Matthew Peterson is a ”Žmanaging partner at Peterson Capital Management. We discuss the investors he admires, hidden assets and fundamental analysis.
1. How and why did you get started investing? What is your background?
My passion for investing began at a very young age; before I was a teenager I was moving small amounts of savings between various bank CDs to enhance returns. I have been working as a professional in the finance industry for over 15 years now and have worked with global financial services firms including Goldman Sachs (GS, Financial), Morgan Stanley (MS, Financial), Merrill Lynch, American Express (AXP, Financial) and Ameriprise Financial (AMP, Financial).
Prior to forming Peterson Capital Management LLC in 2010 and launching Peterson Investment Fund I, LP in 2011, I split time between Wall Street and London as capital markets manager in the financial services vertical at Diamond Management and Technology Consultants. My primary client was Goldman Sachs and I worked with other top-tier investment banks, global payments firms and international insurance companies. My roles spanned both the U.S. and U.K. offices with a focus on risk management and derivative processing.
Before Diamond, I worked with Merrill Lynch and founded M. Peterson Financial Services, a financial planning firm that offered client-planning services to American Express Financial Advisors (now Ameriprise).
I hold a chartered financial analyst (CFA) designation with a Bachelor of Science in economics and minor in mathematics from the University of Puget Sound.
2. Describe your investing strategy.
Peterson Investment Fund I is a long-term value-based fund with a concentrated portfolio of about a dozen positions. Value investing is an investment paradigm that involves buying securities when shares are underpriced based on fundamental analysis. Our objective is to achieve long-term outperformance of the Standard & Poor's 500 including dividends.
We find many of our opportunities in the stock of public companies that sell at discounts to book value, sell for low earnings and free cash flow multiples and have sustainable business models with high returns on equity.
As a deep value investor, I am focused on paying the lowest price possible for the securities in our portfolio. One portfolio performance enhancement tool that I utilize is a strategy that I identify as “structured value.” Structured value combines modern portfolio products such as options, warrants, etc., with the time-tested application of value investing principles. The combination of products can allow for the purchase of shares for below market prices. We apply strategies such as cash collateralized put writing as tools to obtain the underlying equity at better prices.
It is a bit of a market secret that you can piece together options and get paid to purchase stocks and build out a portfolio. This is distinctly different from most uses of these products. We are not trading for short-term gains but instead receive immediate cash in the form of premiums with the desire to purchase the undervalued equity far in the future.
Structured value provides us with an important advantage over the traditional buy-and-hold strategy. We are paid a premium up front that reduces our net purchase price to a level that is often below the market price. Sometimes we are able to purchase stock for a net price lower than any that has ever existed in the market. As shares appreciate, a lower entry price will ultimately lead to higher returns.
3. What drew you to that specific strategy?
Value investing has always been a very attractive way to build wealth. Early last decade, while working on Wall Street, I began to notice the product silos that existed in the capital markets. Large U.S. institutions expanded into new areas with new teams and new trading desks with very little transparency. Sometimes technological and even physical barriers are established between different financial product teams. An equity trader is rarely comparing portfolios with a fixed income trader, and the futures desk is not speaking with the expert on equity warrants.
I noticed that option desks had hedges that were offsetting other equity hedges and recognized that combining several products could provide a real pricing advantage. For example, long dated options or LEAPS rise in price, sometimes significantly, when volatility increases. Simultaneously, falling equity prices create opportunity for a value investor. By shorting a highly priced long dated put option and accepting delivery of the stock we are ultimately paid to buy the stock we wanted to own. This can allow you to move into a portfolio at very attractive prices often far below the price in the market.
4. What books or other investors influenced, inspired or mentored you? Which investors do you follow today?
There is a long list of superinvestors that I admire. Warren Buffett (Trades, Portfolio) and Charlie Munger (Trades, Portfolio) are excellent examples, as are Lou Simpson (Trades, Portfolio), Guy Spier and Mohnish Pabrai (Trades, Portfolio). There are several managers emerging that people will be watching years from now, value investors like Jeremy Deal of JDP Capital Management and Michael Lee of Hypotenuse Capital Management are exceptional stewards of capital.
