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GreatQuarter, a CFA Charterholder, is a former institutional high yield bond analyst, and now an individual investor. We discussed why investors should be honest with themselves, how to get the most out of conference calls and an update on their Optical Cable thesis.
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?
GreatQuarter: Sure. I look for mispricing. And I look for a catalyst to bring the price of the security closer to where I estimate it should be.
When I was an institutional analyst, I was assigned industries to follow: chemicals, manufacturers, homebuilders, cable TV, and others. There is a certain amount of frustration that comes with knowing an industry well and seeing current action and future opportunities developing outside your focus industries. Now, I can let the pursuit of profit lead me in different directions depending on what is going on, or more importantly, what might be setting up.
Having been trained as an institutional high yield analyst, I’m comfortable focusing on cash, cash flow, and loan covenants. The focus on cash gives me a different perspective than many equity analysts, many of whom primarily focus on revenue and EPS metrics. An apt description of my focus: special situations value.
Investment ideas can come from anywhere. Seeking Alpha is a great source of ideas; the dialogue in the comment section sometimes adds a valuable dimension to the article. News items might lead to a search for companies that could be affected. Other times, a Peter Lynch-type “buy what you know” situation presents itself. Sometimes, it’s looking through sold-off stocks trying to find something temporarily depressed. Sometimes, it’s competitors of companies I already follow. At other times, ideas come from friends.
Part of my process is thoroughness. That can be weakness or a strength. Thoroughness is noticing that a new signatory is on a loan document, doing a Google search, and realizing the signatory works in a different office in a different state. (Unfortunately, thoroughness does not necessarily prevent missing something material.) Thoroughness gets me dragged into rabbit holes. That personality defect leads me to do in-depth research.
SA: What is a good analyst?
GQ: I had a candid conversation with an (unnamed) head of investor relations. I asked her, of the many sell-side analysts that cover her company, what distinguishes the analysts who were good from the ones who were the best. She responded that good analysts dig into the financials and build great financial models. The best analysts build great financial models, but they go beyond that to understand how the company is run.
That fits with my thinking that companies are groups of individuals, united by leaders and culture. Digging into the people will help investors to better understand the company, the company’s strengths and weaknesses, what the company should do, and what decisions might be made.
Ideally, once in a while, an analyst can read a situation like they are watching a Shakespearean play unfold:
SA: Do you have reflexive rules that help you to shortcut analysis?
GQ: No. But, I have a number of guides, for instance:
1) If management sues short sellers, I probably don’t want to own the stock. If the company sues the short sellers, that makes me wonder if the company might feel they have more to hide than the average company. Why would I want to own it?
A famous example of a company suing short sellers is the case of EROS, which filed a lawsuit in September 2017 when EROS stock was $14.30 and now it’s $2.21. (I have no position in EROS.)
2) When evaluating a company as an investment, I consider insider buying and selling. I looked at OOMA as an investment, because I like their telephony product. But a review of insider trading shows lots of sales, but only one buy, going back to 2015. Do the insiders know more than investors? Yes. Ooma might end up being a good investment. But for me, I think I have better odds of successful stock pick by looking at companies that don’t have years of insider sales.
3) Particularly dangerous: insider sales in cyclical companies when everything seems to be going great: these managements develop an uncanny sense of timing cycles.
4) Lots of debt in a cyclical industry is a problem. I learned to be cautious if there is little breathing room prior to the next inevitable cyclical downturn.
5) Roll-ups – serial acquisitions in the same industry to consolidate the industry – seem to encounter more than their share of problems. I tread cautiously.
6) Related to roll-ups, lots of acquisitions and/or divestitures. Fertile ground for accounting games.
7) On the SEC’s EDGAR filing system, late filings: NT 10-Qs or NT 10-Ks (NT = “not timely”).
8) Lots of management turnover, especially in the CFO position.
9) Not enough board turnover.
10) Board members who don’t seem to possess skill sets that would be needed by the company.
11) Unusually high pay for top management and/or for the board of directors.
12) Incentives. Ideally, as an investor, I want to see an incentive based on stock price and EPS. Rare. [RH] In its proxy filed with SEC in May, 2017, RH set “price objectives of $100 per share, $125 per share and $150 per share in each of these first four years.” At the time, RH stock was $57.14. Two and a half years later, RH stock has tripled to $175.84.
