"Effective questioning brings insight, which fuels curiosity, which cultivates wisdom"
- Chip R. Bell
White Falcon’s due diligence on current and prospective investments involves meeting with management teams. With many corporations back to the office, your portfolio manager met 15 listed companies in Vancouver and Calgary. We meet management teams to get a deeper understanding of the business but to also get an appreciation of strategy, capital allocation, and importantly, company culture.
Over time, you realize that businesses are a sum of their people and culture. Most businesses consist of a group of people who come together to build a product or service and market it to sell and make a profit. Out of all these businesses, we are looking for a rare subset of businesses that have built a winning culture. A culture where management thinks in years and not quarters, a culture that prides itself on consistent execution, a culture where employees work hard but are treated well, and importantly, a culture with rationality and common sense embedded across the organization. Our most important task in meeting management teams is to recognize company culture.
In addition, meeting with company management’s help us in a few other ways:
Micro to Macro
A very common question we get is - what do you think about the market? What is happening with inflation? How high will rates go? When will markets bottom? Between the mumble jumble, our recurring response is ‘I don’t know’ and that ‘it's complicated’. It's not because your portfolio manager has commitment issues; but because, at any one time, there are often good bullish arguments for why the markets should go up but also equally good bearish rationale for why markets should go down.
We often take our macro clues from the micro. Talking to businesses helps us understand ground realities. As an example, the consensus among businesses that we met was around easing supply chain pressures, falling input/commodity prices but increasing pressures on employee retention and compensation. This may mean that while near term inflation is falling, longer term inflation may not fall back to Fed’s 2% target as the labor market is tight and wages are rising.
Importantly, most businesses cited a healthy demand environment. Good businesses are able to increase prices to their end consumers. While Wall Street is worried about future earnings, it is likely that competitively advantaged businesses are able to pass on the price increase due to which earnings actually rise on a nominal basis. These higher nominal earnings may be a positive surprise for the market. Importantly, as is the case in many inflationary emerging markets, businesses in good industry structures may not be keen to pass price reductions to their consumers which will help margins.
Nothing compares to leaving the desk and talking to people! Oil and Gas has been the only sector to have positive market performance this year. White Falcon, unfortunately, has been underweight in the sector. While all energy companies are making supernormal profits and trade at relatively low multiples, the key question one needs to answer to invest in the sector is if these earnings are sustainable. The sustainability of these earnings depends on the price of oil as well as the cost controls instituted by these energy companies.
In Calgary, we learnt that many public companies are not growing production because they currently do not have a ‘license’ to grow. Shareholders have asked management teams to prioritize cash returns with debt paydowns, dividends, and buybacks. In addition, high inflation/shortage in equipment and labor has meant that energy companies have had to do more with less. Due to pressures on both capital and operating expenditures, supply of oil and gas is unlikely to grow meaningfully in the near term. While investors focus excessively on demand, we believe that supply dynamics in the oil and gas industry will be very relevant to returns over the next decade. We are carefully watching companies with low marginal costs, long reserve life and superior cultures in order to build a more meaningful position in the sector.
In investment management, one of the most important tasks for the portfolio manager is to build conviction. This conviction is what allows one to hold and, importantly, add to their investments when other investors are capitulating.
"In theory there is no difference between theory and practice - in practice there is"
- Yogi Berra
In theory, investing is simple. Study a business and understand the its key drivers. Using these drivers, calculate the cash flows this business will produce in perpetuity and discount it back to the present to ascertain its intrinsic value. Then, buy the stock when it is trading below this value and sell the stock when it is trading above this value.
In practice, investing is very nuanced. Price drives sentiment. When market prices decline, one inevitably questions all the assumptions that went into calculating the intrinsic value of the business. In tough times, an understanding of the management’s strategy, its execution capabilities as well as the culture of the company can be the difference between having the conviction to hold or dispose of an investment. This knowledge is built by meeting management, asking questions that are relevant to understanding the inner workings of the business, and comparing the performance of the business against their answers.
As an example, we own a position in Aritzia. We have followed the company and talked to management multiple times but, this time, in Vancouver, we had an opportunity to tour their facility and see the business in action. With this, we had a renewed appreciation for the detail oriented culture of the company. This culture, which comes directly from the founder, plays a key part in Aritzia delighting consumers with their everyday luxury strategy. On the other hand, this culture also means that they cannot open stores any faster in the US (which is a big part of our thesis). Conviction in this company and its future trajectory allowed us to add to the position in June and July (reducing our average cost to C$36.38 per share) as the stock was under pressure.
It is important to mention that there are also a few downsides to meeting management teams. First, we know that a lot of CEO’s are intelligent and charismatic individuals - otherwise they wouldn't have risen to the top of the corporate ladder. It is easy to be influenced by them. Second, as long term investors we tend to own investments for many years. During this time, it is easy to develop a friendly relationship with management that can color one’s rational view of the investment. Your portfolio manager, having met hundred's of management teams over his career, recognizes these shortcomings and tries to factor this into the eventual decision making.
In conclusion, meeting management teams is an integral part of our research process. We always come back with a list of businesses that we understand a little better than we did before. Importantly, it helps us understand ground realities, provides us market intelligence, and assists us in building conviction.
Disclosure: White Falcon has a position in Aritzia. None of the above is investment advice and we can be wrong in our work. Everyone should do their own work to come to their own conclusions.