How to generate extreme returns (Part 2) – The market exists to serve, not to guide.

In ground rules, I stated that “Your manager seeks to avoid permanent losses, but not quotational losses. A security can trade at any price, hence price volatility can never be avoided.”

That a security can trade at any price should be both seductive and intimidating. The stock bought at $10 yesterday can trade at multiples higher today or $1 the day after. Any price is possible. Many investors have this principle seared into their psyches during the Covid-19 downturn.

If volatility is threatening, one is looking to the market for guidance. A large decline from purchase triggers fear, which activates the human instinct to abandon self-thinking and follow a higher order, in this case the crowd and the market, for guidance. Succumbing to these instincts is a grave mistake. Investors should look to the market for opportunities, not for guidance, and embrace volatility as a provider of opportunities.

But doesn’t the market know more than any individual? Isn’t the wisdom of crowds worth following? In truth, the market may not know more than the individual. The market price is the product of many buyers and sellers who are not always motivated by fundamentals. They may transact based on emotions such as fear and greed or on technical factors such as portfolio rebalancing.

Therefore, the investor who keeps a cool head and has conviction in the right fundamental perspective may actually know more than the market. He looks to the market for opportunities, not for guidance.

To have conviction in the underlying fundamentals of a stock is to follow the rules outlined in part 1. Practice investing based on cash flows and avoid speculation; avoid excessive leverage; know the boundaries of your knowledge; have processes that guard against destructive human instincts.

Following the aforementioned rules effectively leads to a focus on the asset and business, not price, resulting in an evaluation of the stock’s fundamentals relative to price, not an evaluation of price alone. A stock does not exist in a vacuum. It is an ownership stake in a business. Even experienced investors forget this during extreme bouts of volatility.

Volatility that feels intimidating functions as a feedback mechanism. It is the market’s way of informing investors that they lack conviction and understanding of fundamentals. Investors who heed the warning would exit and reflect. Those who don’t will eventually succumb to destructive instincts and look to the market, instead of independent thought, for guidance, suffering losses as a result. Yet this is the brutal fate for the majority of investors, providing the minority that keeps a cool head with opportunities.

How to generate extreme returns (Part 1) – an introduction

First published on 2/29/20. Revised on 4/11/20.

My goal as an active investor is to out-perform standard stock indices by a large margin over an extended period.

A standard stock index is a formidable opponent, as the vast majority of active investors would attest. Most generate returns insufficient to beat a passive investment in a diversified index in a single year. Those who do are unlikely to repeat the performance in other years. However, those who maintain sustainable market-bearing returns exist, albeit in small numbers.

Achieving extreme returns can be a complex study weaving disparate topics from finance to psychology. Yet, similar to complex phenomena in the physical sciences, simple rules, governed by constraints, underlie chaos. Simple does not imply that the rules are easy to learn or execute. Rather it means that the rules are clearly defined and hence possible, though difficult and unintuitive, to learn. This series of studies attempts to explain the simple rules underlying the complex, oftentimes disorderly, achievement of extreme returns.

First, avoid permanent loss.

 “Compound interest is the eighth wonder of the world. He who understands it, earns it … he who doesn’t … pays it.” -Albert Einstein

It is perhaps counterintuitive to introduce the topic of extreme returns in the form of loss avoidance. It is akin to telling a new driver that the point of driving is, not to travel from A to B, but to avoid accidents. Yet the practice of defensive driving to avoid accidents inevitably leads to safe travel. Similarly, the practice of avoiding losses eventually results in returns.

Loss avoidance unleashes the power of compounding to produce extreme, if not downright mind-boggling, returns over time. A $10,000 investment generating 10% per annum provides $1.7 million profits in 30 years. However, a single year of loss can cost years of profits. In the previous example, a 50% loss in the 30th year is equivalent to losing all profits in the prior 7 years. Consecutive 50% losses in the 29th and 30th year wipe out profits accumulated over the prior 15 years.

Second, to avoid permanent losses, one must invest, not speculate. Investments are decided based on cash flows, and speculations on anything else.

