In their latest episode of the VALUE: After Hours Podcast, Tobias Carlisle, Jake Taylor, and Asif Suria discuss:
- Uncovering Hidden Value in Overlooked Small-Cap Companies
- How to Stay a Value Investor When It’s Time to Sell
- What Computational Irreducibility Teaches Us About Investing
- Mitigating Take-Under Risk When Stocks Drop 50% or More
- Passive Investing Is Leaving Micro-Cap Companies Undervalued
- Share Buybacks Can Double the Value in Small-Cap Companies
- Why 10 to 15 Positions is the Sweet Spot for Micro-Cap Investors
- Why GreenFirst Represents a Classic Ben Graham Investment
- Why Medical Facilities’ Surgical Hospitals Offer Hidden Value
- The Simplicity of GreenFirst vs. the Complexity of FG
- GP/LP Structures are Ideal for Micro-Cap Investment Strategies
You can find out more about the VALUE: After Hours Podcast here – VALUE: After Hours Podcast. You can also listen to the podcast on your favorite podcast platforms here:
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Transcript
Tobias: This meeting is being livestreamed. This is Value: After Hours. I’m Tobias Carlisle, joined as always by my co-host, Jake Taylor. Our special guest today is Whit Huguley. He’s River Oaks PM founder. It’s a micro-cap fund. How are you, Whit?
Whit: All is well. How are you guys?
Jake: Welcome.
Tobias: So, let’s start out. What’s River Oaks? What’s the strategy? What are you doing there?
Whit: Yeah, sure. I think it’s probably easiest to take one step back, actually, and go back to– It was about a decade ago, I decided to go back and get my MBA at Tulane, here in New Orleans. I was working for a startup company before that. And honestly, the plan was to get my MBA and start my own company in the startup world after I got my MBA. And I got super lucky, I guess. I took an investment analysis course early on and read The Intelligent Investor and got the inoculation that I’ve heard thousands of value investors talk about.
Jake: Condolences.
[laughter]Tobias: Helped nothing over the last 15 years.
Jake: [laughs] Yeah.
Whit: I was totally hooked. I read all these books behind me, amongst many more. But it was funny because at the same time I was getting my MBA, I was actually studying for the CFA as well. So, I was learning the efficient market at the same time that I was reading Ben Graham, Warren Buffett, Peter Lynch, Joel Greenblatt, all those investors. And it was just such a juxtaposition, reading how you can’t beat the market, studying the cap-end model, doing the beta for every stock, and at the same time, reading Joel Greenblatt, making these investments that are clearly capitalizing on an inefficient market.
So, once I got my MBA and ended up getting my CFA as well, I moved out to California to work for a private equity fund. And the first deal we worked on, I built a pretty model, did all the reading, all the background due diligence. And the way the deal was determined was what they called pistols at dawn, where there was two 50% owners of the company. We were going to back one side of the company, and the other 50% owner wanted to buy the whole company as well. They both wanted to buy each other out. So, what they did was they wrote what they thought the value of the company was on a note card and flipped it. And whatever value was higher, that’s what the other 50% owner paid for the whole company. That’s when the efficient market hypothesis really died for me. I started cracking up.
Jake: Did you win?
Whit: I believe we lost, actually, which ended up being a good thing.
Tobias: So, they each wrote down a number and the highest number wins and the highest number pays the other person that number.
Whit: Yeah. So, I think–
Tobias: Got it. [crosstalk] that’s good.
Whit: Yeah. It was so funny because I just had this perfect model built out. All these, if this changes and this changes. I think it taught me a few things. One, that the markets are inefficient. Especially this was a private company, but I think it was around $100 million net worth company, but they taught me markets are inefficient, A, because humans are inefficient but, B, there’s just so much more behind businesses than spreadsheets, financials, 10-K’s, all that.
And I got super lucky working for this private equity fund called AGR. It was a pretty large fund, but the deal team was rather small. So, I got to do a little bit of everything. I got to go to conferences, visit management teams, just build models, all the due diligence, boots on the ground, if you will. And that’s when it really set in that– I think it’s the Warren Buffett quote, I have written here. “Shares are not mere pieces of paper. They represent part ownership of a business. So, when contemplating an investment, think like a prospective owner.” That’s when it really set in, is that you really are buying the percent of a business here. You’re not buying a ticker symbol or anything like that. And that’s through private equity, I really gained that businessowner long-term mindset mentality.
And I think going back to the efficient market hypothesis, I think I like– This isn’t a direct quote from Warren Buffett, but he uses it through talking about bridge and all these other things. But he’s basically saying, ironically, investors believing the market is efficient is what causes it to become inefficient. And I find that super interesting to think about, but–
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Uncovering Hidden Value in Overlooked Small-Cap Companies
Jake: What do you think that does with a large amount of indexing then that’s happening? Do you feel like in the amount of time that you’ve been managing money that markets are more or less efficient right now?
Whit: I’ve noticed– So, I started River Oaks Capital in 2020. I left private equity and moved back home– I left California and moved back home to New Orleans to start my own fund. And I’ve noticed it definitely getting more inefficient in micro-cap and small-cap. I can’t really comment on large cap, but it’s just– there really is very little index funds that buy ownership in micro-cap and small-cap companies.
