Feature interview
Ranjit Thomas, CFA is an accomplished finance and business executive who manages an investment fund and advises businesses on strategic and financial issues. Stock Scanner offers actionable, concise ideas of US-traded stocks. Members receive a weekly report with investment ideas, brief analysis, and tips to execute via stock and/or options (that can generate additional income). It is designed to expand an investor's bandwidth by providing a few pre-screened ideas every week, resulting from earnings announcements and stock movements. We discussed his preferred valuation methods (and why he doesn’t focus on catalysts), one way to avoid value traps, and how lessons learned from one of his best calls can be applied going forward.
Seeking Alpha: Walk us through your investment decision-making process. What area of the market do you focus on and what strategies do you employ?
Ranjit Thomas, CFA: I focus on US-traded stocks, mostly American companies, but also the occasional ADR. I look at stocks across all market caps and sectors. I avoid some like small biotechs (too binary) and MLPs (complicated tax implications). I would say my strategy is sensible value investing with a recognition of the value of growth. So I'm not necessarily looking at something that's cheap on earnings (but maybe secularly challenged). I'm most interested in long-term compounders that will be around 50 years from now. I also look at the company's capital allocation decisions because the compounding can come from the business growing and the share count reducing. I look at why an opportunity may exist, whether the market may be ignoring some relevant facts, and what a company's earnings could be a few years out. I do not ignore the things that managements like to pro-forma out like stock compensation and restructuring charges. I do, however, knock off things like unrealized gain on securities, which companies are now required to take through their income statement - a big mistake on the part of the FASB, in my opinion. I place a multiple on earnings taking into account the quality of the business, its predictability, management, capital allocation, and growth. This part is more art than science, and is more like a point estimate standing in for a reasonable range. I also pay attention to the balance sheet and cash flow statement and use some forensic techniques to make sure the earnings are not being inflated. One metric I do not use is EBITDA because it does not account for the capital intensity of the business, and I frequently find short opportunities where it is being misused to value companies.
SA: You were a partner at a billion-dollar technology stock-focused hedge fund - can you discuss key lessons learned from your time there that you apply today in your investing? Do individual investors have any advantages compared to hedge funds, and if so what are they?
Ranjit Thomas, CFA: The number one lesson would be to know everything there is to know about a company. That means reading all the recent press releases, the latest 10-Q and 10-K filings, transcripts of recent earnings calls, and any investor presentations. Curiously, all this information is much more easily available these days, but fewer investors actually take the time to go through it. People would rather chase stocks based on a qualitative thesis or even try to glean non-public information, rather than just assimilate what's in the public domain. I would say this is an advantage an individual investor can have against a hedge fund that is aiming to do what they would consider proprietary analysis. It's hard for a hedge fund to go to an institutional investor and say that their strategy is to read a company's public documents! They are more likely to be successful raising capital by saying they do something complicated like analyzing satellite images.
SA: How is your version of value investing similar and different to that of Graham and Buffett (or other famous value investors)? Have you invested in any “unconventional” value ideas that worked out? If so, which ones?
Ranjit Thomas, CFA: I would say that Graham's version was more of cigar-butt investing without a focus on growth. There wasn't much information dissemination at that time, and stocks frequently traded below the value of the company's liquid assets. Opportunities like those rarely exist today. Buffett started off that way but pivoted to recognizing the value of growth, especially companies that have a long runway. In terms of fundamentally valuing a company, I'm in agreement with both of them. I give growth more credit than Graham did, and possibly a little more than Buffett does. I'm more comfortable investing in technology stocks than Buffett is because I need to use my degree in electrical engineering a little bit! I've invested in the large-cap tech stocks like Apple (AAPL), Microsoft (MSFT), Alphabet (GOOG) (GOOGL), Facebook (FB), and even Amazon (AMZN). At 30x EPS (and double that in Amazon's case) they wouldn't be considered value stocks, but if you can grow your business 10x over time, then the business will deliver value even at a high multiple. For a recent example, I invested in and recommended BioNTech (BNTX) when I discovered what a fabulous deal the company had struck with Pfizer.
SA: What valuation methods do you use to determine fair value? Do you require catalysts to close the discount to fair/intrinsic value or is value enough of its own catalyst?
Ranjit Thomas, CFA: A business is worth the amount of cash it can return to shareholders over time, appropriately discounted. So any method you use is effectively a shortcut to measure this. I find multiples placed on future earnings to be pretty reliable. Except in rare cases, I do not waste my time on catalysts. They are hard to predict in advance. For a long investment, you do not need specific catalysts if the company just starts returning capital to shareholders. Say, a stock is undervalued at 10x EPS and the business is stable. If the stock does not rise, the company can buy back 20% of its stock in two years. Now the EPS has gone up 25% and the multiple is 8x. If investors still don't notice, then the company can keep buying back its undervalued stock and creating value. At what point people wake up and send the stock up is hard to know. You can see how well any large company stock has done over the last decade and there have hardly been any catalysts except the occasional earnings beat. On the short side, just insiders selling and the share count growing can be a powerful catalyst.
