What Happened to all the Diamonds in the Rough?

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What Happened to all the Diamonds in the Rough?

There are two good times to be an investor: when valuations are low overall, and when dispersion is high. The valuation point is pretty obvious, and dispersion less so: there are times when the overall market is expensive, but the cheapest assets out there are really incredibly cheap. From 2000-2003, for example, small-cap value stocks outperformed by 93 percentage points relative to the rest of the market; for value investors, the market meltdown of the early 2000s basically didn't happen.

Dispersion in asset prices is usually correlated with where the overall market is, though. Sometimes, what counts is being born at the right time. In the late 1940s, for example, the S&P traded at a mid-single digit P/E ratio. Individual stocks were even cheaper, with plenty of companies trading at less than their net cash on hand. One reason was that nobody was paying attention. From Robert Sobel's Dangerous Dreamers:

Soon after World War II, Elmo Roper conducted a poll for the New York Stock Exchange to learn what people thought about that institution. He discovered that most believed Wall Street was home to some of the nation's slickest and most accomplished crooks. And a substantial segment thought that the stock market was a place where cattle were sold.

When the market is unpopular, it can lead to a wide dispersion in value between the cheapest and most expensive stocks for obvious reasons—nobody is paying attention, and no one is investing in order to push prices closer to their real value. But there's a less obvious mechanism: companies themselves spend less time thinking about their stock price, and put less effort into getting it higher. Companies' own financial decisions are a natural brake on market excesses, at least some of the time. Archegos' unwind was partly caused by the executives of ViacomCBS announced plans to issue $3bn in stock (as Yet Another Value Blog points out, they were more in the habit of buying back stock, and had talked about how their elevated share price showed that the market had finally caught on to how valuable their streaming business was).

And there's a third-order effect that's even stronger: a depressed stock market, or one that's indifferent to fundamentals, is very bad at rewarding companies for finding executive talent. Stock prices move when CEOs arrive or depart, especially when a bad CEO is replaced by one with a better reputation. Firing people is unpleasant, and CEOs tend to go out of their way to get along with board members, so replacing an underperforming CEO means the even more unpleasant task of firing a friend. So the natural tendency is that, absent strong monetary incentives, underperforming CEOs will tend to stick around. Getting on the good side of a dozen board members is a lot easier than running a company, so some subset of people who try the latter will settle for the former if it offers the same job security. Part of the reason stocks were especially cheap and inefficiently priced in the 1940s was that there wasn't a lot of upward mobility in management in the preceding decades, so the people in charge were disproportionately likely to be the ones who had survived the Great Depression and were bracing for another one. One piece of evidence for this is that when a new generation did enter the workforce, they did quite well; 28% of Harvard Business School's class of 1949 retired with the job title of President, CEO, board chair.

When you read about the heyday of value investing in the 50s and 60s, one of the things that stands out is that they were able to find tiny cheap companies with high-quality economics and good management teams. Not only was the market for stocks inefficient, but the market for talent was, too. There are, of course, plenty of talented managers at all sorts of companies, but there are far more financial institutions that spend 100% of their time trying to identify these companies and pour as much capital as possible into them in order to make them scale faster, which means that the companies don't stay tiny or cheap for very long. And plenty of companies also devote a lot of effort to recruiting through M&A. A small company CEO can quickly end up heir-apparent CEO to the much larger firm that buys them. So the upshot of this is that the statement “this small, obscure company is in a good business, is well-run compared to its peers, and looks quite cheap” requires a lot of explaining, because so many forces conspire to ensure that sufficiently good companies remain neither small not cheap for long. It can still happen—a potentially great company can get sidelined by a run of bad luck.

One reason for this is that the talent stratification starts earlier. Over the last century, elite schools in the US have switched from targeting the social elite to aiming for more meritocracy—they still have legacy admissions, sure, but it used to be much closer to a pure legacy system with testing as a formality. Harvard apparently had an 82% acceptance rate in the 1930s, and Yale only got aggressive about recruiting students who didn’t follow the prep school track in the 1960s under Kingman Brewster. So for someone born in the first third of the twentieth century who didn't happen to attend Andover or Phillips Exeter, there was a very good chance they wouldn't end up on the standard meritocratic ladder, but that they would be able to work their way to the top of whatever local insurance broker, ball bearing manufacturer, or mining company they happened to work for.

It’s probably economically efficient to have a better market for talent; you can make a bigger difference as a VP at a huge company rather than at the very top at a smaller one, especially if the entire executive team at the company you work for is smart; smart people are complementary to one another.

But can we work backwards and find a case where talent wouldn’t find its level, and where there could be great executives who remain undiscovered? Some possibilities:

