Being a contrarian can be a lonely existence. It involves doing nothing for long periods of time. And then when you do something, you are usually going against conventional wisdom at the time. But loneliness is not the hardest part of the job. The hardest part is being an obvious idiot when you get things wrong.
All investors make mistakes. Most successful investors say the best you can expect is to get six or seven out of 10 right. That’s been consistent with our experience over the past decade. The difference as a value investor is that you get things wrong in ways that are obvious, seemingly stupid and embarrassing.
Into the face of Jumbo concerns
Online lottery ticket reseller Jumbo Interactive (JIN) is a darling growth stock these days. But it wasn’t always that way.
We first bought into the stock at around $2.50 a share. From there it fell more than 60% and we added significantly to the holding at less than $0.90 per share. As a value investing opportunity it was simple. Its market valuation was just $39m. It had $17m in cash, a pile of franking credits and an Australian business making $8m of pre-tax profit a year.
But the issues with the business were well known in 2015. Jumbo was wasting money on international expansion gambles in Germany, the US and Mexico. It had one critical supplier, Tatts Group, that could terminate its distribution agreements and kill the business overnight. And, perhaps most worrying long-term, Jumbo sells exactly the same product as Tatts for a 10% premium. Why does anyone even use it?
When the share price was getting hammered, everyone was focused on these flaws in the business model. Blind Freddy could see that this business didn’t have a future.
Taking a contrarian view involved coming to terms with just how much money would be wasted, how profitable the Australian business could be and what the chances were of losing that big supplier.
Jumbo turned out well — the stock is up from $1 to $6.50. But imagine if Tatts had pulled the pin soon after we bought it. It would have been easy for our investors to turn around and say: “you guys should have seen that coming — everybody else did”. Which, of course, is why the opportunity was there in the first place.
Wrong on Freedom and looking stupid
The Forager Australian Shares Fund owns funeral insurance company Freedom Insurance (FIG) in its current portfolio. Freedom’s share price is down more than 60% over the past two weeks after being called before the Royal Commission into Financial Services and the release of an ASIC paper condemning its business model.
Forager made the investment knowing that Freedom’s sales model was potentially flawed. Here’s what I wrote in our research document in November last year:
“The direct sales business model could come under threat. Regulators could require personal advice to sell life insurance products, for example. There’s something ugly about phone sales of insurance product and I can imagine it getting a lot more scrutiny if it continues to grow. I would put the probability at low but meaningful and the impact very high.”
A probability assessment of “low” can be debated. The point is that we made the investment knowing full well that there was a chance of something very bad happening. We thought there was enough potential upside to compensate for that risk and that there was some downside protection in the company’s existing customer base (the latter part of that thesis is about to be put to the test).
In Freedom’s case, unlike Jumbo, that risk has become a reality. And when a risk that everyone was worried about comes to the fore, the nuance of chance and probability gets lost. It simply looks like we failed to understand something that was blatantly obvious to everyone else.
Making mistakes is something you get used to quickly in this business. Regularly looking like an idiot, though, is something I find much tougher. For me, that’s the hardest part of being a value investor.
I have some sympathy for you Steve, I have had similar experiences in my investing life. Here’s a question I ask myself constantly – is it better to be a value investor or ignore valuations and just buy the highest quality stocks and hold them long term?
There are 8 stocks that I regard as the highest quality stocks on the market. My definition of high quality is consistently high return on equity over many years (i.e. 10 years or more) and increasing profits in most years.
The annual yearly return over the last 5 years for these 8 stocks is : ARB 13%, BKL 43%, COH 31%, CSL 29%, REA 19%, REH 21%, RMD 24%, TNE 25%. The 10 year return is also very good.
You could argue that those stocks are currently at very high prices compared to their valuations and their prices may drop in the future, but it is a good return for virtually zero effort and a high “sleep at night” factor.
Who knows what the next 5 years will bring for these stocks, but these long term returns do make me question my value investing process.
