One of the calmer moments of putting my kids to bed comes when the children settle down to listen to a bedtime story. Recently, in my household, we have been thumbing through the Enid Blyton canon, joining the various alliterative groups of young crime-solvers as they track down smugglers, foil kidnappings, and apprehend roguish gangs of thieves.
One such story that we enjoyed together was The Mystery of the Missing Necklace, wherein the Five Find-Outers endeavour to track down a prized pearl necklace, stolen from a mansion and hidden somewhere in their village. The solve, in the end, comes in the dramatic setting of a travelling waxwork museum: one enterprising thief simply places the necklace over a second-rate waxwork of Queen Elizabeth I, figuring that no one would give such an obviously visible item a second look. Unfortunately for him, as is often the case in Blyton-land, he does not consider the fiercely intelligent gang of pre-teen detectives, hell-bent on utilising whatever free time they have to catch crooks. Find-Outer-in-chief Frederick Trotteville notices the necklace and realises that the best place to hide something everyone is searching for is often right where everyone can see it; after all, that’s where nobody would ever think to look.
This story, as with all forms of art, contains within it a critical message for the discerning investor.
The best place to hide something everyone is searching for is often right where everyone can see it.
Take a second look
Being a successful investor typically means, in the long run, ending up with more money than you started off with, and with more than you would have otherwise been able to earn by simply owning an equivalently risky basket of assets. For investors like us – who take ownership stakes in public businesses – this equivalent basket is the broad equity index, which tracks the performance of all listed companies in a region as a whole.
In our efforts to reliably beat this hurdle, we cannot win simply by investing in companies which are not accessible to anyone else: there are several equity managers who have badly burned their investors by veering too far outside of their agreed universe.
As a result, our job is to identify and own the most attractive companies, but to do so where these companies are accessible to everyone else. Of course, the most attractive companies are what everyone else is also looking for, and so in the majority of cases, companies that are worthy of being well-regarded usually are, and sport commensurately high prices which set the bar for future performance extremely high – often too high, in our view.
Where, then, are we to find attractive opportunities: truly impressive companies that are available at prices reflecting a lack of interest worthy of a shoddier operation? The answer, of course, is by looking where no one else is looking but at what everyone else can see – the jewels hiding in plain sight.
The answer is by looking where no one is looking but at what everyone else can see.
Can you spot a counterfeit?
To accomplish this task, we must take a leaf out of the Enid Blyton playbook, looking carefully at each opportunity on its own merit, ignoring conventional wisdom and thinking things through ourselves from first principles.
By way of example, consider the investment merits of two companies, whose identities – in true Famous Five fashion – shall remain a mystery for the moment. Which, if any, would warrant the time and effort needed to undertake an investment evaluation?
Company A is an airline which operates in the fiercely competitive commercial aviation market, a market littered with the corporate corpses of operators bankrupted by ruthless competition, commoditisation, oil price exposure and constantly increasing regulation. In addition to operating in a volatile industry, Company A in particular has its own unique list of troubling characteristics: for many years, it struggled beneath the weight of an enormous pension plan, committing vast sums of money to plug the funding shortfall. It also has a precarious position with labour unions – around 90% of its employees are unionised and regularly go on strike, – which causes ruinously expensive interruptions to its business. Finally, the company has a concentrated exposure to revenues from just one major airport, rather than having a balanced geographic diversification across its operations.
Taking a broader, more historical view can be a huge asset.
Company B is a different animal entirely. Over the past decade, Company B has seen its revenues grow annually by 4.7%, meaning that revenues are 60% higher today than they were ten years ago. For some context, that is better than several phenomenal and much-loved companies, such as WalMart, Pepsi, and L’Oreal. A fantastic management team has been able to not only grow revenues, but has done so whilst staying on top of costs, meaning that profits have risen even faster – growing at a compound annual rate of 21.5% per year. This growth has come from formidable competitive positions in its key end markets: in one key product category, Company B has a 58% market share, a dominant position that leads to substantial pricing power and impressive margins. Within that category, Company B’s individual products lead their markets across the board, with the top ten largest products by sales each having the leading market share.
