Investment Strategy Statement - Ranjit Thomas, CFA

Summary

• I am a value investor who focuses on US stocks and options.
• While stories may be nice, I zero in on numbers, specifically GAAP earnings and free cash flow.
• I take a skeptical view of rosy projections and occasionally post short ideas.
• I do not pay much attention to catalysts as they are hard to find in advance.
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Investment strategy

I follow only stocks listed on US stock exchanges. I may look at an occasional ADR, but my universe is mostly US companies, even though technically some of them may be headquartered abroad. The reason for my restrictive coverage is because such companies report results in a standardized manner, and it is easy to access their financial information. One can also have some level of confidence that the reported numbers are accurate.

I like companies that focus on the right metrics (not adjusted earnings or EBITDA), execute well, and don’t make excuses. I am willing to pay up for quality, but not for hope. I am a purist who believes that GAAP earnings and free cash flow (properly calculated by subtracting stock compensation from operating cash flow) are the gold star metrics to use when evaluating a company. I also look at how the company is allocating capital, and prefer that management is returning some of it to shareholders. I am agnostic on dividends.

I avoid specialized sectors like MLPs, REITs and small biotechs. Everything else is fair game. Industrials, consumer goods, healthcare, technology, financials – bring it on! I pay attention to investability, so mostly large and mid-caps, definitely no micro-caps. My ideal holding period is forever, so that taxes are not recognized on the investment. This has worked fantastically in positions like UnitedHealth (UNH), AutoZone (AZO) and Visa (V), but less so when a company like Alaska Air (ALK) makes a horribly overpriced acquisition after a period of able management.

Our portfolio supplements positions with an options overlay. The primary risk management tools are diversification (50-100 positions), appropriate position sizing, and short exposure. In a particular year, our objective is to do a few percentage points better than half the equity market performance (reflecting the portfolio’s effective net exposure). In a normal year, this would translate to a high single-digit return, although favorable markets over the last decade have resulted in it being higher. Over time, we expect to generate a return better than the equity markets with less volatility.

It’s easier to come up with a sound strategy than to stick with it. I have made my fair share of mistakes buying stocks I shouldn’t have. But I believe I have avoided big errors made by many who think of themselves as value investors: ignoring GAAP earnings in the mistaken notion that they don’t capture the company’s true economics, introducing dubious terms like maintenance capex (always too low) and sum of the parts (always too high), or thinking the future is going to be very different from the past.

Investment process

Most of the positions I oversee are ones I have held and followed for a long period of time. I go through earnings and other news releases for a few hundred companies. I also look at the top movers every day. If anything catches my eye (e.g. a stock with great earnings but muted price reaction), I research further. I look at the most recent financial filings, analyst reports and conference call transcripts. I look at the forward estimates for the company and determine if they are reasonable. I evaluate the quality of the business by looking at factors like barriers to entry, competitive position, management quality, etc. Finally, I develop a value for the stock based on the company’s sustainable growth in EPS.

My investment decisions are based on financial analysis and my knowledge of the world. I have always been an avid reader, and have read two newspapers a day for at least thirty years. That is a hard knowledge base to replicate.

An ideal long is a well-managed company at a reasonable valuation and a long runway for growth, returning cash to shareholders. An ideal short is a company that focuses on non-fundamental metrics, makes overpriced acquisitions, ignores stock compensation, takes regular “one-time” charges, and has a declining business with debt. Based on experience, I do not focus too much on catalysts as they are hard to determine in advance. It could be as simple as a company continuing to buy back its stock and growing earnings, or it could be gradual insider selling finally breaking an overvalued stock.

My background

I started my career twenty years ago in management consulting, which gave me a quick grounding in how businesses operate. After that, I have worked in the financial industry in private equity, investment banking and hedge funds.

I founded an investment advisory firm ten years ago. We manage an investment partnership and also advise businesses on financial topics like shareholder value creation.

I have benefited tremendously from reading what people like Warren Buffett and Bill Gross have shared with the world. In a small way, I try to share my experience and knowledge with those who can benefit. I have volunteered for the CFA Institute as a grader and competition judge and am on the Associate Board of the Council for Economic Education.

Investment successes and failures

I was fortunate to start my investment firm in 2009 when there were bargains galore, especially companies with debt, since they were pricing in the risk of bankruptcy. United Rentals (URI) was at $7 (and I watched it go down to $3), Domino’s (DPZ) was at $8, and there was a company named Valassis at $1.50 when it had $1 of free cash flow. On the flip side, in a steadily rising market, our portfolio has suffered painful losses on short positions that were acquired (and many subsequently written down) like Green Mountain Coffee, Petrohawk and Palm.

I believe my focus on GAAP earnings helped me identify the flaw in the business model of serial pharma acquirers like Allergan (AGN) and Valeant far before anyone else, assert that Ascent Capital (ASCMA) was worthless, and most recently point out that Brighthouse Financial (BHF) wasn’t a value stock.

I don’t publish often, because good ideas are hard to come by, and take time to write about. Also, most of the time I have nothing meaningful to say about a stock we own. Occasionally, I may notice a stock down a lot and put together a quick article drawing attention to it. When possible, I make sure the title is catchy! I’ve found that people are very touchy about negative articles, resulting in taunting emails, insulting messages and vitriolic comments. These are always anonymous, and I never hear from them when the stocks crater, like Colfax (CFX), EchoStar (SATS) and Scientific Games (SGMS) have!

Conclusion

It is hard to be an equity investor. You are a residual owner of a business, getting what is left after vendors, employees, debt holders and the government are paid. On top of this, you have little control over the managers who work for you, who can spend your money on overpriced acquisitions, increased employee benefits or charitable donations.

I believe that although the American market is the best one to invest in, most companies can create more value by maniacally focusing on the right metrics. I disagree with their belief that investors are overly focused on quarterly earnings, thus hamstringing their efforts to focus on long-term value creation.

Disclosure: I am/we are long UNH, AZO, V, ALK, URI. 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.