struggling students may be too far gone to save. For a company, this could mean operating in an industry on the verge of being smothered by regulatory restrictions, having an uncooperative board and management, or possessing a failing business model that would be better off liquidated rather than continuing as a going concern. Similarly, struggling students may face insurmountable challenges such as drug addiction, learning disabilities, or mental health issues. These serious issues can severely hinder the operations of a company or the success of a student.

In both cases, it is crucial to recognize and understand these risks. While students, being real people, cannot simply be “left alone” and may require greater support and intervention, investors must be vigilant in identifying distressed companies that are beyond saving. The signs and risks associated with such companies, including structural issues and management unwillingness to change, can indicate that the company is not a viable investment. Understanding these risks is essential for making informed decisions, as investing in a company that is too far gone can lead to significant losses. In both scenarios, recognizing when a company or a student is beyond saving is crucial for allocating resources effectively and mitigating potential risks. Outside of this scenario, however, there is no child too far gone that is not worth saving.

Now, with that being said, there is always potential for outliers. In this scenario, it would be a richly valued company that continues to execute above-average operating performance for extended periods of time. This could be due to a superior business model, “genius” management at the helm, or simply benefiting from industry tailwinds. These factors can sustain periods of outperformance for a long time, which can have tremendous impacts on an investor who bought shares even at premium valuations. These “Golden Geese” can be compared to high-quality students who go on to have wonderful careers. It often seems that their teachers, parents, and even fellow students all know they were destined for greatness—whether they are academically superior or an athlete rising above the rest. These companies and students can produce some of the best returns and outcomes. However, these are the outliers and not the norm, so it is important to approach them with caution.

Navigating the Investment Landscape

When navigating the investment landscape, it is crucial to exercise caution with seemingly flawless, richly valued companies. Any cracks in their performance can lead to significant reevaluations and potential losses. Conversely, recognizing the potential for mean reversion in distressed situations can present unique opportunities for savvy investors. By carefully assessing the fundamentals and growth prospects of struggling companies, investors can identify potential turnaround stories that offer substantial returns.

As a whole, most students will become average individuals. While academically successful kids have a higher chance of achieving more successful careers, this often involves significant investments in the student, such as tuition for private schools and other educational expenses. This parallels the investment world, where many high-returning companies are often priced out of good returns due to their premium valuations. If these companies revert to average performance, the investor could face significant losses. Conversely, investing in a below-average company at a bargain price can lead to substantial gains if the company shows any positive performance improvements. Both students and companies have numerous variables that produce a wide range of outcomes, making the comparison apt. The key with mean reversion is to understand where you are likely to get the best percentage increase. Often, this can come from a distressed company that improves to an average level, similar to how a struggling student can achieve significant gains with the right support and direction.

Conclusion

High school teaches us that success is not always linear, and mean reversion is a powerful force that should not be ignored. Just as a struggling student can surprise everyone and become successful, a distressed company can turn its fortunes around and provide great returns for investors. By understanding and applying the principles of mean reversion, investors can make informed decisions that balance risk and reward, leading to more effective investment strategies and potentially greater market-beating success.

In summary, the lessons learned in high school about growth, resilience, and the potential for change are directly applicable to the stock market. By recognizing the potential for mean reversion and making strategic investments in undervalued opportunities, investors can achieve substantial gains while navigating the complexities of the financial world.

The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance.
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Why Go the Overlooked Route? Exploring the Potential of Small and Obscure Stocks

In stock market investing, the glittering allure of blue-chip stocks often overshadows the less conspicuous segments of the market. However, there lies a potentially rewarding strategy in venturing into the realm of overlooked and small-cap stocks. This article delves into the compelling advantages of investing in these hidden gems and sheds light on why some of the world’s most acclaimed superinvestors commenced their journeys in these uncharted territories.

By investing in the largest companies available in the market, investors often unknowingly limit the potential returns they can generate. This limitation isn’t necessarily their fault per se, given the substantial industry that revolves around the buying and selling of large-cap stocks. Analysts are constantly updating their forecasts for these kinds of stocks; when you turn on the business channel, these are the stocks they discuss, and most likely, these are also the stocks that investors’ peers talk about when discussing stock market investing. While blue-chip stocks do have their place in a well-thought-out portfolio—for stability, dividend growth, or wealth preservation purposes—they serve a specific function. 

However, a truly enterprising investor looking to generate above-average returns knows that seeking exceptional returns from these blue-chip large caps is a fool’s game. Often, the tailwinds that have benefited the firm in reaching large-cap status have already been utilized. This implies that the best days for the firm are usually behind them, and even if a solid return can be obtained by holding these stocks for the very long term, the opportunity cost becomes significant when comparing these kinds of investments to more obscure investments. This is why, although blue-chip stocks do have their place in a portfolio, they are not the most attractive area of the market for generating above-average returns.

The fluctuating landscape of the world’s largest companies from 1989 to 2021 exemplifies the impermanence of corporate preeminence and underscores an important principle for wealth accumulation: the largest companies are not always the best investment for growth.

In 1989, the largest companies by market capitalization were predominantly from the banking and energy sectors. Names like the Industrial Bank of Japan, Sumitomo Bank, and Exxon Mobil represented the pinnacle of economic strength and investment security. These industries were the mainstays of a high-performing portfolio, deemed safe havens for investors across the globe.

Transition to 2021, and the scenario has dramatically transformed. Apple Inc. surged from a position far removed from the top echelons to a market capitalization surpassing $2 trillion, indicative of a broader shift towards technology and innovation. Microsoft and Amazon, once nascent entities or modest contributors to the overall market, emerged as behemoths with valuations in the trillions.

This transformation elucidates a vital point: yesterday’s market leaders are not guaranteed to retain their dominance. The rapid growth of technology and the advent of the digital economy have propelled new entrants to the forefront, often at the expense of established players. Companies adept at leveraging technological advancements, engaging with shifting consumer trends, and expanding into new markets have outpaced their traditional counterparts.

This historical juxtaposition highlights the limitations of a strategy overly reliant on the largest companies. It reminds us that sectors which once seemed unassailable can be overtaken by innovative disruptors. For the investor whose goal is wealth accumulation, this historical perspective advocates for a more nuanced approach than the conventional wisdom of investing only in the biggest firms.

The Allure of Larger Returns

Small and obscure stocks frequently offer the tantalizing prospect of larger returns. The principal reason behind this is their lack of visibility in the market, which can lead to significant undervaluation. For the astute investor, these stocks represent an opportunity to buy in at prices that do not yet reflect their potential future worth. As these companies grow and gain recognition, their stock prices can increase substantially, potentially yielding robust returns on investment.

When it comes to growth and capturing market share, the math gives an undeniable advantage to the smaller market participants. For a stock with a market capitalization of 500 million dollars, doubling its market value to 1 billion still leaves the company within small-cap territory, offering substantial room for growth. In contrast, a company valued at 500 billion dollars must accrue an additional 500 billion dollars to reach a one trillion-dollar valuation and a doubled market cap. The challenge is amplified by the simple fact that the company might not have an addressable market large enough to capture that additional 500 billion dollars in value.

This phenomenon can be thought of as a form of economic gravity. The larger a company becomes, the more challenging it is for that company to double or triple in value. The fact that a company with a 20 million dollar market capitalization only needs to secure an additional 20 million dollars of market value to double is a far more attainable feat than for large caps to attempt the same percentage increase. This is particularly pertinent for investors seeking growth investments, as the smaller arena often presents more favorable conditions for rapid expansion.

The allure of higher returns from more obscure stocks isn’t solely attributed to the company’s ability to grow its market share. Some companies operate in niche markets, which allows them to secure a dominant foothold over the specific clientele they cater to. This advantage becomes evident in their ability to raise prices in line with, or even above, inflation, fend off competition through a strong hold on their market, and the capacity to distribute to shareholders an above-average return due to lower reinvestment demands for generating revenue.

Indeed, the distinctive appeal of higher returns from stocks of companies in niche markets stems from several strategic advantages that go beyond mere expansion of market share. For instance, consider the cement and limestone industry—a sector where companies often exemplify the behavior of leveraging local competitive advantages. These companies have a product that is fundamental to the construction and manufacturing industries, thereby catering to a persistent and reliable demand.

After the initial capital-intensive phase of establishing quarries, these businesses can benefit from economies of scale and reduced reinvestment needs. The geographically bounded nature of their operations creates natural barriers to entry, often resulting in localized monopolies or oligopolies. Such positioning allows these companies to operate with substantial pricing power. As their production costs rise, perhaps due to inflationary pressures or increased regulation, they can typically pass these costs onto consumers, aligning price increases with or even exceeding inflation rates.

Whether an investor is seeking a growth opportunity with the potential to capture market share and increase market value over time, or searching for a unique opportunity where the investment is safeguarded by pricing power, exploring opportunities in the smaller, more obscure areas of the market opens the door to a wide range of possible investments. These opportunities have the ability to generate returns that are often far more attractive than those offered by the largest companies in the market.

The Institutional Oversight

Large institutional investors—such as mutual funds, pension funds, and large asset managers—often eschew smaller stocks. The primary reasons include liquidity constraints and regulatory compliance, which limit their ability to invest heavily in smaller companies without influencing the stock price excessively. This institutional oversight provides individual investors with a unique advantage: the ability to operate under the radar and capitalize on opportunities before they become widely recognized.

Investing is a highly competitive venture, often populated by highly experienced individuals armed with ample resources, all of whom are fervently scouring the market for attractive opportunities. For smaller investors, it becomes increasingly challenging to compete with these large-scale players in the arenas where they excel. One strategy to sidestep this intense competition is to look for areas inaccessible to the largest players. By focusing on obscure market segments too small for large-scale investors to make meaningful investments, a smaller investor can drastically reduce the competition vying for shares.

In these less-traveled parts of the market, buyers and sellers are typically individuals—company insiders, individual investors, or boutique hedge funds—rather than the dominant large asset managers. By concentrating on smaller market areas, an investor not only lessens their competition but also boosts their competitive position. An informed investor can often hold a considerable edge by understanding a company that is not as widely known as some of the bigger names. This could mean a lack of analyst coverage, which allows the investor to develop their own perspective on the company’s narrative instead of being swayed by external influences.

The ascension of passive investing strategies, led by behemoths like BlackRock and Vanguard, has fundamentally altered the investing landscape. The tidal wave of capital that flows into index funds and exchange-traded funds (ETFs) often results in these large institutions owning substantial stakes in a myriad of companies. This form of investment, while efficient and cost-effective for individual investors, carries broader implications for corporate governance and market dynamics.

Passive investment ownership can skew and redirect the decision-making processes within companies through the consolidation of proxy votes. These institutions wield significant influence over corporate policies and board elections due to their sizeable shareholdings, often voting in unison based on predetermined policies or the recommendations of proxy advisory firms. While this can promote some beneficial practices, it can also result in a homogenization of corporate governance, potentially stifling unique strategies and innovation that might arise from a more diverse shareholder base.