So, when I started my fund in 2020, I really used that private equity businessowner long-term mindset and was investing, and still am investing, in micro-cap and small-cap publicly traded companies. Since I’ve started my fund, I think I’ve had two aha moments. The first was visiting management teams. As I mentioned, I started the fund January 1st, 2020. So, it took a little while till I could visit management teams in person because of COVID.
Jake: Right.
Whit: But the first management team I visited, I wore a nice shirt, got all dressed up. It was a $100 million market cap, or $200 million. The average size of the company we have ownership in is $250 million. And they were like, “You’re the first person that’s been here in like four or five years.” And I would go to shareholder meetings and show up early. And I’m one of two investors. Sometimes, it’s just me. I couldn’t believe that the due diligence that we were doing in private equity wasn’t happening in micro-cap and in small-cap public companies, because the private equity companies, we were buying ownership, and we were about the same size. I just couldn’t believe that due diligence wasn’t happening.
I think for visiting companies, it’s good for two reasons. One, you see a company that is trading at five times earnings, you’re eager to get on a plane, you’re like, “Oh, my gosh, I can’t believe how cheap this is.” And you get there and you realize that it should be trading at zero. It’s trading at five times too much, that none of those cash flows are ever going to see the shareholders’ pockets. They’re either going to go to board fees, increase the salary of employees, or a poor acquisition. So, that’s one area that’s been very valuable in visiting management teams.
The second area is once in a while, you’ll fly out to Fort Worth. I flew out there, visited Dayton Judd, a company we have ownership in called FitLife, and he could run a Fortune 500 company. He just, at the time, was under the radar. And that’s what makes the traveling all worth it, is finding these wonderful companies that are just totally undiscovered. I think partially because of what you mentioned, Jake, people just are passively investing and totally ignoring these areas of the market. Some of it is they’re just small companies and people just ignore them for whatever reason.
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Share Buybacks Can Double the Value in Small-Cap Companies
I think the second aha moment I had was becoming, I guess, what you would call suggestivist investor. Originally, when I was visiting these management teams, I was just visiting them to assess their trustworthiness, whether they were good at operating the business, amongst other things. And it wasn’t until maybe about two years ago that I started to suggest capital allocation possibilities. It’s like “Your company is valued at 50 cents on the dollar, have you thought about buying back shares?” And I realized that in the micro-cap, small-cap area, a lot of these CEOs are really good operators, but they just don’t think about capital allocation that much. It’s not like nefarious or anything like that. It’s just not something they have much expertise in.
So, most of my suggestions have been– And oftentimes, I’ll reach out to other minority shareholders as well, and we’ll kind of all team up and send the same suggestions, but it’s almost always just buy back shares. And it kind of like leads into what I heard Toby talk about recently about the two ways to generate return for long-term business-minded shareholders. I would love to hear him talk more about that, but the shareholders yield and reinvested capital, but the shareholders yield is the part that I find extremely interesting right now in micro-cap and small-cap.
Tobias: And why is that?
Whit: I think it goes back to what you said. If you’re buying ownership in a micro-cap or small-cap company, it’s an inefficient market. And there’s no way to know whether an inefficient market isn’t going to get more inefficient. So, the way I’m thinking about it is the market cap is always going to stay the same. And I think the way you put it is for a long-term business-minded investor, you don’t need the multiple to rewrite. I think it’s been talked about– So, I think what you dove into is then the long-term business minded investor gets returns either through, one, shareholder yield, which is dividends plus share buybacks and, two, reinvested capital.
I think a lot has been talked about how reinvested capital isn’t getting properly valued in the market, whether it’s through David Einhorn or other large investors have talked about how the markets are broken in that aspect. But I don’t think it’s been talked about how just this layup capital allocation opportunity that’s happening in micro-cap and small-cap companies where they’re trading at five to seven times earnings. Obviously, you have to do the due diligence to assess whether those are sustainable earnings. But if they are, you can buy back, you can create a 15 plus percent shareholder yield by buying back shares.
I don’t see another area of the market that has this layup capital allocation opportunity where– There’s a company I own called Citizens Bank where I legitimately think it’s 100% undervalued. So, every time they buy back shares, it’s turning $1 into $2. And I don’t think there’s any other area of the market that offers management teams this simple of a way to allocate capital. And I think John Huber talked about it in one of his recent articles that he wrote that I could post on Twitter after this. I can’t think of the exact name, but there’s no difference between buying back shares at a five to seven PE ratio and reinvesting in a company at a 15% to 20% return.
And I think a lot of that is getting missed right now, that people are getting upset about how undervalued and inefficient and how, because of passive investing, no one’s paying attention to small-cap and micro-cap companies. And instead of getting upset, they should be capitalizing on this opportunity to just increase shareholder yield as much as possible. I think there’s a quote here I have by Tom Gaynor that I think goes really well with what you were saying, Toby, about you don’t need the multiple to rerate. He says that what publicly traded companies are worth is 90% dominated by the cash flow they produce over time and 10% by what the market will pay for these companies over time. And that’s how I think about it as well.
And I think from my private equity background, you’re pretty much forced to think about it that way as well, is you’re thinking, “How much cash can I get out of this business?” You’re not thinking, or at least we weren’t thinking, “Oh, is one day–”
Jake: What’s my exit multiple?