Investors perceive a business having two values: the observable market price, and the unobservable yet conceivable intrinsic price. Investors establish the intrinsic value of a business on an absolute basis, meaning it is based on the sum of future cash flows discounted by appropriate interest rates. Speculators have little consideration for intrinsic values. Their chief concern is future price movements based, not on fundamentals, but on predictions of the behavior of others. Some assets, such as collectibles, can only be speculated and never invested because they do not generate cash flows. Hence they can only be priced based on past transactions. Their values are based on circular reasoning, that is they are bought because they were bought in the past. This increases their prices, attracting more buyers, further increasing prices, and repeating the cycle. The speculative logic can collapse any time.

To further differentiate investors and speculators, one distinguishes absolute valuation from relative valuation. Believing that a business should trade at 20x earnings because its peers do is an example of relative valuation. However, such speculative logic quickly collapses with second-order thinking. If one purportedly buys the business in question at lower than 20x peer earnings, the purchase would increase the peer group multiple higher than 20x, which is the impetus for further purchases. Circular reasoning inherent in relative valuation means that the logic can collapse at any time.

Third, stay away from excessive leverage.

Investors have to be ready for the markets to do anything. It is challenging to tell what will cause a crisis, so investing with a plan to defend against crises is absolutely necessary. The more leverage is used, the lower the ability to ride through temporary quotational losses, the weaker the defense against crises.

Fourth, define your circle of competence and stay within it.

“Real knowledge is knowing the extent of one’s ignorance.” -Confucius

“There is nothing wrong with a know-nothing investor who realizes it. The problem is when you are a know-nothing investor but you think you know something.” -Warren Buffett

“It ain’t what you don’t know that kills you. It’s what you know for sure that just ain’t so.”-Mark Twain

To avoid losses, you have to avoid what you don’t know. The successful investor does not have to know everything, but has to be certain of the boundaries of his knowledge.

To evaluate a business, the investor has to know the factors that are important and knowable. The intelligent can identify the important elements, but only the wise can tell whether they are knowable. The wise is aware of the limits of understanding.

For example, it is easy to identify oil prices as a primary determinant of revenues for an energy exploration business, but it is utterly unwise to believe that one can forecast oil prices with certainty. Oil prices are important but unknowable. Forecasting customer retention for a software subscription business that has maintained consistent retention for 20 years is relatively more certain. Retention rates are important and likely to be knowable in this example.

For some businesses, the important factors are never knowable. Their prospects can never be predicted with certainty. Hence these businesses can never be wise investments. Buffett places them in the “too-hard” pile. Why leap over 7-foot hurdles when you can step over 1-foot hurdles?

Fifth, maintain a process that guards against destructive instincts.

“If the Earth formed at midnight and the present moment is the next midnight, 24 hours later, modern humans have been around since 11:59:59pm – 1 second. And if human history itself spans 24 hours from one midnight to the next, 14 minutes represents the time since Christ.” -waitbutwhy.com

The implicit mathematics shows that the existence of modern humans occupies one-tenth of 1% of 1% of time since the formation of the Earth, and the existence of civilization (crudely defined as time after the birth of Christ) is one-thousandth of that. In short, humans have not existed that long, and human civilization occupies a tiny part of that short history.

Hence, the human instinct has mostly evolved in environments before civilization. The important implication is that instincts useful during pre-civilization may not be so now.

Consider the human instinct to follow crowds. Pre-civilization, humans lived in hazardous environments with dangerous predators, and lacked sufficient food, water, and shelter. A tribe offered better protection against hazards and more resources than the individual. There was safety in numbers. The tribe was so essential to human survival that following others became a basic instinct. Fast forward to today, investors are unlikely to live in conditions similar to those their ancestors did. There is no pressing need to live closely with others in a tribe to protect against hazards or obtain necessities, but the instinct to follow others still exerts itself because our instincts are mostly shaped during pre-civilization.

Following the crowd in investing is detrimental. If one buys and sells stocks when the crowd does, one would buy high (the crowd buying increases prices) and sell low (the crowd selling lowers prices).

To weed out destructive instincts, investors require a systematic process that provides fair treatment to all analytical thoughts. Any thought has to be properly judged and given due process. The lack of due process is akin to a court with only one attorney. The sole attorney may present an excellent argument, but a judge can never find it valid without weighing other perspectives.

Along the lines of the same analogy, the investor takes the role of an attorney (when presenting his own perspective), listens to opposing attorneys (when considering the perspective of others), and finally arrives at a conclusion, whether presented or not (when weighing all, available and unavailable, perspectives as a judge).

