Atlanta, GA | 404.775.3321 | BGordon@Bluegrottocapital.com

The Research Funnel: Identification to First Investment

I’ve received a lot of variations of the following question: “How do you follow such a large potential universe? How can you focus in on creating a portfolio with so many options?” Since I could spend an entire meeting going through this, I thought writing about it would be a better way to explain. In some ways, I think this piece explains my idea generation process in a better, more granular way than my investor deck. For this reason, it should be required reading for anyone interested in investing in Blue Grotto Capital.

I can get started looking at a company from several different pathways, which I’ll address in no particular order:

Screening

I have found a number of good investments, both long and short, through investment screens. I have found the metrics that lead to the most promising shorts are high ev/sales, high leverage (especially when combined with deteriorating cash flow), high DSOs (days sales outstanding), negative free cash flow, and declining revenue. I usually use a number of these metrics in combinations in screens. I also find heavy amounts of insider selling and big increases in short interest are usually good indicators.

On the long side, empirically the best metric for value historically is EV/EBIT (based on historic back tests). However, it is also interesting to screen for low EV/EBITDA, low EV/sales, low price to book, and high FCF yield. Insider buying is a great indicator and positive earnings revisions (i.e. the company is beating analysts’ sales and earnings projections) usually also are good indicators. We also screen for high growth and growth acceleration in sales or earnings. As with shorts, if a number of these metrics are in combination, this suggests a better signal.

I have also described looking for investments based on geographic or industry regressions, which can indicate the potential for mean reversion in a sector or geography. While this is strictly a top down valuation screen, after we find indications that a sector or geography is cheap, we dig into the components of that index and look for companies with a combination of favorable fundamentals and attractive valuation. One example is after seeing MLPs were cheap based on regressions (see below), we did a study of all the potential MLPs we could invest in and settled on the ones benefitting from having a strong business position (for instance they have a moat in attractive basins), good corporate governance (shareholder structures in some MLPs can be problematic), and attractive absolute and relative valuations.

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While in the case of MLPs we found attractive investments, a lot of times sectors or geographies are cheap for reasons that we can’t get our heads around. For instance, two of the sectors that screen as cheap on regressions right now are drug stores and furniture retailers. These sectors face obvious secular/competitive issues that I don’t feel like I can take a contrarian stance on based on my current knowledge base. I put these in the “too hard” category and move on.

Since what country and sector one invests in at various points in time explain a large percentage of one’s returns, having a process for global and sector asset allocation is important. Geographic and sector regressions are a way of focusing on areas where value or overvaluation may provide opportunities. Then we drill down into individual companies within whatever sector or geography looks cheap and look for companies that really stand out. For instance, following the “PIGS” crisis in 2011/2012, we found several cheap stocks in Italy and Spain, in businesses that we thought could compound well over the long-term as well.

A Mosaic: Following the Bread Crumbs

Screening is the easiest starting point to describe. More ideas come from what I’d describe as a mosaic we’re constantly developing (the investment book nerd in me refers you to Common Stocks and Uncommon Profits by Phillip Fisher as the first promoter of this concept). Most come in sectors or companies I have followed for years. This is natural, something Buffett calls a “circle of competence.” If you understand industry dynamics impacting a business and the underlying key issues to focus on it is easier to handicap whether price of the company’s stock is correct or way off. I have also found that when I research one company in a sector and talk to people in the business, it inevitably leads me to find strong and weak companies I was not researching in the industry.

For example, I started following the firewall/network security companies in 2012 when Checkpoint Software “blew up,” making it look quite cheap on EV/FCF, around 8x. I had followed Juniper and Cisco and knew they were losing share in the firewall market and thought Checkpoint was among the market leaders (please note this is at the time and not a current statement, as Checkpoint is currently losing market share). We dug into the space by speaking to resellers, customers, all of the companies’ management teams that competed in the space, etc. We also read through a number of the filings and conference calls of companies in the sector, research reports by the sell side and tech research firms, blogs by participants in the space, and attended the annual security show in San Francisco.