Ahh… the value investing life. You look for situations where the probabilities are stacked your way, “Tails I lose, heads I win – a lot more”. When it comes up heads you are a hero. When it comes up tails you look like a fool, because everyone has hindsight and no one takes the time to see the risk-reward play before it happened.
“A probability assessment of “low” can be debated.” Yep. That’s the only thing I would debate you on here. It of the banks and other financial institutions were looking at getting rid of the parts of their business that sold this very kind of product, partly because it looked bad, but also perhaps because they thought the likelihood of it becoming regulated was very high.
Watching the RC go through junk insurance policies should have rung alarm bells, I found it hard to believe that this was not going to get clamped down on hard.
Steve, travelling the lonely desert sands, is all about resilience training…
continue on with critical contrarian thinking that obsessively examines 80,743 variables in the ideas lab,
always in knowing Forager’s support team is FOR always close behind in the caravan for the long road trip of a in perpetuity…
m-d-M
Off topic comment here. I’m a big Forager fan but the one thing that irks me from time to time, is you seem to be drawn to companies that wouldn’t pass my ethical screen. I heard Steve take a question in the 2017 roadshow explaining your stance on ethical investing, which is fair enough. And I agree it’s subjective as I personally have no issue with the mining/energy sectors and don’t see why they should be indiscriminately excluded from ethical indices (although I would assess them on a company-by-company basis). However the gamblers, TGA, FIG, etc are not companies i would want to support directly (just my personal opinion). I heard you recently on sky saying the lastest FISF addition is a gaming company too. Do you see any reason Forager might be drawn to these types of stocks, and is there any consideration to incorporate some kind of ethical screen/weighting into your process? thanks
Back on topic: it’s only a problem if you worry too much about what other people think. I’m reading Mark Manson’s book now and that might be helpful for this, although it is full of gratuitous swearing so clearly it won’t suit everyone. I try to remember that most people are too worried about what everyone else is thinking of them to be thinking about me, so take a deep breathe, and carry on. Humour always helps too 🙂
Thanks Adele,
Our aim in the short to medium term is to find a way of giving investors information about the ethical rating of the portfolio – with an aim of letting you make a decision about whether it’s right for you or not. One day, but certainly not in the near term, we could offer two options.
Personally, I think it’s a horribly complicated area. If the Royal Commission is anything to go by, there is hardly a listed company in the financial services sector that would pass an ethical screen at the moment. If we are going to rule out banks, insurance companies, miners, gambling companies, alcohol and cigarettes, we are down to a very small universe on the ASX.
I’ve taken the view that it’s my job is to make you money on the stockmarket (which includes, by the way, trying to screen out unsustainable business models), and that you can decide how you are going to use that to change what you think should change. I know it’s a lot easier to invest in an ethical fund, but my view is that it’s going to make a lot more difference if you are prepared to pay more for your electricity or vote for someone who increases your taxes but throttles the pokie industry. If I owned Aristocrat shares, selling them to someone else isn’t really going to change the world.
Re Freedom specifically, I didn’t know until recently how aggressive its sales tactics were … and was of the opinion that direct sales of simple insurance had a place in the world. It’s not like people were getting good advice or product from the banks or planners (for the most part). I thought being able to buy your own insurance without going through a horribly conflicted “channel” was a good thing. Clearly, though, their behaviour has been at least as bad.
Cheers,
Steve
To be fair to Steve and the Forager team, they had to make an investment decision based on the available information that they had at the time. The Royal Commission has uncovered the dirty laundry of Freedom Insurance Group. If anyone had this particular information available to them at the time, then they wouldn’t have touched the stock with a 10-foot pole. It would’ve been difficult to predict late-2017 that an inquiry with the widespread powers and scope of a Royal Commission would have occurred. In addition, the level of malfeasance on the part of the banks and financial services sector has been a shock to everyone including some industry insiders (see Marcus Padley’s wonderful tirade on ABC News Breakfast). I think it’s fair to say that, in the long term, no one wants to invest in publicly listed companies that have a reputation for dishonesty and the exploitation of consumers.
