Variant perspective. Taking in the details of a situation that most people are seeing and crafting a different perspective from them. This is a core principle idea in investing. I want to take a moment to reflect on how this core principle idea can be applied in my own investment process.
The example I am thinking of comes from my most recent investment: Hennessy Advisers. I have a variant perspective, it seems, from the market. At a superficial level it appears that the market is discounting Hennessy Advisers because of the move from active investment strategies to passive investment strategies. While there has been additional pressure on the stock price as a result of general downturn in the market, I'm going to focus on my variant perspective in relation to the active vs. passive debate.
Simply having a variant perspective is not enough. It has to be a grounded, rational variant perspective which supports an investment thesis. In order for this to work I need to have a strong understanding of the dominant perspective as well. I reflected on this a lot with the 'retail is dead' dominant perspective and made a decision to not even wade into that debate because I believe the complexity was too high for me and that too many people were already in the game for me to add some sort of variant perspective with an edge.
So what's the difference here with regard to the passive vs. active debate? Obviously many people are having this conversation and so why does my logic not follow the same path as with the retail debate?
Here are some reasons:
- Investment management companies are typically asset light, highly efficient on return measures, and can scale down expenses with revenue declines really simply. It is highly unlikely that a company like this would go bankrupt without a glaring mistake.
- Disposal of assets on in this debate is much simpler. We are not relying on underlying valuation of real estate to support value of company which could take years to work out if ever. Rather we are looking at companies with usually liquid assets.
- The active vs. passive debate is not a zero-sum game. It's literally impossible for the market to function if everyone moves to passive investing. It's less a question of whether one will win or not but rather a question of balance. This is not the case for the retail debate where I can envision a drastically different world with regard to retail then what currently exists.
Those are general reasons but let me get more specific with regard to Hennessy Advisers.
- HNNA is taking advantage of depressed valuations through a roll-up strategy of other small investment management companies which has generated consistent earnings growth even as outflows have continued.
- Generally the company manages funds which are quantitative in nature. The strategies are simple to screen for and only require annual rebalancing and investigation. What this means is that the human resources required to create their portfolios are minimal and this is reflected in there only 23 employees who generated $20.615m in net income which translate to $896k of income per person.
- In comparison to two similar investment management companies Waddell & Reed Financial and GAMCO Investors I found that Hennessy Advisers is more efficient (profit margin, ROI, ROE) and is similarly valued if not undervalued against most metrics.
- Even in the most recent drastic market downturn of 2008 the company still made money. So this suggests to me that the company has built in measures to reduce expenses along with revenue to ensure that profit is achieved.
The variant perspective that I'm taking in investing in Hennessy Advisers is that even if we continue to see a flock to passive investment strategies that there will always be active investment management strategies which will generate income. While outflows can continue to decrease returns and compress margins Hennessy Advisers has a lot of room to navigate this and has taken advantage of the very trend affecting it's price.
But the variant perspective is not reason enough to invest. Instead it's important for me to have a value perspective as well which looks at the margin of safety. In order to investigate this I looked at an extreme decline in income that happened in 2008. In 2007 net income was $4.133m and in 2008 it dropped to $1.611m which is a 61.02% drop. Putting aside the importance of their ability to maintain profitability in a worst case scenario, if we apply a 61.02% drop in net income of $20.615m today they would still generate $8.036m in income. With 7.917m shares outstanding this would translate to around $1.02 EPS. So the company in an analog to a worst case scenario would still be trading at a P/E of around 10. And keep in mind this is a company that has seen annual EPS growth of around 40% over the last five years.
Merging a variant perspective with a value perspective is a great way to ensure that even if you're wrong you won't lose a ton of money. Taking time to review your investment thesis to understand what is the perspective that causes people to sell to you in relation to your decision to buy is a crucial way to continue to learn as an investor. Along the way if we don't grow our intelligence we'll never be able to grow our returns. So use a value perspective along with a variant perspective to help that learning be less painful. You may even make some money.
Disclosure: I am/we are long HNNA. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.