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Checkpoint had just gone through a weak part of a refresh cycle for firewall boxes but when we spoke to people in the industry their solutions were well regarded, and the company was starting to sell “blades,” which were additional pieces of software sold on a subscription basis with the basic firewall solution. Researching Checkpoint eventually lead me to the IPO of Palo Alto Networks, because they were cited as the biggest share gainer in the industry and I had previously spoken to Nir Zuk, the company’s founder and CTO (I spoke to him about Cavium and semiconductor companies selling into the firewall space too). While our firm didn’t get a huge allocation to Palo Alto Networks since GMT Capital doesn’t trade a lot and therefore didn’t pay a lot of commissions to get access to “hot” IPOs, I would have never known Palo Alto Networks was the industry's emerging growth company had I not followed Checkpoint and the industry landscape.

In addition, when FireEye came public and the stock went parabolic, I knew from conversations in the industry that Palo Alto, Checkpoint, Fortinet, and Cisco were all developing virtual sandboxes that identified threats that had gotten behind the firewall. This along with additional research lead me to correctly identify that FireEye’s products would become an application the firewall companies sold at a significantly lower price, leading to share losses. That is widely known now, but when FireEye’s stock went parabolic to close to $100 in 2014 (we shorted it prior to its peak), to a market cap greater than Checkpoint’s (the leader in the entire network security space), we knew it was an obvious short (FEYE eventually bottomed out around $12).

You have to start somewhere and in the example above I started by following one company, Checkpoint, then branched out to other players in the industry and to peripheral spaces. I originally knew about Checkpoint just from seeing them at a tech conference and from talking to a coworker who invested in the stock in the late 1990s, reaping gains of 10x from the investment. He thought they were a great company, which was consistent with the management presentation I saw, in addition to the company’s absurdly high margins and returns on invested capital. We made around 60% in our Checkpoint investment in just over a year, plus as I indicated made additional investments in Palo Alto Networks and FireEye.

Channel Research and Interviewing Management Teams

We are constantly attending research conferences and trade shows and talking to industry participants, which can be the senior executives at companies or less senior people who are closer to the front lines. This work can be time-consuming and at times it seems not to lead anywhere, but it builds on the mosaic we’re developing constantly (as discussed above). However, there are two other benefits to doing this blocking and tackling work.

First, one question I’m always asking channel resellers or customers is: what is selling well or poorly? When I talk to senior executives I ask: what competitor do you respect the most? What product or service are you buying significantly more of or less of? When I hear a certain product is selling off the shelves or collapsing and this is inconsistent with the current narrative on Wall Street, my ears perk up. First hand research that gives me a variant perception on a business, especially if a complete disconnect, can be very profitable. If we hear something like this, we’ll double down on our research on this particular company – a lot of times we’ll be working on a completely different company and come across this kind of data point. When you have a solid variant perception on a company, this can lead to a surprise in the market that is key to take advantage of especially when a valuation is high (for a deteriorating product) or low (for an improving one).

In a number of what I call “tech widget” shorts, one can do first-hand research on a limited number of companies that are customers. An example of this, probably my favorite short of all time, was Entropic Communications. We started shorting in 2010 and into 2011. Entropic Communications was a fabless semiconductor company that engaged in the design, development, and marketing of systems solutions to enable connected home entertainment. The company’s primary offering was home networking chipsets based on the Multimedia over Coax Alliance (MoCA) standard, with this division comprising between two-thirds and three-quarters of revenue at the time. MoCA facilitates IP transport over coaxial cables and has primarily been used for “whole house DVR” solutions in which cable or DBS set-top boxes in any room can communicate with and stream programming from a home’s primary DVR. The primary advantage of this is that it allows someone to view DVR programming from any room and/or pause programming in one room and resume watching in another.

