18
Jun
2017

The Red-Headed League

“For strange effects and extraordinary combinations we must go to life itself, which is always far more daring than any effort of the imagination.” Sherlock Holmes

I’ve been re-reading Sherlock Holmes stories, like The Red Headed League. One reason the stories are so effective is that the reader understands the genre, but it’s still hard to see what Holmes can see, there are always unexpected twists. But then when Holmes has solved the case and he explains to Watson, it all seems so obvious in retrospect. I am finding that even when you vaguely remember the story, they are still entertaining stories to read over again.
For instance in “The Red-Headed League” Jabez Wilson asks Holmes for his advice. Wilson has answered a newspaper advertisement asking for red headed applicants to do highly paid work.

“TO THE RED-HEADED LEAGUE: On account of the bequest of the late Ezekiah Hopkins, of Lebanon, Pennsylvania, U. S. A., there is now another vacancy open which entitles a member of the League to a salary of 4 pounds a week for purely nominal services. All red-headed men who are sound in body and mind and above the age of twenty-one years, are eligible. Apply in person on Monday, at eleven o’clock, to Duncan Ross, at the offices of the League, 7 Pope’s Court, Fleet Street.”

The red headed Wilson waits in a long line of fellow red-headed men, is interviewed and he is the only applicant hired (the other applicants were deemed unsuitable: their red hair was either too dark or too bright.) It turns out that the highly paid work is copying out the Encyclopedia Brittanica.
I’m intrigued by this story, and why Sherlock Homes is so successful. But I am also interested in investment “stories.” What management write in their Annual Reports and shareholder letters, not the financial numbers that they report. Currently there is a lot of computing power that can analyse numbers and ratios.  Computers are good at calculating formulas and following screening rules. But it’s much harder to analyse a successful story. There is no formula, otherwise authors would only ever publish bestsellers.  One thing we do know is that a story, like other forms of art, doesn’t have to be “realistic” or even “plausible” in a narrow sense.

What makes a good story?

Good stories are about unlikely, unusual or infrequent events, but a good story must be “believable”.  

The Brothers Grimm stories are full of talking animals, how “realistic” is that? Or the Arabian nights include flying carpets, secret caves that open with passwords and a bottle that contains a Genie. Yet, these are some of the most told, and most memorable stories we have in our culture.
I think the key to a good story is where something is different, but everything else stays the same. On the borderline between clichéd familiarity (predictable) and unfamiliar, surreal nonsense (incoherent). And talking animals and magical events allow us to recognise the familiar, from an unanticipated direction.

Story is about eternal, universal forms, not formulas. –Robert McKee

Hugely successful companies like Facebook, Apple, Amazon, Google, Netflicks increasing in value 100x are improbable. But going back and reading what management wrote before they were successful, you can read how “believable” their stories were. This is also true for ASOS (a 20 bagger), Burford (a 9 bagger) and WPP (which has increased in value 1000x since 1985). Berkshire Hathaway, the ultimate bagger, also has a well written Annual Reports going back to the late 1960s.  These really successful companies are infrequent, but they do exist.  And because they are outliers, they don’t fit the economists’ narrative of “efficient markets” and “normal distributions”.  But that’s like saying that because red haired people are 1-2% of the population, they don’t exist and should be ignored.  But I am much more interested in the outliers, that have delivered abnormal returns.  I find the gingers so much more interesting.

And perhaps there are some companies that have been disastrous investments can also tell good stories – but I’ve been looking quite hard and haven’t found any. If anything bad investments tend to be over optimistic, “chest thumping”…”our story is so exciting” types. Atlas Mara might be a good recent example.

A great story stock

Anyway, in the spirit of a Sherlock Holmes story, here are some comments from a management of a company that went on to be hugely successful (and whose website I’ve repeatedly used for over the last decade.)
I think you’ll agree the founder sets it out the “story” well.

It’s All About the Long Term
We believe that a fundamental measure of our success will be the shareholder value we create over the long term. This value will be a direct result of our ability to extend and solidify our current market leadership position. The stronger our market leadership, the more powerful our economic model. Market leadership can translate directly to higher revenue, higher profitability, greater capital velocity, and correspondingly stronger returns on invested capital.

