In a recent conversation with an industry peer, it was mentioned that their firm only invested in companies that were the “#1 or #2 player in their industry”. And since I have never had such a restriction on my own investment framework, I thought about this. Would this restriction be helpful, and an improvement on our process at Ballina Capital? Selectivity is vitally important to good investment performance. Perhaps this could help?
“Quality” is the area that we are delving into today. Quality has long been a buzzword in investment finance, but with factor performance taking greater influence in industry parlance, Quality has been minted as a concept. Everyone is looking for Quality. There are no Investment philosophies out there that describe that they are looking for the “most terrible companies that they can find”. It is my experience that the Quality factor that Quantitative analysts view through their lens, is very different from the Quality viewpoint that prevails on the Buyside at Large Institutions.
Quantitative analysts have to have a metric that they can use or calculate. This is no different for scoring Quality. They could compile data of the Ratings (Buy, Hold, Sell) of Sellside analysts. But some stocks are not covered at all. If they could poll the Buyside, this would lead to a better result. But Buyside views of Companies are secret, for good reason. So much of the Quality factor comes back to financial metrics like margins, and returns. Meanwhile, on the Buyside, at the firms where they say they look for “Quality”, “Compounders”, “Wide Moats” and “Strong Management”, something different occurs. The Buyside, with a strong contribution to the debate from the community of sellside analysts, engage in what I would describe as a “Groupthink” discussion of what is Quality. These companies that win over this debate may actually have poor margins and returns, especially in the most recent period where Growth has been so important. In my experience, the buyside Quality Groupthink discussion is one that is hard to withstand with a differing viewpoint. It’s a little like coming to a handbag connoiseur and saying the latest Coach handbag is better than a Hermes Birkin bag. The handbag expert isn’t going to be accepting of that wide of a range of opinion. The phrase “Everyone knows this is the best” along with “Everyone knows that is rubbish”, are the kind of viewpoints you will hear. The quality companies have sellside reports that use words like “Strongest”, “Best”, “Monopolistic”, “Pricing Power”, “Most Efficient”, “Lowest Cost”, with abundance. Admitting that you own the Quality companies doesn’t get a strange look, or furrowed brow, at any investor conference or meeting. This is the comfortable place for an analyst.
Yet the Quality Groupthink pursuit is also, in my experience, a hard game to be a part of. For one thing, it is very backward looking. And we are trying to produce strong investment results on a look forward basis. Internationally, this Quality game gets even harder still. Take the initial suggestion from my peer, of finding #1 or #2 players. International equity markets have proportionately fewer companies that can meet that standard. Apple, Walt Disney, Google, Caterpillar and Amazon are U.S. listed behemoths. Internationally we may have companies like LVMH, but there are great numbers of companies that have strong country or regional footprints. Many of the International companies that have strong niche positions are small, and or have limited free floats, so they fall off the radar of the large Institutions. Buying an International stock at a “Quality” price only to find out that it is something quite a bit less will, in my experience, turn out to be quite painful.
The more that I thought about this, I thought about Ben Simmons and Alex Caruso. For those that are not familiar, Simmons and Caruso are professional basketball players. They were each eligible for the 2016 NBA draft, an annual two round process where the teams get to select players under an order that favors the weakest teams. Each draft class is evaluated heavily by media experts (a little like the sellside), and of course, by the teams themselves (Buyside). This process begins years in advance given the importance of selecting the right players, and with the advent of more video tools, statistics and analytics. Ben Simmons is originally from Australia, and played one season at Louisiana State University. In November 2014, NBA Hall of Famer Shaquille O’Neal called “Simmons the best player in the world”. The superlatives that began with “How many 6’10 18 year olds can do this?” abounded. Ben Simmons was Quality. As the 2016 NBA draft approached, virtually no one dared to suggest that the team with the #1 pick, the 76ers, should pick anyone but Simmons. And they did. He won Rookie of the Year in his first full season of 2018, and has gone on to be named to three NBA All Star teams.
In all, sixty NBA players were drafted in 2016. Alex Caruso, though eligible to be drafted, was not one of them. Alex Caruso is from College Station,TX, and played four years for Texas A&M. He averaged an unremarkable eight points a game for the Aggies. His pre draft analysis from Draft Express included the descriptors “passive at times offensively”, “more turnover prone than you might hope”, “his handle is sloppy”, “a reluctant driver”, and possessing a shot that is “easily contestable for defenders”. There were positives as well, like Size, defense and passing. But Caruso was not “Quality”. You would definitely get a quizzical look for mentioning him to a Hoop addict.