Entropic was first to market with its MoCA chips, which were slowly incorporated into most DVRs. At between $6 and $9 each, Entropic’s MoCA chips were expensive additions to set-top boxes. While Entropic was the primary beneficiary of the growth in this market, they had 100% market share while Broadcom dominated the set-top box

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processor market. Since the product was a standardized one, it was just a matter of time before Broadcom and ST Micro integrated MoCA with their existing system-on-a-chip (SoC) solutions, which were already in most cable boxes and allow the set-top box manufacturer to get the tuner(s), video decoder, modem, and MoCA functionality in one chip. An analyst we spoke to who covered Broadcom said, “The company will include MoCA on its chip at little to no additional cost and call it a win because their ASP won’t decline on their integrated chip.” This was echoed by experts we spoke to, who indicated, “There is no way Entropic can price lower than Broadcom and ST Micro given the integration advantage for Broadcom and ST.” One expert we spoke to said 15% annual declines sounded about right and even Entropic stated on their most recent conference call that they thought pricing pressure in the near-term could be even more pronounced than 15%.

Meanwhile, Entropic’s revenue run rate suggested the company was shipping to over half of set-top boxes at the time, despite MoCA not being deployed in a substantial number of set top boxes. As we interviewed procurement people at the major pay-TV distributors, they told us they planned to adopt Broadcom’s product because it was much cheaper.

The point here is we were able to probabilistically handicap that the bear case was correct largely by talking to a handful of customers in the set top box, DBS, and cable space. Investing is all about handicapping probabilities and investing when they are highly in your favor.

The second reason to do blocking and tackling work is you are constantly getting a sense for 1) which companies have sustainable competitive advantages in various businesses and 2) which companies have unique business cultures or management teams that could lead to outsized returns (or weak management teams for shorts). The company may have a product advantage, unique moat, or reputation as having a superior management team. Knowing this is great and leads us further down the funnel to then going through a mental checklist on financial quality, valuation, and business timing.

Is A Company Interesting After Identifying It? Going Through Valuation, Timing, and Quality

This piece started by talking about idea identification and not the due diligence and research process, but what probably has come out by now is that these processes bleed together. However, as my team and I are following this research process, for each company I am looking for certain characteristics to determine whether it might be interesting to dig into.

Perhaps it seems to fit my mold of names that have earned high returns for me in the past. As I have addressed in my marketing deck, I have found most longs that meet my hurdle rate have at least one of the following: 1) an extraordinary management capital allocation process, 2) a strong business moat, with a lot of green space to grow that moat, 3) a cycle, either idiosyncratic adoption driven or supply-driven in a cyclical business (if an industry is starved for capital long enough, returns tend to go up); 4) an extremely low multiple; or 5) a leveraged balance sheet with the potential for de-leveraging due to high cash generation. On the short side, I look for tech widget shorts, high customer concentration, flawed business models, the 3 Fs (fads, frauds, or failures), and businesses that are deteriorating at a significant rate. Many of the best ideas have multiple characteristics that fit these molds.

However, let’s say for simplicity first-hand research uncovers a certain company’s service that’s doing really well right now. That is enough to make me curious and explore further. For the next step, I’ll pull up the company’s financials to try to get a sense of whether it meets my criteria for being a good long from a financial point of view.

First Check Quality

First, I’ll look at the company’s long-term return characteristics. Does the company generate significant cash through the cycle? Are returns on invested capital decent? I generally like to invest in companies with consistently high cash flow from operations to cap-x and gross margins. Research by Credit Suisse’s Michael Maubossin suggests companies with higher profitability tend to earn higher returns over time and that persistence of high gross margins exists as the following charts show.

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Total Return for the Highest and Lowest Quintiles of Profitability (1990-January 2016)

Source: Credit Suisse HOLT®. Note: Gross profitability is calculated using the average of the assets at the beginning and the end of the fiscal year

Source: Credit Suisse HOLT®. Note: Top 1,000 global companies excluding financials and utilities, 1950-2014; Calculations use annual data on a rolling 1-, 3-, and 5-year basis.

In general, once a company is established enough to go public, it is usually difficult to drastically change underlying unit economics. If a company is a low margin distribution business, usually it doesn’t evolve into a higher gross margin business. It is easier to scale a high gross margin business to profitability at the EBITDA and EBIT line,

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but my experience is that massive changes in margin structures generally don’t materialize – despite the presence of many management teams that promote the potential for such improvement.