The complexity of achieving extreme returns is proportional to its rewards. Identifying simple, clear rules is akin to locating a lighthouse, essential in pointing the right direction amid the perplexing, inundating, and stormy sea of investing.

“It [referring to investing and achieved outsized returns] is not supposed to be easy. Anyone who thinks is easy is stupid.”-Charlie Munger

Get hooked to this maker of tobacco alternatives

Turning Point Brands (NYSE: TPB) is a manufacturer and marketer of OTP (Other Tobacco Products) and hemp-derived CBD products. Attractive product economics, in the form of non-cyclical demand and strong brand loyalty, support pricing power, consistent margins and cash flows, and high returns on capital (~40% gross margin, ~10% FCF margin, 20% ROIC). TPB stock increased from $10 to $55 between 2016 and 2019 on the back of strong growth in vaping, but cratered to $20 after rising teen addiction and increasing lung injuries from illicit vaping products in Q419. The FDA banned most e-cig flavors on January 1 2020, and required manufacturers to go through an arduous, expensive approval process (ie PMTA) to continue sales of e-cig. FDA approval, though costing $10-20mm, will ultimately benefit TPB and other well-capitalized survivors by shutting numerous small players and legitimizing surviving vaping products. The vaping debacle had taken attention away from the established OTP segments that provide at least $50mm FCF (and may account for the entire current value of the company) and the company’s strong balance sheet ($140mm available liquidity), which provides ample liquidity for PMTA approval process and a free call option in the form of transformative M&A targeted at vaping products (ie NewGen segment). As proof of non-cyclical demand and brand loyalty, on April 2, TPB affirmed Q1 guidance, first made in February 26, implying that impacts from Covid-19 are minimal. Valuing the OTP segments as strong cash-flowing businesses and the NewGen segment at cost (ignoring the potential for transformative M&A), the stock provides 77% upside.

The OTP segments – Smokeless and Smoking – generate stable cash flows ($50mm FCF) that fund the growth engine, which is the NewGen segment housing proprietary brands and distribution of third-party brands related to e-cigarette, CBD, and other vaping products (50% revenue CAGR 2014-19 before disruption. More on this later). The OTP segments contain dominant brands in the categories below:

-Chewing tobacco (part of Smokeless). Brands: Stokers (20% market share, 2nd largest in industry), Beech-Nut, Trophy, Durango, Wind River. Collectively 29% market share. Chewing tobacco is cured tobacco in the form of loose leaf, plug, or twist, delivering nicotine without smoke associated with traditional cigarettes. Industry growth is about low single digits;

-Moist snuff (part of Smokeless). Brand: Stoker (4.5% share, one of fastest-growing brands in the market). Moist snuff, also known as snus, is cut tobacco that can be loose or pouched and placed in the mouth. Industry growth is about low single digits;

-Cigarette paper (part of Smoking). Brand: Zig-Zag (35% share in premium market, largest premium brand). Industry is shrinking in low single digits;

-Cigar wraps (part of Smoking) Brand: Zig-Zag (75% share overall).

Buffett said that one may assess the quality of a business by the ease with which it raise prices without losing customers. By this benchmark, the Smokeless segment is a quality business because it raised prices by 4.3% and increased volumes by 3.4% from 2016-19 on average, while expanding EBITDA margins to 38% from 32%. Moist snuff was the key driver, contributing 54% segment revenue. It is manufactured and packaged in the company’s Tennessee and Kentucky facilities in a proprietary process that results in a superior product. In addition, smokeless products align with increasing smoke-free ordinances and increasing consumer awareness of relatively lower health risks compared to traditional combustible tobacco. The Smoking segment is a lower quality business in which revenue has been stagnant since 2016, but it still delivers admirable ~40% EBITDA margins. Smokeless and Smoking collectively generated ~$50m FCF in 2019.

Standard DCF with conservative assumptions shows that the OTP segments are worth at least the entire company value ($400m mkt cap at time of writing). This implies that the market ascribes zero to negative value to TPB’s growth engine, the NewGen segment, and assumes the segment to be consistently loss-making. This dire assessment is very unlikely to play out because of a strong track record of execution, ample liquidity to survive the PMTA process, and favorable competitive dynamics post-PMTA.

