Wednesday 24 January 2018

Finding investment ideas, Brighthouse Financial; Dignity plc; and favouring breadth over depth

I am often asked how I source my ideas - particularly operating as a one-man band running a global equity fund. I currently have approximately 150 stocks in my portfolio across more than a dozen countries, and typically generate about 4-5 new ideas a month. This month has been particularly productive - I have unearthed 10 ideas, or nearly 1 every 2 calendar days, and if I work in a focused manner, I am sometimes able to go at a rate of 1 a day (so much for global markets being devoid of value opportunities).

Many are confused about how I manage to do this. How, it is asked, can you keep track of 150 stocks? My response is that I don't - those are just the ones I like. I actually keep track of thousands and thousands of stocks.

How do I do it? Simple - I try to look at new stocks, all the time - typically 5-10 new stocks a day, 7 days a week (when I am not traveling or otherwise distracted), while also 'checking in' on several dozen stocks I already follow each day. And I cover so much ground by honing directly in on the things that actually matter, and ignoring all irrelevant, extraneous detail.

I am a big believer in Peter Lynch's dictum (Peter Lynch was the greatest portfolio manager of the past few generations in my view) that he who turns over the most rocks wins, and I endeavour to turn over as many rocks as I can, as fast as I can, and believe that in markets, the returns to breadth exceed the returns to depth when researching stocks. A few examples - one successful, one unsuccessful - in the past few days may serve to highlight the process somewhat.

Although it is important to always be looking at stocks, you can and should prioritise your search in areas of markets where you are most likely to find opportunities. Certain regions and industries are relatively cheap at any given point of time, and others are relatively expensive. This is based, to a large degree, on where these economies, industries, and markets are at in their respective economic, industry, and investor sentiment cycles, which wax and wane over time like the seasons. It is important to have this contextual understanding firmly in place before you proceed.

I prioritise looking at regions, industries, and market segments that are out of favour or are going through downturns, because that is where cheap stocks are most likely to be found. In recent times, that has included recession-addled emerging markets such as Russia and Brazil (as well as peripheral Europe and Greece); regions with prevalent pessimism about the economic outlook or risks (such as China/HK and Japan), and neglected industries people are pessimistic about including autos, coal and other commodities (until recently), oil and oil services, B&M retail, traditional media, and banks and other financials. Of late, some value has begun to emerge in the UK, as well, as Brexit anxieties have begun to weigh on both valuations and earnings.

In addition, there are many other predictors of stocks being cheap and potentially prospective. Spin-offs have traditionally done well as a group. Companies buying back a lot of stock and/or with management buying shares often do well. Companies where there is a significant degree of insider ownership, or which are family run, generally outperform. Companies in boring industries, or areas where there are considered to be weak growth opportunities and/or a bad narrative in place about the outlook are worth looking at (as these opportunities are hard for the financial industry to 'sell' to clients); and low expectations and/or widespread uncertainty are also very bullish indicators.

Consequently, any companies exhibiting any of these attributes, or fitting into any of the other areas of markets where value is likely to be found, move straight to the top of my list, and are where I focus my energies. This immediately narrows the field of potential opportunities down to a manageable number of prospective hunting grounds. And one way to have stocks come onto you list is to look at what other investors you respect and who have similar investment philosophies are doing and investing in. If they flag a stock that fits into one of the clusters of opportunity outlined above, then it is often worth a look.

Brighthouse Financial

One such example is David Einhorn, who recently published his 4Q17 investor letter. I disagree with Einhorn on many things, and his performance in recent years has been poor, but he has found much more success with the long side of his book than his short side, and some of his longs have been well selected and have performed well. I own both Aercap and General Motors - both of which are in his top 5 holdings.