13) Violating loan covenants. (Although if a management shake-up would be positive, violating covenants might lead to a shake-up, depending upon how things play out, so violating covenants could be positive in the long run if the violation were to induce needed change.)
14) Red flag for red flags. Don’t get overly upset if you find a fault in management or a company; everyone has faults. All managements have faults. Even great analysts from time to time develop tunnel vision. Widen the aperture to make sense of the big picture.
SA: What do you find to be a good mindset for analyzing?
GQ: “How do you know when management is lying?” asks Sallie Krawcheck, the chairman and CEO of research boutique Sanford C. Bernstein. Sitting in her clutter-free corner office, the 37-year-old Krawcheck waits for the perfect punch-line pause. Then, with the slightest of smirks, she leans forward to answer the question: “Their lips are moving.”
(Irony alert: two years after this 2002 interview, Sallie Krawcheck became Citigroup’s CFO.) I am guessing Sallie Krawcheck was using humor to emphasize to investors the importance of independent thinking. I don’t think she meant that management lies all the time. Maybe management spins much of the time, but who doesn’t, a bit?
Separately, and most importantly, we shouldn’t lie to ourselves. We shouldn’t get too optimistic. How much money have investors lost because they lie to themselves? Lots more than they lost because management lied to them (I guess).
To get myself into the mindset of analyzing, I try to get myself a little depressed. Uggh. I try to get a little less hopeful. Because often something goes wrong. If you are a little depressed as you analyze, your projections might be more likely to include adverse developments. Generally investors are optimistic to a fault, even if that optimism expresses itself as optimistic pessimism like: “Yay! The company is going to have to file for bankruptcy.”
Even during the short expanse of an hour-long conference call, both management and institutional analysts get depressed as the call goes on. In “Manager-analyst conversations in earnings conference calls,” Jason Chen, Venky Nagar, Jordan Schoenfeld write: “analysts are more neutral than managers over the call and that the tones of both parties drift downward as the call progresses.”
Not only should an analyst think independently with respect to management, an analyst should think independently with respect to other investors. In nearly every stock, there are great investors on each side – long and short. The greatest can be wrong. And the weakest can be right.
Solution: get depressed early.
SA: What type of reader should follow your work?
GQ: A reader who will think through different issues that I present and come to their own conclusion. Hopefully, I will lay out a number of considerations, including factors that may ultimately turn out to be most important. But I want the reader to make up her own mind. I like reading others’ research, even if I disagree with the conclusion, because it helps me to think through different points of view. If after reading my Seeking Alpha articles, the reader comes to the opposite buy/sell conclusion, that is OK with me. I just hope to add value in some way.
A lot of time, everyone agrees with the identification of the issues surrounding a company, but then depending on how one weights probabilities, you could go long or go short. In other words, the difference between a decision to go long or go short could be a disagreement on the perceived probability weightings rather than a disagreement on the perceived issues.
SA: You’ve listened to more than your share of conference calls in your day – in general what are useful questions analysts can ask on calls and what are less constructive questions?
GQ: “Great quarter guys” is of course the best preface to any analyst’s questions, but only if the analyst is not easily embarrassed.
The all-time best quarterly conference call question — which has never been asked — might be:
“Management, during your many rehearsals for this quarterly conference call, what practice questions made you the most uncomfortable, why did those questions make you uncomfortable, and how did you answer them?”
Some analysts will ask questions which are a variation on: “how can you management be so fabulous?” So funny! They are trying to ingratiate themselves to management, which will potentially benefit them by allowing them to bring in their investment banking side of the house, etc.
Other analysts will ask a softball question to let buy side clients know they are on the call and on top of the company. Some analysts will ask an obscure question with the goal of leading others to think that they need to plug in just one more obscure piece of data into their amazing proprietary financial statement model. Some excellent analysts will ask questions whose point is not obvious; I listen for hints of the thesis they might be developing.
The best questions are those that are on target for the company. For one company, it might be a question about a growth strategy through acquisitions. For another company in the same industry, it might be a (likely futile) question about the sale of the company, debt, bank willingness to go along with the company’s plan.
