Robert Robotti – DCF Should Be Renamed The “Deliberate Certainty Fabricating” Model

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One of our favorite investors at The Acquirers Multiple – Stock Screener is Robert Robotti.

Robotti is the President and Chief Investment Officer of Robotti & Company. Robotti & Company has been in the securities business since 1983.  Robotti specializes in identifying undervalued securities often in cyclical businesses that are cyclically depressed. He prides himself on a disciplined bottom-up approach and holds a BS from Bucknell University and an MBA in Accounting from Pace University. Some of his areas of coverage include Special Situations, the Energy Industry and Home Building.

One of our favorite Robotti interviews was one he did with Value Investor Insight earlier this year. It’s a must read for all value investors.

Here’s an excerpt from that interview:

At the risk of over-generalizing, your investments would seem to be more bets on industry cycles improving than individual companies improving. Is that fair?

Robert Robotti: When I started my business in the early 1980s my original focus because I’m an accountant was on buying cheap stocks relative to companies’ balance sheets. So I bought a lot of cheap stocks and found out in many cases why they were so cheap: they were poor businesses that couldn’t justify their book value because they weren’t going to generate adequate returns on it. That generally made them poor investments.

What I found did work was investing in companies that were discounted but run by very smart capital allocators who knew how to grow the business, or that were in understandable, cyclical businesses that were cyclically depressed. That’s where we’ve ended up spending most of our time.

It’s not that we won’t invest in companies with their own idiosyncratic issues. We’ve spoken with you before about Skechers, the shoe company that had a very hot product flame out and left it struggling with bloated inventory and litigation over intellectual property. In that case we thought the stock was discounted enough that even an unambitious recovery of earnings power could provide a lot of upside in the stock. If to justify the purchase we’d had to get too deep into making calls on the fashions and trends in shoe retailing and Skechers’ ability to come up with the next hot product, we probably wouldn’t have done it.

Contrast that with looking at homebuilding in 2009. Single-family housing starts in the U.S. were at around 450,000, an all-time low over a period in which the population had significantly increased. As an investor, it’s an easier starting point for me to conclude that this level of housing starts was not the new norm and then go out and look to invest in companies like Builders FirstSource [BLDR] or what is now BMC Stock Holdings [BMCH] that we thought were well positioned to benefit from a homebuilding recovery. I have more confidence in my ability to do that well than to figure out if Skechers’ product pipeline is up to the task.

One important skill when investing in deeply cyclical stocks is to avoid the ones that don’t make it through the cycle. Any advice on that front?

RR: I’d make a couple points on that. One is that we try to emphasize companies with some level of differentiation that allows them to grow through the cycle and substantially improve their competitive positions in the downturns. We’ve also spoken about Subsea 7 [SUBCY], the largest global service provider in the engineering, design and implementation of complicated deepwater drilling projects.

We believe its expertise provides it with a differentiated and sustainable advantage in an area of the market, deepwater, that continues to grow as a percentage of energy-majors’ total exploration and production budgets. The company’s scale and balance sheet allow it to opportunistically invest through low points in the cycle when others struggle. The result is that it’s a growth business with cyclical earnings, which allows us to buy in cheaply at various points in the cycle without the same level of risk we’d have in a less-differentiated commoditized business.

The second point I’d make is that in certain situations I will invest in companies where the possibility the equity goes to zero has to be recognized as part of the equation – and my record on that front is not spotless. Charlie Munger has talked about how depending on the probabilities you assign to the up and down case, it may be a perfectly reasonable bet to accept the possibility of a zero if your upside is 5x or more. I agree.

When I first invested in it in 2009, Builders FirstSource was troubled, losing $50 million a year. I thought the business and the balance sheet were strong enough that it would make it through the worst of the cycle, but there was some chance of a zero. But as is the case with many of our ideas, our base-case upside was many multiples of what we were paying. If things got really bad we expected a capital raise that would dilute our stake, but the margin of safety was big enough that even if that happened we thought we’d come out fine. That’s exactly what happened – shares outstanding have more than doubled – but our returns so far have been very good and we still believe there’s a considerable amount of upside from here.

Given what you’re looking for, how do you tend to generate ideas?