In his recent quarterly, he noted that he had taken a top-5 position in Brighthouse Financial (BHF US) - provider of fixed and variable annuity products, as well as life insurance. His short-form investment thesis was outlined as such:

"We initiated a large long position in Brighthouse Financial (BHF) at an average of $57.92. BHF was spun out of MetLife and was formerly most of MetLife's U.S. Retail business, selling annuities and life insurance. BHF appears to be a traditional spin-off - an underperforming and unloved part of a larger, more successful company. The tone of the spin-off road show was noticeably downbeat, with management advancing a business plan that does not sound particularly exciting for shareholders. Notably, despite very conservative capitalization and high risk-based capital levels, the base expectation calls for no capital return until 2020. The result is a valuation of just 56% of book value and 6.4x 2018 EPS estimates.

"There are many stocks today that don't appear to have any cushion built in for a bear market. We are short quite a few of them, but on BHF, analysts are laser focused on the downside from a bear market. That seems too pessimistic. The converse of the downside of adverse capital markets is the upside to favourable markets. The flow-through from favourable capital markets, possibly combined with better-than-forecasted execution typical of spin-offs of this type, should yield an ability to return capital much sooner than expected. With the shares trading at approximately a 40-50% discount to similar companies with normal capital return policies, there is plenty of upside to the shares as the market begins to discount normalization. Management is well incentivized if the shares appreciate. BHF ended the year at $58.64". 

From this thesis, and a quick scan of the company's website and presentation, it could be immediately discerned that there was a lot to like here, and that it ticked many of the boxes I outlined above. The company was a spin-off - check. It was cheap (0.56x book and a high single digit PE) - check. It was in an opaque insurance sector with complexity - check (complexity is often discounted as investors cannot be bothered doing the work). It was in an out of favour (though starting to come back into favour) financial sector - check. Management were incentivised to improve performance - check. There were no prospects for capital returns until 2020 - a reason for investors to ignore the stock now and check in later - check (markets favour immediate gratification - there was an opportunity here to take a longer term view and wait for a re-rating coming into 2019/20 ahead of increased capital returns). I was intrigued. These indicia all pushed BHF towards the top of the list of new stocks I ought to look at.

The first thing I did was go to their website and download their latest investor presentation, which was about 50 slides in length. Initially, things were looking promising, until I happened upon slide 24 of the deck. After reading this, I knew the stock was going to be a pass:

Here we have the fundamental issue staring us in the face. BHF is a long-tailed insurance company, and the key issue for long-tailed insurance companies is this: how do you value their liabilities?

The issue for banks and other lenders is the quality of their assets - predominately loans and other bonds/financial instruments. Banks go broke when their assets turn out to be worth a lot less than they thought because their counterparties can't pay them back (or where they have a liquidity crisis they cannot resolve).

The issue for (long tailed) insurance companies is different, and instead centres on the value of their liabilities. The asset side of insurance companies' balance sheet still has risk, but it is usually relatively low, as they generally invest their assets relatively conservatively (typically mostly in high grade corporate and government bonds). However, their liabilities are subject to much more uncertainty, often involving the use of numerous discount rate and other assumptions.

Insurance companies write policies which entail future liabilities to policyholders, and receive premiums which wind up as assets on the balance sheet which are used to fund those liabilities over time. Hopefully, the spread between what the company earns on those assets vs. their obligations under these insurance contracts (net of costs) is large enough for them to make a decent profit. Importantly, unlike for non-financial companies, insurance company reported earnings - like many other financials - depend on the use of assumptions about the valuation of those liabilities, the accuracy of which we may not find out about for years if not decades. Consequently, the assumptions being used need to be scrutinised. Otherwise the earnings being reported are meaningless, and can be wiped out by major 'reserve strengthening' write offs many years down the track.

Here in this slide we have evidence that the assumptions being used by the company may not be sufficiently conservative. For their key variable annuity block of business (variable annuities grant policyholders differing levels of payouts depending on the performance of markets, but typically with some minimum payout guaranties), they are assuming a long term return on equities of 8.5%, and 6.5% in total including 3.5% on high-grade debt instruments (primarily government bonds). That seems much too aggressive. Based on the current level of US equity pricing, 8.5% pa long term returns are most unlikely - markets are priced to return about 5%, at best. And long term government bond yields are still sitting below 3% and are arguably just as likely to fall over time as rise.