5. How has your investing changed over the years?
Superior investing has a lot to do with having a superior process. Our process for portfolio construction has been greatly enhanced over the years and now includes four distinct steps that each contribute to alpha creation. As in most things, concentrating on the process is the surest way to achieve the desired outcome which, in our case, is long-term outperformance of the S&P 500.
There are many nuances that make each step independently powerful. Combining them provides us with a significant advantage.
The first step is understanding superinvestor 13F reporting.
Our objective is to uncover the few market securities so deeply undervalued by the marketplace that they warrant a long-term position in our portfolio. Today the New York Stock Exchange and Nasdaq list more than 5,000 actively traded companies and approximately 10,000 public securities exist in the U.S. alone. Most are fairly valued, most of the time. Without using tools to efficiently narrow the scope, our fund might search for years before identifying a single desired “cheap” stock.
Many fund managers reach for a quantitative screening tool to narrow their search for undervalued securities. Common screens, such as low enterprise value (EV) to EBITDA, high return on equity (ROE) or increasing profit margins, may narrow the search but do not always result in a cheap pool of securities. This approach to eliminate expensive securities introduces what statisticians classify as type I errors of incorrect rejection and type II errors of incorrect inclusion. Many cheap stocks are eliminated (type I error) and other expensive stocks simply screen cheap for a reason (type II error). Howard Marks (Trades, Portfolio) reminds us to use second-level thinking. If a lot of value funds screen on similar metrics to find their cheap stocks, those companies will be oversubscribed and will not be cheap.
A much more effective screening mechanism is to evaluate the positions being purchased by the top superinvestors in the world. Each quarter, the SEC requires large fund managers to file a 13F report disclosing U.S. holdings. Our quarterly analysis covers nearly 100 value funds and quickly narrows thousands of potential opportunities to a few hundred that are being actively acquired by the most successful value investors of all time. The SEC website, GuruFocus and the Manual of Ideas are all good resources for step one in the process.
The second step is performing fundamental analysis.
Step two in our process is fundamental, bottom-up analysis. This is continuous and consistent with the practices employed by value analysts globally. With a subset of firms to examine, it is sometimes very clear why a firm is attractive. Other times, it is unclear. Fortunately, we only need to find a few exceptional ideas each year to keep our low turnover portfolio compounding.
Fundamental analysis confirms the most attractive opportunities. Perhaps the intrinsic value based on discounted free cash flows is much higher than current market prices or maybe high returns on equity and low earnings multiples appear attractive. Corporate financial practices, like aggressive buybacks – what Charlie Munger (Trades, Portfolio) refers to as corporate cannibalism, or spinoffs, might be further increasing the value of an opportunity. Finally, qualitative features such as shareholder-friendly management, owner-operators with exceptional capital allocation capabilities, positive feedback loops and long-term margin protection may also exist.
The third step is applying structured value.
Step three is where we look for creative opportunities to obtain a desired position for below market prices. Rather than making outright stock purchases through limit or market orders, we might sell insurance on the shares we want to buy. We engineer these contracts by combining various put options or related products and selling the contracts to counterparties. We collect a premium for the contract immediately and commit to purchasing their undervalued securities in the future if they remain below our specified price. Because market conditions are volatile and counterparties can be fearful, owners of stock are sometimes willing to overpay irrationally for downside protection on wonderful businesses. So when there are opportunities to obtain large insurance premiums on quality firms at attractive prices, we sell the contracts in the market.
The final enormously important step is portfolio construction.
Portfolio allocation and the implications of diversification versus concentration is a common debate between academics and professionals. I have found the Kelly Criterion to be the most compelling objective approach to capital allocation. Applying the Kelly Criterion to a portfolio requires some sacrifice with the acceptance of short-term volatility yet rewards the patient investor with long-term outperformance. Kelly provides a very useful mathematical framework for evaluation. The ultimate conclusion is typically a much more concentrated portfolio than traditional portfolio theory would suggest.