RR: We often find new ideas in industries in which we’re already active. Our stake in Builders FirstSource led us to invest in BMC, where we owned 15% of the equity and I was on the board from 2012 to 2015. From owning both of those companies we learned a lot about all kinds of homebuilding products, one of which that caught our eye was oriented strand board [OSB], a substitute for plywood in framing out a house.

The market for OSB had gotten way oversupplied, depressing supplier prices and margins, but we expected that to correct as demand from builders improved and new capacity was unlikely to come online. We then went looking for the prime beneficiaries of OSB pricing coming back and ended up investing in Norbord [OSB], whose stock was extremely cheap, which had a savvy 50% owner in Brookfield Asset Management, and which had significantly improved its market position in 2015 by merging with a large competitor.

As somewhat of an aside, I would argue that the stocks of many suppliers to homebuilders are interesting today even though their share prices have recovered dramatically from their lows. Single-family housing starts should increase sharply from current levels and many of the supply businesses – as is the case with oriented strand board – would not have to add any capacity.

So contrary to the general perception, for at least the next few years a lot of these supply businesses should be less susceptible to negative cyclicality, given how low we are today in the cycle, and should be much less capital intensive, given the slack capacity available. Maybe that impacts how they’re valued, but even without a re-rating that means they have the potential to generate a considerable amount of free cash flow.

A related source of ideas for us is following industry-related themes. For example, given the vast amounts of low-cost developable natural gas in North America and the difficulty in exporting it, we believe natural gas prices here will remain low and disconnected from world energy prices for maybe the next ten years. Who are the beneficiaries of that? One we’ll talk about later is Westlake Chemical [WLK], which is 70% insider-owned, generates considerable free cash flow that it reinvests intelligently, and has a competitive advantage against global players whose input costs are significantly higher.

With what time horizon do you typically invest?

RR: When making a new investment we’re usually looking out two to three years, but we require enough of a margin of safety that we’ll be fine if we get the timing wrong – which we often do. When I invested in Builders FirstSource I thought U.S. single-family housing starts would get back to the 40-year average level of more than one million by 2014. I still believe that will happen, but it’s 2017 and it hasn’t happened yet.

We’ve owned many stocks for a very long time. SubSea 7, for example, I’ve owned in greater or lesser amounts for 20 years. The shares are up 50% from last March, but when we look at it today we see the potential, in U.S.-dollar terms, for the company within the next three years as activity levels come back to earn as much as $3 per share.

That’s better than the 2014 peak of around $2.40 – since then they have reduced the cost structure of the business, finished a large cap-spending cycle, formed differentiating alliances, and seen some key competitors go away. They have access to plenty of capital for growth. If we’re right on earnings power and the stock earns even a 10x multiple, we’re at a $30 price. That can take longer than we expect and we would still have an attractive IRR from the current price. [Note: Subsea 7’s U.S. ADRs currently trade at $13.65.]

Time horizon is an edge we can have. We’re intensely focused on maintaining perspective as new information arrives, but frequently our additional analysis confirms the need to remain patient. Very often throughout our history our long-term conviction has led us to double up when a position initially works against us.

All this is difficult, especially when you’re managing other people’s money and inactivity can imply ignorance or in decision. We think a decision to remain patient is an active decision, no less important than buying or selling.

Fortunately our client capital aligns well with this view. You can’t have a patient, long-term view with actively impatient client capital.

Is it fair to say your valuation efforts revolve primarily around estimated normal earnings power and applying a normal multiple?

RR: We are very much focused in our analysis and valuation on the earnings power of the business when the broader industry cycle or trends play out the way we expect. I wouldn’t say, though, that we count on a “normal” multiple. We want to be able to justify any investment using below what we might consider normal multiples.

We do usually expect the multiple to go higher than that, but we don’t need that to find the opportunity attractive.

Do discounted-cash-flow models add value for the types of situations in which you’re investing?

RR: Very often not. In most DCF models you estimate cash flows a certain number of years out and then assume some terminal growth rates for revenues and costs. That’s not so relevant in highly-cyclical businesses. Changing around your assumptions on the timing of the cyclicality has a dramatic impact on the present values you calculate. It’s just not an approach we’ve found very helpful. In many cases it’s nothing more than what I call a “Deliberate Certainty Fabricating” model.

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