Seeking Alpha’s transcripts are a great service for investors. Reading transcripts is more time efficient than listening to conference calls. By comparing sequential transcripts, it is easier to see how management’s narrative and analysts’ focus change over time.
Thinking about conference calls from the point of view of management, I imagine management is sitting around an oak conference table in their leather chairs. They have a computer in the middle of the table with a list displaying the information for those that called into the conference call. From the list, management will signal to the “operator” which analyst will ask the first question. Typically, the company will choose a well-respected analyst who knows the company well, has a buy recommendation, and knows how to play nicely with management. At the beginning of the Q&A segment of the call, the company will want to set a professional and positive tone of the Q&A segment of the conference call. If management unexpectedly gets a tough question that they don’t handle well, some companies might have a go-to analyst to call on next, by shuffling the order of questioners on their computer screen. Following a management stumble, the tone of the call changes for the better when a bullish, supportive analyst starts with “Great quarter, guys” and asks a leading, bullish question. (Description of InterCall system starting on page 7🙂
SA: What should investors be careful of?
GQ: I will talk about negativity.
Harvard Business School Professor Teresa Amabile did a classic study “Brilliant but Cruel: Perceptions of Negative Evaluators” in 1983 focused on negative and positive book reviews. She found that negative reviews sounded smarter, even when a learned panel independently judged the positive review to be higher quality.
There are plenty of situations where it is appropriate to be negative. Just don’t be perpetually seduced by the siren song of negativity. Negativity sounds smart. But, sometimes it’s stupid.
It’s important that we investors be negative at the right time and guard against negativity at other times. We need to (try to) be self-aware. Regarding the overall stock market, CNN’s Fear & Greed Index helps self-awareness by providing a real-time snapshot of investor emotions. If I am feeling negative regarding the overall stock market, I check CNN’s Fear & Greed Index; if I am negative and the Fear & Greed Index is negative, it might be time to rethink my negativity. Excessive negativity can be bullish, of course. Like Christmas Eve, 2018:
The S&P 500 closed at 2351.10 on December 24, 2018. That was the spike low. The Fear & Greed Index helped to illuminate how bearish investors were. The S&P is up 31%.
Notwithstanding my earlier admonition not to be too negative, the Index currently reads 91 – “Extreme Greed”; that might appropriately raise some questions for the bulls. But while a low Fear & Greed Index seems to be a valuable tool at stock market lows, a high Fear & Greed Index shows less reliability at stock market highs. In a Seeking Alpha article, contributor JAMM Investing made the point that “nearly half of the total return of the S&P 500 came during that 20% of the time when market sentiment was strongest.”
SA: Can you bring readers up to speed on Optical Cable (NASDAQ:OCC) as you’ve been following this for a while and this is an under the radar company?
GQ: When Ted Weschler (Warren Buffett lieutenant) filed a 13G indicating he bought 5.25% of OCC, I started researching the company. When he increased his position to 9.99%, OCC became even more interesting.
The stock jumped after each of those two disclosures and then fell back, and now is modestly below Weschler’s cost, I estimate, as well as below my cost. OCC is a valuable company in a consolidating industry. In my estimation, OCC needs to adopt a sales culture. That might require new management. Or it might require that OCC be acquired. OCC rebuffed an acquisition 13 years ago at twice OCC’s current price. Management shows no sign of preparing to make a big change.
But maybe its lender will encourage a big change?
In FY2019 Q2 and Q3, OCC fell short of the previously negotiated requirements of two bank loan covenants. The new loan amendment signed by OCC and Pinnacle Bank was signed by an employee who works in a Pinnacle office that is 107 miles from OCC, whereas the original loan office was 7 miles away. Maybe the Pinnacle loan officer is an expert in the cable manufacturing industry. Or maybe Pinnacle is not keen on maintaining OCC as a customer after OCC’s financial performance in FY2019. If OCC violates more covenants as the current June 30, 2020 maturity draws closer, I wonder if the bank will encourage big changes at OCC; it might be the most effective way of ensuring Pinnacle’s loan is repaid. At the close of FY2019 (October 31, 2019), OCC might have violated two more covenants. We may have to wait until December to hear if that is the case.
