How to Find Out of Favor Stocks and Avoid Value Traps – William Martin (Graham & Doddsville)

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William Martin is the Chairman and Chief Investment Officer of Raging Capital Management, an investment firm he founded in 2006. Prior to Raging Capital, he co-founded a number of financial information and media companies, including Raging Bull in 1997, Indie Research in 2002, and InsiderScore in 2004.

Martin seeks out companies with either uncovered emerging growth potential or deeply out of favor stocks and a catalyst that will make that change.

A couple of years ago, Martin did a great interview with The Graham & Doddsville Newsletter where he discusses his investment strategy and, how to find out of favor stocks and avoid value traps. Here’s an excerpt:

G&D: How did you first become interested in investing?

WCM: I started investing when I was 10 years old; my first stock was Hershey Foods. My grandparents invested my college money with Mutual Series, which was run by Michael Price. He was literally one of the first investors I was ever exposed to, via his letters which I read when I was a kid. From there, I attended the University of Virginia. In my sophomore year, I became president of the student investment fund.

The capital for the fund was provided by John Griffin of Blue Ridge Capital. Like Price, John Griffin‘s approach to investing, particularly on the short side, was very influential to me as I was beginning to learn and think about investing. After my sophomore year I took a bit of a career detour, as the company I had started in my dorm room, online finance site Raging Bull, attracted $2 million in venture financing from internet incubator CMGI.

My partners and I left school and ended up raising another $20 million in financing less than a year later, ultimately selling the company in early 2000. It‘s safe to say we gained quite an education in a short period of time, both on the up and the down of the cycle.

Like many of the companies I have been involved with, either in terms of starting or funding, Raging Bull passion for technology and the markets. After selling Raging Bull and prior to starting Raging Capital Management in 2006, I started my own independent research company in Princeton, where I wrote an investment newsletter.

Of course, I no longer write newsletters but this business ultimately grew to include InsiderScore.com, which is an analytics and research tool that is today used by approximately 250 hedge funds and mutual funds. I am still an owner of InsiderScore.com, but I am no longer involved in the day-to-day operations.

G&D: Can you tell us about your firm and what has changed since you started it?

WCM: We are based in Princeton, NJ, manage $275 million, and are entering our seventh year of business.

The team includes two Columbia Business School graduates, Wolf Joffe and Fred Wasch, who is our CFO, as well as Allan Young and Matt Furnas. On the long side we usually hold 30-35 names. Our top 10 ideas typically represent half of our capital, so we do take larger positions when we believe we have a clear edge and conviction.

We focus on two general areas on the long side. The first is emerging growth businesses, where we can hold the companies for a few years and ideally make ―multi-bagger‖ returns. It is a very entrepreneurial approach to public market investing. We try to leverage our network and creativity in order to connect the dots and find companies that can really show break-out growth.

Usually those ideas represent about a third of our capital. We don‘t have a set limit on that amount, but usually these ideas are harder to find, and they are typically higher risk so we size them a bit smaller. Our other area of focus on the long side is finding deep value investments with a catalyst.

I‘ve always enjoyed hunting for out of favor stocks. Of course, along the way I‘ve made my share of mistakes and invested in plenty of value traps.

There are certainly a lot of cheap stocks out there, and a lot of them are cheap for a reason. Further, corporate governance is very poor and hard to change at many companies. Over time, I have learned from my mistakes. Today we look for beaten down stocks, but ones that have a clear catalyst.

We look for companies undergoing management or board changes, companies where there is activism (sometimes our own), or a company with a changing technology or product cycle. These positions are typically weighted higher because the downside is often protected by the company‘s cash buffer or what we think is a high intrinsic value.

The short book is a very important, and probably the most underappreciated part of what we do. We estimate that we have generated on average more than 1,500 basis points of alpha per year on the short side.

For example, in 2011, our strategy was up over 30% net of fees, and we made 69% of our returns on the short side. The short book usually has around 40-50 names in it spread across 50 to 70 points of gross exposure. We don‘t believe in using ETFs for shorting, as we view that as lazy. We also don‘t use derivatives to create synthetic short exposure.

We try to short the largest, most diversified basket of what we believe are crappy, overvalued, fraudulent, fundamentally challenged businesses, and then try to size them appropriately in our portfolio so that we can sleep well at night and be emotionally neutral. We don‘t want to be over-thinking and worrying about one or a few large shorts.

Whereas on the long side we try to connect the dots, read a lot, and talk to many people to source ideas, on the short side we try to be more systematic and methodical in terms of screening names. For example, over the years we‘ve built a proprietary key word database for SEC filings which includes approximately 500 keywords of names of insiders, auditors, or terms that raise our level of interest.

For example, a term like ―preferred ratchet, which you often see in venture capital, can indicate distress, as the reset provision can be toxic on the wrong balance sheet. One of our senior analysts, Allan Young, has a forensic accounting background, and he will regularly go through the most interesting hits. That‘s one of the ways we have sourced ideas on the short side.

G&D: Can you talk about an area where you have improved since starting Raging Capital Management?

WCM: I‘ve always thought of myself as a long-term focused, value investor, and frankly one of the worries I had when starting my business was that I would turn into one of those managers who‘s overly focused on short-term performance to the detriment of long-term returns.

In fact, the opposite has happened in that I believe the regular performance reporting structure has been a positive construct for me. Specifically, as a ―long-term nvestor, I found I was often willing to look past a company‘s bad numbers or ignore my gut.

Now, I have no excuse— intellectual honesty has been forced upon me. My job each day as a portfolio manager is to look for the best places to put my capital to work, and avoid and manage the risk. Our portfolio is still dominated by true long-term or contrarian ideas, but a lot of the intellectual dishonesty has been rooted out.

If you wish to read the full interview that Martin did with The Graham & Doddsville Newsletter, you can find it here.

For more articles like this, check out our recent articles here.

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