If one were to shift to more realistically conservative assumptions, as is shown in their slide, the NPV of their VA book would decline precipitously, and to a degree roughly approximating the degree to which the company's book value currently exceeds its market capitalisation. The company's insistence on maintaining a larger capital buffer above regulatorily mandated levels is also, arguably, a tacit acknowledgement that they believe their assumptions to be aggressive. Adjusting the value of their liabilities to the use of more conservative assumptions wipes away the apparent undervaluation of the stock.

Has Einhorn not thought of this? The same Einhorn that wrote an entire book Fooling some people all of the time about Allied Financial (a book I have read and recommend)? Einhorn noted in his short-form thesis that markets were in an enthusiastic mood at the moment and were rising rapidly, and yet investors were not willing to allow BHF to assume future market equity returns were good. There is actually no inconsistency here. Investors are buying up markets at the moment with positive medium term return expectations, but most investors agree that at current market valuations, aggregate long term market returns will be well below historical levels.

The other issue is that the value of an annuity company centers on its ability to effectively borrow long term money at below-market rates, and then invest those funds in higher-returning assets. That is what gives the business model value. The problem for annuity companies is that we are currently living in a world with very low interest rates, which significantly reduces the value of this ability (just like how low rates negatively affect the value of deposit franchises held by companies such as Wells Fargo - transactional accounts typically yield little interest, and so these funds are worth a lot in a high interest rate environment where the funds can be lent out at high interest rates; in a low rate environment where the funds cannot, the value of these deposits significantly declines).

My conclusion, reached after about 20 minutes or so of work, was that this stock was probably a pass. The stock was optically cheap but likely for valid reasons - the assumptions underpinning the valuation of their liabilities looked aggressive, and after adjusting them, the discount to book value would disappear. And given the low rate environment in which we are living, which has reduced the value of annuity businesses, coupled with the company's recently-weakened distribution position, 1x marked-down book (marked down to more realistic liability assumptions) appeared full (although by no means expensive). I had turned over a promising stone, but it had not yielded anything.

I might be wrong. I might have missed something. And even if I have not missed anything, the stock might rally back to 1x book regardless. I don't care. I'm looking for no brainers, and BHF didn't pass my first cut, which is designed to preserve time resources for more promising opportunities. I will keep the stock on my watchlist and check in again from time to time, or revisit my view if the situation is explained to me better and allows me to view the stock in a different light (or if the stock price drops a lot), but for the moment, it's onto the next one.

Dignity plc

After finishing my work on BHF, I was scrolling through a watchlist of several thousand securities I follow a couple of days ago when I noticed something unusual - ASX-listed funeral services provider Invocare (IVC AU) was trading down 5%, in a broader market that was rising. Something was going on.

A quick search revealed no announcements from the company, so I did a news search, and after poking around for a while, discovered the reason: Market-leading LSE-listed funeral services provider Dignity plc had downgraded its earnings outlook and was trading down about 50%.

I have followed Invocare for a while and am familiar with their business. It is a good business - profitable, stable, and predictable - and has yielded shareholders very good returns over time. However, with the stock trading at 25-30x earnings, it is well outside the 'strike zone' - particularly because in recent years they have started to lose market share to cheaper, low-end providers (as well as providers of more new-age funeral services), and because the market has reacted complacently to that threat, failing to ascribe any discount to the stock to reflect these adverse development whatsoever.

Invocare was trading down because although Dignity operates in a different market on the other side of the globe, Dignity is a similar business to Invocare facing similar issues, and it had just issued a surprisingly-severe profit warning (to holders accustomed to steady, profitable growth), noting that they had taken a strategic decision to cut the prices of its 'simple' funeral service offering in order to stem market share losses. Investors paying attention to Dignity had correctly surmised that there was a growing risk Invocare could well imminently follow a similar path with a similarly savage share price correction. Although IVC had weakened 5%, it was still very expensive, and hence there was certainly no opportunity to be had with Invocare on the long side any time soon - if anything the research suggested Invocare was a good short.

