5.01.2012

On Paradigm Shifts

Yesterday it was announced that Microsoft would make a strategic investment in Barnes and Noble's digital and college assets as part of Newco subsidiary. MSFT's $300M investment, for 17.6% of the entity, would value Newco as $1.7B, meaning BKS' stake would be worth $1.4B.  Prior to the announcement , Barnes and Noble boasted a market cap of $825M.  Obviously someone was wrong here.


A week before, a someone wrote of BKS on the Value Investor's Club. The write-up made a lot of sense, breaking down a sum of parts valuation of the enterprise. The argument had been made before: BKS is worth more broken up. But investors, as expressed by a short ratio of 50% of the flat held the viewpoint that BKS was the next Border's Group - a dying hard line retailer exposed to digital penetration of its main product. The thought that someone would value the the Nook business and college business at $1.7B would be implausible to these people.

I just got off the phone with a good friend of mine. We had a discussion whether, over the long term, being able to predict earnings beats / misses makes one a good investor. Maybe in the short run, especially those with acute trading skills. More importantly I postulated, being a good investor, in the long run, has a lot to do with spotting paradigm shifts.  That's how you make 2x, 3x, 5x, 10x on your money. You don't make that sort of money on predicting whether MSFT will beat this quarter or the next.

At work, on my desk, I have Charlie Munger's quote laid out, smack in my face: "Invert. Always Invert." A thought experiment I like try with friends, interview candidates, or just passing the time: Come up with the long thesis for the highest short interests S&P 500 stocks out there.  Currently that list includes:
  • Washington Post
  • RR Donnelley
  • Game Stop
  • Pitney Bowes
  • Frontier
  • Harris
  • Avalonbay
  • Federated Investors
  • Borgwarner
  • Plum Creek Timber
Let's take AvalonBay.  AVB is up 20% in the past year driven by increasing rents in the high end apartment space. The short thesis (plural) is pretty well understood:
  1. Rent growth is going to crack (for whatever reason) which will cause its trading multiples to collapse
  2. Along the similar lines, their large development pipeline will not translate into the growth the sell side is expecting putting pressures on multiples
  3. Its dividend yield is too low for a REIT. Higher interest rates will put pressure on the company from yield seeking investors
Let's invert these:
  1. Rent growth is going accelerate which will cause trading multiples to expand
  2. Their large development pipeline is not fully reflected in the price and multiples should expand
  3. Interest rates will stay low for a significant amount of time and AVB is in a position to expand its dividend through FFO growth
Are any of these three situations 100% out of the question?  Absolutely not. Do I believe they will happen? Me? Personally I do not. But I understand the rationale one way or the other and I can better size my position given the upside or downside potential in the 3 bearish cases and 3 bullish cases. 

From an investment standpoint, the less your paradigm shift is accepted by the marketplace, the more money that can be made from that viewpoint. One of the most lucrative paradigm shifts in the past 5 years was that Chinese RTOs are, more often that not, frauds. While you had a few people here and there in the very early years question the legitimacy of these companies, the general consensus (look at old Seeking Alpha posts) were these were thriving businesses. A paradigm shift is really a switch from an accepted, mainstream call, to one that is contrarian in nature.

Why does a contrarian make the most money in the market?  Because, believe it or not, it is the path of least resistance. Think of a spring. A spring is an amazing, amazing analogy for valuation. As you extend a string further from its neutral position, it gets harder and harder to pull it further until the spring just will not uncoil anymore. Just so, like in valuation, as valuations become more and more stretched, valuations just cannot go any further.  And because of this, the contrarian doesn't have to be as right as much as his counterparts who play for singles.  He can have a few 3 or 4 or 5 baggers, which come from a contrarian outlook, make up for many "small" wins.

I think another interesting example are the coal names. During the M&A flurry, coal names traded at a hefty, hefty multiple for such a cyclical business. To make 100% of your money from those levels would be disastrously hard. But today? ANR is flirting with an all time low in an environment where people could not hate coal more. If, or better yet, when coal normalizes, a 100% return would be a lazy Thursday.

Of course, being contrarian to just be a contrarian is a fool's errand. It espouses circular logic that inevitable would lead an investor to ruin as bad companies, inevitable cheap, do file, go away, and an investor is left with a permanent loss of capital. This is where concepts like investing in clean balance sheets or high up in the capital structure come into play because your chance of a good egg drops precipitously. Of course the 2-3-4 baggers become 1.5-2x investments but in the long run an investor that can turn out 50% on investments with limiting the zeros will far and away crush his competition.

Instead of thinking, "How are my EPS projections different than the Street's this quarter" think "In 3/5/10 years the general consensus is this company will be X.  I think it will be Y".  X could range the gamut from bankrupt to taking over the world. X will be priced in. Y is not priced in and the more radical, less accepted your vision is, the more money you can make off the investment.

Think about this next time you read a 10K and make a snap judgement about an investment. Try to argue both the bull and the bear thesis. This will make you a dynamic investor that can make money over the long run in any investing environment.

8 comments:

Owen Bernard 5/02/2012  

Excellent post. I am reminded of munger quoted as saying "Manage to the opportunity, not to the plan," as Ron Burkle recalls when he approach munger to finance a deal. My paradigm shift idea in similar a thought process is Earthlink.

http://wizardsinvestmentcorner.blogspot.com/2011/11/earthlink-mr-market-looking-through.html

John 5/02/2012  

Yes, excellent post!

Are we starting a "paradigm shift club"? LOL.

My paradigm shift idea is RIMM

http://www.portfolio14.com/2012/04/research-in-motion-is-absurdly-cheap.html

AndyinSanDiego 5/02/2012  

Love the line "Invert. Always Invert"

Anonymous,  5/02/2012  

Well said. Value or growth investing, the only way to consistently make money in the market long term is figuring out how the market will view this company in the long term

John 5/02/2012  

I spent more time thinking about this.

I think the key to avoid being contrarian for just contrarian sake is to ask the question: "what insight do I have to give me an edge over the market?"

David Merkel 5/02/2012  

Coal. ANR used to have a good balance sheet when it was CLF. I think the long bull run in energy names let the coal industry get lazy -- debt is far higher industrywide for a cyclical business.

It feels like Steel in 2002, but there's no Nucor to clean up and rationalize the industry.

The coal sector could be facing a protracted slump, particularly if China's economy goes into a genuine recession.

horn,  5/03/2012  

Probably should give credit where due for the quote to the actual author, Carl Gustav Jacob Jacobi, the famous mathematician who said it ~100 years before Chaz was born.

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hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.