Separately, China turned on its first 5G networks on Friday November 1, in about 50 cities. China has eight times the number of 5G macro base stations, according to Bernstein Research. If the US sets a goal of catching up, it could benefit OCC and other industry participants.
On its October 29, 2019 quarterly conference call, Corning indicated it expected meaningful 5G-related orders, but it was not clear on the timing.
On QCOM’s quarterly conference call held on November 6, 2019, the term “5G” was said 115 times, including 75 times in the question-and-answer segment with analysts. QUALCOMM Chief Executive Officer Steve Mollenkopf ended the call with: “2020 is the year of 5G.” QCOM will directly benefit from 5G. OCC will not, but OCC should indirectly benefit. But, with respect to OCC, the magnitude and the timing are uncertain.
I think OCC is an appealing candidate to be acquired. My article from mid-October is here.
SA: Readers could easily assume a company that has (or is about to) violated a debt covenant is a short but could it ever be a contrarian opportunity?
GQ: Violating a debt covenant for the first time is typically not a big deal. However, violating a second covenant the following quarter establishes a pattern. In their research “Creditor Control Rights, Corporate Governance, and Firm Value”, Nini, Smith and Sufi argue that after a covenant violation, “there is also substantial anecdotal evidence that creditors work ‘behind the scenes’ to affect changes in the way that the company is run and managed”. “Creditors can offer advice to management and the board, quid pro quo, that suggest actions the company can take to maximize the chance of receiving a covenant waiver. (bold added).” If management is not making needed changes at the company, and if the bank is encouraging the company to make the correct changes, then violating a covenant might, in the end, be positive for a company’s stock price. On the other hand, if the company does not have clear changes that can change the situation, violating a covenant might suggest the beginning of the end.
SA: You identified Ted Weschler as a notable investor to follow from your work on OCC – are there any others? Perhaps a few less well-known ones? What is the best way for readers to track their activity?
GQ: I have a number of investors that I communicate with privately. Each are experts in specific securities or investment styles. Some have answers. Some have questions (thought provoking questions). Some have different points of view.
The idea of following other investors is complicated. One danger with following others is herding, where a majority of investors are positioned the same way. If (or when) something changes, the stampede to change positioning can cause a meaningful, adverse move in the affected security. The CFA Institute published a piece that identified “herding – being influenced by peers to follow trends” as the most important behavioral bias to be aware of. We all do herd, to a degree. But it is important to keep that instinct in check. Humans are herd animals.
On the other hand, in “Judging Fund Managers by the Company They Keep”, Cohen, Coval, and Pastor found that herding can be good, as long as you are herding with the right managers. “We develop a performance evaluation approach in which a fund manager’s skill is judged by the extent to which the manager’s investment decisions resemble the decisions of managers with distinguished performance records… our measures reveal strong predictability in the returns of U.S. equity funds.”
BofA Merrill Lynch’s Global Fund Manager Survey for October, 2019 found that institutional investors are currently overweight cash and US stocks, and underweight stocks in Japan, emerging markets, eurozone, and particularly the UK (presumably due to Brexit fears), as well as “highly skewed toward defensives, away from cyclicals.” The Fund Manager Survey helps to shine light on potential herding issues. Typically, loved markets are expensive. Hated markets are cheap. That situation can persist a long time.
SA: How did you arrive at the U.S. quarter dollar being the Great Quarter avatar?
GQ: Of course, it is called a “quarter”; that is a start. The back story: years ago, a work colleague/friend and I were working in adjoining offices as high yield analysts, each covering about twenty companies (“credits”). During earnings season, a dozen of each of our companies would issue press releases and hold conference calls in the space of a week. We had to read the releases, participate on the conference calls, update our financial models, and write sage insight for our professional investor clients. And cover developments in all of our other companies as well. My friend would stumble into my office at the end of the day, lay a quarter on my desk, and mutter “great quarter.”
Thanks to the PRO team. I hope some of these thoughts are helpful to some of your readers. Good luck investing to all!
Thanks to GreatQuarter for the interview.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.
Additional disclosure: GreatQuarter is long OCC.