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How to Stay a Value Investor When It’s Time to Sell
Whit: Yeah, we just weren’t thinking about that. And it’s something I’ve been thinking about a lot recently. The one pushback I’ve heard on buying back shares in micro-cap and small-cap areas is that the volume is too low and it’s hard to buy back shares. And for the first year or two of running River Oaks Capital, I was somewhat in that camp and I understood the argument. But about two years ago, we bought ownership in this company called Medical Facilities and over two years they bought back 40% of their shares. It’s under $200 million market cap company and it’s listed on the Canadian Stock Exchange, which has pretty restrictive– you can only buy back 25% of the volume per day. They did do a tender offer, but they’re on pace from just buying back 25% of the volume per day to buy back 15% of the company this year. So, I think good management teams find a way to buy back shares, especially if it’s at five to seven times earnings. And I think the way–
When I’m reaching out to companies that we have ownership in, the way I phrase it is that if you were to issue a press release that today we bought 10% ownership in another business at a five PE ratio, I think the market or investors would love that announcement. But for some reason, they’re missing out on the opportunity to buy 10% ownership in their own business at a five PE ratio. And I don’t think there’s any difference in the two. In fact, it’s probably better because you know your business better than the business you’re acquiring.
And I think the second reason investors shouldn’t get mad about it is from switching, there are plenty of advantages of being a private company, but one of the biggest advantages of being a public investor is that you can average down your cost basis without anything materially bad happening to the company, which is another reason not to get mad about the share price being below fair value.
For instance, I own a company where a family owns 30% of the company. There was a family dynamic and half the company– So, they split the shares up amongst the family, and half the family decided one day they were going to sell all their shares. So, the stock went down 30%. And because I had done due diligence, visited the management team, knew the company well, I knew nothing material had changed in the company at all. So now, I was just able to buy ownership at 30% below where I was buying it at.
In the private markets, I don’t think you’re offered that opportunity very often. If you are averaging down “30%,” it’s because something materially wrong has happened in the company. It sounds silly to say out loud, but I really do think having an inefficient share price or a share price of fair value is a net positive for a business-minded long-term investor.
The other thing I was thinking about that I think you said one episode, Jake, Value: After Hours, and this isn’t a direct quote. So, I apologize if I’m misquoting you here, but you said “A time to consider selling is once you get the return you deserve, or somewhere around there.” And the way I interpreted it, and I’m going to tie this back to the “low share price is good,” is that if you’re going to be a value investor while buying remain a value investor, while selling don’t turn into a growth investor when you’re selling. And I think the example you gave was Fairfax, how Fairfax has always remained around book value. So, it’s only ever grown at how much book value has grown. So, it hasn’t tempted you to sell at above or quickly sell, I guess. And it kind of has turned you into– Or has made the journey easy of being a long-term, business-minded investor. So, that’s another thing I’ve been thinking about of the positives of the share price being below intrinsic value. So, yeah, we would love to–
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Tobias: Let me give a quick shoutout to–
Whit: Yeah, sorry.
Tobias: No worries, no worries. Petah Tikva, Israel in the house. Lewes, Delaware. Chapel Hill, North Carolina. Tomball, Texas. Copenhagen, Denmark. Bendigo, Victoria, early start. Dubai. Regina Saskatoon. Hamburg, Germany. Columbus, Ohio. Long Wheel, Quebec, Canada. Sooke, British Columbia, Canada. Toronto, Nashville. Kennesaw. Valparaiso, Mac, what’s up? Jupiter, winning, Nashville, got that one. Leuven, Belgium. Limerick, Ireland. Porto de Mós, Portugal. I think that’s it.
Jake: I like it better when you guys give him–
[crosstalk]Give him ones that are not real things that make him say stupid words. That’s my–
[laughter]Tobias: Last time I saw you was at the Berkshire Hathaway Annual Meeting. Did you hear [unintelligible 00:20:59] over the weekend? He said Berkshire’s a cult, and he’s very fortunate to have never been to a meeting because it hasn’t muddied up his thinking.
Jake: How dare you, sir?
Whit: Oh, man. Well, the first thing I’ll say is, yeah, I sat with you all, and I thought you all were joking about how much chocolate you eat at the meeting. [crosstalk] And I had to leave before the–
Tobias: [crosstalk]
Jake: Yeah.
Whit: I will say at the meeting, part of the thing I was thinking about is how many connections I’ve made because of the Berkshire meeting. I think I’m probably on this podcast right now because of the Berkshire meeting. I think the people I exchange ideas with, I would say 50% or more are because of the Berkshire meeting. So, I don’t know if cult is the right word by any means, but I was thinking what’s going to happen to value investing when Berkshire is gone. I’ve heard a lot of people talk about that, but that was what kept going through my mind during the meeting, is just, I was sitting around 15 investors I had gotten to know well, that I don’t think I ever would have met without going to– I think I’ve been to Omaha five plus times now. So, yeah, that kept crossing my mind.
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Why 10 to 15 Positions is the Sweet Spot for Micro-Cap Investors
Tobias: How do you think about portfolio construction as a micro-cap guy? How many positions? How big?