In addition, looking for businesses with high cash flow from operations to cap-x ratios usually results in better outcomes. These businesses require less capital to maintain and throw off more cash that can be used for acquisitions, buybacks, or debt paydown. Capital intensive businesses can be good if the capital is being deployed at extremely high returns, but again this is usually not the case. If cap-x is high as a percentage of sales, usually it stays high and vice versa.

Lining up strong business positions with attractive returns on capital that are sustainable is hard because most businesses don’t have meaningful moats. While it’s easy to pull up historical margin and return profiles, the more important work on quality is trying to determine why these attractive returns will persist? Digging in some more we try to determine that the company has a business model advantage: for instance, a network effect, scale advantage, customer stickiness or inertia, patents or IP that is impossible to replicate, etc. If that is the case, then the next step on the checklist is to figure out whether we can earn a high enough return using realistic or even pessimistic assumptions.

Next Look at Valuation

Next, I’ll look at the valuation and see if I can use back of the envelope math to determine if the stock has the possibility of meeting my return goal of a 3-year double on the long side (or if we were talking about a short 50% 3-year downside). For some companies I look at P/E and for some I look at FCF yield. If the company is levered I think using EV/EBITDA is a better check on risk/reward (levered companies can look deceptively cheap on FCF yield because of the effect of leverage, but leverage is a double-edged sword and EV/EBITDA captures leverage risk better). Here I’m just extrapolating historic or recent growth rates (if I think that is a good proxy) and using median multiples of where the stock has historically traded to see if I can get a high return. If the stock is well over 20x P/E or FCF, then I’ll usually be uncomfortable with the downside potential and/or will not be able to get enough upside unless the company has hyper growth or there is a huge margin uplift story that seems plausible (in this case the ev/sales might be cheap). Some ideas I’ll rule out and move on just based on valuation.

Eventually my analyst and I will do a model on the company where we have a much more detailed understanding of the key drivers of the business. We also have a proprietary 3-year outlook in the model that acts as a front page and makes it easy to visualize what multiple and assumptions that need to be achieved to hit our return hurdle rate. I find models are good in that they help in understanding the key drivers of the business, but a model is garbage in, garbage out. Focusing on competitive positioning, supply/demand, and forces impacting an industry is a far greater use of your time in determining where a stock goes in the medium term.

Unfortunately, I’ve sat in many group meetings with management teams where the other investors were primarily focused on short-term issues -- whether the company will “beat numbers,” for example -- and not the key issues that will drive the business. I also have talked to analysts who think that because they stare at a spreadsheet for a long time or build it from scratch that it will make their stock pick work better. A spreadsheet is only as good as the assumptions you put into it. Those assumptions are based on what is happening in the real world, which should be your focus.

What I’m constantly looking for is asymmetry – situations where I think there is low risk/downside if I am wrong and we can make high returns if I am right. One way to find this is through framing, essentially drawing an analogy to a better, bigger business on the short side or to a worse, smaller business on the long side. One example of a short we found to be highly asymmetric was Tuesday Morning. The retailer, which sells housewares and accessories as a “treasure hunt” concept, had gone on quite a run. A new management team, recruited by an activist investor, had come in and improved comps and operating performance. However, the activist investor who helped make the improvements had sold most of his shares and the company still wasn’t making any money by the time we looked at it.

We decided to visit the stores in Atlanta as a starting point for our analysis. The first thing a customer notices when walking into a Tuesday Morning outlet is how little money is spent in opening and operating a store. The stores are essentially barren boxes with cash registers and rows of white racks upon which merchandise is loaded. The last store we visited (~12K square feet) had three employees working at 5pm on a Thursday, and the store

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was quite grimy with mismatched buzzing fluorescent lights, drooping ceiling tiles, and HVAC venting that looked like it had not been cleaned since the Reagan administration. However, the company had achieved some progress, growing same store sales under the new management team. Below we show the progression of same store sales and margins, probably the most important metric in the retail business, at the time we started shorting the stock.