To circumvent the pitfalls associated with large passive shareholders, investors may consider turning their attention to smaller companies that are not constituents of major index funds. These companies are less likely to be influenced by the voting power of passive giants, allowing for a more varied and potentially responsive ownership structure. This environment can empower individual shareholders and enable company leadership to pursue strategies tailored to long-term growth and innovation, free from the pressures of passive investors who are often more focused on short-term metrics and benchmark alignment. Moreover, the investment in such companies can provide a haven from market movements that are artificially influenced by the substantial capital shifts within index funds, offering opportunities based more squarely on fundamental performance and less on the prevailing currents of passive investment trends.

Enhanced Relevance of Fundamental Analysis

In the arena of overlooked stocks, fundamental analysis becomes not just useful, but crucial. In the absence of constant media coverage and ubiquitous analyst reports, these stocks offer a fertile ground for investors willing to perform deep, fundamental research. Evaluating financial statements, assessing management quality, and understanding the company’s market position are all paramount. For the discerning investor, this intensive scrutiny can uncover stocks whose intrinsic values are far greater than their current market prices, thereby offering significant investment opportunities.

The reality is that pricing for large-cap stocks is far more efficient. Their financials have been meticulously combed through by numerous analysts, which increases the likelihood that any fundamental advantage is already reflected in the share price. It is far more likely for a small company to harbor hidden value than a large company. This is not to say that large companies cannot experience strong fundamental performance, but rather that this robust performance is typically already factored into the shares, which likely trade at premium valuations.

In the case of smaller companies, especially those that are not as well-promoted, there is a greater chance of uncovering hidden value. This may be due to assets that have not been revalued to reflect their current fair market value, or cash flows that are not fully captured in reported earnings. By meticulously analyzing the financials of companies that are obscure, investors can discover and capitalize on hidden gems, which can lead to particularly attractive returns.

Pathways Pioneered by Superinvestors

Historically, many of the market’s superinvestors—such as Warren Buffett and Peter Lynch—began their illustrious careers by focusing on small, obscure stocks. They hunted for undervalued stocks in overlooked corners of the market, exploiting inefficiencies created by the lack of analyst coverage and general investor interest. Their success stories have illuminated a path for modern investors, suggesting that diligent research and a focus on less popular stocks can lead to exceptional long-term gains.

Warren Buffett has candidly acknowledged that due to Berkshire Hathaway’s massive size, replicating the astronomical success from his early years at the helm is nearly impossible. The principle behind this admission is straightforward: the larger the asset base, the harder it is to achieve high percentage gains. It’s a matter of scalability—Berkshire Hathaway, with its current heft, cannot maneuver with the same agility it once did when it was a smaller entity.

Furthermore, Buffett has posited that if he were managing smaller sums today, he would be confident in his ability to generate approximately 50% compounded annual returns. Although this bold assertion remains untested in today’s market conditions, it underscores his belief in the advantages smaller sums afford in terms of investment flexibility and potential returns.

Buffett’s speculation is rooted in his own historical performance during his partnership years, a time when he famously focused on overlooked sectors of the market to realize substantial gains. By applying a rigorous investment approach to lesser-known and undervalued companies, he was able to uncover opportunities that were not apparent to or accessible for larger investors.

This serves as an inspiration for the small-scale investor today. By emulating Buffett’s early strategies—seeking out the obscure and the overlooked, conducting thorough analysis, and exercising patience—there is potential to significantly outperform the market. While the scale of individual investor operations is far removed from the juggernaut that is Berkshire Hathaway, this difference in scale may, in fact, be a strategic advantage, allowing for more nimble and potentially lucrative investment choices.

Conclusion

Choosing to invest in small and overlooked stocks is not merely a contrarian approach but a strategic one, characterized by the potential for substantial rewards. While these investments do involve higher risks and require more intensive analysis, the payoff can be disproportionately large compared to more mainstream investments. As we navigate through evolving economic landscapes, the ability to identify and capitalize on these opportunities remains a valuable skill for any investor seeking to maximize their investment portfolio’s growth.

This exploration into the overlooked corners of the stock market not only encourages a more meticulous investment strategy but also aligns with the pioneering practices of some of the most successful investors in history. Embracing this path can lead to discovering potent investment opportunities that others may have ignored, paving the way for significant financial gains and enhanced investment acumen.

The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance. 

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Idea Generation: The Art of Discovering Potential Investment Opportunities

Investment idea generation is a critical skill for active investors. Without the ability to create investment theses independently, one might be better off opting for passive investments or relying on a professional manager. True idea generation parallels the investigative nature of journalism and forensic accounting, diverging from typical Wall Street stereotypes.

When searching for potential investments, it’s crucial to use your time efficiently. An investor must be able to quickly dismiss ideas that have inherent flaws and dedicate more time to those with profit potential. One way to quickly identify an idea to pass on is by assessing the potential for catastrophic risk. Catastrophic risk for companies refers to the potential for sudden, severe events that significantly disrupt business operations and can lead to substantial financial losses or even bankruptcy. Such risks are typically characterized by their low probability but high impact, and include scenarios like accruing unsustainable levels of debt, facing crippling regulatory measures, or experiencing critical failures in key technological systems. These events can threaten a company’s survival by undermining its financial stability, damaging its reputation, or severely hindering its operational capabilities. In essence, catastrophic risks for companies encompass any major disruptions that can precipitate drastic negative consequences, potentially leading to a complete halt in operations or the dissolution of the business itself.

Once an investor has identified some ideas with low catastrophic risk, their next task is to analyze the nature of each opportunity. By grouping opportunities into different categories based on similar characteristics, investors can better understand how an investment thesis might unfold, whether through short or long holding periods, and whether it involves low or high risk. This analysis also helps in assessing the opportunity cost and aids in determining appropriate position sizing within a portfolio. By becoming familiar with different types of investment categories and understanding how their characteristics compare to others, investors can develop a sort of muscle memory. This familiarity enables them to quickly envisage potential scenarios and how situations might unfold when searching for new investment ideas.

Strategies for Uncovering Investment Opportunities

Raw Data Analysis

Start with a broad dataset, such as an A-to-Z list of stocks from an exchange. This approach helps in identifying overlooked opportunities which might not be evident through standard screening tools that other investors are also likely to use.

Combing through a list of stocks in an A-to-Z style allows investors to generate ideas based on their own interpretation of financial statements and business performance. This method ensures that they don’t overlook opportunities that other, less thorough investors might miss. However, the A-to-Z approach is undeniably time-consuming. Thus, a crucial skill for investors is the ability to quickly assess a company’s performance and valuation from a bird’s eye view. By discerning which companies warrant a closer look and which should be passed over, investors can efficiently sift through opportunities, pausing for deeper analysis only on ideas that spark potential interest.

Often, a company may pique an investor’s interest, but it might take a while before an opportune time to buy presents itself. This underscores the importance of actively building a database of companies of interest. For example, an investor might discover an intriguing company through raw data analysis, add it to their watchlist, and stay informed by reading quarterly reports and other company publications. Years later, an event may occur that turns the company into an absolute bargain.

Idea generation for investing is a long-term commitment, and it could be years between identifying a potential idea and the buy thesis finally playing out, leading to an addition to the portfolio. This is why patience and discipline are crucial to successful idea generation.

Investment Categories

Corporate Events

Events like spin-offs, mergers, acquisitions, bankruptcies, and liquidations can create potential for value. Keeping an eye on such corporate changes can unveil opportunities that others might miss.

Corporate events can often shake up the business world, leading to opportunities that were not previously available. For instance, a corporation may spin off a seemingly unrelated business segment. If this segment has been grouped with other operations of the corporation for a while, the public might not be aware of the actual value associated with its operations. It could be misvalued based on misinterpretations of operations, incorrect assumptions about business performance, or it could be trading at a discounted price due to holders of the parent company selling shares of the newly spun-off company. By closely examining spin-offs, an investor can potentially find opportunities that were not available before the spin-off.

Joel Greenblatt, a renowned value investor, capitalized on a significant opportunity during the 1993 Marriott spin-off, which is often cited as a classic example of successful special situation investing. Marriott Corporation announced its plan to split into two separate entities: Marriott International, which would handle hotel management and franchises, and Host Marriott, which would own the hotel properties. The restructuring plan involved allocating substantial debt to Host Marriott, while Marriott International would operate with less financial burden. This led many investors to believe that Host Marriott would struggle under the heavy debt load, causing its shares to be initially undervalued.

Greenblatt recognized the undervaluation and saw a potential mispricing opportunity due to market overreaction to Host Marriott’s debt situation. He invested based on his analysis of the assets and operations of both entities post-spin-off. As the market began to reevaluate and better understand the real value of Host Marriott and its capability to manage its debt, its stock price corrected upwards. Marriott International also benefited from a lighter debt load and its profitable management business, adding to Greenblatt’s overall profitability from the investment.

This investment demonstrated Greenblatt’s ability to see past initial market reactions and understand the intrinsic value of both entities, allowing him to profit from the temporary mispricing created by the spin-off. His strategy exemplifies the importance of deep value investing and strategic analysis of corporate actions, highlighting how adverse situations can be leveraged to uncover lucrative investment opportunities.

Similarly, an investor can profit from mergers and acquisitions. When a merger or acquisition is announced, there is sometimes a premium on the acquisition price compared to the current trading value of the security. The likelihood of the merger or acquisition actually taking place contributes to the price spread between the purchase price and the currently traded price of the security. If the spread seems wide enough for-profit potential, an investor can engage in what is usually called merger arbitrage.

Merger arbitrage is an investment strategy where an investor aims to profit from the price discrepancies that occur before and after a merger or acquisition is announced. Typically, when a company announces it will acquire another company, the target company’s stock price usually rises to reflect the offer price, but often remains below the offer price until the deal is finalized. This price difference, or spread, presents an opportunity for investors.

In merger arbitrage, investors buy shares of the target company at the current market price and may short sell the acquiring company’s shares, betting that the target company’s share price will eventually rise to match the offer price if the merger is successful. The profit comes from the spread between the acquired company’s market price at the time of the trade and the final acquisition price. This strategy carries risks, particularly if the deal falls through or faces regulatory hurdles, which can cause significant losses.

Bankruptcies and liquidations are corporate events from which investors can potentially benefit. By analyzing companies during distressed periods, enterprising investors can find potential bargains on assets or operations that are substantially undervalued. It is crucial to understand the legal nuances in these scenarios and to tread lightly to avoid getting burned. Additionally, knowing the differences between Chapter 7 and Chapter 11 bankruptcy is essential for making informed investment decisions.