Whit: Yeah. Right now, I have 15 companies, or we have ownership in 15 companies. What I really think about is I want to accentuate the wonderful companies or the best ideas we own without– I love investing without risking what I’m doing. So, I think 10 to 15 companies is about the capacity of the amount of companies I can keep up with. I try to visit management team in person at least once, hopefully twice a year, talk to them on the phone much more than that. I think 10 to 15 is about the upper limit for me personally in being able to do that. And honestly, if I’m being like, how many wonderful or undervalued–? Not the point of undervalued, but how many wonderful micro-cap companies are out there, it’s more than 15, but it’s not thousands, maybe not even hundreds. But if you dig deep enough, there really are some wonderful businesses out there. So, that’s what I found, 10 to 15 to be about the right number for me.
And as far as weighting goes, I really think the highest weighted companies are the ones where I feel like I have the least chance of losing money. For instance, the company I talked about, Citizens Bank, has more cash at the holding company than the current market cap of the entire company. So, it’s like even the sinkhole story that Joel Greenblatt talked about where he made an investment and it was a bank or subcompany fell into a sinkhole in Florida. Even if that happened, I think I would get the current market cap back at Citizens Bank.
So, when I’m weighting those 10 to 15 companies, I tend to put more weight onto those types of investments where it’s like– I mean, an overused term, but heads I win, tails I don’t lose much type of investment. And then, more of the companies that probably have a little more growth potential but don’t have that traditional Ben Graham downside protection, I won’t weight as heavily. I think my views on that are changing a little. I’m putting more weight into the wonderful companies, regardless of even if they are at a slightly higher PE ratio.
But yeah, I think 10 to 15 has been where I keep landing as what’s manageable, what I’m able to invest in while using a business-owner long-term mindset, and not get too spread thin as far as keeping track of all these companies.
Jake: How many do you feel like you can keep up with on a kind of a watchlist or on your bench?
Whit: Yeah. I have 15 companies I invest in. I think the bench right now is about 20 companies. So, I think– And some of it will just be like, I’ll put a price next to it, and if it gets to a certain price– So, yeah, I would say about 30 companies are– There’s 15 I own and then another 15 or so that maybe– Yeah, 15 to 30 on the bench that I can keep up with. And if something material changes or the price goes down, I’ve talked to that management team, I could kind of dive in pretty quick to start buying ownership in the company.
So, there’s about five companies I have right now that I would love to buy ownership, and I think are about 20% to 30% overvalued. And the second, if they ever come down, I’ll start buying ownership in those companies. I’ve already done the due diligence. I’ve already talked to the management team, flown out to visit them. I think that it’s slightly overvalued. And I like the 15 companies we have ownership at their current prices more right now.
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Passive Investing Is Leaving Micro-Cap Companies Undervalued
Tobias: What do you think about this idea, that passive– That’s Michael Green’s idea that passive is sort of inexorably trending towards more and more of the market. And so, that means that because they’re all market capitalization, float adjusted, weighted, that means the biggest companies get the most money. So, that immediately leaves everything that’s not S&P 500 basically kind of stranded. And even the S&P 500, the smaller ones in there. So, micro-caps are just as beaten up as they’ve been. And either it’s secular, in which case there’s no recovery, or it’s an opportunity like the early 2000s, where we’d just gone through a tech cycle and everybody had been hunting for high ROIC compounders, and it left all of these pretty good cash flowing businesses out there. And I think that’s what attracted private equity activists into that. Can you see that happening again, or do you think that passive is unstoppable?
Whit: Yeah. I heard you talk about that, and I think it’s super interesting, because I was picking up on the same trend that just larger companies are getting– There is such a bifurcation in the market right now, I think. There’s a good quote I had written down here by Nick Sleep. It says, “When there is a frenzy of activity in one area of the market, there is often anti-bubble of discarded companies in another area of the market.” And I really feel that’s what’s happening in micro-cap and small-cap companies right now.
I think what’s interesting is I think it would be really hard to index micro-cap companies because as I mentioned, I visited plenty of companies where when I visited them, I think they’re always going to be worth zero. They’re just run for the management team and the board. And I don’t think there’s many of those in the S&P 500 or maybe even in the Russell 2000. So, I do think it makes sense to actively invest in micro-caps because you can weed out those companies.
I think going back to your question, will private equity come in and take advantage of this opportunity? It goes back to what I said. When I’m investing, I’m assuming the market cap is never going to move. I’m even conservatively assuming that if it’s $100 million market cap and they reinvest $10 million into the company, it’s still going to stay $100 million market cap. So, I’m only thinking about how are we going to get returns from cash out of the company, whether it’s dividends or share buybacks.
I think going back to the company I mentioned FitLife, when I visited Dayton Judd in Fort Worth, I do think eventually– So, he took over the company in 2018 and he’s just done an incredible turnaround job and it was underpriced all the way until the end of 2023, like significantly underpriced. I do think eventually, if you run a business well enough for long enough, people do find it regardless of where it is. I don’t make that assumption when I’m investing in a company where I do think it does eventually happen. If not, you just get that 10% to 15% shareholder yield through dividends and share buybacks that I was talking about.
But I think the second interesting thing about FitLife is that it uplifted from over the counter to Nasdaq at the end of 2023 and the share price went up 70% to 80%. There was a good acquisition in between that, but part of that is it got included index funds. And I don’t really know how to think about that because I would not describe that as value investing, as buying a company assuming that one day it will get included in the index fund going back to what you said on multiple expansion, but it certainly seems that once a company is eligible for an index fund, their valuations tend to go up quite a bit. And yeah, if you just look at obviously, they’re two different companies, but Nvidia versus some of the valuations in micro-cap companies right now, I would be curious if there’s ever been a spread this wide on a PE ratio differential.
