Many great value investors have said that their ultimate test of whether or not to invest in a stock is to know the bearish argument better than the short sellers and why the bearish argument is flawed.
In that respect, I recently visited Joe Feshbach, who manages Joe Feshbach Partners, LLC, to chat about investing and to learn a thing or two. Joe and his brothers were some of the most renowned short sellers in the early '80s and '90s, so I was very intrigued when Joe opened a long-only fund focused on crisis investing.
I figured, who better to understand a company involved in a crisis or scandal than someone who spent decades on the short side? Here are some of the things I learned during our conversation.
An overcrowded trade
Feshbach got out of the short-selling game because it became too competitive. Two decades ago, there were few hedge funds and fewer short sellers. Nowadays, hedge funds are everywhere and the pickings are much slimmer.
Short sellers used to get positive rebates on the short proceeds -- this is because a short seller effectively borrows someone else's stock and sells it for cash in hopes that the stock price will fall. Then they can return the stock later at a lower price and pocket the difference. The cash from the short sale earns interest, and a portion is shared with the short seller, which means the cost of carry is positive.
Nowadays, so many short sellers clamor to borrow certain stocks that they actually have to pay to borrow shares -- the cost of carry is negative, often egregiously so. Furthermore, short-selling capital gains are taxed at short-term capital gains rates (typically 35%), whereas on the long side, long-term capital gains are taxed at roughly 15%.
Is value investing too cool now?
During the dot-com bubble, value investing was about as cool as bell-bottoms, and value-investing emperor Warren Buffett was labeled a dinosaur. Five or six years and one stock market crash later, value investing has become, well, just plain cool. In my opinion, there are more Buffett wanna-bes (my hand's in the air) and value-investing neophytes than ever before.
However, Feshbach sticks to one of the last bastions where substantial value can be found by going into scandalous or crisis situations. These are situations where companies might be suffering from government investigations, management turmoil, competitive threats, accounting scandals, and litigation. Oftentimes, other investors won't even look at a company like this because they'll decide it's out of their circle of competence, they don't have the stomach for it, or they don't know how to handicap the odds.
Dealing with hairy situations
Not only does Feshbach invest in companies that make other investors' stomachs turn, he also runs an extremely concentrated portfolio with five to 10 positions. In order to get comfortable with these seemingly ultra-risky positions, Feshbach does grassroots research -- he mentioned Phil Fisher's Common Stocks, Uncommon Profits as a great book to learn how to do 360-degree research -- and looks for strong cash flow, a strong competitive position, and most importantly, a situation where the bearish argument is based on misperception.
Overblown competitive threats
Tempur-Pedic (NYSE:TPX) is a stock Feshbach bought in the $11 range (it's currently at $26) after the market sold it off because of competitive fears. I remember being skeptical of Tempur-Pedic after the sell-off -- how can one get comfortable with a company selling mattresses that cost $1,000? Couldn't bigger competitors come in and crush it?
It turns out I was suffering from the same misperception as the general market, and as a result, I didn't even do any research to see if I was wrong. Feshbach, however, noted that when Tempur-Pedic's products faced incoming competition from other bedding manufacturers (other visco-elastic mattress manufacturers), Tempur-Pedic's sales actually went up, because customers could then compare Tempur-Pedic's products to the competitions and see the difference in quality.
Feshbach was also able to learn through industry research and talking to retailers how powerful Tempur-Pedic's brand actually is -- occupying a Nike-like (NYSE:NKE) position within its niche. Feshbach thinks that Tempur-Pedic's stock, which trades at a 9% free cash flow yield and is cheaper relative to competitors Sealy (NYSE:ZZ) and Select Comfort (NASDAQ:SCSS), has a very wide moat and still has substantial room to run.
More misperceptions
Some of Feshbach's other portfolio holdings are Jackson Hewitt (NYSE:JTX), Sirva (NYSE:SIR), and Comverse Technology. These stocks all follow the crisis investing mold because of accounting scandals, delistings and government investigations. The key is that Feshbach believes misperceptions have knocked the stocks of these companies too low. In Jackson Hewitt's case, Street analysts have mistakenly focused on a government investigation into a franchisee and slower unit growth and ignored substantial free cash flow, large buybacks, and a 2.5% dividend yield.
With relocation expert Sirva, accounting restatements, poor past risk management, and a deep housing downturn have masked a strong competitive position and a business capable of producing substantial profits. Comverse has suffered from options backdating and accounting restatement issues, which has obscured the fact that the competitive position is intact and the company has already taken restructuring steps to right the ship.
At the end of the day, the common theme is that Feshbach looks for opportunities where brushing the clouds and misperceptions away reveals solid businesses that generate hefty free cash flow.
Related Foolishness:
- Pabrai's Perspectives on Investing
- Pabrai's Perspectives on Investing: Part 2
- Value Investing Lessons From Centaur Capital
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool has a disclosure policy.