• Industries that 1) attract passionate people, and 2) have bad economics. I've written before about how airlines fit this category: planes attract plane nerds, and the biggest companies get access to the best hardware in a way that doesn't quite apply in other industries. If you were obsessed with fine food, you might dream of owning a restaurant, but you probably wouldn't aspire to be the CEO of Subway or McDonald's—but if you're really into giant aircraft, there are only a few places where you can be responsible for buying a few A380s, and they tend to be fairly large airlines. Entertainment is another case where the industry attracts people for reasons that go beyond its economic merits.
• Industries that require specialized skills but aren’t glamorous. For some companies, the Colorado School of Mines is a more important brand name than, say, Princeton. And this means that those executives are on a different status ladder.
• Family-controlled companies. One issue with these is that a decent contributor to value investors’ returns is M&A, and a company that’s been family-run for more than a generation a) probably wants to stay independent, and b) probably selected the heir-apparent based on their willingness to stay independent. (There is a small family-controlled shipbuilding company that periodically has a cheap stock, and has been written up on ValueInvestorsClub no fewer than five times. By contrast, the common stock of Bank of America, which is worth almost 4,000 times as much, has been written up four times. The shipyard is trading where it was ten years ago. And, yes, the stock is very cheap.)
• Find a way to filter for bad luck. If the combination of still small but very good is hard to explain, one way to find examples of it would be to explicitly look for companies that have run into a major problem, and then try to figure out if it’s non-fatal. This can be dreary work; analyzing companies is hard enough, but analyzing a company and a lawsuit is even tougher.
• Other countries are less relentless about stratifying by assumed talent than the US, especially countries with norms against hostile takeovers. Spend some time looking at small-cap Japanese stocks and you can find companies trading at free cash flow yields in the teens, and growing at a healthy pace. In theory the expected return from buying a stock like that is 20% or more. There are other companies that have liquid assets on the balance sheet worth more than the market price of the company. In practice, some of these companies are effectively controlled by other businesses in the same extended corporate family. So they might be profitable, or those profits might accrue to the parent company in some opaque way, or might just never be returned to shareholders.

The situation in Japan is changing ($), partly driven by regulation and partly by activist investors who are pushing for it. Which raises an important point about the diamonds-in-the-rough problem. The reason the 50s were so great for value investors was that in the 1960s, so many conglomerates grew by acquiring cheap companies, many of which were public. So there was an actual catalyst. The same thing applied in the 1980s with private equity, and again in the 2000s. Cheap stocks arise from the absence of the various forces that push their prices back to their fundamental values. So value investing turns out to be something like a macro play: finding underpriced stocks is a lot of the work, but a big component of the returns is finding a reason they'll trade where they should.

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Elsewhere

A Different EV Network Effect

The car industry grew up right alongside the gas station industry, with each side feeding the other's network effect. Electric vehicles need the same kind of growth in charging stations as well as vehicles sold, but the mechanics of charging cars versus pumping gas mean that they have some extra opportunities: Ford's F-150 Lightning may have vehicle-to-vehicle charging. This is partly a practical move and partly marketing: at least judging by their ads, the pitch for Ford's trucks is that their owners are self-reliant (and a giant pickup truck is indeed useful in many cases). No one wants to buy a vehicle that makes them independent and then constantly worry that they're too far from the nearest charging station. Since different vehicles won't necessarily be compatible with one another, it also creates a modest vehicle-level network effect. High fixed cost, declining marginal cost, and nonzero network effects are a pattern that has done very well in the past.

Supply Chain KPIs

The number of ships waiting to unload at Los Angeles has dropped from 86 to 61, but this is a function of a new queuing system that has more of them waiting farther out, not a drop in overall waits. It's still a positive development: under the new system, ships can reserve a spot in line and then choose a speed that gets them to the port when they'll actually be able to unload. This doesn't have a meaningful effect on how many ships the port can handle, but does mean that ships are burning less fuel for a given distance traveled.

The Underwriter's Loop and Cyber Risk Insurance

A while ago I spoke to a very informed observer of cyber risk who shared the story of The Hartford Loop: in the early 20th century, steam boilers frequently exploded, and Hartford Steam Boiler Inspection and Insurance Company ended up paying for them when it happened. The company discovered a modification that dramatically increased the safety of boilers, and started offering insurance only to the boilers that complied. This was a clever way to internalize an externality and save lives.

Resilience is a cyber risk insurance company that just raised $80m and operates under similar principles: they're selling insurance, but also offering services that make it less likely that the insurance will be necessary. It's hard to insure against the full economic cost of a hack, since that cost is hard to measure and can accumulate over time. But using insurance rates to set an implicit price on bad security before the problems hit is a way to line up the incentives and make this happen.

Pro-Regulation Tech

The two groups of people who spend the most time demanding that social networks face stricter regulations on what content they can post are 1) opponents of Facebook, and 2) lobbyists who work for Meta Platforms, Inc. Meta knows that the company best equipped to actually follow strict rules about what people can post is the one with the most moderators and the most data, and that's them. Something similar is happening in the buy-now-pay-later space, where Affirm is calling for regulations on how BNPL companies disclose their costs ($, FT). It's not exactly bootleggers, Baptists, and BNPLs, of course; Affirm does actually have a more transparent fee structure than some operators. Part of what the company worries about is the proliferation of payment options on checkout screens. If every incremental option offers a lift to merchants, they'll keep adding them, and Affirm probably doesn't want to be stuck striking expensive exclusive deals with everyone. Better to cut off some operators entirely, impose uniformity on the market, and turn it into a purer competition based on conversion optimization and underwriting skill.

Local Chips, Global Companies

Samsung has agreed to build a $17bn chip fab in Taylor, Texas ($, WSJ), and the Japanese government is allocating $5.2bn in subsidies for chips, two thirds of which will go to Taiwan Semiconductor Manufacturing ($, Nikkei). The ideal for both countries would be to have manufacturing controlled by domestic firms, but that's not an option just yet. So they end up in the odd situation where even tech nationalism is partially outsourced to more competitive foreign companies.

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