Chapter 7 bankruptcy, often referred to as liquidation bankruptcy, involves the dissolution of a debtor’s non-exempt assets by a trustee. The proceeds from the sale of these assets are used to pay creditors. This form of bankruptcy is typically utilized by individuals and businesses that find themselves unable to repay their debts and seek a fresh start by clearing their obligations through asset liquidation.

Chapter 11 bankruptcy, known as reorganization bankruptcy, allows a company or individual to restructure their debts under the supervision of a court. In this process, the debtor maintains control of business operations as a “debtor in possession” and proposes a reorganization plan to keep the business alive and pay creditors over time. This form is often used by businesses looking to restructure their operations and debt in order to return to profitability.

Not all liquidations are a consequence of bankruptcy. In some instances, a company may be well-capitalized but have lackluster operations, leading to a return of capital to shareholders. This triggers a series of payments to shareholders, reduces the asset base of the company, and potentially increases return on equity metrics. However, sometimes this can be an act of winding down operations, signaling the end of the corporation. Liquidations of asset-rich companies are not as common as they once were, but they still occur in niche situations in the market. It is also possible that future economic environments could lead more asset-rich companies to liquidate and pay out shareholders. This is why understanding how to evaluate liquidations is an important skill for investors.

Ben Graham, the father of value investing, adeptly profited from liquidations during his partnership days. He had a keen eye for undervalued companies, especially those that were asset-rich and underpriced relative to their realizable market values. During his career, particularly in the early years of his partnership, Graham focused on companies that were either in liquidation or had the potential to liquidate, a strategy that often provided a safety margin by valuing the business’s assets rather than its earnings. He would purchase stocks at prices well below their conservative estimates of liquidation value, betting that even in the event of a company winding down operations, the proceeds from the asset sales would exceed the market capitalization of the business. This approach was grounded in his fundamental principle of seeking a margin of safety, ensuring that investments had a lower risk of loss. Graham’s strategies during these times not only led to significant profits for his investment partnership but also laid the groundwork for modern investment theory concerning distressed and value investing.

Long-Term Quality Investments

Investing in high-quality companies at reasonable prices and holding them for the long term remains a sound, tax-efficient strategy to generate attractive returns.

Investing in high-quality businesses that exhibit competitive advantages is a way to achieve attractive long-term returns. This approach often differs from event-driven investment strategies, where medium-term performance and entry price valuation are the most important factors. When investing in high-quality businesses, the long-term returns generated through business operations become the defining factor in investment success. This requires a deep understanding of the business model and a good idea of how a company might be positioned a decade down the line. Both qualitative and quantitative analyses are crucial in these scenarios.

Management quality and corporate governance are important in protecting the quality of the business. Any signs of deterioration must be taken into account, as they could affect the inherent makeup of the business. Recognizing the value of a brand and other forms of intangible assets is as important as analyzing the value of tangible assets held on the balance sheet. Often, high-quality businesses recognized by the market as such trade at premium valuations.

It then becomes the investor’s job to decide if paying up for the business is worth it or if patiently waiting for opportunities of weakness to purchase shares at a relatively cheaper price is a better option. When investing in high-quality businesses, patience becomes the defining factor, both in the process of discovering a high-quality business, waiting for an opportune purchase price, and holding for the long term to patiently accumulate profits from the business.

Investing in high-quality businesses is a lot like planting the seeds of a tree; it may take many years between the initial planting of the seed and the tree reaching maturity, but the end product can often lead to jaw-dropping results, similar to a small seed growing into a large oak tree.

Warren Buffett’s investment in Coca-Cola is a quintessential example of his long-term investment strategy focused on high-quality businesses. In 1988, Buffett began buying shares of Coca-Cola, paying what many considered a premium price at the time. Despite the seemingly high entry cost, Buffett recognized Coca-Cola’s enduring brand value and its dominant position in the global beverage market, which aligned perfectly with his investment philosophy of understanding a business deeply and believing in its long-term success.

Buffett’s Berkshire Hathaway has held onto its Coca-Cola shares for over three decades, illustrating a profound commitment to long-term investing. Over this period, the dividends from Coca-Cola have grown significantly. In fact, the annual dividends Berkshire now receives from Coca-Cola are several times the original cost of the investment, demonstrating the power of patient capital and the compounding benefits of owning shares in a high-quality company.

This investment underscores several key elements of Buffett’s strategy: identifying companies with strong brand recognition and consumer loyalty, paying a reasonable price for excellent businesses (even if it seems high at the initial purchase), and holding onto those investments for a very long time.

Turnarounds

Investing in turnaround companies—those currently underperforming but with potential for recovery—can be lucrative. These investments often require quick action and a clear understanding of the company’s intrinsic value, offering a hedge against market volatility.

Turnaround situations are challenging and are not for the faint of heart, as they often require decisive action in the face of uncertainty. Unlike bankruptcies and liquidations, companies in turnaround situations are distressed yet still hold potential for recovery, revitalizing operations and returning to profitability. Sometimes, turnarounds naturally resolve themselves, especially in cyclical industries where a series of unfortunate events might cause a decline in performance. In such cases, patience is crucial as cyclicality works both ways; economic environments may shift, leading to an industry revitalization that returns the company to a profitable model and alleviates investor fears for the time being.

Cyclical industries present a tricky but potentially profitable investment avenue, but investors must be cautious. At the peak of the cycle, an investor might mistake a cyclical company for a high-quality company due to strong growth and high returns. This could tempt an investor to pay a premium for the shares, assuming that this strong performance will continue indefinitely. However, investing in cyclical industries at peak times is risky; when the management is optimistic, public sentiment is positive, and performance is strong, it’s typically the worst time to invest. As the cycle turns, performance may slow, investor sentiment can sour, and layoffs may begin, causing shares that were once valued like those of a high-quality business to plummet, trading more as bargains than top performers. This shift can devastate investors who purchased at the peak, leading to significant losses or long periods holding lackluster stocks until the cycle turns favorable again.

The best strategy for investing in cyclical companies is to pay the most attention to them when they seem least attractive performance-wise. By learning about the industry and specific company history, as well as reviewing past financials and performance, an investor might be able to identify consistent indicators of cyclical bottoms and tops. This knowledge can help them make informed decisions about the most attractive times to purchase shares.

Another form of turnaround investing involves scenarios more challenging than cyclical turnarounds, particularly in cases of company mismanagement or disastrous events that affect the outlook of the company. When management acts in ways that are more harmful than helpful, it can significantly affect both performance and public sentiment about the company. Additionally, due to human hubris, it might not be evident that current management is intent on revitalizing operations. Corporate executives might be hindered by incentive structures that do not promote the necessary actions for a successful turnaround. Sometimes, the actions required, such as winding down unprofitable operations, reducing excess capital, or firing incompetent employees, are unattractive. Management, especially those lacking significant personal investment in the company, may not have the desire to roll up their sleeves and address these issues. This reluctance can be exacerbated if executives are already receiving attractive compensation, further reducing their incentive to implement challenging changes.

On top of mismanagement, disasters can occur that put companies in dire straits. For instance, company-wide fraud might be discovered, damaging the business’s reputation; whistleblowers may come forward about unethical practices; or tragic accidents could raise uncertainties about future operations. In turnaround situations that extend beyond cyclical issues, external forces such as regulatory reforms or activist investors often need to intervene to facilitate necessary changes. These situations require a careful approach to investing, as they involve navigating complex issues that could either lead to significant recoveries or further decline.

Activist investors are shareholders who purchase substantial stakes in a company to influence its management and strategic direction. They actively engage with the company, often developing and advocating for plans that aim to improve business performance and shareholder value. This may include proposing changes in management practices, cost structures, or strategic initiatives. Activist investors frequently seek representation on the company’s board of directors to exert more direct influence. This involvement can lead to proxy battles, which are contests between the current board and management and the activist investor to win the support of other shareholders for their respective visions for the company. While proxy battles can be costly and contentious, they can also lead to significant returns if the activist’s strategies are implemented successfully and lead to improved company performance.

Carl Icahn’s proxy battle with Phillips Petroleum in the mid-1980s is a notable example of the intensity of proxy battles and activist investing. In 1984, Icahn began buying shares of Phillips Petroleum, which had recently become a target for a hostile takeover. Icahn, disagreeing with how the company’s management was handling the situation, saw an opportunity to influence the company’s decisions to unlock shareholder value.

Icahn proposed his own plan, which involved a more aggressive corporate restructuring than what management had proposed. He launched a proxy battle seeking shareholder support to replace the board and implement his strategy. This confrontation highlighted the deep conflicts that can arise between a company’s existing management and activist investors, who may have very different visions for a company’s future.

The battle was intense and costly, involving public campaigns to sway shareholders, negotiations, and legal maneuvers. Ultimately, the standoff ended when Phillips Petroleum agreed to a series of concessions that included buying back a significant amount of stock at a premium. This buyback effectively placated Icahn and other investors while allowing the company to remain independent.

This proxy battle with Phillips Petroleum underscores the high stakes and significant impact of activist investing, demonstrating how determined investors like Icahn can challenge and influence corporate giants through intense and well-strategized campaigns.

Fast Growers

Companies that are significantly expanding their market share, even in slow-growing industries, can provide substantial returns. While these investments require understanding the qualitative factors that drive the company, they also need caution due to the potential for rapid changes in valuation.

Fast-growing companies can experience exceptional returns in a relatively short time frame. If an investor is able to identify a company poised for rapid expansion, they can substantially benefit if the business performance materializes. By staying informed about market trends and industry changes, an investor can pick up on characteristics of businesses where demand is likely to increase. This often involves understanding not just the operational metrics of a business but also the story behind the business and what could contribute to sustained growth. Fast-growing companies typically increase sales at a high rate, but these sales may not immediately reflect in profits since companies often reinvest in the business through hiring skilled professionals and conducting research and development.

Although this reinvestment is beneficial when funds are wisely allocated, it can become problematic if over time the increased sales do not translate into increased profits. It is important to balance growth and profitability, because growth purely for the sake of growth can have detrimental consequences on the long-term health of the company. Caution is crucial when examining fast-growing companies because it is easy to become captivated by the allure of the business and fall in love with the story that is portrayed. Often, there is no quantitative margin of safety whatsoever in fast-growing companies, and any slight misstep in performance can lead to a drastic revaluation of its once high-flying stock price. This is why qualitative analysis and a firm grip on operational metrics are vital for a sober evaluation of the company.

Investing in fast-growing companies is a risky strategy, but it can be a source of substantial profits if the investment is made before a period of substantial growth, allowing the investor to benefit from the operational tailwinds.

Peter Lynch, one of the most successful and well-known fund managers, made a famously lucrative investment in Dunkin’ Donuts, which serves as a classic example of his investment philosophy. Lynch, who managed the Fidelity Magellan Fund from 1977 to 1990, was renowned for his strategy of investing in understandable and relatively simple businesses with strong growth prospects.

