“Beware of geeks carrying calculators”
Most finance majors at MBA programs during the 1980’s, were introduced to Modern Portfolio Theory. We were taught about efficient markets and introduced to the Random Walk notion that stock prices in the public markets were efficient and factored in all available information such that their purchase or sale represented a zero net present value transaction. Weak form, semi-strong, and strong form efficiency were the buzz words of the day. We studied options pricing models, derivative securities, arbitrage pricing theory with its seemingly common sense underpinning of the law of one price. Back then, finance was being pushed from an art to a science, moving from approximation to mathematically precise security valuation. In contrast to cutting edge finance academics, one astute professional investor, named below, once opined, “It’s better to be approximately right than precisely wrong”.
At the height of this new era of financial mathematics, in May, 1984 a Columbia Business School Alum, Warren Buffett, was invited to speak at a seminar in celebration of the 50th anniversary of the seemingly outdated Graham and Dodd’s Security Analysis. Published in 1934, the investment text was the bible of value investing whose philosophy was investing in securities at a value with a significant margin of safety relative to the price paid. In speaking to stock prices Graham believed, “in the short run the market is a voting machine and in the long run a weighing machine” implying in the short run stock prices may be mispriced but in the long run their prices will move directionally with a company’s intrinsic value. In finance parlance, intrinsic value is simply the present value of future cash flow to be derived by an enterprise at an appropriate discount rate; with the discount rate asymptotically approaching the risk free rate based on the certainty of the cash flow stream. Contrary to Modern Portfolio Theory, rather than dwelling on portfolio covariance, alphas, betas and other Greek nomenclature, Graham and Dodd’s disciples employed a rigorous fundamental, intrinsic value approach to valuing a business and profited by finding discrepancies between a company’s enterprise value and the value of small pieces of the business represented by shares trading in the public markets. While lacking the theoretical precision generated by other quantitative approaches (e.g., Black Scholes), these super investors from Graham and Doddsville, identified significant, yet approximate, valuation gaps between intrinsic value and stock prices, and profited handsomely. During Buffett’s lecture he tracked the 30 year performance of his Graham and Doddsville peer group, all of whom consistently outperformed the market. In so doing, Buffett presented a record of returns that was statistically impossible to achieve per market efficiency theorists and irrefutably challenged the efficacy of the Modern Portfolio Theory.
Since the time of Buffet’s speech at Columbia a new investment asset class, grounded in fundamental analysis and intrinsic value, emerged in the form of Private Equity. Over the past twenty years, this asset class has matured and become far more efficient, arguably more efficient than the public markets. Consequently, over time private equity returns have compressed as massive capital inflows from pension and endowment funds sought to improve their overall portfolio returns. Indeed, approximately $1.5 trillion of capital was committed to the private equity industry over the past five years. The industry’s longevity has spawned more professionals in the field and today there are approximately 1,700 firms compared to 700 twenty years ago. Moreover, the number of investment banking firms and professionals has proliferated. More professional investors and advisors, coupled with the internet and its effect on information dissemination have resulted in robust auction processes in the middle market. With that backdrop, limited are the days of acquiring a company, through an auction process, at a reasonable value and generating returns through leverage, its subsequent amortization, and a quick exit.
As the asset class has matured, fund performance measurements have matured too, as institutional investors refine their overall asset allocation strategies. While internal rate of return and cash-on-cash multiples remain key metrics, the volatility or consistency of returns, be they IRR or cash-on-cash, at the portfolio company level is now being evaluated. While residing squarely in the Graham and Dodd camp, one useful term we have borrowed, with author’s license, from Modern Portfolio Theory and embedded in our mission statement is the concept of superior “risk adjusted returns”. That is, the concept of measuring the distribution or variance of Portfolio Company returns within a given fund. For example, a private equity fund might make 8 investments with 6 wipeouts and 1 grand slam home run creating a top quartile return, but that speaks little as to the ability of the fund manager to consistently replicate that performance; and in the context of overall asset allocation make the private equity portfolio risk profile look more like a venture capital fund.
As a private equity fund manager, MCM Capital Partners is entrusted with investing its limited partner’s capital, with the objective of achieving investment returns greater than those achieved in the public equity markets. In so doing, we strive to achieve this objective with minimal volatility (i.e., without losing money on any portfolio company investment). Accordingly, our “intrinsic value” investment strategy is conservative in an otherwise high risk asset class and we seek to drive returns not through undue leverage, but rather through appropriate investment selection, working with our management partners to navigate challenges and profitably grow our businesses, and to optimize the results of our liquidity events. In many respects, though we’ve never met, Buffett, Graham and Dodd have shaped our investment philosophy. While not explicit, Buffett’s pithy quotes, highlighted below, have clearly influenced out thought process.
“Rule No.1: Never lose money. Rule No.2: Never forget rule No.1” In evaluating investment targets, we seek to avoid businesses with undue customer or vendor concentration or those businesses whose revenue streams are highly cyclical or unpredictable. Our investment approach centers on understanding the competitive position of our target businesses and the economics of the businesses in which they operate. A central element resting in this approach is understanding the “moat” protecting a business’ ability to generate high returns on capital employed and the moats impenetrability. Accordingly, we look for companies with attributes such as, for example, unique manufacturing or engineering capabilities, low cost supplier status, high customer switching costs, or dominant distribution advantages serving markets that will endure over time. We prefer to utilize leverage prudently, as the consequence of financial leverage in challenging times far outweighs the benefit of the same in a robust economy. While we have certainly dealt with many portfolio company challenges, by applying this discipline we have almost universally avoided realizing losses on our investments.
“Investors making purchases in an overheated market need to recognize that it may often take an extended period for the value of even an outstanding company to catch up with the price they paid.” Lenders and private equity investors suffer from extreme bouts of amnesia. It seems only yesterday we experienced one of the worst economic meltdowns of our working careers. Yet, EBITDA multiples for good companies are again reaching nose bleed valuations as lenders have jumped head first into the market.
“We don’t get paid for activity, just for being right. As to how long we’ll wait, we’ll wait indefinitely.” While it’s certainly more fun to be doing deals, there are times when markets become overheated. During the late 1990’s and mid 2000’s private equity multiples were lofty which resulted in our not finding suitable opportunities at reasonable valuations which is paramount to success.
“You only have to do a very few things right in your life so long as you don’t do too many things wrong.” Many private equity investors and investment bankers speak in terms of deal activity as a measure of success. To the contrary, investors, be they private equity or otherwise, are in the business of allocating capital to generate appropriate returns. In our mind broad portfolio diversification doesn’t reduce risk if the right investments were made to begin with. Through the years we have become much better asset selectors and while we have successfully managed portfolio company challenges, we would much prefer to avoid them at the onset.
“When a management team with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.” Industry selection is critical to investment success and unfortunately we have learned in a commodity business you’re only as good as your dumbest competitor, reinforcing Rule No. 1 the importance of the “moat” in predicting cash flow generation for the long term.
Despite the market efficiency brought to Main Street, if Buffet was a microcap private equity investor he would certainly be optimistic about his prospects because of fundamental supply and demand equilibrium. Driven by aging business owners there will likely be a flood of companies up for sale in the coming years. M&A pundits have estimated approximately 40% of the family-owned businesses in the United States will experience a leadership change in the next five years. Beginning on January 1, 2011, the oldest of America’s baby boom generation started turning 65 at a rate of 10,000 per day which will go on for the next 19 years. An estimated 9 million of America’s 15 million business owners were born in or before 1964. Indeed, it’s estimated almost $5 trillion in liquidity will be created by 2015 as they exit, which will certainly present opportunities for microcap private equity investors over the next decade.