2020 Annual Letter
Annual letter | 15 min read | Reflections on my investing debut and creating long-term significance
Originally published on midstoryventures.com in December 2020.
My Investing Debut
To my friends on this value investing journey,
It is my pleasure to present to you my first Annual Letter. I believe this quote fits the theme of this Annual Letter and all Annual Letters to come.
“We enjoy the process far more than the proceeds.” Warren Buffett
Aswath Damodaran makes a similar point when he says that valuation is not an art, nor it is a science; rather, it is a craft. And like all crafts, you learn by doing. The more you do it, the better you get at it.
In these letters, I will write about the evolution of my process and my overall journey as an investor. I hope by publishing these letters, you will find some things that will help you on your own journey.
Early Aspirations: A Path to Business Ownership
Since this is the first one, I thought I would take the chance to explain the origins of my investing journey.
Ever since I was young, I’ve wanted to be a business owner. Back then, I thought the only way to become a business owner was by starting your one yourself.
I started my first business in college — a consulting business. It was the most thrilling year of my life.
I loved talking to business owners, customers, and employees — figuring out what makes companies good and what holds them back from being great, then building a plan to get them to where they want to be.
But by the end of the year, I was exhausted. I quickly learned that I didn’t like managing employees. I had to put out a new fire every day. I knew I needed a change.
Around this same time, I joined an entrepreneurship program at my university. I was linked up with a mentor who was a small business owner, operator, and investor. By the time I met him, he was in his 50’s, so he spent more time as an investor than an operator.
I wanted to be like him, so I asked him how to be an investor. He gave me two pieces of advice which would change my life forever.
“Read Rich Dad Poor Dad. If you want to be rich, you should never, ever work for money. Make money work for you.”
“There is a guy named Charlie Munger. He is the right-hand man of Warren Buffett. Look into him — you’ll find everything you need.”
I spent that entire summer reading Rich Dad Poor Dad and looking into this Charlie Munger guy. I stumbled upon InvestED, a podcast by hedge fund manager Phil Town. After listening to the first episode, I learned two things.
When you invest in a business, you become a business owner. You have the opportunity to make significant changes through your rights as a shareholder to hold meetings, approve directors’ nominations, and vote on proposals.
When you invest in a business, you are voting with your dollars. You are supporting a company that you want to see in the world 20 years from now, and whose mission and values align with your own.
That was it. That was exactly what I was looking for. And that was the beginning of my investing journey.
Investment Philosophy: A Private Business Owner Mentality
My journey started from my interest in business ownership, not the stock market. As a result, I have a unique way of thinking about business ownership and being a business owner, which gives me a significant advantage over other investors.
#1 Business Ownership
Benjamin Graham once said, “Investment is most intelligent when it is most businesslike.”
To me, the stock market is simply the most efficient and effective way to become a business owner. It gives me access to buy or sell thousands of businesses at ready price.
As a result, I have an almost oblivious way of interacting with my broker. I hardly ever look at stock prices for the companies I own. You will never find me measuring my success or failure with the company’s stock price.
Like a private business owner, I measure my company’s progress by its growth in market share, customer loyalty, and profits.
#2 Business Owner
Warren Buffett once said, “That whole idea that you own a business, you know, is vital to the investment process."
Marcus Lemonis says it this way: “If you don't know your numbers, you don't know your business!”
To me, it is a prerequisite as a business owner to not only know your numbers at all times. And I believe the ultimate test of this is the “Emergency Board Meeting.”
I’ll give you a real-life example. This year, my friend was brought into an Emergency Board Meeting for a private company in which he was a significant shareholder. An acquirer made an offer to the shareholders to buy the entire company. He and his Board members were not expecting this. They did not know what to do. Some were fearful, others were greedy.
This happens in the public stock market all the time. Mr. Market offers different prices every day. Human nature dictates that you will have emotional reactions to it. Are you prepared?
My first line of defense is to simply look at stock prices as infrequently as possible (see section above). My second line of defense is to know my numbers at all times.
To pass the “Emergency Board Meeting” Test, you need to know the business so well that if you were suddenly pulled in as a Director and needed to give strategic advice at the Emergency Board Meeting, you wouldn’t skip a beat.
Writing A Newsletter: Three Lessons from 2020
This was my first year as an investor. The only way to get better in investing is to learn by doing, and in this “debut” year, I pushed myself to take my craft to a new level.
I challenged myself to find, analyze, and write about five companies that I would be interested in owning. This is the Midstory Ventures newsletter that you see today. I published a 5,000 word diligence report on a new company every month from July to November. The companies were Collectors Universe, OTC Markets Group, Nathan’s Famous, Wingstop, and Winmark Corporation.
