On businesses with zero visibility - a response to Kuppy
Businesses with zero visibility should be worth less. Always.
When not talking about how soon we were going to die due to hyperinflation, I find Kuppy a very thoughtful writer and investor, despite disagreeing with most things he says. His track record at Praetorian is enviable and he made a nice profit with his investment in the housing market last year, as well with oil. His text on the tiger 50 was incredibly well timed. I often make fun of him on Twitter, but I usually read everything he writes on his blog.
Therefore, I couldn’t not write a quick reply on what he gets wrong on his recent post about businesses with zero visibility.
In the essay, Kuppy starts talking about how great a business Praetorian (his hedge fund) is, but that because the business is breakeven on fees, he basically has no visibility whatsoever in the profits the business will generate at any point. Nonetheless, Praetorian is a great business, has no capital requirements, doesn’t need to retain capital, and would be very undervalued by anyone. He conjectures it’d be worth 1.5x Fee-related revenue, and to be honest, I don’t think he’s too off the mark. Brookfield, a much larger manager that has hundreds of billions in assets (and actually turns a profit on a fee-related basis!) trades at 3.3x FY22 fee-related revenue.
Why is it that most people on Wall Street dislike asset managers? There are some reasons like “you don’t want to be junior to highly paying sharks”, poor governance, key men risk, the industry is in secular decline, alpha has become scarcer over time. I could talk all day about why asset management is bad business.
But the most important reason for an asset manager’s low valuation, as Kuppy himself points out, is the poor visibility.
There are many ways on how visibility can be poor: the market can go down, you can produce no alpha, customers can remove their money at the absolute worst point. You can produce an outcome that is a zero. Ask Melvin Capital shareholders if the high ROIC of their business was enough to bail them from a bad long-tail outcome. It didn’t matter that the next two years were the best years to have a short tech book, because Melvin didn’t live to that.
Then we can go the main point of his point, his stocks with zero visibility.
At my fund, we call these things “zero visibility businesses.” We don’t mean this in a pejorative sense. Instead, we mean this in the factual sense. It’s simply impossible to predict the quarterly results and as a result, we’re likely getting a bargain—frequently an unusually good bargain.
And in many ways, the fact you can impair your capital investing in a business with low visibility means that the expected value is lower than one where this doesn’t happen. And it is perfectly rational for the market to value one less than the other.
Let’s have an example.
We have two businesses, Consistent and Unpredictable (details in the footnotes)1 with 11% ROIC. Their key difference is that Unpredictable business has a different ROIC every year. Yes, it’s the same 11% ROIC on average, but it has a 20% volatility. But this means that 67% of the time, the ROIC is going to be between -9% and 31%. 33% of the time, it’s going to be even further way from the mean. How does it change the net present value? I simulated 1,000 times.
The Consistent business has a $140 NPV present value (1.4x book), but the Unpredictable business has an average $129 NPV, not only that, but the median outcome is $111 NPV, 21% less than the predictable business.
Notice this exercise is considering how one would value a business with perfect foresight2 and how one would value a business at least with the foresight on how random the business is going to be: the mean and standard deviation. In reality, there’s radical uncertainty in both businesses. You don’t know what the ROICs are going to be, nor their probabilities distribution.
For the Consistent business (say a company like Roper), even though there’s uncertainty, you sorta assume what you have is going to persist. But instead of discounting it a 4% rate like you’d do with a U.S. Government Bond, you discount at 9.5%, the famous equity risk premium.
For the Uncertain business, there are some other considerations that may make you pay less for that asset:
You don’t know what the average ROIC is (nor the standard deviation). This is worsened by changing industry dynamics, recent M&A, and so on. So perhaps you ended up using an average 10% ROIC3 for the business, for your own margin of safety, right?
It’s ridiculously hard to believe in the quality of the asset when there’s hell on earth. With a business like Roper, each quarter you have a good snapshot of the earnings power. It’s tough to persist believing a company is good business when it didn’t turn a profit in the last five quarters and the ROIC is below your average for 11. You start wondering whether your toy is broken. Because of reasons like that, people ask higher returns to hold assets like these from start.4
When things go bad, when a pandemic happens, or your country goes to war, it’s possible that things go even worse for the Uncertain business than to the rest of the economy. They cut their dividend, they have don’t have cash to enjoy the opportunities that would show up to invest in a downturn5 There’s significantly less optionality in these Uncertain Business, at least when their radical uncertainty is correlated with the economy, because nor you, nor the business, can enjoy panics.
Therefore, not only does it make mathematical sense for a business with low visibility to trade at a discount, but there are also behavioral reasons this discount is likely to be greater than a pure mathematical toy model.
Both businesses have an average ROIC of 11%, an reinvestment rate of 70%, a cost of equity of 9.5%, and a perpetual growth rate of 2%. They will be modeled through a 50-year period, in which they grow their capital base retaining capital. What they don’t retain, they pay as dividends. These businesses are financed only through equity.
In reality, if you had perfect foresight over the cashflows, you wouldn’t need an equity-risk premium, because there is no risk.
I keep talking about ROIC, but in reality you can transfer this 1:1 to price to book multiples through the formula P/B = (ROE - g)/(Ke - g)
One way some pundits call it is beta. I recalled reading, but couldn’t find who it was, a chart of industry beta and operating leverage of the business. Obviously, business with operating leverage (e.g.: fixed costs and variable revenue) had higher betas. Another way of saying that uncertain businesses have higher cost of capital, at least if people are using the higher betas to discount Micron with a higher Ke.
Roper deployed $335M to buy two companies in 2009, or 6% of its market cap, just like they would at any other year.