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What Computational Irreducibility Teaches Us About Investing
Tobias: Well, I did love tracking the spread. It’s pretty wide, but I haven’t looked at it for a little while. At the top of the hour, we should do JT’s vegetables.
Jake: Yes, sir. So, this week, this is– in diving, they have degree of difficulty. I think I might be a little bit– This might be a belly flop because I might be going for one too many rotations than I’m capable of. We are going to be talking about this concept called computational irreducibility. Two large words. I’ll see if I can make it more simple. But do you guys know much about Stephen Wolfram? Have you come across him much?
Tobias: I know vaguely who he is. I know he’s got a website, you can put some computations into it.
Jake: Yeah, there you go. So, he’s a mathematician, computer scientist, and he’s known for– He created this computer program called Mathematica that’s been commercially quite popular, which has allowed him to do a lot of– It’s not really citizen science, but much more choosing his own adventure in the scientific world as opposed to academia, which oftentimes, you get pushed into a little niche.
Anyway, he also wrote this book called A New Kind of Science. And another one of these guys that was just wildly precocious, published his first scientific paper at the age of 15, completed his PhD in theoretical physics from Caltech by the age of 20, making him one of the youngest ever. In 1981, at just 21 years old, he won the MacArthur Fellowship for his significant contributions to science and technology.
I don’t know what you were doing at 20, but I certainly wasn’t getting MacArthur Fellowships or getting a PhD from Caltech. But anyway, his work is really about exploring simple rules leading to very complex and surprising results. And I happen to watch– this came about because I watched Nassim Taleb, had him give a talk in an interview with him this past summer for Taleb’s Real World Risk Institute class. And I don’t know if you guys have ever seen anything out of there before, but it’s kind of interesting.
So, one of the key concepts that I’d never heard of before that was this idea of computational irreducibility, and it’s used to describe a situation or a system where you can’t find a shortcut to simplify or speed up the outcome of a process. You have to go through every single step to see what happens. I’m going to try to start with a really simple example. Let’s say you’re building the Millennium Falcon out of Lego bricks. You start with the basic instructions, and you’re putting it together piece by piece in a certain order. And it might be pretty simple instructions. But as you follow them, you end up with the exact replica, and it’s quite complex. You could make any crude spaceship you wanted by dumping the pieces on a table and fiddling around without the instructions, but to get the exact pieces in the right order, you have to go step by step. There aren’t any real shortcuts. And so, that’s really kind of what the irreducibility part of it is.
So, a few other examples. Like, reading a book, you can’t just jump to the last page and then expect to understand everything that came before it. Baking a cake, you need the right ingredients in the right proportions, bake for the right amount of time at the right temperature, you can’t speed it up. Perhaps a more nerdy example is suppose you wanted to find the 1000th prime number, there’s no formula that directly gives you the 1000th prime number without– You have to basically go and calculate all the prime numbers before it, and you have to check each one by one to determine if it’s a prime. And then, once you’ve reached the thousandth one, you know what that answer is. And it’s irreducible, because you can’t avoid going step by step to reach the goal. And maybe my favorite is Buffett’s got a little example of computational irreducibility when he said, “You can’t make a baby in nine months by getting nine women pregnant.” [chuckles]
All right, so, in the world of math and science and computers, these same ideas apply. And for some problems, you just can’t jump straight there. So, imagine a computer program that creates a pattern by following these simple rules. And at first, the pattern looks simple, but then, as the program runs, it can get very complex and surprising. And if you want to know what the pattern will look like after a lot of steps, you need to let the program run the whole time to see what happens. Stephen has this thing called the rule of 30, and it’s something that he discovered. It’s easier if you go and play around with it yourself and there’s a website to do it to see these interesting patterns emerge. But I’ll try to explain it real quick, kind of how it works.
Imagine that you have a row of squares up at the top, and each square can either be black or white. Okay? And so, it’s kind of zero or one type of thing. You start with a single black square in the middle, and the rest are white. Then, you follow a rule to decide the color of each new square based on the color of the squares next to it. So, it’s kind of like it starts to descend downward you’re filling out these squares.
So, the rule of 30 is a specific way to decide the color codes. I’m not going to go into all of the little details of how it gets determined, but it’s fun to go play around with it. And you can kind of start to see how something super simple, like we’ve got two rules here. It creates these surprisingly complex, maybe even borderline magical outcomes.
So, Wolfram and Taleb were talking during this interview about what he called pockets of reducibility. Basically, it describes math or physics, where we can sort of boil the world down into sort of understandable words and concepts that we can then share with each other. And really, what they were saying was that stuff that we have to fit into our brains that we can then turn into narratives and explain to each other and map them out. And so, Wolfram was saying that something that actually kind of shocked me. He said that we have evolved to operate in certain pockets of reducibility. And this is based on our senses, our biological structures, our measuring devices, and it might have even been inevitable that we ended up with these exact pockets figured out.