Lynch’s investment in Dunkin’ Donuts exemplifies his approach of “investing in what you know.” He discovered Dunkin’ Donuts not through exhaustive financial analysis from afar, but through a personal experience. As the story goes, Lynch liked the coffee at a Dunkin’ Donuts shop, recognizing the company’s appeal through its simple but effective business model of selling doughnuts and coffee, which had a consistent and repeatable demand.

Recognizing the potential for expansion, Lynch saw Dunkin’ Donuts as a company that could scale up significantly, especially since it had a formula that could be replicated across multiple locations. At the time of his investment, Dunkin’ Donuts was primarily an East Coast chain, but it had clear potential to grow nationally.

Lynch invested early in Dunkin’ Donuts, and as the company expanded, he and the Magellan Fund benefitted enormously from the tailwinds of the business’s growth. This investment is a quintessential example of how Lynch applied his principle of finding “growth at a reasonable price” (GARP). His knack for identifying everyday products that could scale up profitably allowed him to capitalize on the growth of Dunkin’ Donuts long before the market fully appreciated its national and even international potential.

This investment exemplifies the effective strategy of identifying and investing in fast-growing companies. It highlights how understanding consumer behavior and recognizing straightforward, scalable business models are crucial for spotting companies with significant growth potential. By investing early in such enterprises, investors can leverage these insights to achieve substantial returns as the business expands.

The Importance of Obscurity

Finding undervalued opportunities often means searching where others aren’t looking. Embracing a contrarian approach helps in discovering stocks that are not only undervalued but also overlooked, providing a competitive edge.

In all the areas for potential ideas mentioned in this article, a contrarian mindset remains at the forefront of successful idea generation. To consistently generate new investment ideas, one must have independence of thought, a strong determination to succeed, and the ability to remain confident in their own investment analysis even in the face of peer criticism. Successful investing, by definition, is not something everyone can participate in. Producing above-average returns requires commitment and often involves doing the opposite of what the crowd is doing. A famous Warren Buffett quote, “Be fearful when others are greedy and greedy when others are fearful,” encapsulates what it means to be a successful investor. One must drown out the noise of the public and look inward to decide what decisions should be made and when.

This does not mean that a contrarian cannot generate ideas by listening to others, but they must be able to recognize inconsistencies in public perception and take advantage when misalignments reveal themselves. No one truly knows if an investment will be successful until after the fact, so being able to comfortably go against the crowd becomes a defining factor for the successful value investor. Often, the reward for contrarian behavior can come long after the contrarian decision has been made. It becomes the investor’s job to keep their head down, eyes on their work, and to drown out the noise of the public.

Commitment to the Process

Generating and implementing investment ideas requires a commitment to deep research, frequent interaction with industry insiders, and an unyielding focus. This can be demanding and may lead to burnout, but dedication is essential for success in investment idea generation.

Finding an investment strategy that aligns with an investor’s specific personality is important for the longevity of their career. It often takes a unique individual willing to deal with turnaround situations, potentially engaging in proxy battles with the board, and making their opinions on the situation and how to fix it known to both management and other shareholders. This form of investment may stimulate some personalities while draining others. Similarly, it takes a unique individual to invest in a fast-growing company, someone who has identified a unique story and potential for growth and is willing to put their trust in management and purchase shares at a premium price. This might make some investors comfortable in their qualitative analysis, while others might be uneasy due to the lack of a quantitative margin of safety.

The same can be said for investors able to identify long-term trends in high-quality businesses, make an investment decision, and then patiently wait for the seeds they have sown to grow. This holding period can extend for a long time, during which a patient investor is comfortable with the lack of action needed, merely checking up on the quarterly reports and periodically reassessing the situation. In contrast, a more high-energy individual might find this form of investing painstaking, like sitting on their hands and watching paint dry.

This is why it is so important for investors to understand themselves—what risks they are comfortable taking and which do not align with their personalities. By finding strategies that align with their own personalities, they can prevent burnout and continue doing what they enjoy. Some investors can engage in more than one kind of investment idea; they can compartmentalize certain investment categories and understand the risks associated with each strategy. They can then position their portfolios accordingly and watch various scenarios play out. By being dedicated and having a desire to continuously learn, investors can make idea generation a lifelong endeavor.

In conclusion, investment idea generation is not just about finding opportunities; it’s about finding the right opportunities that align with one’s investment philosophy and psychological profile. It requires a blend of analytical rigor, creative thinking, and steadfast dedication to uncover and capitalize on unique investment prospects.

The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance. 

Ryan Jacobs No Comments

How to Deal with Volatility… Or Lack of It

Volatility is a force within the market that can either hinder or assist in the success of an investment. Volatility refers to the fluctuation of a stock price. The more stock prices fluctuate, the more volatility is associated with the security. In modern finance, risk is heavily associated with volatility, and it is assumed that a more volatile security is riskier.

However, value investing teaches us that volatility itself is not inherent risk within a security. Value investors focus on the underlying value of a security, considering what the company is worth. If a company’s stock price drops but the underlying fundamentals remain the same, then the security has actually become a better deal, increasing its intrinsic value per share.

Value investors should not be daunted by market volatility. It’s crucial to understand that markets aren’t always efficient, and they frequently move due to reasons unrelated to the actual business developments of individual companies. Markets can sway due to various causes, ranging from macroeconomic factors like changes in GDP numbers to fluctuations in interest rates. When such volatility impacts an investor’s portfolio, it’s imperative to conduct a bottom-up analysis of the owned securities. Doing so anchors them in their original investment rationale, preventing them from getting swept up in the macroeconomic upheavals of the moment.

An investor’s role can be likened to that of a gardener. While gardeners cannot control the weather, they meticulously care for the seeds they’ve sown, hoping the conditions will favor a bountiful harvest. Similarly, investors might not have direct influence over broad economic forces, but they can strategize in anticipation. Just as a gardener might choose seeds based on predicted weather patterns, investors can base their decisions on economic forecasts, enhancing the likelihood of fruitful returns.

Value investors can take advantage of volatility by utilizing temporal diversification. This strategy involves spreading stock purchases out over periods of time to prevent overexposure to stock fluctuations and being caught in a downtrend after a purchase. Temporal diversification allows investors to average up or down into a security, giving them time to learn more about the business and take advantage of fluctuating stock prices.

Individual investors have a distinct advantage in practicing discipline through temporal diversification. Unlike professional investment managers who often feel pressured to generate ideas swiftly to outperform due to their fee structures, individual investors don’t face the same urgency. This freedom allows them to deploy their cash more patiently, rather than feeling compelled to be fully invested at all times. This patient approach offers protection from immediate significant price drops that can occur after an initial purchase. Additionally, by spreading their purchases across different time periods, investors can guard against systemic risks. For instance, during market downturns that might decrease the price of a security when the broader market is overvalued, this strategy provides a cushion. In essence, temporal diversification and averaging into securities can serve as a strategic approach for individual investors, helping them navigate the challenges posed by increased market volatility.

On the other hand, investors also face the challenge of dealing with a lack of volatility. This occurs when investments seem to languish, with no significant price drops that would turn the security into a greater bargain, and no upward volatility to outperform relative benchmarks. The lack of reassurance that an investment thesis will come to fruition can lead to a frustrating holding period.

Lack of volatility in stock prices, or even stagnant business performance, can significantly impact an investor’s psychological well-being. It’s a common jest that value investors often arrive early to the party. This means they recognize a valuable asset, but it might take a considerable amount of time before its true value is realized in the market.

Moreover, a company might be performing exceptionally well operationally, but this may not be reflected in its share price immediately. This lack of immediate price reflection can be disheartening. Additionally, the absence of volatility translates to a lack of stimulation, which can be challenging for novice investors. Business conditions often need time to evolve to a point where a long-term investment thesis becomes evident. Herein lies the importance of patience as a hallmark of a successful investor. In many cases, holding onto a security for extended periods, without frequent trading, can yield the best returns.

To combat the monotony of a non-volatile market, investors should seek intellectual stimulation elsewhere. This can be achieved by exploring new investment ideas or monitoring potential ones. It’s not uncommon for a company to be recognized as a promising investment, only for a significant duration to elapse before it’s opportune to buy its shares. To navigate this, maintaining a database of potential companies, routinely reviewing possible investments, and scouting for fresh opportunities are all effective strategies. These methods address the challenges posed by a lack of volatility without necessitating frequent trading.

It’s imperative for investors to perceive stock purchases as business acquisitions. Reducing the frequency of stock price checks, viewing stocks as tangible businesses, and emphasizing the generation of new ideas over daily market fluctuations are all pivotal strategies. These tactics can help mitigate the anxiety stemming from stock performance. Investors must recognize that most stock theses require time to manifest, often spanning 3 to 5 years. Hence, cultivating patience and adopting a long-term perspective are essential in managing the challenges of volatility, or its absence.

How investors handle periods of underperformance, not just in a specific stock but across their entire portfolio, can significantly influence their long-term success. Understanding one’s emotional and rational responses during stressful times is crucial. This sentiment is even more pronounced for investment managers who must communicate with clients frustrated by underperformance relative to benchmarks or other managers.

Position sizing plays a pivotal role in managing volatility and overall performance. Investors who become overly stressed by portfolio losses, especially substantial ones that most long-term investors encounter occasionally, should consider adjusting their strategy. If they find themselves deeply affected by these downturns, it might be prudent to adopt a less conviction-driven approach. This involves limiting the percentage allocation of each position within the portfolio, thereby reducing the potential risk associated with each security. However, this approach has implications. Holding more securities, each with a smaller portfolio percentage, means that more successful investment ideas are needed to make a significant impact. This increases the number of investments to be selected and monitored, leading to more positions to track and, logically, reducing the chances of outperforming.

Professional investors, especially those concerned with relative performance, often have teams of analysts at their disposal. To achieve a less volatile portfolio, they might opt for high diversification. When executed diligently, this strategy can yield attractive risk-adjusted returns. However, this is just one method to navigate volatility.

By truly understanding and embracing price volatility, and recognizing the advantages of a long-term perspective, savvy investors can adopt a more conviction-based portfolio approach. This involves placing greater emphasis on their highest-quality ideas and maintaining a long-term mindset of at least 3-5 years. Such an approach offers a significant competitive edge against investors who are constantly seeking numerous new ideas while remaining wary of volatility.

Accepting periods of underperformance as temporary fluctuations and effectively communicating the long-term investment strategy, either to oneself or to clients, can have a profound impact on portfolio returns. It’s essential to recognize that periods of underperformance are a potential outcome of a concentrated portfolio. While it’s not guaranteed that every portfolio will experience these downturns, many investment partnerships have demonstrated the ability to outperform the market consistently. However, it’s equally important to acknowledge that the potential to outperform also comes with the risk of underperformance.