6. Name some of the things that you do or believe that other investors do not.
Most portfolios are far too diversified, and human psychology plays a much greater role in our financial markets than most people think.
7. What are some of your favorite companies? Where do you get your investing ideas?
In value investing, where turnover is low and positions are regularly held for a decade or longer, it is advantageous to observe other notable investors in the space. The SEC EDGAR website is a great place to review the 13F filings of these managers. A large new buy from a concentrated manager is often a strong conviction signal and can be a great shortcut to discovering a mispriced security. There are relatively few portfolio managers using these tools appropriately and thus a new superinvestor position does not immediately cause a rise in its share price. Often, by being patient and by employing the structured value practices discussed, an investor is able to put many millions to work at a better price than a multibillion-dollar fund manager.
Watching the SEC filings closely will alert an investor to hidden gems. One such opportunity exists today in the remaining TARP warrants of several firms who received bailouts funding in the aftermath of the 2009 financial crisis. These warrants are not a well-followed product yet they have exceptional characteristics. TARP warrants are simply very long-dated call options that offer the right to purchase stock in the future for a set price. Some even reduce the future strike price with each dividend payment. These warrants mostly expire at the end of the decade and are overlooked by institutional, professional and retail investors because they are so uncommon. Lack of participation makes a less efficient market where prices swing to extremes and present opportunities to buy stock for very attractive prices.
Today you can find opportunities in TARP warrants on undervalued securities like Bank of America (BAC, Financial) and General Motors (GM, Financial). The equity itself is attractive and by using the warrants you will have slightly higher volatility, but you will supercharge the compounding ability over a period of years.
8. Do you use any stock screeners?
Stock screens are useful for specific information like capturing a global set of competitors in an industry. Other screens like the Magic Formula created by Joel Greenblatt (Trades, Portfolio) identify some interesting opportunities. The best screens are unique screens, for example, identifying companies with improving management incentives. I do not think that replicating common screens for companies with low cash flow multiples will get you very far.
9. Name some of the traits that a company must have for you to invest. What does a high quality company look like to you?
Our portfolio consists of firms that trade in the market for far below their intrinsic value. Intrinsic value can be determined through a number of methods including discounted cash flow analysis or by identifying firms selling below their liquidation value. I greatly prefer companies that can compound their growth for years so we can ride the expansion without incurring any taxable liability from selling. This requires us to identify a sustainable competitive advantage. Smaller firms with high returns on equity managed by exceptional capital allocators that happen to be selling for low multiples to earnings have a long runway and are all-important characteristics of a quality firm.
It is also important to look for advantages that do not show up on the financial statements. Perhaps there are hidden assets or brand recognition that you get for free. Qualitative features such as shareholder-friendly management, owner-operators, positive feedback loops and long-term margin protection are all attractive. It is often also useful to examine the larger ecosystem in which a firm operates. A company that is making money at the expense of their customers or suppliers will often have a much more difficult time maintaining that advantage. Alternatively, companies that create a win-win scenario with those parties in their close proximity will ultimately receive protection when something unexpected arises.
10. What kind of checklist do you use when investing?
Having predetermined items in a checklist format is a very valuable tool for a portfolio manager. It is surprising how underutilized they are. I am constantly updating and improving my checklists and many of the items are quite fundamental. In my checklists, among the many sections, I question my personal biases, I review Porter’s five forces, and I re-examine the current and target capital structure.
One checklist is also not enough. I currently have a new investment checklist, and I have a crisis management checklist. I am also developing a checklist to use before selling and an in-flight checklist to help me monitor existing positions. Checklists are evolving tools that grow with one's understanding of the world. I actively search for new red flags and new opportunities and incorporating them into the formal process.
