One of our favorite investors at The Acquirer’s Multiple is Ken Shubin Stein.
Ken Shubin Stein is the Founder and Portfolio Manager of Spencer Capital Management and the Chairman of Spencer Capital Holdings. Spencer Capital is a value-oriented investment management firm with a successful long-term track record investing in undervalued securities and special situations. He is also an Adjunct Professor at Columbia Business School, where he teaches the Advanced Investment Research course.
One of my favorite Shubin Stein interviews was one he did with the Graham & Doddsville Newsletter. It’s a must read for all investors, here’s an excerpt:
Graham & Doddsville (G&D): You have a fairly non-traditional background for a value investor. How did you become interested in investing and how did you make the transition from getting your M.D. to investing?
Ken Shubin Stein (KSS): From an early age, I’ve always had an interest in both health care and investing. My mom introduced me to investing when I was a kid and she is the first one who taught me about buying stocks. I was exposed to Warren Buffett in the early ’80s, and that was pure luck. Buffett is so good at writing about it that he makes you think you can invest well too, even though it’s difficult.
But he makes it accessible and that’s how I became interested. I started investing early, and quickly took over handling investments for my family. I was investing concurrently with my science and medical training, and eventually made a decision that I wanted to make investing a career.
One of the things about investing that is different from a field such as health care is that the spectrum of approaches that people follow is wider. There are certainly lots of debates in health care but, in finance, we have different views on fundamental concepts about the way the world works and there are conflicting ideas accepted at business schools—an obvious one is the efficient market hypothesis, another is the question of whether volatility is risk. These simple, core questions are debated decades after first being asked and I find that interesting.
G&D: How has your medical and scientific background helped you as an investor?
KSS: It’s been helpful in terms of understanding how to perform research, how to think about a question, how to think about what are the critical factors, and how to collect the data and analyze the results. We think about process a lot, and we’ve tried to create a process that maximizes our chance for great outcomes.
For us, a process needs to be explicit, repeatable, and flexible. If it’s not explicit, then the process can’t be studied and used by different people and, if it’s not repeatable, then you can’t iterate and improve the process.
Lastly, a process needs to be flexible because there are many different situations in life. Things change. The credit markets change and attractive opportunities change. You may be evaluating a hard asset that is not producing cash flow, but has the potential to generate significant cash in the future. Or you may be evaluating a high return on capital business, like an asset management firm, that produces significant cash flow, but the important assets of the firm walk out the door every night. So the process has to be explicit, repeatable and flexible to allow it to be improved over time.
I learned to be a lifelong learner from my parents and from my medical and scientific training. Early in my career, I worked for two fantastic surgeons named Russell Warren and George Murrell, both at the Hospital for Special Surgery, and they both epitomized lifelong learning and continuous improvement. They take it seriously and they’re both very good at it.
G&D: Can you share your process for evaluating a prospective idea?
KSS: We use a four-step process for evaluating ideas. Step 1 is to form a hypothesis. Step 2 is the study design, or, said another way, identifying the important questions and developing a plan to answer them. Step 3 is doing the work to answer the questions; this is analogous to running the experiment. Step 4 is analyzing the data and then refining our hypothesis.
We iterate this four-step process over and over again. We borrow tools from other fields. We look at what’s available in the science of cognition or decision-making. We think about how to apply to our circumstances work that’s being done academically about human thinking. We put effort into applying these ideas; this requires some creativity and some guesswork. We make educated guesses about how to apply something. I’ll give you a specific example.
Charlie Munger famously has his list of 25 psychological tendencies of human misjudgment—25 mistakes we make in how we think. We went one by one through each cause, rephrasing it in our own words, and tried to figure out how we could apply it to our checklist process to improve our decision-making.
Whether you call it behavioral finance or neuroeconomics or innate and acquired cognitive biases, these terms are circling around the same basic issue: how do our brains make decisions under different circumstances? For decades, people have been trying to describe this idea academically. Now there’s diverse vernacular in that world because it hasn’t coalesced into one unified field yet, but what’s really interesting to me is how to take that learning and specifically apply it. How do we develop de-biasing techniques?
How do we develop standard operating procedures that can help us make better decisions? It’s all very humbling because it’s complicated and nuanced; applying it is difficult and, to a degree, personal. So it’s going to work differently for different firms and different people, but we work hard on applying it and making it practical.
G&D: Can you share a couple of past investment ideas, including an activist idea? And any current ideas you would be willing to talk about?