SA: To follow up, you’ve said that what's nice about value investing is that you soon find out whether you were right or wrong - what do you look at (price and/or fundamentals) to determine if you’re right or wrong? Is there anything you can do to reduce the chances of investing in a value trap?
Ranjit Thomas, CFA: Well, as the saying goes, price is truth, and that is true in most cases. For a long investment, I would see if the fundamentals came in as expected and the price went up. As I discussed in the answer to the prior question, you are not going to have a divergence for long, except I suppose in a long period of rising interest rates where the discount rate keeps going up. For a short investment, unfortunately, you can be right on the fundamentals but still wrong on the price as in an age of easy money people can pay elevated multiples for little earnings. In such cases, you have to make a decision on whether that situation is likely to change and if necessary throw in the towel. Diversification certainly helps lessen the impact of taking losses on a particular investment. I would say value traps are businesses that are in secular decline, so it's important to avoid those, or not pay too much for them. The other kind of value trap is one where the earnings that a company claims are not representative of actual earnings, because they exclude regular charges and the like. A good example is Brighthouse Financial (BHF), which is supposedly at 4x EPS. Now, how can a stock stay flat and remain at 4x EPS for more than 5 years in spite of the company periodically buying back its stock? The answer is because the real earnings are a whole lot lower. Read my articles on the company to find out more!
SA: Looking back at one of your best calls (Danaos increased ~10x over 18 months after you said to buy in December 2019), what are key takeaways from your analysis there that you can use to identify similar ideas going forward?
Ranjit Thomas, CFA: I periodically look at the top movers - stocks that are up and down the most that day. Danaos (DAC) caught my eye one day because it was down a lot. I took a quick look and the stock was at less than 2x earnings at that point. Some of the banks who had got equity in the company by converting debt were presumably selling and were not price sensitive. The company had done an equity issuance as a condition for a prior debt restructuring. Now there is only one case where a stock should trade at that valuation, and that is if bankruptcy is imminent i.e. the company's business is declining and any cash flows that come in have to be used to repay debt until it cannot anymore. However, in this case, the business seemed stable. There were some concerns about related party transactions, but that seemed more than reflected in the price. So the risk/reward was favorable. After that, the pandemic hit, which should have been bad for the business as global trade normally suffers in such a scenario. However, the US government sent everyone money, people couldn't spend on services, and redirected their dollars towards goods. Trade picked up and there was really no recession in goods, and ultimately a shortage in shipping capacity.
SA: A recurring question in this interview series is about the mispricings created by the coronavirus and its short and long-term impact – can you weigh in on this?
Ranjit Thomas, CFA: That's a tough one. Clearly, there were mispricings early on when everything got sold. Then when the tech sector boomed, but sectors like financials were still depressed even though they were doing okay. I don't see many mispricings today with everything up. If anything, there are trillions of dollars in market cap in unprofitable or marginally profitable companies. This is a direct consequence of all the money that has been printed that needs to find a home. If you're going to make only 1% in fixed income, you might as well take a flyer on a stock at any price since the opportunity cost is low. Unfortunately, there's nothing on the horizon to suggest this will change. Is the government going to spend less any time going forward? Not a chance. Will the Fed tighten? Maybe a little bit, but they would rather live with inflation than be accused of snuffing out a recovery.
SA: What’s one of your highest conviction ideas right now?
Ranjit Thomas, CFA: Rather than give an individual stock, let me try and broaden the idea and suggest a theme. Low interest rates and people working from home have caused a boom in the home-building sector. However, the stocks in the sector have not gone up too much as investors fear reversion to the mean. And I suppose these aren't flashy names. Beazer Homes (BZH) for instance is at 5x EPS and is holding a lot of cash on its balance sheet. I expect interest rates to stay low for a while, aiding this sector. On a related note, lumber prices have gone up a lot even after a recent pull-back and the companies making it are raking it in. Interfor (OTCPK:IFSPF) is a Canadian lumber producer trading at 3x forward EPS. The stock is not very liquid, so if you're looking for a larger company, Louisiana-Pacific (LPX) at 9x forward EPS fits the bill. The company makes siding and plywood, both benefiting from the housing boom.
***
Thanks to Ranjit for the interview.
Ranjit Thomas, CFA is long AAPL, MSFT, GOOGL, FB, AMZN, BNTX, BZH, IFSPF, LPX.