Operating margins declined from a peak of 13.4% in 1999 to 0.1% in 2013 (excluding a host of one-time expenses) and had last reached double-digits in 2005 and at the time had remained below 2.8% for the past six years. Meanwhile, the most successful competitor was HomeGoods, run by TJX Companies, a best in class discounter, which was a continued threat to Tuesday Morning. Furthermore, while analysts threw out crazy earnings power numbers for Tuesday Morning, HomeGoods’ margins were 11.5%. We thought Tuesday Morning was highly unlikely to match this number. Don’t forget, the stores were already bare bones, and the company’s store footprint lacked meaningful scale. With the stock at $18, we estimated that if the company was able to grow same-store-sales and expand margins to 5%, the stock would be worth closer to $11. This was what we came up with as a best-case scenario for the company.

The more likely scenario for the company was the one that played out. Namely, the company was able to grow same store sales for a while based on pricing and merchandising improvement, but then hit a wall. The stores just lacked mass appeal and the concept was weak, which is why we wanted to short the stock in the first place. The CEO who engineered the turnaround retired, same store sales slipped further, and margins came crashing back down, driving the stock with it.

However, the point here is that by framing the upside risk to where HomeGoods' margins were and to the company’s historical capability, we thought the downside of being short was relatively limited. We believed the stores were unlikely to do that well, but even if we were wrong it was unlikely we’d lose a lot of money. So we lined up asymmetry and framed the situation by looking at a better company as a point of comparison.

Third Look at Business Momentum

If the valuation at least seems promising or not a factor in ruling out the company as a potential investment, then usually the next step is to go through the last couple of earnings reports. Here I’m trying to get a sense for how strong business trends are recently. If I’m looking at something as a long and the business has experienced down sales or earnings in the most recent quarter, then this can end up derailing the idea for the time being. If business trends are positive for a long or deteriorating for a short, this is generally a good sign that I’m on to something. I think being on the side of business momentum is a key way to avoid mistakes – academic research shows there tends to be a post-quarter drift for companies that report good or bad earnings in either direction. I may send out an excerpt from my book with a chapter on how to avoid value traps, but one of the key punchlines is to always align with improving business fundamentals and if they aren’t improving, wait for validation before getting into a position. This is even more important on the short side where one can short a business and have it compound against you if it is growing at a fast rate. Better to be short when a business is compounding at a negative rate or have very strong probabilities that this will be the case in the next six months.

One caveat to my rule of thumb here on business momentum is that I’ve learned that cyclical businesses need to be looked at differently than steady or growth businesses. One should generally be more contrarian when examining cyclical businesses and the best investments in cyclical businesses are when there’s already been a multiple year down cycle in the business. This also makes valuation a different thought process on cyclicals.

If valuation, quality and timing seem to be lining up, then the next step is to really dig into the business. I would note that normally for valuation, quality and timing to line up like this is rare – the steps I talk about above tend to rule out 90%+ of businesses I am looking through. But since I’m taking short cuts to think through quality (high ROIC, does the business model seem to make sense and is there some kind of moat?), timing (looking at recent

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quarters), and valuation (back of the envelope math), I can cover a lot of ground quickly this way and go through a big universe of companies.

This is where you start to do due diligence on the management team, get much more granular on the business fundamentals and drivers, and figure out touchy-feely things like the business culture. If the goal is to own something for at least 3 years, perhaps longer, then you really want to make sure you understand all the important issues, identify the key issues and have a strong handle on them, understand what industry data points you need to be monitoring, etc. If I’ve gotten this far, the most likely way an idea will be derailed at this point is if I find 1) the management team has demonstrated unethical behavior or has a bad reputation, which might not be discovered until this step in the process, 2) a less obvious competitive threat or dynamic comes to your attention, or 3) it becomes clear that the durability of the business is not good, meaning there is a risk of technological obsolescence, demand falling off (for instance the business is style driven or could be a fad), or concentration risk.