Internet businesses are very different beasts to traditional companies.  Most internet businesses failed, yet the successful ones went on to be hugely successful.  Like books, most of the books that are published go nowhere….but the great stories are hugely successful. The universal forms still apply.

A rule says, “You must do it this way.” A principle says, “This works…and has through all remembered time.”  The difference is crucial.  Your work needn’t be modeled after the “well-made” play; rather, it must be well made within the principles that shape our art.  Anxious, inexperienced writers obey rules.  Rebellious, unschooled writers break rules.  Artists master the form.  – Robert McKee

The founders obsession with market leadership, cashflows, long term perspective translate into billions of dollars. Those are valuable principles.  The management commentary does make some specific comments about the business model, but I’ve taken anything out that makes it too easy to guess which company this is. I don’t want to give the game away. I want to give hints, like a Sherlock Holmes story. Maybe you’ll reach the end and think “but of course…I should have seen that. It was obvious all along.”  That’s how I feel reading his words.
The above quote and the bullet points below is from the first letter to shareholders that the Chief Executive wrote, and he outlines some core principles. Including:

We will continue to measure our programs and the effectiveness of our investments analytically, to jettison those that do not provide acceptable returns, and to step up our investment in those that work best. We will continue to learn from both our successes and our failures.
We will make bold rather than timid investment decisions where we see a sufficient probability of gaining market leadership advantages. Some of these investments will pay off, others will not, and we will have learned another valuable lesson in either case.
When forced to choose between optimizing the appearance of our GAAP accounting and maximizing the present value of future cash flows, we’ll take the cash flows.
We will share our strategic thought processes with you when we make bold choices (to the extent competitive pressures allow), so that you may evaluate for yourselves whether we are making rational long-term leadership investments.
We will balance our focus on growth with emphasis on long-term profitability and capital management. At this stage, we choose to prioritize growth because we believe that scale is central to achieving the potential of our business model.

These could all just be empty words. But reading back I find it fascinating how the company has stuck to its core principles. At the time sales were growing at 838% year on year, and customer accounts were up from 180,000 to 1.5 million a 738% increase. The growth rate has now slowed, but the company is logarithmically bigger. Being a website, the company still didn’t employ many people, employees grew from 158 to 614.
Naturally, when you know which company it is, it seems obvious. Maybe there are enough clues there? In the Red Headed League, Holmes is immediately suspicious of Wilson’s apprentice, who is prepared to work for below the going rate. And who takes photographs and disappears into the basement to develop them.
There is another clue that Holmes mentions in passing. He sees that near to Wilson’s shop is “Mortimer’s, the tobacconist, the little newspaper shop, the Coburg branch of the City and Suburban Bank, the Vegetarian Restaurant, and McFarlane’s carriage-building depot.”

Some more clues

Presumably, I need to give the reader more clues about the company whose story I’m quoting. I actually nearly invested in this company. I was working at Credit Suisse at the time, and we had an academic talk to us about valuation. He was really into his Discounted Cashflow valuations (and DCF models), and used this company as an example of how the valuation came from future expected cashflows rather than currently reported profits, or “Return on Capital”, which was low. Interestingly he has now published a book on stories and numbers. http://amzn.eu/8fanKiT
I didn’t invest. I thought that the founder was too focused on growth for the sake of growth, and I underestimated how well he could reinvest and extend.
That was a really expensive mistake, I would have turned a £10,000 investment into a million. I should have read this part of one of his later shareholder letters.

In closing, consider this most important point: the current online experience is the worst it will ever be. It’s good enough today to attract 17 million customers, but it will get so much better. Increased bandwidth will result in faster page views and richer content…. we’ll see significant growth in non-PC devices and wireless access. Moreover, it’s great to be participating in what is a multi-trillion dollar global market, in which we are so very, very tiny. We are doubly-blessed. We have a market-size unconstrained opportunity in an area where the underlying foundational technology we employ improves every day. That is not normal.