By challenging myself with a newsletter, I made massive improvements in my investing process. Here are the three most valuable things I learned as an investor by launching this newsletter.
#1 Investment Research is 80% Scuttlebutt, 20% Filings & Financials
Early in the year, I found that a 6-point research checklist was extremely helpful to compartmentalize the various parts of the business and its stock. I generally think about a company through six different lenses.
Durability: What is the underlying premises of the company?
Moat: Do competitors have a will and/or a way to steal the company’s customers?
Quality: What are the unit economic returns of the business?
Growth: Will the company do more business in the future than in the past?
Value: Are the company’s owner’s earnings worth more, relatively, than another metric?
Capital Allocation: How does management think, talk, and act?
The checklist even helped me think about how to translate qualitative aspects into quantitative value. For example, let’s look at a 20-year record of a company's ROIC (return on invested capital), one of the most important metrics to consider.
Quality refers to the height of the returns. It is the difference between a company having 25% ROIC and 100% ROIC. Quality refers to the company’s choice of business model as it relates to capital efficiency (and float). A restaurant that is completely company-owned and a restaurant is completely franchised will have two different return profiles.
Moat refers to the predictability of the returns. It is the difference between a company whose ROIC has a high coefficient variation and a company whose ROIC has a low coefficient variation. Companies with strong moats have extremely stable and predictable returns for decades, assuming no changes in the capital intensiveness of the business model.
Durability refers to the length of the returns. It is the difference between a company with short-lived adequate returns and long-lived adequate returns. It is the foundation of the business. The more the landscape shifts, shakes, and transforms, the less certain you are about the company’s runway of returns, the height of returns, and the predictability of returns — it is all connected.
I found this to be a simple way to bridge the narrative with the numbers. But it is only effective as the information available.
Oftentimes, I found that determining the length of the returns, predictability of the returns, and height of the returns for the next 10, 15, 20 years was really hard, even after reading dozens of filings & analyzing decades of financials.
That’s when I realized the importance of scuttlebutt. Scuttlebutt filled in a lot of the gaps to those questions that the filings & financials could never fill.
Filings & financials take up 80% of your time but contribute to 20% of your investment research. Scuttlebutt takes up 20% of your time but contributes to 80% of your investment research.
#2 Writing Helps You Think Like a Journalist
Writing is one of the most challenging, but more beneficial skills to master in the investment process.
Bruce Berkowitz has a quote that says: “We continually challenge ourselves… with investments we own or consider owning by playing mental war games… We call this stress testing process ‘killing the company’.”
The practice of writing and rewriting is the act of waging mental war against yourself, challenging everything you believe.
It takes a long time for me to write 5,000+ words about a company. Not because it is a lot of words, but because I am constantly killing the way I view the company. I find myself constantly rewriting paragraphs because I am not afraid to change my mind.
For example, let’s say I am writing a paragraph on a company’s customer loyalty, I put myself in the customer's shoes (empathy) then build a preconceived idea. The logic sounds good in my head, but when I write it out, I start seeing the flaws.
Have I considered how product economics influence customer loyalty? Have I considered how physical distance to competitors decreases psychological switching costs? Have I considered how the purchase frequency influences customer loyalty?
As a writer, you hate having these thoughts. You may have written anywhere from 250 to 500 words just on this topic alone. It took you maybe half an hour or an hour to write out that entire section. You know you’ll have to spend at least another hour researching those questions that popped up into your head, but will you?
As an investor, I love having these thoughts. That’s why I love writing. It is rare to find someone who is more willing to challenge your thoughts than you.
Writing gives you an outlet to put out an idea, tear it down, put out another idea, and tear it down again. At some point, you’ll find an unbreakable idea — an idea you cannot disprove with hard facts. That’s when you as an investor, investigator, and writer have hit the jackpot. That’s an idea you can bet on.
That’s why my writing is long. I am not afraid to be what others call “long-winded.” By writing out the nuts-and-bolts of my reasoning, I can always revisit it to tear it down in the future if it doesn’t make sense.
Most of the time, you will never get to a point where you have an unbreakable idea. This might be because management is vague. Other times, it might be because you can’t calculate certain KPIs. There are dozens of reasons why you may never have an untearable idea.
That’s why you’ll often find contradictory/disproving evidence or caveats in my writing. I can’t find the information I needed to come to a definite conclusion.
I was recently introduced to the board game, Clue. The objective is to find out who is the culprit. You’re forced to make guesses, collect clues, make more guesses, and collect more clues until your guess cannot be disproven by other players. That’s when you take the leap of faith and make an assertion.
Clue is a lot like investing. Writing gives you the outlet to make guesses, make clues, and make more guesses. And I think this is why Buffett encourages us to “think like journalists.”
