EL: How do you find short ideas? Do you limit downside risk? What indicates to you that a company is a scam?
MR: Most good shorts have a common theme – there’s some set of factors that cause investors to get more enamored with a business than they otherwise should be. It could be a really hot product (prone to being a fad), or a highly promotional management team (prone to over-promising and under-delivering), or a once-successful business that’s now being slowly marginalized, but still trading at a sky-high valuation (prone to investor disappointment). We use various screens to uncover likely candidates, and we also just keep our eyes open to businesses that potentially fit one of these policies.
As for limiting risk, we do take a number of precautions, because there’s no doubt the risk/reward of shorting is vastly inferior to the economics on the long side. First and most importantly, we maintain a strict rule which actually comes from the original Motley Fool Investment Guide: Never short an open-ended situation – i.e. a company that has what could potentially be a wide-open, long-term growth opportunity – no matter how overvalued it might look today. Second, we size our shorts much smaller than our longs – typically only half the size, on average. Third and finally, we maintain individual position loss limits on our shorts (1.5% of the fund) in order to protect against the theoretical potential for unlimited loss. At times, we’ll purchase puts instead of shorting the common in order to get built-in loss protection.
EL: Do you have any favorite investment metrics that you particularly like to look for in a company? What do you look for when reading a company’s financial? When calculating FCF, how do you separate maintenance and growth capex (capital expenditures)?
ZA: I would say that it is important to approach each new idea with the goal to best answer the question “what is it worth?” first and foremost, and then based on the type of business it is, to apply the valuation methodologies that are most appropriate for the job. For example, while we love simple businesses at low multiples to earnings and cash flow, there’re other ideas that may be just as good or better where the business isn’t currently generating any free cash flow at all. Or where the recent cash flow produced by the company doesn’t reflect how much value the business is actually creating. We try to answer the question of what a business is worth by using a combination of metrics that make the most sense. Whatever valuation approach we choose to take, it’s always rooted in the fundamental truism that a company’s value is equal to the discounted value of all future free cash flow.
MR: As for the question of growth versus maintenance capex, we do sometimes make that distinction, particularly for fast-growing businesses with heavy capex requirements. The differentiation between growth and maintenance capex is helpful in getting a handle on what free cash flow might look like at a different stages of a business’s life cycle. For instance, a growth retailer typically generates little, if any, free cash flow during its early growth phase, but then it can generate a monsoon of free cash once it stops adding new units. By understanding the different capex requirements at these different stages of growth, it helps us more precisely model the company’s free cash flow over time, and thereby reach a better estimate of intrinsic value. The key, however, is to remember that growth capex is still capex – and it’s only the true free cash flow which should be discounted within a DCF model.
EL: What is the investment book that taught you the most? Who are some of the great investors you admire and why?
BA: Warren Buffett has called Benjamin Graham’s The Intelligent Investor the best book ever written on investing, and I can’t disagree with him. It was the first investing book I ever read and it gave me the proper foundation for sustainable success in the market. I consider myself very fortunate to have read the Mr. Market parable, along with the rest of the book, before being exposed to the Efficient Market Theory and the like in college.
As for great investors that have influenced me, I’ve read as much as I can about Joel Greenblatt, Seth Klarman, and Eddie Lampert (Sears Chairman and one of the few who earned more than a billion last year as fund managers), primarily. They all reiterate the basic tenets of Buffett and Graham, but hearing them from different perspectives really helps crystallize them in your mind. Lampert, in particular, is a great case study since his recent history involves remarkable capital allocation at public companies, enabling you to actually see the effect of massive share buybacks, improving operating cash flow, the emphasis of profitability over same-store sales, etc.
MR: I’ve always had a fascination with why stocks are priced the way they are – and, more significantly, what makes a stock worth a given price. In my quest to understand stock valuation, I probably benefited most from reading Aswath Damodoran’s Valuation, which is basically the bible on discounted cash flow analysis. It helped me think through the mathematics of how a company’s intrinsic value is comprised of all its future free cash flow. That understanding of valuation theory is my single most important tool as a value investor. Even when I don’t run an actual DCF spreadsheet, the principles of DCF provide me with a framework for rationally approaching any given investment opportunity.
As for influential investors, I resonate strongly with Philip Fisher’s philosophy on identifying great businesses that can grow and compound over a long period of time. I give Tom Gardner credit for shaping my Fisher-esque views on how to identify the world’s best businesses – those with enduring competitive advantages, repeat-purchase business models, great balance sheets, high returns on capital, etc.
EL: Are there any investment ideas out there that you currently find attractive and can talk about?
BA: The market gave a 30% haircut to Whole Foods Market (NYSE: WFMI) back in November, likely because of the perception that Whole Foods reported “disappointing” same-store sales. I use that word very loosely, considering that their reported comps were still in the high single digits – numbers most grocers could only dream of. John Mackey, the CEO, is very open with investors, explaining that the company is focused on maximizing economic returns. Instead of building new stores just to please Wall Street, the company tries to spend money only when the return on capital exceeds that of the cost. I know it sounds like common sense, but unfortunately it’s not too prevalent among public companies. With a unique shopping experience and a loyal base of customers, Whole Foods still has plenty of growth ahead.
ZA: We also like the recently announced acquisition of Wild Oats (Nasdaq: OATS), which offers a nice value creation opportunity if it can get Wild Oats’ margins up to Whole Foods level. Finally, coming back to Mackey, this is a man who clearly works for the joy of the game, and now pays himself $1 a year. We’ve had a lot of success investing in companies where the CEOs pay themselves a pittance but have significant ownership stakes in their business.
EL: And just for fun: Do you think the Dallas Mavericks can win the championship within Dirk’s career? What are your opinions on Mark Cuban?
MR: This should be the year that Dirk not only gets a championship, but the MVP as well. I actually think the Mavs have the type of emerging talent, unselfish team play, and bench depth that can fuel a series of championship. Mark me down as believing in a Mavs dynasty over the next three seasons.
As for Cuban, in spite of his embarrassingly bad reality show, I like the guy – particularly in the context of his role as Mavs owner. I truly admire his passion, which has clearly been the driving force in turning the Mavs from worst to first. Cuban says a lot of provocative things, which is part of his charm, but the one topic on which I have to disagree is when he says the stock market is just like gambling. Yes, the stock market has animal spirits of greed and fear, but unlike a casino, the stock market is comprised of real businesses, with real assets, real cash flow, and therefore real and growing value. In the long term, gamblers lose a fortune, while investors make a fortune. But then again, he’s the billionaire.
And finally, this is the end of the interview. Personally, what Bryan Adkins answers to Emil’s question on the investment book to read reflect exactly what I have experienced from the start. The only logical way to sustainable financial success in the stock market is to have a strong and the correct fundamental, and this relates to those preached by Graham.
Coincidently, I like the business model of Whole Foods Market as well. Not only is the CEO a great model for management, the basic concept of chain-store is in itself a scaling business. To add to that, the way Whole Foods treat its employees, customers and suppliers is world-class, almost like how Sam Walton did for Wal-Mart with his grounding principles. Sam, in his biography mentioned, if he were to start a whole new business in 1990s, what would he do? He said he’d still be in the retail business, but he’ll focus on niche retail business and food is one of it. I’m not recommending that the stock is good to buy but what I’m saying that this business will be much bigger than it is from today. Mark this down.