Iconix Brand Group is a brand management company with a collection of 35 well-known consumer and entertainment brands including: Joe Boxer, London Fog, Ocean Pacific, Umbro, Starter, Danskin and an 80% ownership in Charles Schulz’s, Peanuts. Unlike traditional brand retailers, Iconix does not design, source, manufacture, inventory or distribute any of its products. Instead, its 150 employees focuses solely on marketing, advertising, merchandising, and licensing its brands to key retailers like Wal-Mart, Target, Kohl’s and Sears. Through its licensing agreements, ICON receives a royalty payment based on net sales with a guaranteed minimum if targets are not met. As of the beginning of 2014, 60% of Iconix’s yearly revenue was guaranteed. Iconix’s business model removes operational and inventory risk, allowing the company to effectively match expenses against revenues. Over the past 5 years, ICON’s revenues have grown from $230 million to $433 million, buttressed by its acquisition of well-known brands.
Hazelton Capital Partners began purchasing shares of Iconix Brand Group in late April of 2012. At the time of the purchase, ICON had been on a steady diet of acquisitions and integration which had been taking a toll on its balance sheet and margins. The earnings power it had promised was falling short of expectations and investors’ frustration was being reflected in the company’s stock price. Not swayed by market consensus, Hazelton Capital Partners saw a company with a robust business model, operating in a niche segment of the retail industry that was patiently and methodically expanding its cash flows. That is not to say that the Fund disregarded Iconix’s current operating mishaps, but instead saw those as short-term, fixable and not impacting any of the company’s brands. More importantly, Hazelton Capital Partners saw a company whose future intrinsic value was significantly higher than what was being reflected in its current stock price and felt that the current weakness in the share price was overly exaggerated. During the two years that Hazelton Capital Partners held shares of Iconix Brands Group, management continued to expand and diversify its portfolio of brands to reflect the growing strength of segments within the economy. Additionally, through its 7 international joint ventures (5 created since 2012) in China, Europe, India, Canada, Australia, Southeast Asia and Israel, ICON has been able to increase its international footprint which now represents nearly 40% of revenue.
In April of 2014, Hazelton Capital Partners decided to sell out of its holding in Iconix. The Fund felt that the valuation pendulum was swinging to the other extreme, and ICON’s stock price was getting ahead of its value. During the Funds’ holding period, Iconix’s management had done a good job acquiring new quality brands, expanding its global footprint, and repurchasing its shares when they were undervalued. Going forward, Iconix’s management will be under pressure to repeat its current success but in a much more challenging marketplace. To continue to grow its revenue, ICON will need to find new brands to acquire and continue to leverage its balance sheet in an interest rate environment that will not be as favorable. Share repurchases will most likely be replaced with debt reduction, making earnings comparison less favorable. Hazelton Capital Partners still likes Iconix Brand Group, especially its business model, but feels that much of the company’s intrinsic value has been achieved.
This article has been excerpted from the Hazelton Capital Partners 2nd Quarter 2014 Letter to Investors.
Formulated by John L. Kelly and popularized by the practical success of Ed Thorp, the Kelly Criterion is a formula used to determine the optimal bet size for a given set of probabilities and payoffs. While the formula can be stated in several ways, one format is an expanded version of the formula that appeared in Thorp’s interview in the book Hedge Fund Market Wizards:
If one knows the odds and payouts of a given bet with precision, the Kelly Criterion bet size will maximize one’s capital over the long run. To give a common example, assume that someone decides to make you a generous offer in a coin-tossing game. The coin is fair, and if it comes up heads, you will win $2 for every $1 you bet; if it comes up tails, you will lose each dollar you bet. Moreover, you are permitted to keep playing the game under these terms for as long as you’d like, as long as you don’t run out of money. You, rightly, conclude that this is a game worth playing and gather all your money together to play.
How much of your total bankroll should you bet on each flip? It’s obviously not 100% because if you bet it all, you are done playing and broke the first time tails comes up. You also don’t want to make tiny bets because while you will be profitable, you know that the bet is so favorable to you, that you want to make a big enough bet to adequately grow your capital. Given the terms of the bet, the amount you should bet on each toss to maximize your winnings over the long term is 25% of your bankroll, as calculated with the Kelly Criterion in the exhibit to the right.
When it comes to applying the Kelly Criterion to investing, one hurdle is that one doesn’t get precise odds and only in the rare special situation or arbitrage does one get a decent picture of the payout. Another hurdle is that when utilizing Kelly, the long run is based on the number of events, not a timeframe. An investor, especially a value investor, will have trouble making enough investments to get the full long-term benefits of applying Kelly. As Ed Thorp wrote in his 2007 article, “Understanding Fortune’s Formula,” “The caveat here is that an investor or bettor [may] not choose to make, or be able to make, enough Kelly bets for the probability to be ‘high enough’ for these asymptotic properties to prevail.”
