What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital.
Ackman Is Brilliant
Research on Wall Street has effectively become commoditized. Analysts and portfolio managers bring very little in the way of originality. In fact, a majority of hedge funds are simply platforms built to emulate one another through strategies that employ capital on a copycat basis.
The research that is performed at the institutional level uses the same information, derived from the same sources to build the same models that are taught in the same business schools.
And when investors in these funds do not receive the returns represented by this menagerie of mediocrity, they blame everyone but themselves. Never have investors stopped to think about how a group as a whole can outperform the markets when their methods, analysis and employees are all linear thinkers, schooled in linear thinking, operating within a completely nonlinear environment.
That is why when an idea comes up from a well established fund manager that is both original and thought provoking in nature, it should be discussed.
Bill Ackman at the Sohn Conference in May gave a presentation regarding platform companies. Platform companies are essentially shell companies that act as a platform for future acquisitions. Ackman argues that Wall Street cannot accurately value these companies. In fact, Wall Street undervalues these platforms on a consistent basis.
When the intangible nature of future acquisitions takes precedent over current earnings, then Wall Street simply ignores the opportunity because it cannot be modeled or simplified through a traditional multiple of earnings approach.
Instead, as Bill Ackman points out in his presentation," investors must value the company based on both the earnings potential of the company's current asset base, as well as the potential to generate additional earnings through future, value enhancing investments. "
This line of thinking delves into the non-linear realm of securities analysis that isn't taught at business school. It involves abstract concepts and probability that are more entrepreneurial in nature. In other words, it's the type of concept that causes smoke to begin funneling out of your typical analysts ears, with the eventual outcome being a complete cessation of brain activity.
When a corporation cannot be easily analyzed then inherently there will be inefficiencies in pricing that asset. Whenever an investment is dominated by abstract, non-linear business concepts, then the markets have no choice but to either a) ignore or b) sell. There is rarely, if ever, a premium given to such a situation.
The inefficiencies become all the more pronounced once an investor decides to move into subsets of the market, such as micro and small cap names that have gone through a distressed event of some sort or another in the not too distant past.
Distress within a public corporation doesn't just cause current management to exit, hoping to forget the experience entirely. It also causes investors to completely abandon the stock because of the complications involved in analyzing the remaining assets on any type of traditional basis. This is further exacerbated by the fact that institutional coverage of these names is nonexistent, which removes a valuable layer of information transparency within an otherwise murky environment.
The subsequent byproduct of such events is a complete misvaluation of assets. This persists even as management and asset quality is improved through various restructuring measures.
Interestingly enough, the issue of undervaluing platform companies doesn't simply resolve itself once an accretive acquisition takes place that allows traditional analysis of the company to be performed. In numerous instances both presently and going back as far as 30 years, the markets often take years to properly interpret the newly-evolved, recently emerged earnings picture. In the meanwhile, the appreciation that takes place for equity holders is both persistent and substantial in nature.
This inefficiency in the marketplace is a boon for investors who decide to participate in this subsector of the markets. After all, confusion is the mother of opportunity.
Leveraging Year To Date Performance
Given current cash levels in the portfolios, I have the opportunity as an asset manager to approach the markets on a highly opportunistic basis over the next few months. We have leverage in that our performance has been so far above our benchmark year to date that a further aggressive posture can be taken as opportunities present themselves.
I don't believe in becoming conservative as performance grows. A conservative posture should only be taken as performance declines. Otherwise, an investor effectively leverages their methodology into periods of time when the markets aren't rewarding that particular discipline, which can lead to disastrous circumstances. As performance grows during a calendar year, so should the willingness to take on more risk.
What is risk? After all, T11 is an unlevered asset manager. We don't create opportunity through utilizing derivatives or margin. In my methodology, risk is the willingness to concentrate further in our best ideas. As an example, if I'm willing to allocate 10% into one of my best ideas, then I increase that amount by 50-100% as performance grows.
This is indeed a form of leverage. I am leveraging my methodology during favorable market conditions. While this is traditionally seen as "increased risk," it is in fact smart investing.
I am a big fan of poker theory as it applies to financial markets. I have written articles in the past for Forbes and my own website that briefly go over the close relationship between poker and investing.
It is a simple truth that in poker when your opponents are outmatched as dictated by the size of your stack then it's your duty to push your bets. You do not become more conservative as your prowess at the table grows. In poker, by leveraging your methodology over weak opponents, your winrate increases substantially over the long-term.
Likewise, in the markets when conditions heavily favor your methodology, as dictated by positive outperformance, then you must leverage your methodology into a "weak table" to borrow a poker term.
By not doing so, you are effectively losing equity by not making the best play possible given prevailing circumstances.
The fundamental theorem of poker as presented by David Sklansky in his book, "The Theory of Poker" states the following:
"Every time you play a hand differently from the way you would have played it if you could see all your opponents' cards, they gain; and every time you play your hand the same way you would have played it if you could see all their cards, they lose."
This theory puts emphasis on efficient action in poker. Basically, making the right play at the right time regardless of outcome increases your expected value and thus, your expected earnings over the long-term.
There is little difference in investing. Your expected earnings over the long-term are dictated by taking statistically favorable actions in a variety of circumstances. This should be done consistently without being swayed by the outcome provided the methodology is statistically viable. Consistent efficient action in investing leads to superior results.
The most efficient action I can take at the present time is leveraging an environment that heavily favors my methodology. While this is traditionally described as "increasing risk" in a portfolio, when you look at it on the basis of long-term expected value the real risk involves not taking the proper action when circumstances favor our play, thereby effectively losing equity by not making the best play possible at the best time.