11. Before making an investment, what kind of research do you do? Do you talk to management?
It is important to consciously avoid introducing psychological biases into the assessment of an investment opportunity and the order of research is extremely important. Our minds tend to give higher weight to the first and latest pieces of information so controlling the order of exposure has advantages. In the ideal scenario, begin with primary research by reading the 10Q and 10K company filings. This information should allow an investor to make a preliminary assessment of firm intrinsic value before becoming jaded with stock prices, analyst reports and news stories. Secondary research from analysts and the media are important as they allow you to understand the view of others and included anything that was missed.
Talking to management is a highly debated topic. On one hand, it is understood that management has mastered a highly influential skillset that allowed for their corporate accent. For this reason, one can expect management to sing praises about their business in a credible and convincing manner. This can be misleading. On the other hand, some argue that it is important to have a relationship with management to fully understand their vision for the company.
It is circumstantial whether or not I speak with management directly. I have only interacted with Warren Buffett (Trades, Portfolio) directly on two occasions yet I am extremely comfortable with the future of Berkshire Hathaway (BRK.A, Financial)(BRK.B, Financial). At a minimum, I look for key language being used in management's public statements. In the August issue of The Manual of Ideas, I read a terrific interview with William Thorndike by Shai Dardashti. Thorndike indicated that management vocabulary matters because the vocabulary used provides an insight into their thought process. When management is talking in term of per share growth and free cash flow and internal rates of return it is a signal that they share a value investing mindset and consider things through a capital allocation lens. Watching the vocabulary in public statements can be very informative.
12. What kind of bargains are you finding in this market? Do you have a favorite sector?
There are still some opportunities to put capital to work; however, we are cautious. The opportunities today are certainly fewer than have existed over the last few years. I find several of the remaining TARP warrant opportunities particularly attractive.
13. How do you feel about the market today? Do you see it as overvalued? What concerns you the most?
Interest rates have been held down for an extended period of time and that drives up asset prices. For years I have expressed warning to my limited partners to get rid of their fixed income securities. Rates have remained low and that has provided a false sense of security. Unfortunately, inflation still acts as the silent killer of these low-performing investments. I think some people fail to recognize that interest rates and bond prices move in opposite directions. I highly doubt interest rates are going down and as rates rise, bond prices will fall.
We have a bifurcated equity market at the moment. Some very large firms are extremely expensive and recent momentum has continued to carry the stock prices higher. Firms like Amazon (AMZN, Financial) and Netflix (NFLX, Financial) sell at hundreds of times next years expected earnings and the prices are irrational. Other firms in the market, however, are undervalued. Index fund investors may struggle with returns over the coming years as some larger firms with great weight in the indices adjust to more realistic prices. During that time, the overlooked underpriced firms of today will appreciate and active management will shine again.
14. What are some books that you are reading now?
I read constantly. Knowledge compounds and that compounding absolutely makes you a better investor. Resources like Benjamin Graham’s "The Intelligent Investor" and "Security Analysis" are foundational. I have also always enjoyed Taleb’s books. "Thinking, Fast and Slow" by Daniel Kahneman is phenomenal. "Red-Blooded Risk" by Aaron Brown is unique and well written. "The Education of a Value Investor" by Guy Spier is inspirational on many levels. Howard Marks (Trades, Portfolio)' book, "The Most Important Thing," is packed with wisdom. "100 Baggers: Stocks That Return 100-1" by Christopher Mayer is a very interesting and enjoyable read. Finally, 32 years since "Influence: The Psychology of Persuasion," Robert Cialdini published a new book this month called "Pre-Suasion," and I have a copy on my desk.
15. Any advice to a new value investor?
Many of the greatest value investors in history are alive managing firms and businesses today. It is important to watch these folks carefully. Rather than indexing, for example, you can own Berkshire Hathaway, a diversified conglomerate of about 100 businesses hand selected by Warren Buffett (Trades, Portfolio) himself. Patient investors able to sit and do nothing for years will outperform the market simply by holding these wonderful companies.
Disclosure: No position in the stocks mentioned.
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