Occasional years of underperformance are not inherently detrimental to the success of individual investors or investment managers. What truly defines their success is how they navigate and respond to these challenging periods. The manner in which they handle underperformance ultimately determines their effectiveness as stewards of capital.

Handling periods of outperformance can be just as psychologically challenging for investors as underperformance, but for different reasons. Investing often involves delayed gratification, where you are rewarded for past decisions. When an investor experiences a series of successful investments, positive reinforcement begins to take effect.

Overconfidence in one’s decision-making can lead to sloppy risk management, while muscle memory might cause investors to cling to methods that are becoming outdated. Investing is about exploiting an opportunity until it’s no longer available. Successful investors often pivot their strategy right when it seems to be working the best. This is because investing is a forward-thinking exercise. Logically, any good hunting ground can become a lousy one after it gains the attention of other hunters. Having a first-mover advantage is crucial for investors, but it’s challenging to adopt if one’s current strategies are working well.

Another adverse effect of outperformance is hubris and arrogance. This can be bothersome when affecting individual investors but can be downright dangerous when seen in investment managers. Periods of outperformance often come with substantial incentives for investment managers, as well as recognition and praise from clients and enthusiasts. It’s common for an outperforming investment manager to be elevated to a guru status. Their macroeconomic insights are highly regarded, their investment positions are emulated, and significant contributions start pouring into their operations. Feelings of euphoria can take over, especially with peers reinforcing their successes. During such times, investors are eager to discuss relative performance, share portfolio statistics, and offer insights to budding investors seeking advice.

An investor, and especially an investment manager, must ground themselves in humility if they want the best chance to outperform over the long term. It’s fulfilling to be recognized for hard work and even more rewarding if it brings value to clients. One vital practice is to invert the feelings associated with outperformance to those of underperformance. For instance, would one be comfortable sharing returns after consecutive years of underperformance? Would one discuss portfolio positions if they are at a loss, or confidently discuss a strategy if it’s currently out of favor? Such introspection can help investors maintain focus and avoid the distractions and self-destructive tendencies that accompany outperformance. Just as flows of praise and contributions can accompany outperformance, criticism and redemptions can follow closely behind. Understanding how to navigate these periods is essential for successful investment management.

Volatility is a defining characteristic of financial markets. In modern finance, it’s often equated with risk, potentially clouding the judgment of professionals when assessing the viability of investment strategies. A genuine value investor, however, welcomes price volatility while maintaining an unwavering commitment to thorough fundamental analysis.

Such an approach enhances the probability of investment success. It acknowledges that volatility does not inherently represent risk; rather, it introduces less predictability in outcomes. Investors with a long-term horizon can leverage this volatility, using it to their advantage to capitalize on price fluctuations. On the flip side, it’s crucial to recognize that periods of low volatility bring their unique challenges.

Understanding that volatility is an intrinsic part of investing in public markets is essential. Being overly fearful of it or excessively exhilarated by its prospects can lead to undesirable outcomes. Regulating emotions becomes pivotal for the success of any investment venture. Establishing internal checks and balances can help maintain an investor’s psychological equilibrium, ensuring that decisions are made rationally and not purely on emotional impulses.

If the idea of volatility or a temporary capital loss is intolerable, then delving into the capital markets might not be the best choice for certain individuals. Every investor has unique traits and circumstances, affecting their efficacy in executing an investment strategy. Some of the most accomplished investors have weathered the stresses of underperformance, only to rebound with consistent outperformance as their investment hypotheses materialize. Equally vital is the ability of these successful investors not to become arrogant during prosperous times. They recognize the highly competitive nature of investing and remain aware that periods of underperformance might lurk around the corner.

In conclusion, it’s imperative for investors to prioritize understanding and positioning themselves aptly in the face of volatility…or lack of it.

The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance. 

Ryan Jacobs No Comments

Understanding the Importance of Beta in a Risk Parity and Value-Oriented Portfolio

When it comes to building an investment portfolio, there are several factors that investors need to consider. One of these factors is beta, which plays a crucial role in both a risk parity and value-oriented portfolio. In this article, we will delve into the concept of beta and its significance in investment strategies.

Beta is a measure of a stock’s correlation to the overall market in terms of volatility. It helps investors assess the level of risk associated with a particular stock or portfolio. A beta of 1 indicates that the stock moves in line with the market, while a beta greater than 1 suggests that the stock is more volatile than the market. On the other hand, a beta less than 1 indicates that the stock is less volatile than the market.

Volatility and correlation are two important factors assessed through beta. Volatility directly relates to the price fluctuations of assets, while correlation refers to the degree to which assets move in tandem. Understanding the relationship between a security and its market can reveal much about the shareholders of the organization. Similarly, analyzing the relationship between a portfolio of securities and their market provides insights into the potential risks and rewards of the investment. Beta, a financial metric often overlooked or misunderstood, plays a crucial role in security analysis by illuminating these relationships.

For a risk parity portfolio, the objective is to maximize returns while minimizing risk. In such a portfolio, the return can be calculated as the product of cash, beta, and alpha. Beta represents the systematic risk of the portfolio, while alpha represents the excess return generated by the portfolio manager’s skill or strategy.

Investing in a group of various betas underpins the ethos of a diversified strategy. Acquiring these betas is relatively easy in modern finance, thanks to low-cost index funds and ETFs designed to match specific markets or mimic certain asset classes. By organizing a group of asset classes with different betas and structuring them within a portfolio based on risk parity principles, it’s possible to create a low-risk base portfolio. It’s important to note that this base portfolio is not intended to be the most attractive investment in terms of potential returns. In fact, it is typically a rather unattractive investment if judged solely on possible returns. This strategy of grouping different betas and structuring them in a basket is meant to be a practical form of opportunity cost management, serving as a middle ground between holding cash and pursuing alpha.

A risk-free rate is essentially an “effortless” return, available to all investors. In modern investing, treasury bills are often associated with a risk-free return due to their wide availability and the backing they receive from the full faith and credit of the U.S. government, which has a very low probability of default. Understanding the balance between interest rates, historical asset returns, and betas is crucial when analyzing opportunity costs. Yields and their certainties are essential for properly analyzing investment opportunities.

If treasury bills or other short-term cash alternatives offer attractive rates and the general stock market appears expensive, it might be logical to hold cash until the market declines. This offers more opportunities to implement thoughtful active strategies. The stock market, viewed as a long-duration asset, should outperform short-duration assets like cash over the long term. For patient active investors, this poses no problem. They can simply wait in cash until general market levels are more favorable, creating a greater volume of active investment opportunities.

This balance between the safest risk-free return and the most attractive actively selected returns is key to producing outsized gains over the long term. It requires patience and diligence but is achievable. This is the essence of generating alpha, or an excess return in relation to a relative benchmark. However, it is important to understand that true investors seek alpha on an absolute basis, not just relative to a benchmark. Benchmarks or groups of assets inherently have faults, including the lack of individual selection, which can lead to irregularities in performance due to unforeseen economic events, speculative bubbles, and benchmark structuring.

Although there are downsides to assets grouped together to mimic a certain benchmark or follow the price action of a specific asset type, they can still fit into a thoughtful investment program. In an risk parity portfolio – more a theoretical construct than an actual one, but useful for capturing the essence of an investor’s opportunity pool based on their specific time horizon and risk tolerance – there are options. These include investing in cash (like depository accounts, CDs, treasury bills, money markets), beta (a diversified portfolio), or alpha (individually selected investments or hiring an investment manager). Cash is the most conservative option but not viable long-term. Alpha is the most attractive but time-consuming when self-implemented and expensive with a money manager. Beta is easy to obtain and cost-effective to manage but has limitations.

Constructing a diversified portfolio is often seen as a passive form of investment due to its approach of mirroring assets, as opposed to actively managed investments that focus on individualized outcomes. However, this perspective can lead to confusion and potentially fatal errors among aspiring successful investors. Price sensitivity and conservative valuation techniques are crucial in constructing a diversified portfolio. In fact, there are significant choices that must be made either by the individual investor or the portfolio manager, which determine the portfolio’s configuration. Learning which assets to group properly and how to structure them within a portfolio to create equilibrium and provide decent returns in various economic scenarios is no simple task.

Creating this type of portfolio requires knowledge of historical returns within various asset classes and benchmarks, understanding the betas of each individual asset group to determine volatility and correlation, measuring the standard deviation to assess the variability of returns, and knowing the current asset prices, which for non-earning assets like commodities are based on supply and demand dynamics, and for income-generating investments like fixed income or stock indexes, are based on yield metrics.

It’s important to note that this strategy never advocates investing in any index regardless of its price. Such an approach is highly dangerous and can lead to prolonged periods of underperformance if executed incorrectly. Understanding how to price assets based on supply and demand, and yield, can help structure a diversified portfolio appropriately. By learning about the historical performance of various asset classes in relation to their current prices, one can discern which assets should be included in the portfolio. The structure of the portfolio is not static and should be adjusted based on the price levels of the given securities. In times when assets are overvalued on a historical basis they can either be reduced in size or eliminated from the portfolio completely until prices become reasonable again. This is especially true for equities which tend to fluctuate between overvalued and undervalued. There is no justification for a long-term capital preservation portfolio to include overvalued assets. Moreover, equities in an index differ significantly from those in bond indices or commodity baskets. Each stock certificate represents a distinct issuer, making group purchases more challenging. By steering clear of overvalued assets, the portfolio can better safeguard against fluctuations and prolonged periods of underperformance.

One way to enhance the returns of a diversified portfolio is through the use of leverage. By leveraging the safest assets within a portfolio, you can hypothetically match the risk associated with riskier assets, thereby enhancing potential returns while maintaining the overall balance of the portfolio. However, utilizing leverage is risky, even with supposedly safe assets. Excessive leverage on even a very stable asset can lead to significant issues if volatility deviates from the norm. While it may seem possible to use leverage consistently to boost returns, the risk of adverse effects increases as the leverage increases, thus diminishing the original intent of this type of portfolio.

A diversified portfolio of this nature is meant to be an attractive medium-term opportunity cost for an investor balancing between cash and actively chosen investments. Alternatively, this portfolio can serve as a form of terminal return for investors seeking relative stability and low risk returns above cash over the long-term horizon. For those seeking to maximize returns while still using this form of investment, implementing a strategy of value infusion appears logical. Value infusion involves incorporating a value-oriented active strategy in conjunction with a diversified strategy. By slowly allocating more capital to the value-oriented strategy when market conditions are favorable, or when attractive opportunities arise, it creates a lower-risk avenue for outperformance without the need for leverage. Understanding the implications of beta in a value-oriented strategy, and how it differs from a diversified portfolio of assets, is integral in effectively executing both strategies.