KSS: Sure. We have a concentrated portfolio and we often hold investments for several years. I’ll talk about a couple of past and present ones. SeraCare Life Sciences was an idea that hit a couple of the edges we talked about. It was a post-bankruptcy, small company that provided reagents and other important things to laboratories.
It was a straightforward investment if you understood it, because, coming out of bankruptcy, there were structural issues of why people couldn’t buy it. It was inaccessible to some firms due to its small size or to firms without stable capital. It required an understanding of how laboratories and the FDA approval process works because some of the reagents that they provide were actually written into the FDA approval process for the test kits using their reagents.
When you run a laboratory, you want to minimize variation in processes so that your results are reliable. So what can you control in a laboratory? What are the variables? Well, the things that change in a laboratory are your inputs such as your reagents, so you usually have complete control over that, and you don’t want to change them if you don’t have to.
So, understanding that, you appreciate the durable, competitive advantage of selling things that are small and relatively inexpensive, but critical to a large process. We invested in the company at around $3 per share. We expected it to be worth $6 in two to three years and it was bought out in less than a year at $4. It was good to be paid $4, but I would have preferred to wait another year or two and been paid $6.These things happen.
Osteotech was one of our activist ideas. Osteotech was a situation where a large institutional investor asked us to partner with them. Activism is about strategy and tactics. You need to have a strategy to create value, but even with that, you can lose an activist campaign if you dot your “i’s” and cross your “t’s” incorrectly.
The company makes the gold-standard demineralized bone matrix product called Grafton, which is frequently used in orthopedic and other types of surgery. Osteotech spent a significant amount of capital on research that was partially productive. They had a dysfunctional sales effort; they had a misaligned management team, and they put much of the money they generated into various things that weren’t productive. The latter is common in healthcare— often a company has something, a drug or device, that generates significant cash and management invests it all in risky ideas rather than returning the profits to shareholders.
So we got involved. We analyzed the situation and we went through our pre-investment checklist for activism. Osteotech passed. We ran a campaign to replace the entire board. We met with ISS and a number of large shareholders, and we made the case that our plan would create shareholder value.
It was a good investment. Shareholders made a 100% return in less than a year from the time we became involved.
An example from the insurance industry is AIG. What was interesting about AIG when we invested several years ago was that, I think, it was one of the most hated companies in America. When we were making our investment, there were bus tours in Connecticut taking people to the homes of executives who worked at AIG so they could see where the “evil” AIG people lived.
Think about that for a minute. These executives likely had nothing to do with what happened; AIG is a large global company. Think about the implication of people paying to get on a bus to come see the home where an executive who works for this hated company lives. This is a great example of behavioral bias. People were embarrassed to say they worked at AIG, and many portfolio managers were reluctant to own the poster child for the financial crisis.
Half a dozen government agencies had been living inside of AIG, going through their books, and the government owned the majority of the company. We had the following thesis: over five years the stock would be at least a triple because we were investing at half of stated tangible book value, investment income was below normal due to artificially depressed bond yields, and the company was buying back significant amounts of stock.
We thought book value was conservatively stated because the government agencies had a bureaucratic incentive to come up with a conservative number. There was new management in place and their incentives— like the incentives of most new management in a turn-around situation—were to state all the problems up front because none of it was their fault. Additionally, bond yields were kept low by the Fed and we didn’t believe that would last forever. And lastly, management was buying back large amounts of its stock, which was a powerful signal that they believed the stock was significantly undervalued.
G&D: Could you talk a little bit about your process for sourcing ideas and figuring out what’s worth your time to analyze?
KSS: Sure, Charlie Munger has spoken about there being three good ways to identify ideas. The first is to look for companies that are cannibalizing themselves by doing significant share repurchases. We look at those and we think about share repurchases, not in dollars or share count, but in percentage of shares outstanding. The second is in spinoffs, and we broaden that to corporate situations or special situations because they have similar dynamics. And the third is cloning or looking at other investors. We read what people do and try to reverse engineer why someone bought something.
In addition to those three areas where we actively look for ideas, we also receive inbound ideas from investors we know or who are part of the Columbia community. Generally, we have more ideas than time and we are usually trying to triage them and decide which ones to work on.
G&D: Are there any ideas that you’re particularly excited about right now?
KSS: Howard Hughes is going to continue to develop its assets and add value over a long period of time. We have owned it since it was spun-off from General Growth Properties when GGP was in bankruptcy. In addition to its tremendous assets, Howard Hughes has a fantastic CEO, David Weinreb, and an excellent, shareholder-friendly board, led by Bill Ackman. I think that, even though the price has meaningfully appreciated, its assets are going to continue to improve for the next five to ten years and intrinsic value per share will increase.
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