My investing skills have improved exponentially since I started this journey as the After Dinner Investor in 2018. The skill growth is mostly due to the low starting point. Even though I could talk the talk pre-2018 as a value investor, I quickly learned that walking the walk is an entirely different thing, and it basically means nothing if you make the right noises about intrinsic value, discounted cash flow, moats, etc. What matters is how you think and what you do. And the best way to improve your investing skills is to think about investing, and to do investing, and to think and do things correctly. Real world experience is where the skill improvement comes from.
So I’m learning a lot all of the time. And one thing I’ve learned recently, is that there is a holy grail of investing, there is indeed a perfect type of investment. It doesn’t matter if it’s a stock, a bond, real estate, or something else, the perfect investments are asymmetric bets. They are bets where your downside is limited and you know what that downside is, while your upside is large. It’s not complicated, it’s as simple as it sounds. But being able to differentiate between good investment ideas and perfect investment ideas is the trick, that’s where the magic is.
Good versus perfect
Good investment ideas and perfect investment ideas look similar. Every time you invest you want to have a margin of safety and some upside. That’s value investing 101. But often times the margin of safety is smaller than we think it is. The brand isn’t as strong as we think, the real estate isn’t as valuable, the product is not as sticky, etc. This is why investing is difficult. Our natural bias is towards action. We want to find investing ideas. So we end up making too many purchases of merely good ideas and we fail to be patient and load up on the perfect ideas. Because the good investments will look like the perfect investments (because they have the same basics, like margin of safety, moat, and upside) it makes it tough to either realize you found a perfect investment idea if you’re too cautious, or for other personality types who are less risk-averse, to be patient enough to wait for the perfect ideas and instead you fool yourself into loading up on good investment ideas that you think are perfect ideas.
Good looks like perfect, that’s what makes things difficult.
But perfect is different. With perfect investments, the downside is smaller than the good investments, and it is also more defined and you have a higher confidence level in your understanding of the very limited downside. And on the upside, with perfect investments the upside is much larger than the upside you get from good investments. Good and perfect investments have the same basic outline, but it’s the degree of downside, confidence levels, and upside that separate perfect investments from good investments.
Very limited, understood downside and huge potential upside
With perfect investment ideas the downside is very limited, and it is confidently understood. And the upside potential is huge.
I have a great example of a perfect investment.
The Dillard’s investment by Ted Weschler comes to mind. Sometime, likely in 2020, Weschler began buying Dillard’s stock. By September 29th, he crossed the 5% threshold and showed up in a 13G. He likely paid $25 to $30 a share. Call it $30. Today, Dillard’s is at $360, and in December they’re going to pay a $15 special dividend. With the special dividend and capital return to date, he is likely at a 12 to 13 bagger, in less than two years’ time. Weschler’s investment in Dillard’s was a perfect investment.
It was perfect not just because of the result, but because of the situation. In the third quarter of 2020, Dillard’s had 22 millions shares outstanding. At $30 a share, that’s a market cap of $660 million. Net debt was $561 million, but tangible book value per share was $63, double the share price. So despite the net debt, Dillard’s was selling for less than half of tangible book value. Why? I believe it was the real estate. On the books, after depreciation, the gross property, plant & equipment was at $1.4 billion. According to their 2019 annual report, for the fiscal year ending February 1, 2020, Dillard’s owned “approximately 43.7 million square feet” of store space across 285 stores in 29 states. That’s on page 10. Then on page F-10 they say, “Property and equipment owned by the Company is stated at cost, which includes related interest costs incurred during periods of construction, less accumulated depreciation and amortization.” This all makes me think that the after depreciation and on the books at cost real estate, property, plant & equipment, is worth way more than the stated $1.4 billion. The stores they own, the 43.7 million square feet, was very likely bought at prices way less than they’re worth today, and just because depreciation is on the books, it doesn’t mean those properties depreciated in real world value.
Also on F-10, they talk about recent property sales, “During fiscal 2019, the Company received cash proceeds of $30.6 million and realized a gain of $20.3 million primarily related to the sale of six store properties.” That sentence shows that two thirds of the sale value were gains, so it does look like the properties are worth more than book value. Who knows if those six stores represent the average value of the other 285. Likely not, as they might have sold some of their worst performing stores and least valuable properties? Who knows.
And you can also do a Seritage-like valuation of the 43.7 million square feet they own. Let’s say they can rent that square footage at $14 a foot (conservative), assuming the costs it takes to redevelop some of the properties. $14 a foot times 43.7 million square feet = $611 million, times roughly a 50% net operating income (NOI) margin, that gives you $300 million as the annual NOI . Give it a conservative 10% cap rate, we’re looking $3 billion in real estate value.