But I think of Alex Caruso and Ben Simmons in relation to the whole Quality stock debate. Simmons on Draft Day 2016 had exactly the type of overwhelming hyperbole about him that sellside analysts bend over backwards to add in relation to the highest “quality” companies. If Simmons was a company, he’d have a “wide moat”. And Simmons has mostly lived up to the expectations. He was NBA rookie of the Year in his first full season, and has been named to the All Star Game on three occasions. I think of Alex Caruso in relation to this debate because the journey that he has taken resembles the type of odyssey that a Ballina Capital idea takes from the beginning. Caruso was undrafted, but signed ironically enough to the very same 76ers. This did not last long. Caruso eventually had more luck with his third NBA team, the Los Angeles Lakers. The Lakers were a struggling team, and gave Caruso opportunities to play. He was still on what they call a “two way contract”, meaning that if he played poorly, he could be let go without financial consequence in short order. Only in 2019, three years later, did Caruso sign a guaranteed contract. He had just come off of a season where he averaged 9.2 points per game, more than 1 point greater than his college average. Lakers Nation said of Caruso “the Tenacity required to claw his way into the league permeates Caruso’s game”. In the following season, 2019-2020, the Lakers went on to win a World Title, with Caruso playing an important role. Caruso has become highly regarded because the Lakers almost always outscore the other team when he is on the floor. Following the latest season, Caruso became an unrestricted Free Agent, meaning he was free to sign with any NBA team. Alex Caruso ended up signing with the Chicago Bulls for a four year, $36.98MM contract.
Today, virtually all NBA analysts would rate Ben Simmons a better player than Alex Caruso. (See the chart below with the Value over Replacement Player, an advanced metric to score the relative value of players). But Ben Simmons has been a victim of the high expectations. The 76ers have Championship aspirations, and in the playoffs, Ben Simmons has played without confidence. The 76ers have reportedly offered Simmons in trades around the league, and received very few interesting bids. A few weeks ago, Yardbarker wrote a report where they did a “redraft” of the 2016 NBA draft. This is a mock analysis of how they would see the draft going if it was redone today. Think of it as a Buyside “reassessment” poll. Yardbarker placed Simmons at #2, and placed Caruso at #14. Yes, Caruso had, at least in this analyst’s eyes, moved up at least 46 spots from his original undrafted status.
Source: Basketball Reference
We at Ballina Capital feel that our repeatable process often leads us to the “Under” class - The undervalued, the under earning, the under managed, the under followed. We believe there is quality there, and mosts Quants would probably agree with us given our portfolio companies margins and returns. Markets outside the U.S. are stock full of companies that can meet this criteria. But these are often companies that would draw the confused look, or a “huh” from an investor peer. This is what Alex Caruso was in the 2016 draft process. If given the chance to study him and watch him play, experts would have determined that he was indeed an NBA player. But they didn’t consider him. The NBA invited 63 players to the predraft NBA combine, where league officials congregate to measure, test and watch prospects play. Caruso was not invited to that combine. Proving his value took time. Given his low cost, his downside was almost nonexistent, and eventually his “quality” shone through, and was rewarded. In the case of Simmons, he has played well for his team, but he has shown enough weaknesses that they cannot receive fair value for him. His previously perceived “Quality”, and commensurate high priced contract, are now a risk. This is similar to the way we at Ballina perceive many of the “Groupthink Quality” stocks in the market. We’re happy that our screens do not capture many of these companies.
Strategy Performance
International All-Cap Value returned 0.57% (gross basis) in October 2021 versus 2.88% for the benchmark. Year to date performance was 22.82% (gross) versus 9.9% for the benchmark.
Global Small Cap Value returned 1.23% (gross) in October 2021 versus 3.73% for the benchmark.[1] Year to date performance was 22.19% versus 15.74% for the benchmark.
Top Contributors and Detractors
International All-Cap Value’s top contributor in October was Galliford Try. The UK construction stock returned 11.6% as investors continued to react positively to the company’s operational and financial momentum. The strategy’s top detractor in October was Sumitomo Mitsui Financial, which declined 9.04%. Japanese banking stocks reacted negatively to the new Japanese Prime Minister’s plans for a “New Capitalism” that includes more taxes.
Global Small Cap Value’s top contributor in October was Galliford Try. The stock returned 11.72% in October, as the UK construction company is still benefitting from reassuring results and guidance provided to the market in September. The top detractor in the strategy for October was Sumitomo Mitsui Construction. The Japanese Construction firm declined 5.9% as investors reacted negatively to the new Japanese PM’s plans for redistribution of wealth.
[1] Benchmark for Global Small Cap Value comprised of 50% weight iShares Russell 2000 Index (IWM) and 50% weight Vanguard FTSE All-World ex-US Small-Cap ETF (VSS)