Even before the vaping debacle in 2019, the NewGen segment has generated consistently positive EBITDA and FCF from 2016-18. Management balanced product and marketing investments in vaping with profits, displaying shrewd capital allocation. 2019 was the first year in which NewGen suffered EBITDA losses. When vaping sales were disrupted in Q419, management quickly shrunk exposure to the vaping distribution business. They consolidated 4 warehouses into a single facility, eliminated low-margin platforms, and wrote off unsalable inventories because of the FDA flavor ban. The PMTA process will likely cause a large reduction in vaping brands and declining distribution profits. Management has responded optimally by investing more in proprietary brands than in distribution capabilities moving forward. It is unusual for a small-cap company to display a strong track record of execution. This is likely made possible by executives who have decades of experience seeing major shifts in the tobacco business. Larry Wexler, CEO, spent two decades at Altria and 17 years at TPB. Graham Purdy, COO, spent 7 years at Philip Morris and 16 years at TPB.

A major transition in the vaping business is underway. In August 2019, the CDC reported increasing lung injuries associated with vitamin E acetate in THC-containing e-cigarettes and vaping products. It is essential to differentiate between THC and CBD because marijuana-derived THC is illegal (except in low concentrations and when prescribed in certain US states) while hemp-derived CBD is legal (See Appendix for technical information). TPB only deals with CBD, not THC, in vaping products. Furthermore, legal vaping products do not contain vitamin E acetate. TPB has clarified in a statement that it does not sell e-cigarettes and other vaping products containing THC or vitamin E acetate.

Yet TPB and other legitimate manufacturers are subjected to regulation designed to weed out illicit production. To protect consumers from illicit THC/vit E acetate-containing e-cigs and vape products, the FDA requires all vaping manufacturers to receive marketing authorization for vape products through a Premarket Tobacco Product Application (PMTA) pathway. The PMTA is an exhaustive and expensive scientific study that considers the risks and benefits of the tobacco product for public health. The US subsidiary of London-based British American Tobacco, an $83B company, submitted 150,000 pages for its VUSE vaping product. At an estimated cost of $120k per product, a standard vape manufacturer with 10 flavors available in 5 capacities and 3 levels of nicotine content can expect to spend $18mm (10*5*3*120k). Numerous legitimate, in addition to illicit companies, but under-capitalized companies in the fragmented vaping market will either shut down or curtail production, leaving well-capitalized peers with significantly reduced competition. For a $400mm market-cap company, TPB is well-capitalized with $95mm cash, ~$45mm in undrawn revolving credit, and ~$50mm FCF from its OTP segments, more than the $20mm expected in PMTA expenses. TPB has the management capability and liquidity to be successful in the PMTA process.

(As a side note, the FTC recently sued Altria to undo its $12.8B investment in Juul. Should the lawsuit succeed, the largest e-cig manufacturer with >70% market share will lose the backing of one of the largest tobacco companies, further tilting competitive dynamics in the favor of TPB.)

The strong balance sheet provides ammunition for transformative M&A. TPB might had completed deals in Q419 if not for the vaping disruption. Senior management appeared to be on the prowl for strategic acquisitions:

We are in deep dialogue in several potentially transformative acquisitions. That does not mean we are certain of the outcome, but we’ll most certainly continue to pursue accretive opportunities that can further propel company growth. We have the access to capital, and we will efficiently deploy those resources to accelerate the company momentum.” -CEO Larry Wexler, Q419 earnings call.

“And Jamie, at the end of the day, like I think you guys all are aware, like vape gate was extremely disruptive. We terminated 60 people, right? And we run a tight ship. And so we have real deals in the pipeline, but they require management to push them through. And if it wasn’t for vape gate, we would’ve had deals done in the fourth quarter. So we — the pipeline is, frankly, stronger. We did move management around where we’ve dedicated some resources solely to getting deals done. And those are moving forward.” -CFO Bobby Lavan, Q419 earnings call.

