In this episode of The Acquirer’s Podcast, Tobias chats with Simon Adler. He’s a Fund Manager on the Schroders Global Value Team and he manages two funds, Global Recovery and Global Income. During the interview Simon discussed the seven ‘red’ questions his team asks to uncover value traps:
Tobias Carlisle: The document that you sent through to me, you discuss four edges that you guys have informational, analytical, behavioral and organizational. Would you just take us through those and give us a flavor of each?
Simon Adler: So that’s quite right. We think we’ve got four edges that can help us try and deliver great longterm returns to our clients. So Informational is the first edge, and this is the screen which we touched on there, that the only place we get ideas from doing a Evaluation screen keeping us in the part of the market where the academic work says you should have the best returns.
Simon Adler: And so that’s the first bit. It takes half a percent of our time, but it keeps us in the right bit of the market. Then the second edge is the Analytical and that’s where the very detailed disciplined, rigorous work’s happening.
Simon Adler: So that’s the 10 year minimum model, the seven ‘Red’ questions, and those are the ‘Red’ questions which… The teams got over a hundred years experience doing Value, Schroders has launched the first Recovery Fund, as I mentioned earlier in 1970, all of that experience we think has led us to understand this typically seven reasons for Value traps, seven reasons why I can achieve on a screen, but know I actually recover. And you as a reader of the Checklist Manifesto by Gawande. I’m sure you’ve read.
Tobias Carlisle: I haven’t, I’m embarrassed to say, but I’m going to write that down now. I’m sorry the Checklist Manifesto yes, I have read that.
Simon Adler: Okay, that’s great. And it talks about the fact that you need a checklist. So what we believe is we need to ask these seven questions every single time. We can’t just say, “I don’t hid our matters for this company.” So we’ll ask these seven questions every time. So questions like “Is there something dodgy in the EV? Is the accounting funny? Is the profits misleading? What’s the structural threat to this business?
Tobias Carlisle: Is that a business question or is that a capital structure or an industry business structure question.
Simon Adler: A bit of everything. So we’re asking particularly about the business. So at this point we’re trying to understand is there on a structural change question, is there a problem with the business? We also ask can this business survive a financial stress test. That’s a capital structure question.
Simon Adler: Is this capital structure good enough for a very tough period, ultimately none of us know if the equivalent of Lehman Brothers is going to go bust tomorrow or in 20 years time. And we want to make sure this business can survive a very tough period. As I say, the arbitrage only occurs five years. They often go through difficult times, the companies we’re investing and we want to see them through.
Simon Adler: Till profits turn into cash, that’s a really detailed accounting piece of work we do. Taking apart the cashflow statement, rebuilding it our way and saying, “Is this a cash profit business? And if not, why not? Is it a CapeEx problem? Is it a working capital problem? Is it cash tax P/E tax and so on. Then we will always ask what’s the quality of the business?
Simon Adler: We have to be very careful to explain because you’ll be unsurprised to know we are not quality investors. I often say I’m happy if we buy the worst business in the world. If we pay a penny and a pound or a cent and dollar on your side of the plot. And many people say to us at that point, “Sure I agree with you.” And then I give them the example. Let’s imagine the worst street in the town you live, the worst one. And then imagine the worst house on the worst street in the town you live.
Simon Adler: Let’s say every single one of these houses is identical except for the one you’re looking at, and they’re all worth a hundred grand. And the one you were looking at stinks absolutely horrific, it has mouse infestation, they’re all dying under the floorboards, no one wants to go near it. But we all know that in two years time that smell is gone.
Simon Adler: And if you could buy that for a thousand every other house on the streets where for a hundred grand would you buy? Everyone says “Yes, of course you would.” We just bought the worst house on the worst street. And so we’re not quality investors, but we want to understand the quality of the business we buying.
Simon Adler: Because if we’re buying the worst house on the West street, we want to make sure we’re getting a very material discount to buy it. Equally, if we’re buying a really high quality business, we want to make sure we’re protected if that business becomes lower quality.
Simon Adler: So we’re very conservative with the multiples we put on companies. So that’s one of the other questions. Then the final question is whether the ESG risk, Environmental, Social Governance, and that’s about saying it on the governance side is the management aligned to us? Do they own shares? Is the remuneration structure good? Is the board got diverse views feeding into it. And second-
Tobias Carlisle: How are you assessing that? How are you assessing the views of the board?
Simon Adler: So we don’t know the views of the board, but what we look at is we look at their biographies. If every single one went to the same university, the same school, same background, we know we haven’t got diversity, but if you’ve got engineers, political scientists, people of all different backgrounds, that means you’re more likely, not guaranteed, but more likely to have a variety of views informing the board.