A third hurdle is volatility. Kelly is designed for optimal long-term return while avoiding the risk of ruin. While we certainly don’t equate risk with volatility, the drawdown that can be experienced using the Kelly formula to size positions can leave even the most steadfast investors a bit squeamish, even if the odds and payouts were known with 100% certainty, which they of course never will be. And a final hurdle of note, also mentioned in Thorp’s article, is that humans tend to underestimate the role of infrequent, high-impact events: what Nassim Taleb refers to as Black Swans. The probability and downside of negative Black Swans may not be given enough consideration when investors look to apply the Kelly Criterion, and thus the formula may tend to overestimate F when applied by the human mind. And continual overestimation leads to ruin; anything above the optimal bet size will lead to total loss sooner or later.
But despite the difficulties and hurdles in its application to investing, the logic behind the Kelly Criterion can be useful in thinking about whether or not to establish a position in a given situation and, if one is to be established, what proportion of one’s capital should be invested in the position.
First, let’s consider one truth in the formula: If PW > PL AND $W > $L, then the bet or investment is worth making, at least before considering other alternatives (more on this in a bit). If both the odds and the payout are in your favor, then the expected return is positive and so the position/bet size given by the Kelly Criterion will be greater than zero. While the formula doesn’t require both PW > PL and $W > $L, generally focusing on ideas that meet both of those metrics can give one an extra margin of safety, and in general, that’s what most value investors seem to do.
Before moving on, let’s expand a couple of definitions to make them friendlier to investing vocabulary:
Estimating intrinsic value based on cash flows, private market values, and liquidation values is something that should be familiar to those that follow a value philosophy; as is considering one’s downside in a worst-case scenario. And because these are estimates—and small changes in certain variables can have large impacts on expected values—it’s important to be conservative in those estimates. Or to use a phrase from Seth Klarman, it’s important to make those estimates “by compounding multiple conservative assumptions.”
Things start to get tricky when it comes to estimating probabilities, which one can’t really do with any degree of accuracy. It is too hard and too close to guesswork, especially when we consider that, according to Sir John Templeton, “No security analyst is ever going to be right more than two-thirds of the time.”
So if we can’t accurately estimate our probability of winning and losing, what can we do? What we believe an investor can do is determine whether or not the odds are likely to be in one’s favor. There are certain things that can increase one’s chance of not losing money on an investment, and certain things that increase the chance of losing should something unexpected or disruptive occur.
In Nassim Taleb’s book, Antifragile, he separates things into three categories:
The fragile is harmed by certain shocks, randomness, and stressors. The robust is neither harmed nor helped by them. And the antifragile grows and improves from them. As Taleb says, “…the idea is to focus on fragility rather than predicting and calculating future probabilities…”
So while we can’t accurately predict probabilities, what we can do is think about and identify traits that will increase our chances of winning and decrease our chances of losing under a range of scenarios. And by trying to avoid fragile traits and invest in situations that are more robust or, preferably, antifragile, we decrease our chances of making mistakes due to estimation error. Below are some examples of these traits among businesses and investments:
“…the fragile wants tranquility, the antifragile grows from disorder,
and the robust doesn’t care too much.” –Nassim Taleb
When the positive traits overwhelm the negative traits, we can be fairly confident that the odds are in our favor. But figuring out which traits are really present and which are illusory takes a lot of work; as does coming up with a proper and conservative estimate of intrinsic value and a worst-case scenario. The math behind the Kelly Criterion gives a good framework for thinking about the questions: (1) Is my probability of winning greater than my probability of losing?; and (2) Is my upside greater than my downside? But there is a lot of work that needs to be done in order to answer those questions with decent accuracy.
“It’s not supposed to be easy. Anyone who finds it easy is stupid.” –Charlie Munger
Using the Kelly framework to explain our current outlook on the investment climate, we can say that we see plenty of things with attractive upside ($W), but the main issue is that we also think there is plenty of downside ($L) in those investments. To optimize one’s capital over time, one should consider more than just the upside if things go right. One must be in the game long enough for the odds to work out favorably over time. The main reason we have so much cash today is that we see a lot of downside coupled amongst the upside.
We look for situations where, if we ran through the Kelly Criterion using conservative assumptions, it would tell us to take large position sizes. Our actual position sizes will, in practice, be much smaller than Kelly, as we manage risk and account for the uncertainties and errors that come with investing. But the idea behind taking big positions in one’s best ideas—especially when one’s downside is well protected—is one in which we firmly believe.