Assessing Management Teams

While I like to talk to management teams of companies I own or are short, I have found this to be a balancing act. While I find it helpful to understand whether the management team is good and if I trust them, if I get too close to management it can lead to lapses in judgement. Senior executives at most companies tend to be very persuasive and good at selling their stories and it’s important to take an unemotional, almost detached stance on each investment. Most management teams are unlikely to flag negatives in their story to you until it’s too late. So having a strong relationship with the management team is most times unnecessary and in some cases, I’ve found it to even be counterproductive. However, the following are ways I like to judge management:

1) Overweight track record vs. what a management team says. As Bill Parcels said, “you are what your

track record says you are.” In businesses that are management-centric – for instance an IT services

company or ad agency – focus on whether there is a consistent track record of growth and profitability. If

a CEO talks a good game but overpays for acquisitions and executes poorly in growing revenue/cash

flow, run the other way. If a company has an incredible track record in generating high returns, then keep

digging and consider investing. Not rocket science but this is the number 1 way one should evaluate

management.

2) If you don’t trust them, run away. Generally, if you think the company massively overpays the

management team, the CEO has stacked the board, or there are signs the management is not being

truthful, you should almost never invest. If you find any members of the management team or board have

been involved in fraud previously, run don’t walk away from the investment or consider going short.

3) Look for companies that focus on returns on capital and shrink equity if high return projects or

acquisitions aren’t available. One of my better investments during my tenure at GMT Capital was in

DirecTV. The company was able to earn 20-25% ROIC growing its subscriber base of video customers.

While growth prospects were limited to growing its pricing in-line with its cable competitors plus slight

subscriber growth and Latin America had on and off currency issues, the company continually kept

leverage at 2.5x net debt to EBITDA and shrank its share count while keeping returns on capital high and

not over expanding in its core business or making ill-advised acquisitions. This allowed it to grow EPS at

a 25% CAGR yet the stock remained at a relatively low multiple, allowing it to continually buy back stock

attractively. Eventually the company was sold to AT&T, a bit of icing on the cake. Similarly, AutoZone in

the period between 2000 and 2016 went up 30x by simply growing steadily and shrinking its equity. It’s

important to note that both of these businesses lack a high degree of cyclicality (at least they did over the

periods discussed), so when recessions hit the leverage they incurred buying back stock didn’t come back

to bite them.

4) High stock compensation suggests a lack of alignment. As I’m writing this, several tech companies

I follow have stock comp that in some cases is as high as their EBITDA margins. While companies tend

to back this out of their earnings for analysts, it is a real cost and given the companies are showering so

much equity compensation on management suggests that either they are not operating in the long-term

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interest of shareholders or that their cost of doing business is much higher than their “normalized earnings”

suggest.

5) Look for ownership alignment. One of the major lessons in the book The Outsiders is owner operators

tend to produce the best results because they are most aligned with shareholders. One of the better

investments I made at GMT was a company called CGI Group, a business process outsourcing, and IT

consulting company based in Canada. That company grew 18% a year over 30 years and one of the

keys was that 80% of its employees were shareholders, leading to alignment. As a result, the company

had a maniacal focus on continued profitability and was able to transform underperforming companies it

acquired by cutting unprofitable business and aligning the workforce to become profitable.

Key Issues

There is a huge amount of noise in the markets and for that matter in life. People who can drown out the noise have an inherent advantage in both. When analyzing a specific company, in almost every case there are a few main issues that are likely to drive whether the company is a good investment or not. At GMT Capital, we called them key issues. For instance, for commodity producers, the price of the commodity is the most important factor and then the likely second-most important factor (or perhaps the first, depending on the environment) is the cost position of this commodity producer (the lower the better obviously). Many of the most important factors for businesses are much more nuanced: for instance, for a cable network, how strong the company’s programming is and how well accepted/popular the programming is will be a key determinant; however, if people stop watching cable television altogether and only watch shows on the Internet, this would be a more important key issue.

Almost every great investment can be distilled down to a few key concepts that overwhelm everything else. If you don’t know what those key concepts are before you make your investment, you probably don’t have a good investment. To be clear, I am not encouraging oversimplification of business analysis. The point I’m making is while most analysts tend to learn all they can about a company, which for the sake of thoroughness is in many cases important, the majority of one’s time should be devoted to what the key drivers of the business will be. Don’t miss the forest for the trees. In other words, spend the majority of your time on what matters for the business and not tertiary issues that may seem intellectually interesting but won’t drive the stock price. Boiling things down to what matters is a skill set that many analysts lack, and I find the smartest analysts tend to miss this point in many cases and as a result they don’t have a good feel for what drives a given stock.