How accurate is all that? I don’t know. My point is that I think the owned real estate was the margin of safety. Even if Dillard’s business model had been broken by the pandemic and they were forced to close down permanently (like the market seemed to fear in 2020), they still had way more real estate than debt. Whether you take the price on the books of $1.4 billion minus the $561 million of net debt, and you’re looking at a tangible book value of $800 million versus the market cap of $660 million, or if you take the rosier, but still likely conservative, Seritage-like approach, valuing the real estate after net debt at around $2.4 billion, either way, you’ve got a big margin of safety because you’re buying that owned real estate net of the debt for less than it is worth.
What about the income statement and cash flow?
But Dillard’s also makes money and has cash flow. This is where the upside of the investment comes from. Dillard’s has cash flowed from operations every year in the last ten years, including during the pandemic. And their operating cash flow minus their capital expenditures has ranged from $400 million to $200 million in recent years. They make money at what they do and they seem to produce free cash flow. They also seem to have a culture of buying back stock, buying back more than $100 million a year (and sometimes much more) in each of the last ten years. Sure, their revenue is flat for ten years basically, and no, it’s not a long-term grower, but sales are steady, they make money at what they do, they produce free cash flow, and they buy back stock.
Let’s say during 2020 you were conservative and said that the pandemic would halve their free cash flow from $200 to $100 million going forward. What should steady, well-managed free cash flow of $100 million a year be worth? I don’t know. Eight times free cash flow? Ten times free cash flow? Let’s call it ten. Now you’re looking at a $1 billion valuation on the free cash flow, $400 million if you factor in the net debt, but that wouldn’t account for the owned real estate at all, so if say the real estate is worth the $1.4 billion book value, now you’re looking at $800 million of real estate after net debt, plus $1 billion of free cash flow valuation, for a combined value of $1.8 billion. And that’s the downside if you thought they could stay in business even if they would be damaged by the pandemic, losing half their free cash flow.
The upside in reality has been much higher. Sales dipped in 2020 from $6 billion to $4 billion, but now they’re back up to $6 billion. They’ve continued to buy back stock. In the past twelve months, cash flow from operations minus capital expenditures is way up, they’re paying out a $15 special dividend, and of course the stock price has come way, way up because they are going to stay in business, sales are back up, margins are up, and I guess Mr. Market likes the buybacks and the way that the management is running the business.
Putting it together
This wasn’t just heads I win, tails I lose a little bit. This was more like heads I win huge because the real estate net of the debt is undervalued currently and they’re likely going to stay in business and that free cash flow has to be valued at something, and tails I don’t lose at all because the real estate net of debt that I’m buying is worth more than the purchase price. The upside was huge, and the more importantly, the downside was limited-to-almost-nothing and it was clearly defined and knowable.
What a home run investment.
Because the upside was big, and because the downside was limited or almost nothing and very knowable, this was a perfect investment.
My biggest investment mistake
I remember sitting at my desk in 2020. At the time (and still as a write this), I was a Seritage shareholder. I had the thought, “I wonder what other retail companies are sitting on a hidden treasure chest of real estate?” And I did some digging, and there I was, staring at page 10 of their 2019 annual report, looking at their properties and how much square feet they owned. It was right in front of me, I understood the basic concept behind an investment like this, but I didn’t keep digging, and for whatever reason I moved on. I also missed the Weschler filing when it came out, and didn’t see it until months later. I will not make either of those mistakes again. I will always take the concept of one investment, like Seritage’s real estate, and see if any other companies have that situation going on, and I am now no longer simply a shameless cloner, but also an intense and ferocious cloner as well.
Missing this 10 bagger (at least) in Dillard’s has been my biggest investing mistake. Before Dillard’s, my biggest investment mistake was losing 20% of my portfolio when Gulfport Energy went bankrupt, but the sin of commission is a greater loss than the sin of commission in this case, and I learned a lot from both mistakes.
One final note is that these perfect investments, when the upside is big, and the downside is limited, understood, and sometimes like with Dillard’s, not really even there, are rare. When you find one of these asymmetric bets where you can gain a lot and lose only a little or nothing, you’ve got to load up. If I had bet 5% or 10% on Dillard’s it would have been a nice win, but I’m not looking for nice wins. I’m looking for huge payoffs and life changers. I think asymmetric, perfect bets, at least for me, call for 20% to 30% to possibly larger bet sizes. If your judgement is correct, then you’ll know what your downside is, and when you know the downside, then the risk is really low, despite the large bet size.
Ted Weschler made the perfect investment with his Dillard’s bet. And lucky for us, it was also the perfect learning opportunity.