I also agree that the direct sales business model pursued by FIG is not unethical, per se. But it is no surprise that when this business model is coupled with an aggressive commissions-based reimbursement structure and an organisational culture of ‘get the sale no matter what’ – that we hear stories of people with intellectual disabilities getting sold products that they don’t need/comprehend. The Royal Commission is a wake up call to all Australian citizens not to be complacent and to ensure that we lobby for governments and institutions to ensure that private firms are acting in the public interest.
Steve and the Forager team. You have my sympathies (as much as it pains me to see the value of the Australia fund drop so much in the short term). Then again, we were warned of these risks in our Product Disclosure Statement. We invest in your fund, not because we are paying you to be correct all the time. We invest in your fund because we want to see you outperform the market in the long-term.
As a side, I’d be interested to hear your thoughts in the next Quarterly Report on where the investment thesis now lies with FIG. Will they be able to reform their business model and practices to become a profitable business again, without the unnecessary sales of life insurance products to people who don’t need/want it?
thanks Steve for taking the time to write a detailed reply, that sounds good and we are comfortable with the knowledge you’re assessing the sustainability of the business model. I would add business culture too. We remain fully supportive of Forager, both funds, and can tolerate a few irksome holdings along the way.
Agreed too on the complexity of ethical investing. Every ethical fund i’ve looked at is off base with my personal ethics. For those funds putting a complete sector ban on Miners and Oil Producers. I have to wonder if these fund managers live in a hut made from tree branches, and pedal their bike into the office each day. And within these sectors there are companies who genuinely care about ESG, and others who don’t really care about anything accept shareholder returns (exxon, last i looked was still fighting the Valdez spill case, after nearly 3 decades!).
I’ve seen global ethical funds full of tech stocks who appear to me amongst the most aggressive tax minimisers, monetise people’s privacy, somehow allowed to run legal monopolies right under the regulators nose, and don’t seem to care much if at all, for the raft of serious problems being created by these insanely profitable networks (e.g. bullying, tech addiction, dangerous drivers glancing down, …). Clearly ethics are very subjective.
Anyhow bottom line we do agree, using our time/resources to pursue our life values and purpose, is a better way to make a difference ethically.
Adele – what is ‘ethical’ is too subjective for an investment manager to decide. What is ethical/unethical is often a matter of perspective and political beliefs. Is selling alcohol unethical? Some people would think alcohol is a destructive social force, while others would see it as something relatively harmless that adds value to peoples social lives, etc. Is coal mining unethical? Yes it promotes global warming. But it also provides affordable energy to poor people in developing country, without which they would not be able to afford electricity. Is providing affordable electricity to people unethical?
I’m not trying to defend coal mining – I’m trying to make the point that drawing ethical lines is complex and should not be the domain of the investment manager. That should be up to society & its regulators. Companies & investment managers should comply with all government regulations, which reflect society’s overall assessment of what is moral/allowable and what is not. But investment managers should not be in the business of forcing their politics onto their investors.
Value your honesty Steve.. hold the line, the opportunities will come
“I’m only rich because I know when I’m wrong. I basically have survived by recognising my mistakes.” Soros
The successful outcome achieved with Jumbo is surely just as subject to hindsight bias as is the downside from Freedom. When you have no way of controlling the actions of executives in charge of a company, nor any way of knowing for sure if they are telling you their true intentions, surely these possible value situations become little more than a roll of the dice, with the investor looking like a genius if they get it right, or an “obvious idiot” if they get it wrong.
At what point too do you take the ethics of a business into account? Laughable I know in light of recent finance industry revelations, but some business models really do look a bit too dodgy to be taking a punt on.
Karin,
The future is always uncertain and subject to risk. The wise investor doesn’t try to avoid risk, but to underwrite it at sensible prices, just like a well-run insurance company does (forgive the FIG pun). What is important is asymmetry, not the ability to predict the future. You’ll note that Forager made a lot more % profits on JIN that it has lost on FIG. That’s what matters in the long term.