In the Ed Thorp article mentioned earlier, he also wrote that “Computing [F] without the context of the available alternative investments is one of the most common oversights I’ve seen in the use of the Kelly Criterion. Because it generally overestimates [F] it is a dangerous error.” And as we contemplate our alternatives to cash, we think not just about the current opportunity set, but also about opportunities that may possibly develop over the next several months. We’ve been and are still close to buying several things; and we continue to build our list of prospects. While we can’t know when Mr. Market will give us the opportunity to put our cash to work, we are ready to move in quickly when we think the odds and payouts are overwhelmingly in our favor.
The above post has been excerpted from the Boyles Asset Management letter to partners.
The mind constantly plays tricks with investors. In a stressful – potentially loss-making – situation the negative pressure risks short-circuiting our analytical ability and when looking at new investments greed makes the investor susceptible to buying into management’s song and dance when showcasing the benefits of the company. No matter how experienced you are as an investor you will always benefit from having a checklist that breaks the spell of the moment and ensures that positive and negative aspects of the situation are covered. It will – if well crafted – also make you focus on the few important key issues of the investment. Further, realizing that there are issues that you don’t have answers to can also be of huge value as warning signs. In The Investment Checklist Texas investor Michael Shearn shares the checklists he has been using for the last decade when researching new investments. The author’s purpose is to teach the reader what he needs to know about the companies he thinks of investing in and help him to evaluate if the company is worth the investors money or not. While not explicitly stated as a target group I think the book will help the franchise type of value investor the most.
The book kicks of with a chapter on how to generate new investments; basically describing a search for bombed out, low multiple, deep value stocks where investor pessimism rules but the problems at hand might be temporary. Then the rest of the text covers a list of topics to be analyzed. They could be; the strategic and operational strength and weaknesses of the company, the financial strength of the business, the growth opportunities, the track record in M&A etc. Most chapters consist of a number of checklist questions with a subsequent paragraph discussing the topic. One of the impressive features of the book is the focus placed on corporate management. More than a third of the book discusses how to analyze the executives in charge. To me this is one of the trickiest areas in investing so even if the text in itself isn’t revolutionary the focus is well deserved and it is relatively rare in investment literature. Overall, he who reads through the chapters will be rewarded with plenty of wise thoughts on how to evaluate a company.
Even so, the book isn’t a jackpot in my mind. The analytical methodology an investor uses should be tailored to the type of investment opportunities he is looking at and the investment style he uses. This checklist to me feels a bit too generic with the inherent risk that it will not be perfect for anyone. For example, take the bombed out type of stock from the opening chapter, if I researched this the task would be to understand what will change to the better and my focus would be: a) What is the risk of the stock being a value trap? i.e is the sector or the company in structural decline and is the current shareholders equity or earnings therefore not representative of the future? b) Are the finances strong enough to sustain a prolonged period of weak cash flows before an improvement occurs? c) What could be the triggers to the turn around? i.e. what will change to make things better? d) And what will the normalized financials look like? An analysis should zero in on the key issues for the type of investment at hand. A lengthy analysis of the quality of current management might not be as important.Getting rid of them might event be the trigger needed. Another thought is if there couldn’t be a way to quantify the results of the analysis. A checklist is never an exact yardstick to go by. Even so, I think a numeric rating of the issues can help an investor in his thought process.At least it has helped me.
For the long term investor a deep fundamental understanding of the business of the companies he owns is crucial. Without it he will lack conviction and will risk selling due to market volatility, potentially missing the structural improvements underway.This checklist will take you a long way in gaining understanding but the last touch on how to build your own checklist must be up to you.
“The less prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs.” –Warren Buffett
We have made a conscious (and, in terms of relative performance, currently painful) decision to remain steadfast with our principle to seek a substantial margin of safety in potential investments. In the past we’ve talked about looking for dollar bills that we can buy for fifty or sixty cents (and later in this letter we talk about this in relation to the Kelly Criterion). At the moment, there appear to us to be few of these opportunities, especially in the United States. While we often come across dollar bills that we can buy for ninety cents, which would seem intriguing were we willing to forgo that principle, such ideas are not what interest us. To us the margin of safety is simply too little.
All around us our “friends” (i.e., other market participants, not our investor friends!) seem willing to “jump off a bridge.” The question for us: Do we lower our standards and follow them into lower prospective returns (and more importantly, lower associated margins of safety); or do we stay dry on the bridge and commit capital only when an attractive prospective return and margin of safety exist. As you can tell from our continuing high cash balance, we’ve chosen the latter.