In a value-oriented strategy, beta takes on a different meaning. While volatility itself is not considered inherent risk for a value investor, the correlation of a stock to the market can pose a significant risk to outsized returns. This is because value investors seek to identify undervalued stocks that have the potential to outperform the market. By choosing stocks with low beta, value investors can achieve uncorrelated and possibly outperforming returns.

Low beta stocks tend to be less affected by market fluctuations and can provide a level of stability to a value-oriented portfolio. These stocks often possess qualities that signify they are overlooked by the general public. These qualities might include factors such as low share turnover, reduced share liquidity, and the lack of analyst coverage. By investing in low beta stocks, value investors can reduce the overall risk of their portfolio while maintaining the potential for attractive returns.

Whether a beta is higher or lower than one has much more to do with those who own the shares of the company than what the company itself does. Companies in the same industry with similar operations can have completely different betas based on how the shares trade, even if their internal returns are similar. An overlooked stock, one with a low beta, means it is unlikely to have a similar shareholder base as stocks with high betas. The lower the beta of a stock means the lower probability it has to move in line with peers, this is a positive attribution for value investors seeking gains based more on individualized outcomes compared to systemic scenarios.

It’s important to understand the implications of low beta on the financial ratios and valuation metrics of securities. A low beta stock is often seen as more stable than its more volatile counterparts, not just in terms of shares traded but also in the dispersion of historical operational returns. Since the nature of a low beta stock implies it is less volatile, it can be inferred that low beta stocks might be valued more like private businesses, in contrast to being assessed mainly on relative technical indicators.

The performance of low beta stocks relies more heavily on the operational performance of the business over the long term compared to industry returns or overall market performance. This is why it can be rewarding to analyze earnings, cash flows, and the potential for unrecognized growth prospects in overlooked stocks. Low beta stocks provide a good opportunity to exercise thoughtful fundamental analysis and benefit from underlying business performance, instead of falling victim to herd mentality or getting caught in the downward trend of volatility often associated with high beta stocks.

High beta stocks, in contrast to low beta stocks, offer a different appeal to value investors. Value investors do not necessarily view volatility itself as a form of risk, and when they consider investing in high beta stocks, they can leverage market fluctuations to their advantage. These stocks allow value investors to capitalize on the market’s ups and downs, often deviating from the intrinsic value, enabling them to build positions at lower costs as prices drop. This approach aligns with the fundamental principles of value investing, where the focus is on buying undervalued assets. Just as with low beta stocks, value investors can actively seek high beta stocks that present opportunities to uncover hidden value and generate attractive returns in the long run.

Unlike in low beta stocks where the analysis revolves around avoiding herd mentality, high beta stocks can be exploited based on their correlation to the market. Retail and institutional investors are often not enterprising investors. They may sell shares of companies for reasons unrelated to the inherent worth or underlying value of a security. For example, if a company is removed from an index or faces other temporary setbacks, institutional investors might be compelled to sell their shares due to portfolio guidelines and fear of relative underperformance. Similarly, retail investors can be lured into securities based on upward momentum, increasing public awareness, only to rush to sell as the momentum begins to fade. Both these scenarios can cause drastic swings that may deviate substantially from any relation to the business’s performance or worth.

In these high beta scenarios, a potential opportunity for investment arises when downward volatility causes the shares of a company, which were previously fairly valued, to trade at a discount. This discount might be either to the net asset value on the balance sheet or to its normalized earnings per share figures and other financial metrics. If careful analysis reveals a proper barrier of protection, and volatility has caused these shares to trade at bargain levels, an attractive way to benefit from the high beta associated with the trading of the stock may become evident.

If initial selloffs were over pronounced or if business performance returns to normal, an investor can benefit from the rebound back to economic reality. Taking advantage of volatility while remaining focused on proper fundamental analysis can create opportunities to generate attractive returns in high beta stocks.

When a value investor takes advantage of a low beta stock, they are seeking “overlooked” opportunities. Conversely, when they target a high beta stock, they are looking for “oversold” opportunities. Both low and high beta stocks have the potential to outperform or underperform the general market. Regardless of the variable a value investor incorporates into their strategy, it’s crucial to understand the implications of a security’s beta within the analysis.

It is important to note that beta is just one factor to consider when constructing a portfolio. Other factors such as valuation, financial health, and growth prospects of the underlying securities should also be taken into account.

In summary, beta, which represents the correlation of a stock’s volatility with the overall market, plays a pivotal role in shaping investment strategies, particularly in diversified and value-oriented portfolios. For diversified portfolios, understanding beta is key to achieving equilibrium and managing risk across various asset classes. It assists in determining asset allocation, helping to balance between conservative and more aggressive investments, and adjusting the portfolio in response to market shifts.

For value investors, the role of beta is nuanced yet significant. Low beta stocks, characterized by qualities like low share turnover and reduced public awareness, offer avenues for uncovering stable, overlooked opportunities. These stocks, often detached from market hysteria, allow for a more fundamental analysis, focusing on intrinsic qualities like consistent profitability and strong balance sheets. This approach can unearth stable, potentially outperforming investments.

On the other hand, high beta stocks present a different kind of opportunity for value investors. These stocks, prone to larger swings due to their strong market correlation, can be leveraged to take advantage of market overreactions. Value investors can capitalize on these fluctuations to acquire undervalued assets, particularly when stocks are unfairly punished by market dynamics unrelated to their fundamental worth.

Yet, regardless of the beta category, incorporating this measure into an investment strategy requires a balanced view. While beta provides insights into stock volatility in relation to the market, it should be considered alongside other financial metrics and market conditions. For a value investor, understanding both low and high beta stocks enables a more dynamic approach, exploiting market inefficiencies while staying rooted in fundamental analysis.

Therefore, beta becomes a critical tool for navigating the complexities of the market. It guides investors in building a diversified portfolio that balances risk and return, and in executing a value-oriented strategy that capitalizes on market anomalies. This understanding of beta, in the context of broader market dynamics and individual stock characteristics, forms the cornerstone of effective and strategic investing.

The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance. 

Ryan Jacobs No Comments

Coffee Cans and Cigar Butts: The Ins and Outs of Long and Short Duration Investments

There are various strategies and approaches that investors can adopt to achieve their financial goals. Two such strategies are the “coffee can” portfolio and the concept of “cigar butts.” Understanding these terms and their characteristics can help investors make informed decisions when it comes to long and short duration equity investments.

In this article, we will discuss the differences between a coffee can portfolio and a cigar butt portfolio. We will also explore the similarities in the analysis process for each of these distinct investment styles. Understanding the nuances of each strategy enables investors to benefit from pattern recognition, helping them identify whether a potential investment aligns with a short-duration or long-duration strategy.

The Coffee Can Portfolio

The term “coffee can portfolio” was coined by Robert Kirby, a renowned investment advisor. It refers to a long-term investment strategy where investors buy shares of high-quality companies and hold onto them for an extended period, often decades. The name originates from the idea that once the shares are purchased, they can be metaphorically put into a coffee can and forgotten about.

Investments suitable for a coffee can portfolio are distinctively characterized by their constant growth, significant free cash flow generation, and longevity.

Constant growth is a vital attribute, as the strategy favors companies showing a consistent upward trajectory in their performance. These firms typically have a robust competitive edge and a resilient business model, enabling them to deliver continuous growth and maintain their market position over time.

The importance of free cash flow generation cannot be overstated in this context. Companies that generate substantial free cash flows are particularly attractive for long-term investment, as this indicates their ability to sustain operations, invest in growth opportunities, and weather economic fluctuations without relying heavily on external financing.

Additionally, longevity is crucial; the ideal candidates for a coffee can portfolio are those that have proven their capacity to adapt effectively to changing market conditions and have a strategic, long-term vision for expansion. This combination of attributes ensures that the investments remain strong and potentially profitable over a long horizon, in line with the long-term holding principle of the coffee can investment approach.

Furthermore, companies fitting the coffee can portfolio criteria must demonstrate strong corporate governance. The core concept of a coffee can portfolio is to “set it and forget it,” making it crucial to evaluate management’s past decisions, compensation, and their vision for the company’s future.

Analyzing the board members is also vital. Insider ownership plays a key role in assessing the ownership mindset of the company’s leadership. When management and board members own significant portions of the company, it aligns the interests of shareholders with those responsible for the company’s operations. This alignment ensures that both groups are incentivized to benefit from the long-term appreciation of the stock.

When assessing the potential attractiveness of long-duration stock investments, industry and market analysis play crucial roles. These analyses help in understanding the broader context in which a company operates and its position relative to industry trends and economic cycles.

Innovation and the ability to adapt in various economic conditions are key factors in selecting long-duration investments suitable for a coffee can portfolio. Companies that consistently innovate and pivot according to market demands are more likely to sustain growth over long periods.

However, it’s also important to recognize that industries undergoing rapid change, such as the information technology sector, require extra caution in evaluating the attractiveness of their stocks. The dynamism of these sectors can often lead to significant uncertainties and volatility.

When analyzing a company within a highly competitive and transformative industry, it’s vital to avoid being overly influenced by potential growth narratives. Such narratives may be easily eroded by fierce competition, or they may rely so heavily on future technology that the potential implications become too uncertain to accurately assess. Therefore, a balanced and thorough analysis is essential to discern genuine long-term potential from mere speculative opportunities.

Durability might be the most important factor when analyzing a stock that could fit into the coffee can portfolio. The Lindy Effect, a concept often used in the context of technology and ideas, can also be applied to the stock analysis process. It refers to the idea that the future life expectancy of certain non-perishable things is proportional to their current age. This translates to the notion that companies with a longer past are more likely to have a longer future. Although this isn’t always the case, as numerous instances show new technology displacing incumbent participants who have held substantial market share in a specific industry for a long time, it remains an important exercise when analyzing a company’s ability to survive over the long term.

One approach to assess the potential of the Lindy Effect is to examine companies that are decades old, sometimes even over a hundred years. This process allows you to study the various industries that have risen and fallen throughout history, understand how companies have adapted and survived during hardships, and observe how management has made changes or implemented new forms of technology to stay relevant in the evolving business landscape.

Incorporating the Lindy Effect into stock analysis is crucial because it forces the analyst to focus on companies that have proven their ability to remain in business for extended periods. This historical perspective is invaluable in evaluating a company’s durability and its potential to be a successful long-term investment.

One-way companies experience extended lifecycles is by exercising dominance in the niche they operate in. A key form of this dominance can be a local competitive advantage. This relates to a company’s strong foothold in a specific geographic region, often due to a deep understanding of local consumer preferences, regulatory environments, or logistical advantages. Industries that typically exhibit strong local competitive advantages include agriculture in regions with unique climates, tourism in areas with distinct natural or cultural attractions, resource extraction in resource-rich locations, financial services in global financial hubs, tech and innovation in specialized clusters, specialized manufacturing in areas with historic expertise, creative industries in cultural capitals, and renewable energy in regions with abundant natural resources.