You think about the relatively slim spectrum of light that’s actually visible to the human eye, that created a pocket of reducibility that we could kind of understand the world in. But there’s no doubt that there are other pockets that we haven’t reduced yet. And that’s really what science is all about, is finding these new pockets and progressively broadening these paradigms that we use to understand the world. And it’s likely that we’ve only colonized a tiny percentage of the available pockets that are out there. He came up with some kind of math. He tried to back into the math of this. I don’t know exactly how he did it, but it was a staggeringly small number as far as the percentage of probably what we’ve actually figured out.
Let’s see if we can get this back to investing, as I always try to do. I think the stock market’s day-to-day behavior is computationally irreducible. I don’t think there’s any formula or model really you could predict where the future state of the market’s going to be on a day-to-day basis. The only way to really know where it’ll go is to let it move forward in real time, reacting to new event that comes in. There’s just too many confounding factors, too many feedback loops, too much Keynesian beauty contest where people are trying to predict what other people will predict, that someone else will predict. And it’s just turtles all the way down of predictions.
And even if you base your strategy on fundamental analysis, I think you still can’t really skip ahead to see what your portfolio will be worth exactly in ten years. The price is going to depend on market conditions, economic cycles, company performance, and that’s all occurring along the way and sort of history will reveal, like time reveals what will happen. So, you really have to let time pass in order to figure it out, and there’s only step by step to get there.
Now, however, you might be able to get in the ballpark of acceptable outcomes if you buy decent enough businesses that you understand, you don’t pay too much for them, you don’t let the market price spook you out into making bad decisions. But I think this computational irreducibility should be a pretty strong reminder for all of us that we shouldn’t really kid ourselves about how predictable the world really is. Economies, sociopolitical events, markets, all these things are really pretty irreducible.
And so, it’s probably best to just prepare, but don’t predict. And I think I will leave it at that.
Tobias: Nice one. Good job, JT.
Jake: Thanks.
Whit: Great.
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Why GreenFirst Represents a Classic Ben Graham Investment
Tobias: That’s an easy segue from that to the next thing. Let me start you off with that. Are you able to talk about some of your positions, Whit? I got a question on Twitter about GreenFirst.
Whit: Yeah.
Tobias: Do you want to take a chop at laying out thesis there?
Whit: Yeah, sure. I can give it a go. So, I think I bought ownership in GreenFirst about three years ago. And obviously–
Tobias: What’s the ticker for that, people [unintelligible 00:40:47] at home?
Whit: Well, it’s traded in Canada, it’s GFP, and then in the US, it’s ICLTF. So, yeah, I bought ownership about three years ago. It’s a little different than any other company I own because it’s a commodity. So, that part’s a little different. And it’s in lumber, which, as we all know, during COVID went through the roof and has since come down to about breakeven prices. I think what made GreenFirst so interesting for me, I was introduced to it by Mike Mitchell, who I know has been on the podcast a few times, is a great guy and we’ve hung out quite a few times.
But what made it super interesting to me is that Paul Rivett, who was the president of Fairfax, bought ownership in GreenFirst. And him, Paul, Mike, the rest of the board laid out the capital allocation plan of what they were going to do step by step. I think this was 2021. And it went from reducing debt to selling noncore assets to cutting overhead costs. They had this, I think it’s like seven- or eight-step thesis, and they have literally executed on this at a pace that I don’t think I’ve ever seen before. Maybe Medical Facilities is the other company owned that’s executed on their turnaround pace this quick. But their ability to divest noncore assets, reduce debt, they must be working day and night. I can’t imagine how hard they’ve been working over the last three ye1ars. But obviously, if lumber is at breakeven, there’s not much you can do about that.
I think what’s interesting is they now own four lumber mills, which are in Ontario, which is a very business friendly providence of Canada, and is where a lot of– Although the timber isn’t as high quality as BC, British Columbia, it’s just a lot more business friendly. It’s where a lot of the major Canadian lumber producers want to be right now. So, I think when lumber does turn around, this is going to be a prime acquisition target. These four lumber mills they have, Interfor, one of the large Canadian lumber producers already own 16% of GreenFirst, and they went to the annual shareholder meeting last year. So, it seems as though they are keeping a very close eye on these four lumber mills. They even were interested in buying these four lumber mills when GreenFirst bought them in 2021.
I think if we’re going into value investing and thinking about it from that perspective, the noncore assets on the balance sheet right now are worth more than the market cap. They have duties that are owed to them by the US government that are in the range of about $40 million. They have a waterfront land in Kenora, which is worth, I don’t know, over $8 million, well over 8 million. And then, there’s a few other pieces– And the overfunded pension plan. All these will take a little time to value, but if you add those three up, that’s more than the $50 million market cap right now.
So, you’re getting four lumber mills basically in my mind for free. Obviously, the factor you have to think through is how long is lumber going to stay at breakeven? Could it go well below breakeven? And if it does, how do they fund that? But with Paul, I’ve talked to Paul for quite a while, and he’s extremely impressive. His speed of capital allocation is second to none. And I really feel the noncore assets plus Paul in the team, Joel, the CEO, is great, gives us extreme downside protection here. Why it keeps selling off every day, I have no idea. And it’s one of those, I think what I talked about earlier, those four selling opportunities where you’re able to average down without the business being materially impacted at all.
Tobias: What are the prospects for better lumber prices? Are you relying on another run in lumber that has had? Like, what is the–?