This is not to say that everything in the market is significantly overpriced. As mentioned, we do come across interesting businesses trading at ninety cents on the dollar, but the impediment to a robust opportunity set at the moment remains the breadth of high valuations. In fact, the average price-to-sales ratio of the S&P 500 constituents of 2.96x approximates that which it was at the peak in 2000; and the median price-to-sales ratio of the same index of constituents of 2.10x significantly exceeds that of the peak in 2000.
In April 2014, John Hussman at Hussman Funds noted:
“Investors often forget that smaller stocks struggled during the final years of the bubble as investors clamored for glamour. Again, the broad stock market was much more reasonably valued in 2000 than it is today, as extreme valuations were skewed among the largest of the large caps. Not anymore… the Fed has produced what is now the most generalized equity valuation bubble that investors are likely to observe in their lifetimes.”
There appear to us to be few, if any, pockets of substantial bargains or portions of the market that are substantially out of favor. This is especially true when you further limit the prospective universe to our circle of competence and preferred financial profile. Most everywhere we look, the prospective return and margin of safety are skewed in favor of the seller. There are some international markets that appear attractively priced, but most are not in countries where we devote our efforts, or would choose to devote our efforts. We’re left to find the random mispriced security we’re able to find.
In the fullness of time we expect our disciplined approach will prove itself, but in the short term it has been painful. Not only have our relative returns suffered, but our absolute return, given the state of interest rates, has been equally painful. One pain we’re working to ignore is psychological pain, as is it always easier and more comfortable to do what others are doing or what is currently working.
Despite the limited opportunity set, the random and occasional things we are studying that may indeed be fifty- or sixty-cent dollars include:
- Australian small-cap companies, with a particular focus on those associated with servicing the mining business. While we have been patient and careful given the exposure to commodity prices, at least we have the opportunity to examine businesses trading 60% and more off their peak market prices, well below tangible book value, and at low-single-digit multiples of prior earnings.
- Miscellaneous UK small-cap companies which, generally speaking, appear to have avoided the remarkable performance of the Russell 2000 during the last two years.
- A variety of one-off circumstances, including an occasional 52-week low (or more importantly in this market, a 104-week low), busted IPO, or relatively illiquid idea.
We hope our opportunity set expands, but in the meantime we’ll continue to work hard on the few things we do find and above all stay true to our principle of seeking a substantial margin of safety before deploying capital.
The above post has been excerpted from the Boyles Asset Management letter to partners.
The following article is extracted from the Bamboo Innovator Insight weekly column about the process of generating investment ideas among wide-moat businesses in Asia. Each month, an in-depth presentation on one such business is featured in The Moat Report Asia.
They say reform is the painful rain that purges the ills; the resilient one emerges stronger and purified, while the corrupt dissolves under the cleansing process.
No one knows such pain more deeply than Deng Xiaoping, the reformist leader credited with opening up and transforming the Chinese economy. Deng’s 110th birthday last week on Aug 22 was celebrated by a poignant scene reacted and broadcast on national TV: Deng was drawing water in the rain to swab his disabled son who was tortured and thrown out of the window of a three-storeyed building at Beijing University by the Red Guards during the Cultural Revolution, when Deng was purged.
State broadcaster CCTV has produced the 48-part drama Deng Xiaoping at History’s Crossroads 《历史转折中的邓小平》 in honor of Deng, with the propaganda campaign eclipsing the official remembrance of the 120th anniversary of Mao’s birth last December. While washing his son’s back, Deng asked, “Son, what is your level of competency in wireless telegraphy?” Deng’s son replied, “Dad, you don’t worry, if the policy permits, I can repair radios. Not only can I be independent, but I can also earn a living for the family.” Deng was comforted and said, “Good, to rely on real knowledge and capability to earn a living, it’s definitely reliable” (“靠真本事吃饭，靠得住”).
Come September, the final plan for the state-owned enterprise (SOE) reform in China will be published, a move to reform bloated inefficient SOE to rely on its own capability to compete. The pilot plan to improve corporate governanceand attract private investmentincludes (1) “mixed ownership,” the Communist Party jargon for introducing more private capital into government assets in a partial privatization, (2) major asset restructuring such as asset purchases, sales and swaps can proceed without approval from the CSRC, (3) curbs on “unreasonably high” executive pay and perks such as spending on cars and accommodations, (4) board-led human resources management, which will allow the boards of directors to hire, evaluate and pay top executives, rather than SASAC (State-owned Assets Supervision and Administration Commission) to appoint senior management and set performance metrics. The goal is to reduce political interference in the management of SOEs by designing the holding companies to focus purely on maximising shareholder value rather than advancing the government’s policy goals and political agenda that seeks to first and foremost legitimize the party in power. The reform process is described in one of Deng’s immortal words: “crossing the river by feeling for the stones.” The launch of the pilot and implementation work is likely to start next year.