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Thoughts on Mental Models, Part 1- Pattern Recognition HLF

February 14, 2013 | About:
whopper investments

whopper investments

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I just finished reading Investing: The Last Liberal Art. The book is all about Charlie Munger’s “mental models” and goes through the basics of several disciplines that Munger suggests forming models from (physics, biology, etc). I enjoyed it quite a bit. The book inspired me to talk about a couple of ideas I’ve been kicking around for a while. One is on the evolution of mental models, the other is on pattern recognition. In this post I’ll talk about the latter, and I’ll talk about the other in a later post.

The pattern recognition part is only loosely related to the mental models. Remember that what makes having multiple mental models so potent is, to put it in Munger’s words, is you go from being a man with just a hammer seeing nails in every problem to being a man with a full tool belt, able to pull out a different tool to handle whatever problem you come across, weather it be a loose socket or a screw that needs tightening.

In a similar way, I think pattern recognition in the market is possibly the most critical skill to investing success. The fact is there’s one way to beat the market- find a situation where the market is mispricing a stock and bet big on it.

There are several ways this can happen. The one that this blog tries to take advantage of the most frequently is stocks that are so small and illiquid that they are off limits for basically the entire investing population. Really the only people who can take advantage of them are small individual investors, and since most small individual investors have zero skill with breaking down financial statements (pick your favorite finance message board for confirmation) and are more interested in day trading and/or following Jim Cramer than learning how to invest, there’s a huge edge to be had here.

The other way you can get an edge is pattern recognition. What I mean by this is spotting a situation where there are a couple of stories in motion around a stock that the market isn’t properly discounting but a skilled investor can because they’ve seen it before. I’ve mentioned this a bit before in my write up on ADVC’s go private failing to go through and how I thought it would lead to management buying shareholders out at a nice premium based on my “go private management” case study.

However, I think the best example comes from Bronte Capital’s investment in Herbalife when the market was panicking after Ackman came out short.

While Ackman’s thesis had several layers to it, the crux of it depended on the government ruling it a pyramid scheme and shutting it down. The thesis caused the market to panic, and the stock traded at a P/E of 5-6x for several days in the wake of the short. A pretty incredible value for a company that was growing healthily with a strong balance sheet and great returns on capital.

But in order to invest, you needed to be sure that Herbalife was sustainable and that the government wouldn’t shut them down. Unfortunately, that seemed pretty impossible. Ackman had done a ton of research and had likely talked to the foremost law experts in pyramid schemes. How could anyone get an edge there?

Well, Bronte used pattern recognition. Combined with simple due diligence it resulted in an investment that’s up almost 50% to date and I think still has a pretty interesting risk / reward.

You can read about the due diligence on the blog. It was very simple, including watching a video of a celebrity endorser and going to one of the debated nutrition clubs.

But the pattern recognition is what interests me more. And it boiled down to two things.

1) Herbalife’s business model is not selling the commodity protein shake a la GNC. Their business is selling the community that encourages you to take the commodity and stick to the diet a la Weight Watchers. (note: this is more business recognition than pattern recognition, but impressive nonetheless).

2) More importantly, Bronte leaned on a “will the government shut them down” model. And for this, he leaned on the biggest “scum bags” in the business world: cigarette sellers. Cigarette manufacturers make a highly addictive product that preys overwhelmingly on the poor. There were always shorts saying that the government would crush the companies with taxes or even outlawing them. And the shorts were burned time and time again as the companies minted money, paid out huge dividends, and bought back huge blocks of stock.

And recognizing that pattern is what made the investment so attractive. There were MLM “battles” in the past on the same scale as the Herbalife battle will play out. This is one of the most professional, largest, fastest growing MLM’s versus one of the world’s most respected investors. To the market, this was an “unknown unknown”. The market had never seen anything like this, and thus couldn’t price in the risk of the company getting shut down.

But by leaning on the “cigarette scum bag” pattern, Bronte saw the risk was low. Certainly much lower than the reward with the stock at a sub 6x P/E.

And so Bronte bought the stock. And has been rewarded handsomely.

So the question is: how do you develop those mental models?

The answer is pretty simple: you need to be a student of business. You need to constantly be reading and studying businesses, so that when one of these patterns comes up, you’ll be ready to recognize it.

For example, I mentioned before that I recently read Cable Cowboys. The book covers the career of John Malone and the rise of the cable industry from the 70 to the late 90s.

So how does a book about an aging business tycoon help with pattern recognition? And given how much the cable industry has changed since the late 90s, how does the book help us with investing?

Well, first, it helps you build the “value creating spin off” model. John Malone is the absolute master of the spin off. He’s mentioned again and again in You Too can be a Stock Market Genius. Reading about all of his spins helps build out the model for profitable spin offs. I know having the model in my head made me dig into the recent Starz spin off. Unfortunately, I didn’t buy, but it helped me think about why Malone was doing the spin and the value that could get unlocked there.

And learning about the cable industry might not help you invest in the cable industry now. But maybe it helps you invest in the next cable industry. I would argue that knowing a bunch about the cable industry would have been a huge boon to investing in rail roads in the early 2000s. Yes, that sounds weird, as the businesses couldn’t be more different.

But they had some big similarities. Cable’s growth was driven by a simple advantage: competition was naturally limited, they had a huge advantage in that it was way cheaper and more efficient to send data over their lines than their only real competitor (telephone), and they had big fixed costs and upfront investments but huge operating leverage.

Railroads had a huge cost advantage over their true competitors (trucking). Competition was naturally limited. They had huge fixed costs and upfront investments but a ton of operating leverage.

Are there differences? Sure. But recognizing the similarities would have helped investors recognize the changing economics of railroads and make a very profitable investment at the turn of the century.

This post is getting a bit long, so I’ll wrap it up here. My next post will talk about evolving mental models.

Disclosure: Long ADVC


Rating: 1.5/5 (2 votes)

Comments

stevenramsey
Stevenramsey - 1 year ago
I listened to a decent portion of the original Ackman presentation on Herbalife and it got dense. But in his Q&A yesterday, he does a great job of laying out the models and patterns you're speaking of for the short. I really don't have a clue if HLF will end up bankrupt or going gangbusters, but there are great arguments on both sides. And there are great mental models for both sides of the HLF fiasco. Listen to it if you have time, he gives an array of good thoughts on a few of his investments.

Also, on Malone, I need to read this book you're talking of. But yes, he is a genius and I think Starz fits the bill for Greenblatt's model of spinoffs:

1 - High free cash flow and high FCF margin business

2 - Great management

3 - High leverage (yet still maybe underlevered)

4 - Insiders are positive on it (Malone invested personal money into Liberty Media just a few days before the spinoff. My thinking here is, if he wanted just LMCA, he could have waited post-spinoff. It seems that in buying LMCA pre-spin, he wanted Starz stock as well).

Something Greenblatt looks at in his book you mentioned, is comparables. And Starz still trades cheaply relative to its peers and historical takeovers in the space.

Here is another perspective: Greg Maffei (Liberty CEO and Starz Chairman) was asked at a recent conference: Of all the Liberty Companies (LMCA, LINTA, LVNTA, and STRZA), which has the best past to value of the next year? Maffei said that, "It's pretty darn obvious to me that it's "Media" because it will educate the mark to the asset values within it."

And technically, Liberty spun off of Starz. Different thoughts there for you.

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