It’s like playing poker. You will suffer bad beats. That’s part of the game. What is important is that you calibrate the odds correctly enough, ex ante. That’s within your control. Outcomes are a function of luck. Probabilities are not. The challenge with investing, of course, is that unlike poker, we never know what the actual odds are/were. When we get a bad outcome, did we just get unlucky, or did we estimate the odds incorrectly? Not always easy to tell! Cheers
Without wanting to get into a debate on ethical investing, in regards to Freedom I think you need to put the numbers aside at some point and question the merits of backing a business that essentially looks to hard sell insurance products to people that didn’t ask for them in the first place. Royal Commission or not, doesn’t sound like a sustainable business model to me.
I agree Mark. Listening to RC today I have little doubt these direct life products will be banned reasonably soon post RC. It’s only a matter of time for promoters of these schemes to come unstuck… this has to come into the thought process of a value investor
Mark – that’s hindsight bias. It’s clear now post RC that some of the practices were unethical. It was not so clear 6-12 months ago. FIG claimed its Google Business Star and Product Review Star customer ratings were high. Remains to be seen how this reconciles with the RC revelations. Even at this point it is hard to disentangle anecdotal isolated cases/customer complaints from the system average. Remains to be seen.
Hindsight bias is a major bias in investing. Everyone is wise after the fact.
Hi Steve,
Congratulations. You have just confirmed you humanity. Welcome my friend to the human race – now what did you learn from the exercise?
Cheers for your candour Steve
As an investor I’m curious “what have you done about your position in the stock now?”. In Jumbo’s case you bought more. For FIG have you trimmed, added or sold completely?
Maybe reduce the qty & frequency of appearances on sky business (just a hunch but seems to be negatively correlated with investment returns 🙂
Yes, this decision looks very stupid especially as everything is now being revealed in the royal commission. My concern is that a proper look at this company should have shown that this was a hard-selling company, with a business model dependent on unethical and desparate sales tactics. This should have been evident around November last year, when the political climate was very anti-big banks/financial institutions and there was a high likelihood of a royal commission.
In spite of Steve calling out ‘hindsight’ bias that we all suffer from, I can see many responses displaying such biases.
Only if Steve (you or I) would know about the outcome of Royal Commission beforehand… then Steve wouldn’t be managing money for a living… you or I won’t bother putting in comments on this blog or any investing blog for that matter and instead sipping Margarita in the Bahamas.
Only if investing is that easy (with hindsight)
Karin,
The future is always uncertain and subject to risk. The wise investor doesn’t try to avoid risk, but to underwrite it at sensible prices, just like a well-run insurance company does (forgive the FIG pun). What is important is asymmetry, not the ability to predict the future. You’ll note that Forager made a lot more % profits on JIN that it has lost on FIG. That’s what matters in the long term.
It’s like playing poker. You will suffer bad beats. That’s part of the game. What is important is that you calibrate the odds correctly enough, ex ante. That’s within your control. Outcomes are a function of luck. Probabilities are not. The challenge with investing, of course, is that unlike poker, we never know what the actual odds are/were. When we get a bad outcome, did we just get unlucky, or did we estimate the odds incorrectly? Not always easy to tell! Cheers
Steve,
Completely agree with your ‘risk of looking like an idiot’ thesis. I argued something very similar about why value investing works & will continue to work, here.
https://lt3000.blogspot.com/2018/05/why-value-investing-works-and-will.html
Cheap stocks have obvious problems/issues/risks associated with them, and very often the discounted probabilities ascribed to those risks/issues are excessive, creating an attractive expected return. It is hard, though, for investors to take advantage of that opportunity because of the reputational risks it entails. Who wants to take the risk of recommending such a stock to a client or a boss if there is an appreciable chance the risks will in fact play out as feared, making one look stupid/imprudent/foolish? It’s arguably the core reason why value investing works over time.
The market is efficient – just in a different manner to commonly argued. It efficiently discounts the reputational risk into the price of the stock. The higher expected return on the stock is offset by the higher risk of reputational damage. Very few people are in fact willing to risk looking like an idiot, so the extra risk premium is often material.