Simon Adler: And that’s important. As many different views going in. When we look at our own team, we want to have a variety of different views and backgrounds feeding in to make sure we’ve got as diverse of thought process as possible. And the second part of the ESG is stakeholders.
Simon Adler: If you’re last 10 years of profits, which is how you got onto the screen for us, have been generated by abusing your stakeholders, whether that’s overcharging your customers, not paying your suppliers on time, not paying your pocket tax rate, massive environmental externalities and so on and so on. We need to make adjustments going forward and we need to understand that. And so we always ask that question as well. So we’re asking these seven questions, a lot of detailed work and that gets us to the end of the analytical edge.
Simon Adler: But the problem with that is at that point we’re all biased. That’s fact that the this Japanese company we looked at, we found some hidden assets or we hate the fact that the board’s not diverse in the balance sheet poll. So the third edge is the Behavioral edges. How do we make objective consistent decisions? And that is about distilling all of that work into two numbers, reward, what’s the percentage upside in the shares and a Risk score.
Simon Adler: So we touched on earlier out of 10 what is the chances of losing our client’s capital? 10 out of 10 high chance, not out of 10 no chance. And then weigh it up. So if we’ve got a company with a Risk score of five an upside of 10%, no thank you. Then we go to the company of the Risk score five and upside of 150%, yes please. If we’re looking for those asymmetric trade offs, if we find a company with a Risk score of 10 you want hundreds of percent of upside.
Simon Adler: So it’s about trying to understand that trade off. And then at that point, something we do is, let’s say I looked at it first other i then say, “Okay, someone else should have a look at this.” So I looked at a company in the last bit of time, which Juan Torres on our team looked at first, then Vera German, looked at, I’ve now looked at it and I’ve now flung it out for Nick Karrage, Andrew Lyddon and Andrew then Amnon to look at it. At that point we’ll have all looked at it basically independently.
Simon Adler: Our own numbers on the whole, going through the seven ‘Red’ questions. We settle the Risk score and then we could sit around and have a debate and say, “Okay, well, four out other five of us think it’s a Risk score of two, but one person has got 10. Okay, there’s something you’ve seen, which we haven’t, or we’ve seen it and we’ve discounted it Let’s chat.” Or the reward is 200% 200% 200% five or 10, where’s the differences? It means we can really drill down.
Simon Adler: We’re not a team that’s trying to brow beat and I’ve done the most work, I know all the answers, don’t challenge me. We all want to have done equal amount of work and there’d be able to have a thorough debate. Frankly, if I have missed something and someone sees it, I’m delighted, I’m genuinely not embarrassed, I’m “Fantastic, that’s really helpful that you saw that coming which I missed.” Or whatever it might be.
Simon Adler: And we’ve worked very, very hard on the culture of the team to encourage that debate. We took a day out with a psychological safety expert as a team to try and get really good at being able to challenge each other in a progressive, open, positive way. And so we didn’t have that debate. And at that point, at the end we could say, “Okay, we all agree this is attractive.” Then we move onto the fourth edge, which is the Organization edge, which is the Value archive. Every single bit of work we do, we save.
Simon Adler: And it all goes into the Value archive. So the 10 year model, the seven ‘Red’ questions, the Risk award score. And then if it’s a buy, sorry, we have the fair Value. So if we’re saying buy a dollar, but I think it’s worth three dollar, it’s in the system. But most of the time we say no. So the last time we did a check, we’ve been saying no to the 95 to 98% of the companies we look at. Most of the time we just say no. And at that point we have to set the price we buy them. So even if it-
Tobias Carlisle: The maximum price that you would pay for it?
Simon Adler: Well, this is one where we said no… So yes the maximum.
Tobias Carlisle: I see.
Simon Adler: So let’s say it’s the same stock it’s trading at a dollar. I think it’s worth one dollar 20 but I want 100% upside. So I say in the system “Okay 60 cents, I’m a buyer.” And then we set, it all goes into this Value archive, it’s now approaching one and a half thousand entries in it, all but some of them are the same company. And then if it gets down to 60 cents, great. I’ll go and have a look again or Juan or Vera or Nick or Kevin.
Simon Adler: Someone will go and have a look again and then say, “Has anything changed? Is there any different to the reward, the risk and so on. Nothing’s changed.” Great. If something’s changed, okay, well now I want it a bit cheaper. Well actually it’s got better, so we buy whatever. And if it’s in the portfolio, it stops us ever having a portfolio that’s too expensive because we can’t fall in love with the company because it hits the Fair Value, someone has to justify on the team if we’re going to keep owning it.
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