However, this lead me to take a closer look at Dignity, and I liked what I saw. The stock very much looked to be in the 'strike zone' of the types of stocks I like to own. My research process took about an hour. I looked at their long term financial track record and trading history on Bloomberg, and saw that - much like Invocare - the company had been a highly profitable and steadily growing business over more than a decade, and a stock that typically traded at 20x earnings or more - close to Invocare. I then went to their website and read their most recent earnings results (1H17, which remained strong); their recent downgrade announcement; and then transcript of their conference call explaining the downgrade. I also leafed through their 2016 annual report quickly.

The following quickly became clear: their 2017 results, soon to be announced, were likely to be at record levels, much like Invocare. In addition, much like Invocare, they had already been warning for 12-18 months of rising low end competition and modest market share pressures, which the market had until recently ignored. However, unlike Invocare, they had decided to take a strategic decision to defend their long term market share position by cutting prices at the low end. This would hurt near term results, but was, in management's opinion, the correct long term strategic decision. They offered no specific guidance on the impact, noting only that they expected 2018 earnings to be 'materially below market expectations', leaving open a wide range of potential future outcomes (likely reflecting the fact that management themselves don't yet know exactly what the impact will look like).

Funeral services comprise about 65% of their earnings. 35% comes from crematorium services and pre-funded funeral services. That 35% appears likely to remain unaffected. Furthermore, of their 65% earnings coming from funeral services, only 8% of their volume comes from 'simple' low-end funerals where they have now cut prices by about 25%. The other 92% have not seen price cuts. A mix shift is likely, and they noted that they expected 20% of volume to come from simple services this year, and this is a relatively fixed cost business, so revenue declines will hurt. But they may also succeed in picking up some new volume as they win back some previously ceded market share. Overall, it would seem that a majority of their business is probably going to be relatively unaffected by this decision, but the market has nevertheless immediately assumed the worst.

The stock is now trading at 7.5x 2017 earnings - well down from highs of some 25x (the stock is now 65% off its highs). The market previously preferred to pay 20-25x for the illusion of steady low-risk high single digit earnings growth, even when incremental market share pressures were being flagged. However, at the present juncture, even if earnings fall 30-50% this year (and I think 30% is much more likely than 50%, if not less), the stock will now be on 10-15x earnings on an earnings base that is now significantly more sustainable and which may assist in winning back lost market share.

Investors are now applying a lower multiple to a lower-risk, rebased earnings stream, which makes no rational sense. They are doing this because of the way investors' psychology works - the risks feel higher now even though they are not, and because investors systematically excessively discount uncertainty (worse than being told earnings are going to fall this year, is not being told by how much, which maximises the sense of fear and disorientation).

A realistic scenario might be earnings dropping 30%, putting the stock at 10x, but then the company says market share has stabilised and earnings are expected to resume growth in 2019. With investors now aware of where the bottom of earnings is, and a more promising outlook for 2019 off a lower base, the stock could well rally 50-100% back to 15-20x 2018 earnings. Not at all impossible.

On the downside, expectations are now already low, and the risk of market share losses and margin declines front and center of investor expectations. Investors already expect earnings to drop a lot, so if earnings decline by more than I expect - say 50-60% and never recover, that scenario is now already in the price. The company does have some debt, but it is well structured, being long term, low interest rate, fixed rate debt, and so should be comfortably able to be accommodated.

The psychology of investors is, incidentally, exactly why Joel Greenblatt's quant approach of buying low PE businesses relative to their ROEs on past earnings (not forecast earnings) works so well. Dignity falls into this category now. It works because if investors misappraise the extent to which earnings are likely to decline, there is scope for a significant share price rebound, but if they are right and earnings do drop precipitously and permanently, that is already in the share price, and so further share price downside is often limited. This is the very definition of a high return, low risk investment, in my view.