On FIG specifically, I wonder if it is not a classic contrarian value buying opportunity right now at 10.5-11.0c, very much in this mould? The stock is now trading at a $35m discount to its tangible book value of $18m in cash & the rest trailing commissions. Market is already pricing in very significant value destruction from losses on existing sales infrastructure unable to be used, as well as policy lapses.
And although complete business failure is certainly possible, there are some alternative potential outcomes. They could get taken out at a discount to embedded value that is still way above the current price. They might still manage to finance the St Andrew’s acquisition, which will give them much needed alternative distribution channels. And they might be able to adjust their sales practices/distribution policies, and/or cut costs, in a way that allows them to break even and preserve some or all of their existing net worth.
Will be interesting to see how this plays out. It’s clear that no one wants to touch FIG at the moment, but it looks to me like it is probably oversold at these levels.
Have they got financing for the St Andrew’s acquisition already secured? If not they might find themselves facing some funding problems and may need to do a rights issue or sell themselves on the cheap to avoid a cash crunch. They are buying at 1x embedded value tho so that should mitigate downside risks to lenders.
Interesting times!
This looks very much like a classic cigar butt that still has a few puffs left in it!
I agree with Lyall. FIG is now trading at 1x cash flow and way below the value of the trail commissions. The upside is a multiple of today’s share price in a liquidation or going concern scenario. The headlines are horrific. But the RC is also picking some extreme cases to make a statement. This is a very biased hearing. Obviously, there’s a need for affordable life insurance solutions. Who says FIG can’t fix itself – and who would deny them the opportunity to do so?
Agree Rob – I’d be willing to bet a lot of the problem cases the RC has highlighted also relate to policies written in the past 12 months. They had some well discussed ‘lead issues’ and problems with retention during FY18. Those issues only seem to have emerged in the past 12 months. Policies written in FY17 and before seem to be experiencing much better retention.
It seems likely that direct insurers saturated the market more rapidly than expected, and resorted to perhaps overly aggressive sales tactics when new originations (and retention experience) fell short of expectations. A stop has been put to that. It doesn’t necessarily mean the whole back book is stuffed tho, or that the entire business model is completely broken. FIG will have to significantly reduce its scale – no doubt, and it is possible they don’t survive, but it is also possible they survive and preserve their book value and find a way to remain profitable in a shrunken-down form. That outcome would likely be more than sufficient for a great outcome from 11c. The losses of capital from the 40-50c level are likely permanent, however.
There is a long way to go in your investing life Steve, another 20 years, 30 years, maybe even 40 years. Mistakes won’t matter too much – as in the long run it is the ten baggers that provide the big returns. And what you need to get those big returns is a slightly better than average intellect, a good eye for value, the right temperament, and lots and lots and lots of patience. Yourself and Gareth certainly have those qualities. Losing 3% on FIG will just not matter.
FIG sold insurance to a person with down syndrome, are phone sales people meant to make judgements about a potential clients intellectual ability? isn’t that discrimination? i have seen programs on the telly about people with DS wanting to live normal lives and be independent. All insurance sales are unnecessary in principle, thats how insurance underwriters make money, writing policy’s covering events that dont happen, I dont see the big deal here.
Actually Mick, I picked the customer had Down Syndrome just from hearing the phone call, and nothing else. Listening to the call, I would have expected the sales person to have recognised that something wasn’t quite right with the feel of the call and the sale was ” too easy a kill.”
However the worst part of the story was when the father lodged a complaint and tried to have the insurance policy cancelled. It was obvious at this point, that FIG should have agreed to cancel the insurance policy. Instead it refused to do so and so helped thrash its reputation. Every good and successful business recognises that the occasional potential sale is just not worth it, and there are rare times that a refund and cancellation of sale is the wise thing to do. It is horrifying that the people at FIG could not recognise that this was one of those times.
Now that the St Andrews acquisition deal is off, and given the possible liquidity event – is FIG as good as dead?