#3 Unlock Pattern Recognition Through Checklists
Experience is what separates the skilled from the elite. And experience is valuable because of pattern recognition. You see things develop earlier, you think more decisively, and you make decisions more confidently.
Warren Buffett once said that the key to improving as an investor was to simply “do one case study after another.”
As a new investor, my pattern recognition is at an all-time low. On top of that, the inherent nature of my investment style forces me to research, analyze, and think about investment opportunities longer than others.
My lack of pattern recognition and my unduly long investment process caused me to miss out on Collectors Universe.
I came across Collectors Universe after running a screen for high-quality companies. It was a small company with very simple operations based out of Orange County, CA. I recognized the product from my old hobbies. It seemed like the industry had a monopolistic / duopolistic industry structure. The ROIC was nearly infinite and the margins were extremely stable due to its take rate pricing strategy.
Then the pandemic hit. Collectors Universe sunk to a market cap of about $150M, or 10x EV/FCF. In April, I pitched the company to a small group called the “LA 10-K Club,” a private group of value investors based out of Los Angeles, CA. However, I was researching another company at the time, so I did not make an investment.
By the time I finished my diligence on Collectors Universe in the middle of June, Alta Fox announced its activist position and the stock skyrocketed. A few months later in November, Collectors Universe announced a deal to take a private equity buyout to the tune of $700M.
I missed out on a company whose market price grew 5x in less than a year. This was my most painful lesson of 2020, not because I missed out on a 5-bagger, but because I saw a huge flaw in my game. I could not see the opportunity right in front of me.
I knew it was attractive, but I didn’t know how obvious the opportunity was. I guess hindsight is 20/20.
To be honest, I was scared. It took me some time to build conviction around durability. It took an even longer time to build conviction around the company’s runway for growth opportunities. I even had multiple calls with customers and the CEO to build conviction.
In the end, I could have gathered all the information I needed and still have missed the opportunity. I did not know how to synthesize the information. I did not have the pattern recognition - the intuition - to pull it off.
What I needed was a tool to recognize the patterns so that I could take advantage of it. What I really needed was a checklist.
An investment checklist is simply a tool to frame an investment problem. A checklist is not a substitute for experience; rather, it is a tool to complement your experience. It is a way to effectively transform the way you see the business and the opportunities that arise.
I once heard Geoff Gannon say, “the only things you really need to determine in a stock is that it is safe, good, and cheap.”
If I used this framework in April, I would have had no problem making the investment in Collectors Universe.
It was clear it was cheap compared to free cash flow and book value. It was even cheap historically and relatively to its peers. It also was clear there was an adequate margin of safety because it was trading below book value. The business was also completely safe from financial risk due to its conservative balance sheet and safe from obsolescence risk due to its necessity in the industry. There were some strong signs that the business still had runway left, especially in trading cards, but it wasn’t even necessary to prove. The company was trading at such a discount that all you needed to prove was that it wouldn’t shrink.
I expect I will continue to have errors of omission like Collectors Universe. That’s the nature of being new and having less pattern recognition under my belt. But as I continue to focus on the process, build my experience, and use my checklist, I know I will be able to make investment decisions with more conviction and with more speed in the future.
A Personal Journey
Ever since I was young, I’ve wanted to be a business owner. Thanks to the stock market, now I am. But my journey doesn’t end here.
I want to become the best investor possible. The more I succeed as an investor, the more delight I can bring to customers, the more jobs I can give to employees, and the more wealth I can generate for investment partners.
Investing is a very competitive field. It requires a lot of time, energy, and focus. The readers subscribed to this newsletter are either full-time investors or aspiring full-time investors, so they too know the sacrifice it takes.
I thought building a legacy as a successful investor would be worth the sacrifice, but then I read what the “Teacher” in the Book of Ecclesiastes said:
“We don’t remember what happened in the past, and in the future generations, no one will remember what we are doing now.” Ecclesiastes 1:11
That took the wind out of my stomach.
As investors, we are long-term thinkers. I wanted to make long-term significance.
There are only 100 or so years in my story. There are only 200 years in which my family remembers my name. And there’s maybe 500 years at best in which the broader community recognizes me for my contributions. In the grand scheme of life, that's pretty short.
I read a book that says that God invites us to partner with Him to impact eternity. I wasn’t a devout Christian at the time, but as a value investor, that made sense.
In Guy Spier’s The Education of a Value Investor, he ends the book with a chapter titled, The Quest for True Value. In this last chapter, Guy Spier challenges us to find meaning beyond money, professional achievement, or social cachet.
Wherever you are in your journey, I encourage you to take some time to think about the value in your quest to compound long-term investments. I appreciate each and every one of you who has helped me on my journey as an investor and I look forward to our friendship for many more years to come.
Sincerely,
Ralph Molina
December 31, 2020