I bought some at 960-980p after about 1hr of research (about a 30-40bp position). I might be wrong. I might have missed something. But I don't care. Because when I invest I am focused on probabilities not outcomes. Based on my nearly two-decades experience investing and attempting to understand investor psychology, I strongly believe that stocks like Dignity right now offer attractive risk/reward potential, and by diversifying, I am also able to diversify away individual security risk and focus on exploiting systematic market mispricings.


In less than two hours, I was able to find one buy idea, and dismiss another superficially promising opportunity that didn't bear scrutiny. I do this all day, day after day after day. That is how you make money in markets - through hard work and a disciplined process.

Furthermore, one of the key takeaways from the above is that when researching stocks, the returns on breadth exceed the returns on depth (coupled with an ability to make fast and relatively accurate judgements). In other words, you are much better off, in my opinion, spending your time looking at lots and lots and lots of stocks and trying to unearth the most obvious opportunities, than investing tremendous amounts of time learning all the irrelevant details about individual issues.

This is because most stocks, most of the time, are not in the 'strike zone', and no amount of detailed research will suddenly make it so. If a stock does not immediately strike you as cheap, it is probably not cheap enough and you should divert your research resources elsewhere and check in again later. Furthermore, not only will detailed research on individual issues deprive you of opportunities to look at other stocks, but it will also make you feel as though you need some kind of 'reward' for the amount of time you have committed to your research process, and therefore tempt you to buy some lest all that effort go to waste. That is a sunk cost psychological bias that is best avoided.

In addition, the more conventional depth over breadth research process also often leads to excessive portfolio concentration - a frequent problem these days. This occurs because a detailed-oriented process does not leave enough time to look at enough stocks, so relatively few good ideas are uncovered. That then requires either a choice to 'diworsify' the portfolio, or excessively concentrate.

My widely diversified portfolio grants me significant flexibility. I am not excessively exposed to the outcome of any individual stock (with some exceptions - I have a handful of large, conviction positions), so can focus on process and general probabilities, rather than feeling the need to predict specific outcomes. In addition, I have the capacity to be extremely patient with individual positions, and have significant flexibility to average down if given the opportunity. Dignity might be a great investment at current levels, but it might halve again for all I know. I will have the capacity to increase my position by many multiples of my initial entry size, if such an outstanding opportunity were to present itself. Conventionally concentrated portfolios give up that flexibility (indeed, the best opportunities I find are often in stocks other value investors cannot buy more of because they already bought full positions at much higher levels and do not have the capacity to risk more capital on the position).

Many people remain bemused at how I am making 50% a year with a 'diversified' 150 stock portfolio. Conventional wisdom says that ought not be possible. The above explains how. You simply do not need to know all the extraneous details. You need to know what is important, and only what is important. As I blogged about in real time last year, I bought Michael Kors after less than an hour of research, and have since made 80% on that position (I still own it). All the important information could be gleaned in less than an hour. Everything else was irrelevant, and ignoring irrelevant information is as important as paying attention to what really counts.

This works, of course, provided you are an experienced investor that understands the ins and outs of many industries; how to value stocks; and how market psychology and cycles work at a very deep level. Blink investing requires a significant amount of accumulated effort, experience, and knowledge, such that relatively accurate judgments can be rendered on a large number of situations very quickly (Buffett claims to be able to form a judgment on most stocks and businesses he looks at in less than 10 minutes). I could not have invested this quickly in these names, for instance, if I didn't already understand insurance companies, or had not previously researched Invocare. But when those prerequisites are in place, it works amazingly well.


*The above analysis is furnished for informational/entertainment purposes only, and is not to be construed as investment advice. The author provides no warranty whatsoever as to the accuracy of the contents of the post, and reserves all rights to trade in any securities mentioned in any article at any time.