Mr. Market

Ben Graham may have likened the late New York Yankees owner, George Steinbrenner, to his allegorical Mr. Market.

Manic, myopic and a believer that the market was a “voting machine,” Steinbrenner made life difficult for members of the organization, especially general managers, when results did not meet his expectations. He preferred splashy trades and signings over a long-term strategy of drafting and developing talent.  

In 1990, Steinbrenner got in trouble with Major League Baseball after it found that Steinbrenner paid a gambler to dig up dirt on a Yankee player that was disputing his contract. The MLB banned Steinbrenner from day-to-day operations.

With Steinbrenner out of the picture, General Manager Gene “Stick” Michael went to work unconstrained.

Between 1990 and 1993, Stick drafted, signed, and traded for players that he could acquire at an attractive value and projected to be good over the long run. He gave players time to grow and make mistakes.

Drafted out of Kalamazoo High School in 1992, Derek Jeter committed a league-high 56 errors, in his rookie season in the minors.

Stick told frustrated coaches to be patient.  

By the time Steinbrenner returned from his suspension in 1993, Stick had recruited future Hall of Famers and All-Stars including Jeter, Mariano Rivera, Jorge Posada, Andy Pettitte, and Paul O’Neill. This core would lead the team to World Championships in 1996, 1998, 1999, 2000, and 2009.

If Steinbrenner was Graham’s Mr. Market, Stick was Graham, a believer that over the the long run, the market behaves like a weighing machine and accurately reflects competitive position, assets, and earnings (or hits and runs). Both believed that good judgment needs to be coupled with an ability to insulate decision making from swirling emotional behavior in the marketplace.

When Gene “Stick“ Michael passed away in 2017, Jeter, said, “[Gene Michael] was largely responsible for the success of the Yankees organization.”

Lollapalooza

In his speech on the intersection of economics and psychology at Harvard in 1995, Charlie Munger listed 24 standard causes of human misjudgment. A few examples include:

·         Bias from over-influence by social proof

·         Bias from over-influence by authority

·         Bias from deprival or loss

On their own, each can lead to errors in decision making. Combined together, Munger said you get a “lollapalooza effect,” which can create large-scale shifts in human behavior.

In Q2 ’20, stock buybacks by U.S. companies nearly halved. Grappling with uncertainty and loss of profits, CEOs pulled back on their share repurchase activity. There was public criticism of stock buybacks by authority figures during the market downturn, disincentivizing this form of capital allocation. Presidential candidate Joe Biden urged every CEO in America to commit to a year of no stock buybacks. CEOs turned to returning cash to shareholders in the form of dividends, the most tax inefficient form of capital allocation. U.S. companies distributed $119B worth of dividends in Q2 ‘20, the highest amount since 2009. 

Noteworthy names not on the list of companies that shied away from share repurchase activity were Apple and Berkshire Hathaway, which bought back shares worth $18B and $5B, respectively, in Q2’ 20. The market’s misappraisal of share prices presented an opportunity to acquire shares at attractive levels for the first time in years.

The CEOs of these companies safeguarded themselves from human biases and act decisively.

Systems

An experienced search fund investor cited the following hierarchy of acquisition outcomes: 1) buy a good business, 2) don’t buy a business, 3) buy a bad business. This hierarchy is not exclusive to the search fund community. Any capital allocator should take note of the practices prescribed in the Stanford Graduate School of Business’ Primer on Search Funds.

The authors harp on the use of systems. When targeting an acquisition, it is critical for the searcher to use a structured approach designed ahead of time but adaptable midstream (e.g., industry and company scorecards). Key to this systematic approach is abiding by the criteria identified for the target business. Examples include a growing end market (83% of search funds target industries >3% growth) and a recurring revenue model (55% of target companies have recurring revenue that is >65% of total). The acquisition target should involve minimal operational complexity. If it is explainable in one sentence and does not require an advanced degree to comprehend, one is on track.

Other areas of the target company to identify include capabilities of middle management, product lifecycle, and the dynamic between the seller and key customers and suppliers.

Understanding unit economics and cash flow is crucial. Key customer data to identify early includes order history, fulfillment history, customer service records and satisfaction surveys. The new CEO should develop a fluency in cash and cash flow management. How is cash verified? Who has control of the cash? What is the billing cycle? How is cash collected? By the 100-day mark, these are all questions that should be easy to answer. Critical to cash flow management is the scrutiny of working capital accounts. This involves an understanding of daily sales, invoices, receipts and inventory. In order to develop a mastery of the business, former search fund CEOs recommend the creation of an automated operating dashboard that includes accounts receivable, accounts payable, sales pipeline and on-time delivery data, among other metrics.

It is critical that the searcher develops a Board that has complementary skills. Well-run Boards insert themselves at critical junctures, openly communicate, encourage development of performance metrics and identify key risks and risk-mitigating factors. The Board exists to exercise an incorruptible duty of care and loyalty.

The Stanford Search Fund Primer is a handbook for searchers and search fund investors focused on finding and operating businesses between $10-$30M Revenue and >$1.5M EBITDA. Yet, the best practices described can be utilized by capital allocators of any size and within any industry.