Brian Gaines and Elegance in Valuation

To evaluate investors one must evaluate how they evaluate their investments. One of the things I look for is what I call "elegance" in valuation. It' s hard idea to define; you kind of know it when you see it. Warren Buffett rarely discusses valuation, but when he does he almost always demonstrates this quality.

I guess what I mean by elegance is the ability to restate a problem (in the context of investing, the problem is most often "what is this asset worth?" or "is this asset undervalued?" or "what is the expected return of this asset?") in such a way that the solution presents itself with disarming clarity. Think of the legendary story of a precocious German schoolchild daydreaming in class in the 18th century. The dour schoolmaster commanded his students to sum all of the integers from 1 to 100, expecting the tedious calculation to occupy at least a half hour of his students' time.

Instead, our precocious schoolchild, the youngest in the class, almost immediately blurted out the correct answer, making the dour schoolmaster even more dour. The child was Carl Friedrich Gauss, who became one of the greatest mathematicians ever, and he solved the problem not by his ability to calculate 1 + 2 + 3 +. . .+ 100 faster than anyone else, but by recognizing immediately that the problem could be restated in a way that made the solution easy: the list of 100 integers could be grouped into 50 pairs, each of which sums to 101 (1+99, 2+98, 3+97, etc.), so the correct answer was simply 50 x 101 = 5050.

There are many professional investors who can "sum the integers from 1 to 100" the hard way, by outworking everyone else or by using technology. But the very best investors are almost invariably elegant in their thinking; they have the Gaussian ability to simplify problems so that the difficult process of evaluating an investment becomes much easier.

A recent example of elegance in valuation caught my eye. It's maybe not up to the level of Gauss' trick but it is elegant nonetheless. My friend and editor John Mihaljevic recently interviewed Brian Gaines of Springhouse Capital for his Portfolio Manager's Review publication, and posted an excerpt on his blog. The excerpt included the following discussion of Netflix (NFLX), a company whose traditionally high P/E ratio and new business model made it unpopular among value investors:

As for investing in Netflix, the important thing for us was we never paid for the growth. When we first invested, we were paying around 5-6x operating income if you backed out the growth portion of the subscriber acquisition costs and made a fair assessment of what it would cost to maintain the subscriber base. Basically, on a story where you had clear evidence in early entrance markets like San Francisco that the product was taking well, you were able to get the growth for free. This was a good example of where we thought we had excellent downside protection with more than 50% upside. We were able to invest very successfully in Netflix on two separate occasions when the market refused to give credit for growth. When the market was willing to give any credit for growth, which was happening at a rapid pace, we elected to exit.

What made this analysis elegant was Gaines' ability to restate the "is Netflix undervalued?" problem in a different way, by substituting business reality for accounting "reality." According to GAAP, subscriber acquisition costs must be treated as an expense on the income statement (I vaguely remember this rule coming about in the mid 1990s and it caused AOL to trade way down). For a growing enterprise that does a lot of marketing, this will depress GAAP earnings, the E in the traditional P/E ratio, which will in turn raise the P/E ratio beyond the reach of most value investors. Gaines' insight was to treat subscriber acquisition costs not as an expense, but as mostly an investment in future growth, similar to a capital expenditure. Only a portion of this expenditure, analagous to maintenance capex, was to be subtracted from the pro forma income statement, as it represented the cost of maintaining then-current volumes.

Gaines' insight had the effect of significantly increasing the profitability of the non-growth portion of Netflix's business, which in turn lowered its operating P/E to a very value investor-friendly 5-6x. Having determined that Netflix's product was performing well, having calculated that he wasn't paying anything for the company's future growth, and having assumed that its heavy investment in future growth would likely earn a good return (or else would dramatically be curtailed), Gaines turned a growth investor's speculation into a value investor's investment, with a significant margin of safety, and was well rewarded. Elegant.