Whit: Yeah. At this market cap, the price only has to go up a slight amount for them to start making $15 to $15 plus million of free cash flow. And on a $50 million market cap, that’s a sizable free cash flow yield. So, I can’t say I really have a macro thesis behind lumber, that’s by no means why I invested in this company. It came across to me as a pure Ben Graham type investment where if you break it apart piece by piece, it’s worth way more than the current market cap. And then on top of that, you get the upside of– In my opinion, this isn’t a matter of fact, but it’s only a matter of time until the four lumber mills get acquired by a larger player. Everyone’s trying to get into Ontario right now, and there’s four quality lumber mills for sale there.
Jake: Is the game eventually liquidation? Like, “Let’s just get all these assets and liquidate them, and then we’ll wind this up for more than we bought in for”?
Whit: Yeah, yeah. If they wanted to right now, they could sell the duties that’s on the balance sheet, and buy back over 50% of their shares. I think the duties are selling at like 35 cents on the dollar, and they have 80 plus million USD of duties. But that whole dynamic is confusing about US collecting duties from Canadian lumber producers and when you’ll get it back, because there’s a whole time value of money. The balance sheet is just extremely undervalued. It’s what I call an excessive discount company or 50-cent dollar. And then on top of that, you get Paul Rivett allocating capital for you, who used to run Fairfax. I don’t think you’re going to find that type of CEO in a $50 million market cap company very often.
Tobias: What’s the difficulty with recovering the duties?
Whit: There is no set time when they are returned. It is just a pure negotiation between the US and Canada. So, the thought is that they definitely won’t be able to return before the upcoming US election. Every year, the US charges Canada, I think– I’m not sure the exact rate right now, but about 20% for all the longer they sell. And then they put it into a safe, if you will. And it just keeps accruing, accruing, accruing. And then one day, Canada and the US come to an agreement and say, “Okay, we’ll return the duties.” And it’s not always– You don’t get 100% back of what they’ve accrued. I think last time it was 80% back. I’m modeling for like 50% back. So, there’s a time value of money because you never know when they will come back. It could be tomorrow, it could be a few years down the road. But what I can say is– I forget the exact number, but it’s in like the $8 plus billion dollars that’s accrued now in the US, and it’s never gotten this high before, before they’ve redistributed it back to the Canadian lumber producers.
And I think what’s equally as interesting is when they are redistributed back, all the companies that want to acquire GreenFirst are going to have a lot of cash on hand. So, there’s a lot of interesting upside opportunities there. And the pace– I’ll go back to the real thesis is their pace of capital allocation and paying down debt and finding ways to return capital to shareholders has been second to none.
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Why Medical Facilities’ Surgical Hospitals Offer Hidden Value
Tobias: What about Medical Facilities? That’s another one you mentioned.
Whit: Yeah, that’s been–
Jake: And can they get a better name?
[laughter]Tobias: What do they do?
Whit: So that–
Jake: Run theme parks, Toby, I don’t know if you–
Whit: They owned a bunch of surgical hospitals. I forget what the exact year they started, but it was at least 20 years ago, I think closer to 30 years ago. They own a bunch of surgical hospitals which are where if you want to get a hip replacement or knee replacements instead of going to your local hospital, you go there. And they’ve become more and more popular as like– I didn’t believe this, but when I talked to the management team of Medical Facilities, you can go in, get your knee replaced and walk out that day.
Jake: And it correlates with pickleball, is that–?
[laughter]Whit: Yeah, you’re probably right.
Jake: You’re long pickleball? [laughs]
Whit: So, I think it was in 2021. An activist investor, Michael Rapp. He works for Converium Capital. When activist on Medical Facilities before that, they had done a bunch of acquisitions of other surgical hospitals, taking on too much debt, and it just didn’t go well. They were paying extremely high dividend yield, and that’s why everyone loved the stock. And then, they had to completely cut the dividend to zero because of all the acquisitions they made, And the share price just plummeted. It literally went– It got more than cut in half.
So, when Converium Capital and Michael Rapp, who I’ve spent a lot of time talking to, came in–, very similar to GreenFirst laid out the capital allocation plan. The vest noncore assets was number one. So, they sold off all the surgical hospitals that the previous management team had acquired, pay down debt, buy back shares, and then eventually I think they will sell. So now, there’s four remaining surgical hospitals left. There’s two in South Dakota, one in Oklahoma and one in Arkansas. And it’s trading about seven to eight times earnings right now.
But what’s made it incredible, an incredible investment is they’ve bought back as I mentioned earlier in the podcast, by the end of the year, it’ll be 40% of their shares. The thesis that I was talking about earlier, about how low share price is good or a share price below fair value is good for the long-term business-minded investor was really reinforced in Medical Facilities, because I’m actually upset a little bit when I wake up and I see that the share price has gone up because I know they’re buying back shares and now they’re able to buy back less shares.
