Monday, April 16, 2007

Value investing lessons from Centaur Capital (Part 1)

This is an interview conducted between Emil Lee, an analyst and a fellow value investor, with the partners at Centaur Capital. Centaur’s founder, Zeke Ashton, was profiled in James Altucher’s excellent read, “Trade like Warren Buffett.” He is dubbed by James (along with Mohnish Pabrai) a Buffett-style hedge fund manager. The following is the interview, conducted via email by Emil.

EL: Please provide a brief history of Centaur Capital

ZA: Sure. Centaur Capital got its start in early 2002 when I moved to Dallas and started a limited partnership called the Centaur Value Fund, which launched in August of 2002. Matthew Richey and I had worked together at The Motley Fool for a couple of years and shared a similar investment framework, so of course I was delighted when Matthew joined Centaur in late 2003. Matthew acts as co-portfolio manager of each of our funds, and so the investment decisions are always made in a consensus fashion. We had about $3 million under management at that time, as I recall, which seemed like a lot of money to us at the time. Bryan (Adkins) joined us in April of 2006 as a securities analyst, and because he is cursed with having multiple talents, he gets to handle our IT needs and has various other duties in addition to being a full-time analyst. He’s been a great “value investment” for us.

Today, we continue to manage the original partnership, and have added additional funds for U.S. and offshore institutional investors as well. In early 2005, we launched a retail mutual fund in partnership with our friend (and also former Motley Fool writer) Whitney Tilson and his business partner, Glenn Tongue. Whitney and Glenn are great investors and really nice people to work with, so that’s been a fun experience for us. The fund is called the Tilson Dividend Fund (TILDX), and we use a value-based dividend and covered call writing strategy that we developed and which we believe is a fairly unique. Across all of our accounts, Centaur Capital had about $70 million under management at year-end 2006. As far as track record, readers can see the results of the Tilson Dividend Fund by going to the Tilson Mutual Funds website ( As for our limited-partnership trck record, I’ll just say that we’ve produced returns over five years that are at the high end of the goals and expectations that we set for ourselves.

EL: According to a shareholder letter, your due diligence process entails printing out a huge stack of annual reports, SEC filings, and whatever other research you can find and then sitting down and reading it all. This is a typical due diligence process. Why do you think Centaur is able to produce a superior track record using the same research methods as everyone else? How granular do your valuation models get?

ZA: First of all, I think you should realize that there is an awful lot of money managed in this world where the decisions are not based on detailed fundamental research or an emphasis on buying assets at prices that are demonstrably less than intrinsic business value.

Matthew Richey: If we have any edge, it’s simply that we try to be highly disciplined – specifically, disciplined to only buy stocks that we determine to be conservatively undervalued, and then disciplined to sell once a stock reaches our estimate of fair value. We’re also highly risk-averse, and we strive to only take action when all our research points to a favorable outcome. We look at a lot of stocks that we mentally toss into the “too tough” category. But for the names where we’ve done our homework and know a price what we’re willing to pay, then it’s simply a matter of waiting for Mr. Market to give us our price – and he often does, if we’re patient.

As to the granularity of our valuation models, we aim to follow Einstein’s advice: “Everything should be made as simple as possible, but not simpler.” The problem with many models, of course, is garbage in, garbage out. It’s of no use to make a model super-granular, but full of inaccurate assumptions. We try to avoid any illusion of false precision by sticking to a handful of key big-picture variables – the durability of competitive advantage, profit margins, capital expenditures requirements, and conservative growth potential – all leading to a forecast of future free cash flow, which we then discount back to present value using an 11% discount rate. We also typically forecast both a base case and a stretch case to arrive at a range of estimated fair value.

EL: According to a Value Investor Insight interview, you often get ideas by running quantitative screens. As a result, your firm is “sector agnostic.” How do you go about getting to know an industry in a relatively short period of time? Do you subscribe to any information sources/trade magazines that you find particularly useful for industry research?

Bryan Adkins: If our screens bring up a handful of names that seem interesting, we’re more inclined to go with the business models that we best understand. Our perspective is the simple an investment thesis, the better. We try to stick with what we know and avoid mistakes. For example, since I’m familiar with the retail model, it’s much easier for me to analyze Home Depot competitive advantages and determine how its makes money than to analyze Bank of America.

We don’t read any particular trade magazines. When I’m researching a company or industry, Google is usually the only resource I need – from Fortune and BusinessWeek write-ups to recent articles in The Wall Street Journal, blogs, and more, the internet pretty much covers all informational bases.

MR: We’re big believers in sticking to our circle of competence. But we also see no reason why our circle of competence shouldn’t be gradually expanding over time. That’s why once or twice a year we’ll look at an entirely new industry. In 2004 and 2005, I began exploring precious metals, while Zeke began looking into oil and gas. Our learning process involved reading annual reports, conference call transcripts, industry-related research reports, and the occasional book on the industry’s history. It was a slow process, but we now have reasonable expertise in both of those areas.

There have been other sectors, however, where after a long, hard look, we decided the industry is too tough for our analysis to pay off, so we simply abandoned it. Such was the case last year after I spent three weeks scrutinizing the debt collection industry. I found that the two main players, Portfolio Recovery Associates (Nasdaq: PRAA) and Asset Acceptance (Nasdaq: AACC), are both great companies run by shareholder-friendly management – but the business model involves too many moving parts for me to identify a clear range of intrinsic value.

Check back later for part 2. That Einstein quote about simplicity, in my opinion, is one every value investor should cast on their forehead. I’ve noticed that great value investors like those at Centaur know what they know and what they don’t know – in other words, they know the boundaries of their circle of competence, but they constantly work on expanding that circle. Interestingly, they talked like Warren Buffett in a lot of ways too.

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