Company B has not rested on its laurels, however, and has opened up a second major category, where it is seeing a repeat of its original success: strong growth, excellent market share, and all the associated profitability that typically reflects those characteristics. Company B also has a small but growing capital-light business – one which can grow without management needing to invest huge amounts of extra cash each year – which has even better margins than the main categories and a faster growth trajectory. Topping all of these wonderful attributes is the blessing of a critically constrained supply chain, which prevents competitors from scaling up and aggressively competing with Company B on price, at least as long as the supply chain remains short. Healthy profitability and cashflow has enabled the company to pay down its debt, which sits at levels well below its conservative targets, and it has no large future pension liabilities.
If forced to allocate some of your limited time, which company would you think to investigate as a potential investment?
What is interesting is that – as the Find-Outers amongst you may have guessed – Company A and Company B are in fact the same company: International Airlines Group (IAG), the parent company of passenger airlines British Airways, Iberia, Aer Lingus, Vueling, and LEVEL. While a litany of misconceptions is ever-present in investor’s minds regarding the frightful spectre of Company A, a closer examination of the actual numbers, and the true market structure, reveals the Company B that lies beneath.
To recognise the string of pearls, you have to stop and look at what many assume to be a cheap fake.
A closer examination of the actual numbers, and the true market structure, reveals the company that lies beneath.
Looking through market myopia
We find that many investors (we would argue most investors) see a company for what it appears to be and move on; they see Company A – a hodgepodge of negative narratives which have in fact been resolved – and don’t bother doing much more work to uncover Company B.
Often, what a company appears to be reflects only its very recent past, with the length of time public investors define as “recent” seeming to grow ever shorter, in our view. Most of the time, this is warranted, with most companies changing only modestly in any given year; sometimes, however, something seismic has occurred, and what a company appears to be can differ greatly from what it truly is.
For instance, a company which is a leader in its industry – with a healthy balance sheet, fantastic management team, and exceptional track record of shareholder-friendly capital allocation – can still undergo severe stress if its core market experiences a downturn, thereby reducing its earnings power in the short-term. The market value of the company will often accompany these short-term fortunes, without any kind of consideration for what the company might actually generate in earnings over a meaningful period of time (which we would consider at least ten years).
In these scenarios, taking a broader, more historical view can be a huge asset. Considering what the company has earned each year over the past decade, through a range of business environments, can give us a good sense of the normal average level to which the company might be able to return over time. If an impatient market is unwilling to wait for the return of these normal earnings, and is happy to sell out its interests to us at a substantial discount to the intrinsic value of the company – the present value of that long-run earnings power – we are happy buyers, and should expect to be rewarded with above-market returns.
Intriguingly, this process is also true of talented growth investors: both suffer from an “everybody knows” complex. For value investors, we must look through the sentiment that everybody knows that the company is cyclical and has no competitive advantages, so it deserves to be cheap. For growth investors, they must be prepared to outbid the market’s expectations for lofty growth, defying the view that everybody knows that the company will grow, and be willing to bet that growth will be even higher and more persistent than the market expects.
We must look through the sentiment that everybody ‘knows’ that the company is cyclical and has no competitive advantages, so it deserves to be cheap.
Whilst value investors benefit from anchoring expectations for the future to the performance of the past, growth investors benefit from casting off that anchor entirely, recognising the occasional exponential value of uncharted waters. Both, however, are able to recognise that looks can be deceiving – and that the best opportunities are often hiding in plain sight.
If Enid Blyton hadn’t been such a successful author – selling over six hundred million books and counting – she might well have made a formidable investor.
Key Information
No investment strategy or risk management technique can guarantee returns or eliminate risks in any market environment. Past performance is not a guide to future results. The prices of investments and income from them may fall as well as rise and an investor’s investment is subject to potential loss, in whole or in part. Forecasts and estimates are based upon subjective assumptions about circumstances and events that may not yet have taken place and may never do so. The statements and opinions expressed in this article are those of the author as of the date of publication, and do not necessarily represent the view of Redwheel. This article does not constitute investment advice and the information shown is for illustrative purposes only.