So, the real story behind Medical Facilities is two of the four surgical hospitals are extremely undervalued. The two in South Dakota are top-notch surgical facilities, A plus facilities. And then, the one in Oklahoma and Arkansas are great too. And as I wrote in my letter, I think they will eventually sell Oklahoma and Arkansas, use that to buy back even more shares, and then sell the two surgical hospitals in North Dakota. And the last thing they said in their step-by-step process was cut out all corporate overhead costs or reduce it significantly and they cut that down a ton. So, it’s free cash flowing about $25 million. The market cap, I believe, is around $200 million. It might have gone up a little, but it’s worth way more than that to acquire, could take out a lot of redundant costs. And as I mentioned, I am not anticipating on it getting acquired, but their ability to buy back shares, they’re compounding capital for us at 15 plus percent right now by just buying back shares. And it’s really rewired my brain on how powerful share buybacks can be is watching this investment over the last couple of years.
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Mitigating Take-Under Risk When Stocks Drop 50% or More
Jake: Whit, have you ever gotten in a situation where, I know I personally have and it’s really frustrating is, let’s say you buy something and it gets cheaper on you and the cheaper it gets, you almost feel like you have to keep doubling down in order to mitigate some of your take under risk. You need to keep lowering your cost basis so that when it gets taken out back at below your original price, everyone says yes because the newest people who came in think that’s a good price for them, but your price was way above that. How do you mitigate for that?
Whit: Yeah, I was just in that exact situation. When I have my Excel spreadsheet of the companies that I own, I do it by market cap, but also by capital invested to see what percent capital invested I’ve had in this company. So, when I’m averaging down, it says I only own– it’s only 3% of my fund, but I’ve invested 8% capital at cost into the fund. So, I’m thinking about that a lot. I think that’s the hardest thing, is when it goes down that much, there’s the risk of take under. I mean, I think your brain immediately thinks, “What am I missing?” I think that’s where the due diligence side has really helped me.
But I had a company recently, Galaxy Gaming, that I would say got taken under. I think eventually they could have sold for $8 to $10 a share and they sold to Evolution Gaming for $3.20. And as it went down, I bought shares. So, we about broke even. But looking back, maybe I should have bought more. It’s extremely hard because I think it went down 50%, 70% from where I originally bought it. So, I was able to at least average down enough to breakeven. But there were some investors– Because when it got bought out for $3.20, it was trading shortly before that like under $2, I think well under $2. There are some investors who made 100% returns. Yeah, that is I think one of the hardest parts of investing is when it’s down that much. And I think that’s what’s happening at GreenFirst right now.
Jake: It’s really difficult too because the lower it goes, probably the greater the chances of a take under start because it’s just like cheaper and someone’s going to notice and then there’s more chance of an activation happening that then takes you under officially.
Whit: Yeah, it’s like the one-
Jake: You have to commit good money after bad, in a way.
Whit: Yeah, it’s like the one time that I wouldn’t mind the poison pill being implemented is when the share price gets that low to prevent that from happening. But yeah, it’s so hard because– Yeah, I totally agree. I think that’s one of the hardest situations, and I’ve been caught in it two separate times.
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The Simplicity of GreenFirst vs. the Complexity of FG
Tobias: I’ve got a question from the crowd. Why own GFP and not the broader FGF entity?
Whit: I just personally much more– I find it much more easy to analyze GreenFirst. I’ve had a hard time valuing FG. I think they’ve changed the ticker symbol. I forget what it is now, but there’s a lot of moving pieces there. And the thing that attracted me to FG was their ownership in GreenFirst. So, I was like, why not just own green first outright? And I really like Paul Rivett and Mike and that management team at GreenFirst. Yeah, that’s why.
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GP/LP Structures are Ideal for Micro-Cap Investment Strategies
Tobias: What’s the process for raising capital? Are you an LP or you an [unintelligible 00:59:15] How are you structured?
Whit: Yeah, I’m an LLC, GP/LP setup. I find that to be particularly helpful in micro-cap versus an SMA for a few reasons. One is what I mentioned, the suggestivist investing I like to do. I find it cleaner when I can go to a company and say, “River Oaks Capital owns 5% of your company, and we would really appreciate if you would consider buying back shares, versus saying, “This SMA plus this SMA owns this percent of your company.”
Jake: Even just voting proxies is way easier for a fund than for an SMA structure.
Whit: Yeah, it’s easier from a fee aspect as well. And it’s also a lot of these companies in micro-cap are very liquid. So, I’m not sure how you would really determine the pecking order of whose SMA to buy the shares in first. So, I did debate in between SMA or an LLC when setting it up, or a GP/LP setup. I’m very happy I went with the GP/LP setup. Obviously, the one downside is the LPs can’t see their position every day, but–
Jake: That might be a good thing with the volatility in small-cap or in micro. It’s like you don’t want to see how the sausage is really made here.
Whit: I think it’s a very good thing and that’s why I try to write such long shareholder letters, is to communicate to investors, “Okay, the share price might not have changed over the last six months, but the value of our company has materially gone up.” And I really like how Nick Sleep and his letters does that. He articulated very well how the share price may not have changed, but here are the positive developments in the company over the last six months or a year.
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Tobias: Hey, Whit, we’ve come up on time. If folks want to follow along with what you’re doing or get in touch, how do they do that?
Whit: Yeah, I’m on Twitter. I believe it’s just Whit Huguley or RiverOaks-Capital.com. And that has my email address, Twitter account, LinkedIn and all that. So, it’s probably just easiest to go to my website.
Tobias: And, JT, if folks want to get in contact with you—
Jake: Don’t. [chuckles]
Tobias: Leave a comment under the YouTube video. Journalytic. Thanks, everybody. We’ll be back.
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