Another form of niche dominance is supply chain control. This can be related to importers and exporters of important raw materials used in manufacturing, as well as the ability to transport goods from the supplier to the manufacturer. By being an essential actor in the manufacturing and raw materials industries, these companies have the ability to maintain consistent pricing power and can exercise control over the supply and demand of the products or services in which they operate.

Industries that have competitive advantages through supply chain control include oil and gas, with their hold on reserves and refining; mining and metals, controlling key resources; automotive manufacturers, managing everything from raw materials to parts production; electronics and semiconductor firms, dominating essential component production; pharmaceuticals, leveraging drug manufacturing processes; agricultural companies, influencing the seed and fertilizer markets; chemical producers, who are pivotal in basic materials; textile and apparel businesses, overseeing the journey from material to garment creation; aerospace and defense firms, controlling critical technology production; and consumer goods and retail giants, managing end-to-end product supply chains.

Additionally, brand recognition and customer loyalty can be the strongest niche factors that keep a customer engaged with a business for extended periods of time. While brand recognition and customer loyalty are intangible in nature, if properly realized, they should lead to tangible value generation. Being a recognized brand allows a company to benefit greatly from meaningful advertisement, fostering an emotional response in customers who are satisfied with the operations.

Similarly, continuously providing a good value proposition for the customer fosters customer loyalty, either through membership programs or high switching costs associated with changing providers. High switching costs tend to be a powerful form of niche dominance due to locking in customers for recurring revenue. However, an even more powerful form of niche dominance is when customers voluntarily return for services or products because of their previous satisfactory experiences, creating a combination of customer loyalty and brand recognition.

Industries that typically benefit from competitive advantages like brand recognition, customer loyalty, and high switching costs include luxury goods where brand prestige drives sales; technology and software firms where customer familiarity and ecosystem integration create loyalty; financial services where trust and complexity discourage switching; telecommunications with long-term contracts and network reliance; the automotive industry where brand loyalty influences repeat purchases; consumer electronics where brand ecosystems create high switching costs; pharmaceuticals where trusted brands dominate; retail and fast food chains with strong brand identities; and airlines where frequent flyer programs foster loyalty. These sectors leverage their established reputations and customer habits to maintain market dominance and deter switching to competitors.

By analyzing companies with a long-term time horizon, analysts can disregard temporary price fluctuations and focus on the underlying economics of the company. Evaluating the management, understanding the operational aspects of the business, and having reasonable expectations about the future enable shareholders to benefit from the success of the business operations over a complete business cycle. Additionally, the tax efficiency of this low turnover strategy, along with the implications of meaningful dividend increases or other sound capital allocation decisions, compound benefits for the shareholders. This approach becomes logical when one recognizes the benefits of investing in businesses that conduct their operations with ease. The discipline becomes evident once an analyst realizes the challenge in discerning what constitutes a good business and determining the right price for that business.

The coffee can portfolio strategy is based on the belief that by holding onto high-quality stocks for an extended period, investors can benefit from the compounding effect of long-term returns. This approach requires patience and discipline, as it involves resisting the temptation to constantly buy and sell stocks based on short-term market fluctuations.

Cigar Butts

On the other end of the spectrum, the concept of “cigar butts” refers to a short-term investment strategy where investors seek out undervalued stocks that have the potential to provide quick profits. The term was popularized by Warren Buffett, who described these investments as companies that are “so cheap that they are selling for less than the value of their assets minus their liabilities.”

Cigar butt investments are characterized by their undervaluation in the market, offering investors the chance to buy these stocks at a bargain price. The primary objective of this investment strategy is to capitalize on short-term price movements, with investors aiming for a ‘value realization event’—the point at which the stock reaches its fair value and is then sold to secure the gains. Unlike the coffee can portfolio strategy, cigar butt investments entail a more significant level of risk. This risk, however, is often mitigated by a quantifiable margin of safety. The undervaluation of these stocks may stem from temporary market conditions, and there’s always the risk that the market may not fully recognize the stock’s true value.

A quantifiable margin of safety is often paramount in cigar butt investing, as the companies fitting this strategy are usually considered inferior. Their business performance can be mundane or even negative, often leaving previous shareholders dissatisfied and further diminishing the appeal of the shares. It’s crucial to understand the psychological differences between this strategy and the coffee can approach.

In the coffee can strategy, considerable time is spent comprehending the future of the business. Confidence in this analysis often stems from examining the long-term profit history, analyzing various earnings metrics from EBIT (Earnings Before Interest and Taxes) and EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization) to net income and free cash flow, and making predictions about future earnings based on current capital allocation decisions. However, this approach is not suitable for analyzing cigar butts. Deep analysis to make predictions based on earnings is a mistake for these companies.

The cigar butt strategy focuses on asset analysis, whereas the coffee can strategy is more earnings-based. The goal in cigar butt investing is to purchase a company at a discount to its worth, hypothetically in a liquidation scenario where assets are liquidated, and liabilities paid off. The remaining value is what is due to the shareholder, serving as the analyst’s margin of safety. The desired outcome is to buy these shares at a price significantly lower than this calculated value.

Once becoming a shareholder, the objective is to either have the market recognize the value of the shares, have the company purchased by a larger entity at a fairer price, or see the excess capital returned to shareholders through dividends or full liquidations.

Another distinction between the cigar butt and coffee can strategies lies in the active involvement required in cigar butt investing. Shareholders of companies trading at a discount often have more concerns about operations than those invested in fairly valued companies. In such cases, it can be beneficial for shareholders to voice these concerns to management and board members, particularly if they possess unique insights or expertise on the relevant issues.

Frequently, the accounting procedures of certain companies can be problematic, whether due to ignorance or intent. Unprofitable business lines may continue to operate, draining value from the organization, or there might be insufficient capital allocation for future operations. These issues can prompt shareholders to express their concerns to management, with the hope that the management will listen and take necessary actions. The ultimate goal of these interventions is to aid in achieving the fabled value realization event, where the true worth of the company is recognized in the market.

Reality often deviates from the simplistic notion of a letter to management causing a significant change in the organization’s top executives. In most cases, management is already aware of operational problems, either having unsuccessfully attempted to resolve them or lacking the necessary incentive alignment to make the required changes. An astute investor must either persistently assert to management that changes are needed or exhibit patience, holding shares of the discounted firm until an unforeseen event leads to a fairer value assessment or a liquidation that returns excess capital.

Patience is crucial in this strategy as these situations take time to unfold. However, it can also be risky; the longer an investor holds a discounted asset, the less impactful the realization event becomes. Worse still, if the company’s capital allocation decisions are poor, they might erode the firm’s value, further diminishing the impact of a value realization event.

Active management is vital in the cigar butt strategy. It’s essential to assess the capabilities and intentions of management, the value within the company, and the potential for realization in the market. If the situation doesn’t seem favorable, it’s logical to cut losses and move on to a more attractive opportunity. Staying locked into an unsuccessful investment increases opportunity costs. Therefore, an investor using the cigar butt strategy must be diligent in searching for opportunities, always weighing options, and ready to sell one position to invest in another. This active approach does result in higher share turnover, incurring more taxes and requiring more time spent on idea generation.

The question then arises: why would anyone choose the cigar butt strategy over the coffee can strategy? The answer lies in the potential returns. Properly implemented, the cigar butt strategy offers compelling returns, making it an excellent way to generate outsized returns early in one’s career. Moving from one successful value realization event to another has a compounding effect, similar to that seen in the coffee can strategy, but with the investor actively directing capital flow to the most attractive opportunities. In contrast, the coffee can portfolio relies entirely on the continuing operations of selected firms. Both strategies can yield outsized returns if properly executed, but generally, the successful cigar butt investor is compensated for the strategy’s active nature.

While the coffee can portfolio focuses on long-term wealth accumulation, cigar butt investing aims to generate quick profits. It requires a keen eye for undervalued opportunities and the ability to make timely investment decisions.

Benefiting from Both Strategies

Investors can benefit from incorporating elements of both the coffee can portfolio and cigar butt strategies into their investment approach. By diversifying their portfolio with a mix of long and short duration investments, investors can potentially achieve a balance between steady long-term growth and short-term gains.

By assessing each opportunity individually, an investor can benefit from both the coffee can and cigar butt strategies. Understanding that both approaches have their benefits and faults is crucial for long-term investment success. Recognizing patterns indicative of a situation likely to succeed under either the coffee can, or cigar butt strategy allows an investor to tailor their analysis accordingly. This helps in determining whether an opportunity is attractive.

Both strategies can produce winners and losers based on similar analyses. It’s the investor’s responsibility to identify which opportunities are most likely to succeed within each strategy and to weigh the most attractive options at any given time. This discerning approach is key to navigating the complex landscape of investment strategies effectively.

It’s interesting to note that some characteristics are universally important in both the coffee can and cigar butt strategies. For example, share dilution is viewed negatively in both approaches. Conversely, share buybacks are favorable as they help increase the earnings per share value for consistent earners and also enhance the value per share of discounted assets.

Furthermore, returns on capital are positive indicators in both strategies. While the coffee can approach favors consistent returns on capital with a potential for growth, even modestly positive returns can significantly enhance the appeal of discounted assets in the cigar butt strategy.

Price discipline is a cornerstone of proper execution in both strategies, as is consistent idea generation and successful position sizing. These factors are essential regardless of the strategy being employed when assessing potential opportunities available.

It is important to note that the success of any investment strategy depends on thorough research, analysis, and understanding of the individual investor’s risk tolerance and financial goals. It’s worth mentioning that psychological aversions can sometimes hinder investors from effectively implementing one of the strategies due to various reasons.

In conclusion, the coffee can portfolio and cigar butt strategies offer investors different approaches to long and short duration investments. While the coffee can portfolio emphasizes stability, longevity, and long-term wealth accumulation, cigar butt investing focuses on undervalued opportunities and short-term profits. By incorporating elements of both strategies, investors can tailor their investment approach to suit their individual goals and risk appetite.

Information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity.  The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies.  This is for information purposes and should not be construed as an investment recommendation.  Past performance is no guarantee of future performance. 

Ryan Jacobs No Comments

Jacobs Investment Management: An Introduction to our Trinity Offering

Traditionally, many investment firms have adhered to a more rigid approach, often emphasizing specific investment styles like a deep value investing approach, a high-quality investing approach, or an indexing approach. These firms tend to maintain a steadfast commitment to their chosen approach, believing that their strategy provides the best chance for success over the long term.

However, Jacobs Investment Management takes a more level-headed approach to address market inefficiencies. Rather than rigidly adhering to a single investment philosophy, we recognize that the financial markets are complex and constantly evolving. We understand that the concept of “efficient markets” is not solely dependent on the inherent properties of the market but is also greatly influenced by the psychology and behavior of investors.

