Borrowed Conviction Is Worse Than Borrowed Money
Riding the coattails of super investors is a favorite sport of many in the investment industry. In this post, let me share one such investment I made, and how I walked away with the same experience as the cat that sat on a hot stove.
Soon after the 13-F season ended a few weeks back, one of my friends sent me the latest filing by a super investor and suggested that I take a look at a specific stock. What is a 13-F filing? Basically, this is one of the documents through which the SEC forces managers in the US with more than $150 million in assets to disclose their holdings. 13-Gs and the more interesting kind—13-Ds—do the same. And, who are these super investors? Some of them are household names like Warren Buffett and Charlie Munger, while many others are just popular among the investment circles. For this discussion, it is not important who that super investor is or which stock my friend wanted me to look at. What I want to share is how I used these disclosures.
It’s common knowledge that kids learn a lot more watching the people in their environment than listening to them. My contention is that we do so even as adults; we learn from the people around us, mimic them, and carry such lessons into new surroundings. What do I mean?
Well, in the past, while working at Advisory Research, Inc. and Keeley Asset Management, I used to relish these 13-F filings. I’d literally rub my hands together and wait expectantly to see the 13-Fs from some of my favorite super investors. These would be filed over several days and so the adrenaline hit could last a few days. I used to get external validation when one or more of the super investors had bought or added to one of our portfolio holdings. Most of the time, maximum excitement would be when one of these super investors had initiated a new position in a turnaround situation: a company that historically had done well but, due to a massive acquisition, management team change, or some other factor, had stumbled, cutting the stock price. The reason? Because it would be a new idea to work on and, given the super investor’s presence, I’d get external validation…or rather borrowed conviction. I had picked up this habit by observing some of my former colleagues. And it remains a common industry practice.
That leads to one of my former holdings, Newell Brands Inc. (NWL). NWL is a consumer brands company that makes and sells a variety of consumer products ranging from coffee makers to candles to cooking grills. One of the more popular brands is Rubbermaid.
In late 2015, Michael Polk, CEO at that time, decided that the best course of action for the company would be to make the splashiest acquisition in the company’s history with money the company did not have. NWL acquired Jarden Corp. for more than $20 billion in cash. How was he going to pay for it? By borrowing massively. Net Debt/EBITDA, a common measure of debt in a business, made an arresting spike from 2.8x on 12/31/15 before the deal to 12.6X after the deal.
One common test I employ to check the quality of the management is to see how the CEO spends the excesses: cash from the business, time on hand, and confidence. Mediocre management teams trip up on one or more of these excesses. Michael Polk tripped up on all three. Perhaps it started with confidence…or over-confidence, which then led to spending money that the company didn’t have, which in turn led to sleepless nights. Right on cue, the business went into a tailspin. Even though revenue increased from the acquired brands of Jarden, most other operating metrics worsened…at a rapid clip. Much of the deterioration was due to excess debt and poor integration of the acquired brands. Shortly after the deal, the stock price actually did well, rising to the low-$50s, but it proved to be short-lived—the stock currently trades under $9.00.
The scene was set for an activist or two. First, it was Starboard, a large fund that works to improve the operations, that was pushed aside by the much-feared activist, super investor Carl Icahn, who took ~10% stake in the company and got three board seats. Carl’s average cost is high-$20s per share. He filed a 13-D. These “D” types are even juicier than 13-Fs. They are typically filed by investors who have some ulterior motives—get involved aggressively in the operations and improve the business over time and/or force a sale of the company.
Now, this is where my past experience investing in such turnarounds kicked in. Years earlier, while working at Advisory Research, I was invested in a company called Tropicana—another Carl Icahn-controlled company that was eventually sold at ~5x my cost. The seeds of my conviction in Carl Icahn were sown. In the case of NWL, I saw a company with a troubled balance sheet, a weak management team that I was sure would be replaced and, most important of all, a feared activist with a terrific track record. I would not have considered NWL seriously had Carl Icahn not taken a big position.
Soon after the filing formalities on NWL were over, Carl opened up his playbook: fire the CEO and most of the C-suite occupants, sell the peripheral brands, and pay down the debt. I saw the opportunity to be alongside a super investor who had successfully turned around or forced the sale of many companies in the past. This is when I added NWL to the portfolio at an average cost of ~$18.00/share in 2018. He brought in a high-pedigree CEO and CFO who executed his strategy well.
As the market saw the improving balance sheet, operating performance, and high-caliber management team, the stock price improved to the low-$30s. Everything seemed to be working according to plan…until it didn’t. In the post-COVID market, demand for the consumer discretionary products that NWL was peddling seemed to be high. But then, in the inflationary period that followed the exuberance, demand for such discretionary products seemed to peter out; the stock price continued to decline as the business stumbled. One of Warren Buffett’s famous quips—“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”—was proved right again. Carl Icahn, who is still invested in NWL, may eventually eke out a win, but I managed to spot the exit sign around a low-to-mid-teens stock price.
Over my investing career I have made mistakes, and I have the marks left by some lesson-inducing arrows that have landed in my back to prove that. Investing in NWL was a mistake, and this particular arrow from Carl Icahn’s quiver left me with a couple of indelible marks: first, borrowed conviction in a super investor, or even the regular kind, doesn’t necessarily lead to desired results. I realized that relying on an outside force to effect changes in the business was akin to handing over a part of my responsibility—genuine conviction cannot be outsourced. Second, turnarounds seldom turn around.
Through lessons forged on the investment battlefield, I have continued to refine my investment criteria. Now, before deploying capital into any security, I ask the following four questions for which I look to get an affirmative answer:
Is it a business that I understand?
Is it a high-quality business that generates high return on incremental capital and has terrific reinvestment opportunities?
Is it run by an honest, competent management team that has skin in the game?
Is it available at a reasonable valuation?
So, what about the email from my friend prodding me to look at this stock now owned by a super investor? I gently pressed the delete button on my keyboard. I genuinely don’t care about super investors or 13-Fs anymore—no borrowed conviction.
We currently own nine stocks in the portfolio. All of them operate with little-to-no debt, generate high return on incremental capital, and a couple of them reinvest 100% of free cash flow back into the business. They all are owner operated or founding-family controlled.
I will write to you about the portfolio and its performance in the mid-year letter which should hit your inbox by mid-July. Thank you.