The Best Investments
Board: Berkshire Hathaway
My best investments have been plays on market sentiment. As much as I love my stalwart value names -- Berkshire, Brookfield, Markel, Loews, Greenlight -- they have not been the stars of my portfolio.
The stars have been far less proven growth names which enjoyed heady multiples and then, for a variety of reasons unrelated to one another except for the common thread of human nature, were suddenly and quite decisively hated by just about everyone. The light bulb for me was listening to the same people who had once ruled out these names as too expensive quite abruptly finding other reasons to rule them out when they became cheap. They were simply going along with the crowd.
Two illustrations from this year, either of which I may have mentioned here in passing:
The Chinese search engine went public on the Nasdaq in 2005 and I bought a few shares based almost entirely on the unbearable lightness of the search business model. Over the next several years, Baidu's rapid growth -- it averaged 80 percent a year over one five-year stretch -- brought it very heady multiples. When they reached triple digits, I got out, but continued to follow the company.
By early this year, sentiment on Baidu had turned around quite completely for a number of reasons. The most reasonable was the fear that it was late to the mobile revolution and risked losing its dominant share of the Chinese search market. But there were others as well, including concerns about its labyrinthine corporate structure (China doesn't allow foreigners to own companies directly in certain sectors considered crucial to national security, including the internet), the discovery of fraud in a number of Chinese companies, mostly small caps, listed on U.S. exchanges and the resulting dispute between U.S. and Chinese authorities over access to audit records, which some alarmists thought might result in the delisting of all Chinese securities from U.S. exchanges.
There was also the fear abetted by permanent China bears that the entire economy was about to collapse in a haze of overpriced real estate and massively overbuilt infrastructure.
Most of these fears were nonsense in my judgment, but they illustrated the nature of market -- and, by extension, human -- sentiment. Just as people look for evidence to support owning stocks they want to own, they seek out support for not owning stocks they don't want to own. The popularity or unpopularity of a given name becomes itself the most compelling reason to confirm one's own bias. I have come to believe that confirmation bias is the single most important factor for most people in determining not only positions in the market, but also positions with respect to many other disciplines, in particular partisan politics. As Paul Simon put it:
A man hears what he wants to hear and disregards the rest.
In March, the multiple the market was willing to pay for Baidu's trailing 12-month earnings dropped below 20 -- well below even the most pessimistic growth forecasts -- amid a gathering gloom about almost everything Chinese. It was, in my view, mostly irrational. Nothing profound about China had changed from a year or two or three earlier, when Baidu was a market darling. Sentiment about the same reality had simply changed, in the manic-depressive way that Ben Graham described.
So I bought a bunch of Baidu in March around $85. Six months later, it's about $150. What's changed? Well, it made a couple of acquisitions in the mobile space, which assuaged those who felt it hadn't noticed the migration from desktops to tablets and phones. And it reported 10 percent of revenues were now coming from mobile, apparently higher than those who thought it hadn't noticed mobile were expecting.
What really changed was market sentiment. The fear of all things Chinese simply abated.
MAKO makes a robot that governs surgical movements in joint replacement procedures; partial knees and total hips for now, probably some other stuff as time goes on. The software increases the precision of alignment, which is the main factor in joint replacement outcomes. MAKO is a development-stage company, which is to say it doesn't make a profit.
For quite a while, it rose mostly because of market sentiment. A lot of people who missed the dramatic rise of Intuitive Surgical, which sells a surgical robot for soft tissue procedures, thought they could make up for it by getting in early on MAKO. It rose from the single digits coming out of the financial crisis to touch $40 in early 2012. Then its sales of new surgical robots slowed and people started jumping off the bandwagon.
Few of them seemed to notice that new system sales were no longer the primary driver toward profitability. Procedure growth was. So even flat system sales were going to have the effect of steadily increasing the installed base and procedure count. As market support for the shares evaporated, the operating results slowly but steadily improved. Early this year, the price dipped to about $10, a level not seen since 2010. My analysis of the operating results suggested they were within four quarters of positive net income, more or less. They paid a penalty for not tapping an expensive credit facility, which told me their internal numbers, too, suggested they could get to profitability without fresh capital.
The precipitous decline in the shares had begun as a reaction to slowing system sales, but it persisted and accelerated based on general sentiment. People were just tired of the story. It was taking too long to play out. People who had held it and watched it decline through a bull market were kicking themselves for their bad decision. So I bought a bunch in the low teens and doubled down in July at $12ish just before Q2 earnings were released. Last month, Stryker Corp. announced it would buy MAKO in an all-cash deal for $30 a share.
I'm not nearly as proficient as many of you at the numbers game. That's why I value the work you do here so highly. It just doesn't come naturally to me. My brain isn't wired in the way Buffett describes.
So I started as an investor as a "story" person -- a Lynch disciple. But I learned the hard way how easy it is to be taken in by a story, how hard it is to distinguish in the early stages the stories that are not only good ideas but also have the opportunity to be executed successfully.
These days, I like to think I have found a certain intuitive space between the two in which one applies value metrics to developmental or growth companies and by watching them over time begins to get a sense of the upper limits of market exuberance and the lower limits of market resignation. Buying at these moments of market capitulation, if one is otherwise convinced of the firm's prospects and viability, can be a productive strategy, in my experience.
Along these same lines, I am beginning to look at companies involved in the conversion from gasoline and diesel to natural gas as a transport fuel. This conversion is accelerating, for obvious reasons, and yet the market seems to be tiring of a story that has been around for years and has yet to produce profits. Just as adoption rates are suggesting one might want to get in, the world seems to be getting out simply because it's grown tired of waiting for the payoff.
The other day, Jim Cramer came on CNBC and urged his viewers to sell Clean Energy Fuels Corp., the T. Boone Pickens invention building out an infrastructure of natural gas filling stations. Cramer parroted a Piper Jaffrey research note that said CLNE had bet on the wrong horse -- it was selling liquefied natural gas while customers wanted compressed natural gas. This was simple nonsense -- CLNE sells both, which are appropriate for different uses. Sales to fleet vehicles that can refuel without time constraints overnight -- garbage haulers, UPS trucks, taxis, etc. -- are principally CNG. Sales to long-haul truckers, who need more capacity per fillup and faster refueling, will be LNG, the product in the American Natural Gas Highway stations CLNE is building out at Pilot Flying J truck stops across the country. CLNE shares fell 12 percent on these specious sell recs. That, to my current mind, was a bullish sign.
Similarly, the shares of Westport Innovations, which owns patents on engine conversion technology and is in a joint venture with Cummins to produce natural gas truck engines, were recently beaten down when it announced an unexpected secondary offering. Existing shareholders were upset and sold. As a non-shareholder, the secondary was good news -- it meant the need for fresh capital was no longer a short-term worry.
Like MAKO, these companies seem to me within a year or two of positive cash flow. Conversion to natural gas as a transport fuel is accelerating. And yet the market is as negative as it has been in some time on these shares. My sense is that, as with MAKO, it's just tired of waiting for the story to play out. These shares have been left out of a four-year bull market. The negative market sentiment is mostly fatigue at waiting for the fruit to ripen. I might feel the same way if I'd been holding these shares the last five years watching them do nothing. But I haven't. Now it seems to me they look interesting.
What I am trying to describe is a hybrid investment approach that uses Mr. Market's manic-depressive nature, as Graham and Buffett recommend, but also a Lynch/David Gardner enthusiasm for what comes next.