If you don’t get this concept of key issues right, nothing else you do investing will matter if you are trying to invest based on business fundamentals. If you don’t understand the key issues impacting a business, it’s probably because you don’t understand the business well enough. It’s also important to make the distinction between knowing what the key issues impacting a business are and being able to handicap them. To make a successful investment, you must be focused on the right issues, but you also have to be able to be sure that they are in your favor. In each write up we do, the first thing we look at is the key issues and one should be able to distill these down to a few pages of writing at most. Richard Feynmann used to talk about how this concept also applied to science: if you can’t explain something in the simplest terms possible and distill it down to its essence, then you’re not clearly thinking about it.

Business Rankings

In our write ups, after addressing the key issues, we look at how a business compares to other potential investments one could make. Since our main limitations are whether the stock is liquid enough and it falls within our circle of competence, we are thinking about how the business ranks compared to all of the businesses one could invest in globally. An industrial distributor is a worse business than a global Internet monopoly from this standpoint. The management team at a local incumbent telecom company is unlikely to stack up to Jeff Bezos at Amazon. This gets you thinking, “if I could invest in anything in the world, why am I picking this stock?” Something usually needs to be extraordinary about the situation when you come at it from this mindset.

We rank business position, timing, valuation, balance sheet, and management. How I think about these categories is addressed to some degree above. If the balance sheet is leveraged, extra care has to be taken around looking at debt maturities, covenants, debt paydown capabilities, and what happens if the thesis goes wrong. Timing (business momentum) is very important in investing in leveraged companies because the market tends to respond

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disproportionately to surprises. Since the equity is a smaller component of the enterprise value, it can swing around a lot more significantly, as the market is assessing the business’s prospects (and at the very least these prospects are judged with a magnifying glass every quarter that is reported).

Just the First Steps in the Process

This piece is largely about how we work through an idea in the initial stages. However, our portfolio management process, which I call Bayesian Updating, is really about continually doing work on the businesses we invest in after the initial decision to make an investment. After we’ve made an initial decision to invest, we’re monitoring the position constantly for data points that confirm or refute our thesis. We’ve made a hypothesis in making our initial investment, but to scale up a position the fundamental data points must be consistent with the theory. It feels different when you own a stock vs. when you are doing the initial work; the risks involved come more to the forefront vs. the upside. Your feedback loop is adjusting to incremental data flow that you’re getting by monitoring industry data, continuing to speak to the management team, continuing to attend trade shows, talking to people in the industry, etc. If you can still model the high returns we target after a few quarters of following data points, and the data points you are monitoring are almost all consistent with your thesis, then it’s much more likely you’re right on the position. As such, as these data points are building your confidence, you are incrementally adding to the position as you go.

It’s important to say here that while I view my portfolio management process as providing a behavioral advantage, it is only because it fits my personality. Great investors tend to adjust their process well to their personality. The biggest biases I try to adjust my process towards are 1) getting in too early to cheap stocks (long) or expensive stocks (short); 2) scaling in to positions helps me because my personality leans towards being risk seeking, so it acts as a break/inhibitor in my process on new ideas. I am also a natural contrarian, so forcing myself to adhere to being on the right side of business momentum is a check on my natural inclination to “fight the market.”

We’ll likely write another piece in the coming months on investor psychology and how that fits with the portfolio management process. This is front and center for me as I build my analyst team as it is important for me to be able to assess how people I’m working with tend to react to situations and their natural inclinations, which may be significantly different from mine. I am lucky enough to have developed a good network of talented analysts I like to talk with periodically and since I know their personalities and how they think I’m better able to judge their ideas and whether I should dig into them.

As we get closer to launch we’ll also comment more on the current environment and potential investments. However, our first few pieces will focus on how we think about investing since I am new to a lot of people – while I have a 12 ½ year track record at a major fund and over 16 years in the business, I am trying to help people understand my process and how I think, through these initial pieces. If you have any feedback or questions, please let me know.

Sincerely,

Ben Gordon, CFA

Founder and Portfolio Manager

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