Jacobs Investment Management acknowledges that different investors have varying levels of sophistication, risk tolerance, and financial goals. As a result, we have developed our Trinity Offering, a multifaceted approach that caters to the diverse needs and preferences of our clients. By segregating our strategies into Preservation, Accumulation, and a Private Partnership, we aim to provide clients with a more tailored and flexible investment experience.

Our recognition of the psychological aspects of investing is particularly noteworthy. We understand that market inefficiencies can arise from the behavior of investors themselves, as emotions, biases, and herd mentality can lead to irrational decision-making. Jacobs Investment Management believes in leveraging these insights to help clients navigate and capitalize on market dynamics effectively.

In essence, Jacobs Investment Management’s approach acknowledges that while market efficiency is a crucial consideration, it is not the only determinant of investment success. By offering a Trinity Offering that adapts to clients’ varying needs and by understanding the role of investor psychology in market dynamics, we aim to provide a more comprehensive and adaptable solution for our clients.

Preservation Strategy

The Preservation Strategy offered by Jacobs Investment Management is designed for clients who place a paramount emphasis on capital protection and the preservation of their wealth. This strategy goes beyond the conventional investment approaches by incorporating a highly diversified methodology that prioritizes risk parity.

In crafting this strategy, we consider both historical returns of various asset classes and the standard deviation of those returns to develop a portfolio composition that aims to effectively offset risks. By doing so, we intend to construct a resilient investment portfolio that can withstand the test of time.

One distinctive aspect of our Preservation Strategy is our approach to structuring the portfolio within the context of economic quadrants, taking into account variations in inflation and economic growth. This forward-thinking framework allows us to adapt to changing market conditions with agility and precision. Whether faced with rising inflation, falling inflation, rising economic growth, or falling economic growth, our diversified approach is designed to navigate these scenarios with resilience.

One of the key advantages of this approach is its ability to alleviate the psychological pressure often associated with deviating from market trends and the herd mentality. By emphasizing a diversified, risk-adjusted approach, we provide our clients with a sense of security and confidence in their investment decisions. This not only helps safeguard their wealth but also promotes a more rational and disciplined investment mindset.

Furthermore, our Preservation Strategy offers an attractive opportunity cost. In an environment where actively chosen investments may come with higher costs and risks, our highly diversified approach stands out as a cost-efficient alternative. It provides clients with a practical and low-cost means of preserving and growing their wealth, especially when actively chosen investments fail to convincingly outperform the risk-adjusted returns delivered by our Preservation Strategy.

While Jacobs Investment Management’s Preservation Strategy offers a robust approach to capital protection and risk mitigation, it is important to acknowledge that this strategy is designed with a specific trade-off in mind. The primary downside to this strategy is its expected lower returns when compared to our other strategies.

Our Preservation Strategy’s emphasis on low-risk assets and risk parity is geared towards safeguarding capital and minimizing the risk of erosion. As a result, it may not yield the same level of return potential as our more actively selective investment approaches, such as our Accumulation strategy or our Private Partnership.

However, it’s essential to view the Preservation Strategy within the context of a broader investment portfolio. One of its key strengths is its role as a solid foundation for an investment portfolio. By serving as a core holding, clients have the ability to gain exposure to our other strategies through what we call “value infusion.”

Value infusion refers to the concept of gradually allocating portions of a portfolio to more actively selected strategies when market conditions and individual client objectives align. This approach helps clients strike a balance between preserving capital and seeking long-term growth opportunities. While the Preservation Strategy may not deliver the highest returns on its own, it plays a vital role in supporting a well-rounded and diversified investment portfolio.

In summary, Jacobs Investment Management’s Preservation Strategy is a diversified and psychologically sound approach designed to serve as a dependable base investment. While it delivers lower expected returns, it prioritizes capital protection and stability. This strategy allows clients to gradually infuse their portfolio with higher-returning strategies when market conditions and individual client objectives align, thus striking a balance between client goals and risk tolerance. Overall, it provides a solid foundation for long-term financial success, considering risk parity, economic quadrants, and offering an attractive opportunity cost for clients’ unique needs and goals.

Accumulation Strategy

The Accumulation Strategy by Jacobs Investment Management is designed to meet the objectives of clients seeking long-term wealth growth. This strategy takes an active approach, emphasizing capital appreciation and the pursuit of growth opportunities. It centers on the idea of investing in high-quality businesses at reasonable prices, prioritizing “wonderful businesses for a decent price” over “decent businesses for a wonderful price.” This psychological understanding is vital, as clients are more likely to withstand market volatility when they comprehend the companies they invest in. The strategy seeks out companies that demonstrate both qualitative and quantitative attributes of a “wonderful business” while assessing valuations for potential returns and future growth prospects. By carefully timing purchases of these quality companies, the strategy aims to hold them for the long term, leading to a low turnover rate and a tax-efficient approach. In essence, Jacobs Investment Management’s Accumulation Strategy provides clients with the confidence that comes from investing in high-quality, growth-oriented companies, aligning with their long-term wealth accumulation goals.

Despite its merits, Jacobs Investment Management’s Accumulation Strategy does come with certain challenges. One significant challenge is the scarcity of opportunities where “wonderful businesses” are available at attractive prices. These high-quality companies are often priced at a premium due to their strong fundamentals and growth potential, making it challenging to consistently find investments that offer an attractive return.

Another consideration is the competition within the market. Many investors and asset managers adhere to a similar strategy of seeking quality businesses at reasonable valuations. This competition for the same pool of quality stocks can lead to reduced opportunities and lower expected returns. It’s a crowded space and identifying hidden gems can be a daunting task.

However, the strategy’s attractiveness persists due to market dynamics. Periods of market volatility and overreactions from investors can occasionally cause high-quality businesses to slip into more reasonable valuation territory. Jacobs Investment Management focuses on these opportune moments, concentrating on businesses that exhibit quality characteristics while also being available at a reasonable purchase price.

In summary, while the Accumulation Strategy offers the potential for long-term growth through quality investments, challenges include the rarity of attractive opportunities and heightened competition within the market. Nevertheless, the strategy remains appealing as it leverages market volatility and overreactions to identify high-quality businesses with reasonable valuations, aiming to deliver consistent returns over time.

Private Partnership

Jacobs Investment Management introduces its Private Partnership strategy, tailored to harness market inefficiencies, and seize opportunistic investments. This strategic offering is finely tuned to capitalize on opportunities within the market, focusing on companies that are undervalued in comparison to their intrinsic worth. These undervalued assets may exhibit a discount concerning liquidation value, going concern value, or even when compared to the valuations of similar companies.

The foundation of this strategy lies in identifying companies with a barrier of protection, guarding against the risk of permanent capital loss. Simultaneously, it aims to unearth latent value within these companies, with the potential for value realization that can translate into attractive returns for investors. In addition to targeting undervalued assets, the Private Partnership strategy casts a keen eye on highly opportunistic investments.

By “opportunistic,” we refer to the pursuit of smaller, often overlooked companies in the market, brimming with growth potential or possessing the capability to deliver returns to shareholders. The strategy recognizes that these smaller firms frequently escape the radar of institutional investors or remain inaccessible to entities with larger assets under management. Leveraging the partnership structure allows for a more aggressive position, enabling a concentration on the most attractively priced assets within the market.

At Jacobs Investment Management, we firmly believe that this strategic framework, uniquely structured as a private partnership, serves as the ideal platform to generate the highest possible returns. By targeting market inefficiencies and embracing opportunistic investments, this strategy aligns with our commitment to value creation and risk management, providing our clients with exclusive access to a dynamic investment approach designed to outperform traditional investment methodologies.

The Private Partnership strategy offered by Jacobs Investment Management is not suited for everyone, and it comes with its set of psychological challenges. Firstly, this strategy is structured to cater exclusively to qualified investors, limiting the pool of clients who can participate in this type of investment. It’s important to note that not all investors qualify for this opportunity.

One of the most significant psychological challenges associated with the Private Partnership strategy is the nature of the investments it targets. Market inefficiencies and opportunistic investments are often structured in this manner due to the distressed or undiscovered nature of the businesses involved. These companies tend to exhibit rapid fluctuations, creating a more volatile experience throughout the portfolio management journey. This inherent volatility can be psychologically unsettling for some investors.

Investors may also be deterred by the fact that many of the companies targeted in this strategy are discounted on a liquidation basis or may not be considered high-quality businesses. Consequently, there’s a potential risk of significant business deterioration while holding these assets. Similarly, opportunistic investments often involve smaller companies with growth potential but without established dominance in their respective markets. Investing in such companies requires psychological resilience to withstand market volatility while maintaining trust in the investment manager’s expertise.

However, it’s important to highlight that if implemented successfully, this strategy has the potential to significantly outperform over the long term. The Private Partnership structure is well-suited for this type of opportunity as it places more control in the hands of the investment manager, allowing investors to avoid continuously monitoring their holdings and becoming overly obsessed with market fluctuations. This strategy is particularly attractive for qualified investors seeking impressive returns over the long haul, but it does come with significant psychological barriers that may challenge some investors’ ability to stay the course during periods of market turbulence.

Summary

Jacobs Investment Management’s Trinity Offering presents a diverse set of investment strategies, each with its own merits and tailored to meet specific client needs.

The Preservation Strategy stands as a dependable base investment, emphasizing capital protection and stability. It provides clients with peace of mind, particularly during market volatility, and serves as an attractive opportunity cost.

The Accumulation Strategy, on the other hand, seeks to grow wealth over the long term. Focused on identifying high-quality businesses at reasonable prices, it emphasizes consistency and aims to balance clients’ understanding of investments with market opportunities.

The Private Partnership strategy is structured to seize market inefficiencies and opportunistic investments, providing exclusive opportunities for qualified investors.

Crucially, the Value Infusion process allows for a customized approach, recognizing that there’s no one-size-fits-all solution. By blending value-oriented strategies with the Preservation Strategy as a base holding, Jacobs Investment Management creates optimal allocations that align with individual client objectives.

While acknowledging that markets can be efficient, Jacobs Investment Management remains attuned to inefficiencies that can be exploited through diligent analysis and strategy alignment. These strategies are designed to accommodate clients’ risk tolerance and time horizon, offering a comprehensive and adaptable approach to investment management.

Past performance may not be indicative of future results.  Therefore, no current or prospective client should assume that the future performance of any specific investment or investment strategy (including the investments and/or investment strategies recommended by the advisor), will be profitable or equal to past performance levels. All investment strategies have the potential to profit or loss.  Changes in investment strategies, contributions or withdrawals may materially alter the performance and results of your portfolio. Different types of investments involve varying degrees of risk, and there can be no assurance that any specific investment will either be suitable or profitable for a client’s investment portfolio.