The topic of transformative M&A deserves attention because studies show that the majority of deals destroy value. TPB appears to have defied the curse so far. It has spent ~$50mm in acquisitions since 2016, of which $26mm was spent to develop the NewGen segment from scratch and the balance in a bolt-on acquisition for chewing tobacco (part of Smokeless segment). The NewGen segment was created with three M&A deals, thus it serves as a useful benchmark in assessing management’s ability to create growth from M&A. Against roughly $166mm ($26mm acquisitions + $115mm debt increase from 2016-19 assuming that new debt is taken solely for NewGen + $25m cumulative interest expenses 2016-19) invested on building NewGen since 2016, TPB generated a cumulative ~$393mm revenue and ~$93mm gross profit. This means that in 3 short years, TPB has recouped about 55% of its investment in NewGen before operating expenses (~18% “return on capital”). Excluding expenses associated with the vaping disruption, the figure would be 70% (~23% “return on capital”). We used gross profit as a measure here because TPB reports low capex relative to revenues (capex ~1% revenues), so “growth capex” is likely to be in operating expenses. Gross profit can then be thought as a proxy to profits before growth investments.

The high “return” metrics showed that NewGen had excellent product economics similar to the OTP segments. Shareholders should feel assured that TPB management would continue to engage in value-additive deals. CFO Bobby Lavan seemed eager and excited yet careful about the deal pipeline (likely to be focused entirely on NewGen):

“But deals, you never want to be forced to do deals. The pipeline is strong. The — frankly, it’s — there are a bunch of companies that I bid for in sort of late summer that have come back and said, is that offer still on the table, which is an interesting dynamic. And so we are sort of evaluating that. I will tell you, there is carnage in the street, blood everywhere when it comes to these cannabis in CBD companies. It is — the opportunity set is massive. We’re just — it’s just a capacity issue … So we’ve got this quarter through. We’ve cleaned up our books, reset the business. We moved Jim Murray straight to deal making, which is awesome, and it’s — we’re going to get stuff done.”-CFO Bobby Lavan, Q419 earnings call.

Because the PMTA process is likely to reduce the number of vaping manufacturers significantly, TPB has made the logical decision to pivot from solely being a distributor to a manufacturer and marketer of proprietary vaping brands. Future deal-making is likely to focus on acquiring growing vaping brands. There is little doubt that vaping would continue to grow in popularity, despite the interruption from lung injuries. Stimulant drugs like nicotine are very difficult to quit because of withdrawal symptoms. That is why nearly 40mm Americans still smoke after a 30-year nationwide campaign against smoking. Smokers are always looking to minimize harm when feeding their nicotine addiction. Vaping reduces harm by delivering much less carcinogens and no secondhand smoke compared to combustible cigarettes. The vaping population grew 7-fold from 2011-18, and is likely to continue growing.

In thinking about the valuation of TPB, it’s best to see the company as having 3 businesses with separate risk and growth profiles. The Smokeless segment is established with ~40% EBITDA margins, above-industry growth, and a clear expansion pathway in moist snuff. The Smoking segment is also established with ~40% EBITDA margins, but has a weak industry backdrop and no clear growth drivers. The NewGen segment arguably has the best growth potential, but also the most uncertain future with M&A integration and developing regulations. Each segment is valued below. Summing the below, TPB provides ~77% upside, which excludes the upside potential of transformative M&A in NewGen.

-Smokeless: r=9%. g=4% (2x global GDP). TV multiple=20.8. NPV=$626mm based on historical 7% revenue growth and 40% EBITDA margins.

-Smoking: r=10%. g=0%. TV multiple=10.0. NPV=$288mm based on historical 0% revenue growth and 40% EBITDA margins.

-NewGen: NPV=$166mm (at cost approximated using cash spent on M&A, debt, and interest expenses). Shareholders should be at least confident that management won’t destroy value.

TPB makes products with great economics but unloved dynamics in the current social context. Chewing tobacco and moist snuff are profitable but dirty. Vaping presents great growth prospects but involves addiction, death, federal agencies, and the revival of Big Tobacco. Investors ought to look past the smoke of temporary dynamics, and stare at the long-lived economics of TPB products.

Appendix

Cannabidiol (CBD) is a compound found in hemp plants and most commonly used to produce CBD hemp oil products. CBD is non-intoxicating and, when derived from hemp, is legal under U.S. federal law. Tetrahydrocannabinol (THC) is a compound found in marijuana plants and is responsible for the euphoric “high” that people experience when they ingest or smoke marijuana. The legal status of THC products differ from state to state.