Can you guess who it is yet?

I’ll give you another clue. This company saw a steep decline in its share price after its IPO. It’s interesting to see how management react to this.

Ouch. It’s been a brutal year for many in the capital markets and certainly for XXX shareholders. As of this writing, our shares are down more than 80% from when I wrote you last year. Nevertheless, by almost any measure XXX the company is in a stronger position now than at any time in its past.
• We served 20 million customers
• Sales grew to $2.76 billion from $1.64 billion
• Pro forma operating loss in the U.S. shrank to 2% of sales in the final quarter of the year, from 24% of sales in the final quarter of the previous year.

The Chief Executive doesn’t get frustrated. He merely points out that the share price got far too ahead of itself, but the company itself is still reporting improving trends. He doesn’t patronise the investors, just explains where the company made mistakes and what they have learnt from the experience.

So, if the company is better positioned today than it was a year ago, why is the stock price so much lower than it was a year ago? As the famed investor Benjamin Graham said, ‘‘In the short term, the stock market is a voting machine; in the long term, it’s a weighing machine.’’ Clearly there was a lot of voting going on in the boom year of ’99—and much less weighing. We’re a company that wants to be weighed, and over time, we will be—over the long term, all companies are. In the meantime, we have our heads down working to build a heavier and heavier company.
Many of you have heard me talk about the ‘‘bold bets’’ that we as a company have made and will continue to make—these bold bets have included everything from our investment in digital and wireless technologies, to our decision to invest in smaller e-commerce companies, including living.com and Pets.com, both of which shut down operations. We were significant shareholders in both and lost a significant amount of money on both.
We made these investments because we knew we wouldn’t ourselves be entering these particular categories any time soon, and we believed passionately in the ‘‘land rush’’ metaphor for the Internet. Indeed, that metaphor was an extraordinarily useful decision aid for several years, but we now believe its usefulness largely faded away over the last couple of years. In retrospect, we significantly underestimated how much time would be available to enter these categories and underestimated how difficult it would be for single-category e-commerce companies to achieve the scale necessary to succeed.

It’s interesting to me that the investment case is so well articulated, that once you take out the specific references and dates it could almost be any successful US tech company. For instance:
It could be Google, the market leadership and focus on the long term. But actually you can see it is not Google by the rate of customer growth. Once google had reached 17 million customers, it was going to expand rapidly, where growth at this company hit a plateau, before accelerating again.
Maybe Facebook? Facebook fell heavily after its IPO price of $34 all the way down to $18 per share. But it didn’t fall 80%. And Facebook has never struggled to report high profit margins since it IPO’ed.
Apple? – well Apple has been around much longer than the other tech companies. It was more of a turnaround story. Although the company above was loss making, it never got into the existential muddle and spectacular turnaround that Apple did. Even when the share price was down 80%, sales were still up 68% year on year.
Netflix? Netflix has been listed for a surprisingly long time, it listed in 2002. But it’s hard to imagine Netflix buying Pets.com.
That just leaves XXXX then. Obvious.

And The Red Headed League?

I will let Holmes explain.  

“You see, Watson,” he explained in the early hours of the morning as we sat over a glass of whisky and soda in Baker Street, “it was perfectly obvious from the first that the only possible object of this rather fantastic business of the advertisement of the League, and the copying of the Encyclopaedia, must be to get this not over-bright pawnbroker out of the way for a number of hours every day. It was a curious way of managing it, but, really, it would be difficult to suggest a better. The method was no doubt suggested to Clay’s ingenious mind by the colour of his accomplice’s hair.”

Well I find it fascinating that the plot was not so outlandish afterall. It was about digging a tunnel underground to rob the City and Suburban Bank. Like the Hatton Garden robbery.  https://en.wikipedia.org/wiki/Hatton_Garden_safe_deposit_burglary Or even more ironically, there was the Baker Street robbery.

So Holmes was right.  “For strange effects and extraordinary combinations we must go to life itself, which is always far more daring than any effort of the imagination.”

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