Oaktree's decision to sell itself does a disservice to minority shareholders.

I generally endeavour to follow Mr. Buffet's recommendation that we "praise by name, and criticise by category". However, in this post I shall knowingly disregard this advice. This is because I feel  particularly strongly about this matter.

I have been a shareholder in Oaktree Capital Management for over a year now. There were a few reasons I chose to make an investment in the company. The most important ones are outlined below:

A. I thought Oaktree was a good quality business:

1. Good quality, trustworthy management with long-term orientation.
2. Good investment return track-record and cautious approach to investing.
3. Serious focus on its philosophy and fiduciary responsibility.
4. 1, 2, and 3 make it a leader in distressed debt investing. 
5. 'Firms', 'Capital', and 'Credit' will always exist in some form.

B. I thought Oaktree was undervalued:

In recent years, as the financial markets have rebounded after the Great Financial Crisis, and achieved new highs, Oaktree has been able to exit positions and 'book' returns. However, as optimism has increased, the number of bargains has fallen. Hence, Oaktree has been unable to redeploy all of this capital. Consequently, they have returned money to some investors in the funds, or have chosen not to raise capital. The 'reduced' AUM, and unavailability of bargains has resulted in lower management - and performance fees. Consequently, earnings of the management company have been low.  

As and when the next crisis occurs, Oaktree's reputation will enable it to raise capital, and the circumstances will present bargains. Thus, as the markets recover, Oaktree would - again -  be able to deliver strong financial performance to its investors. This in turn would enable Oaktree - the management company - to generate greater profits. At least, that is the business story Mr. Marks and his firm have long presented.

As of today, my thesis for Oaktree Capital Management remains largely unchanged. Thus, I am confused by Oaktree's sudden decision to sell itself. Firstly, I fail to understand why you would sell the company at a time when earnings are lower than they will likely be in the future. Oaktree itself says that "[its IPO] has not been a great success. Maybe [we] are not suited for public ownership." It is difficult for me to swallow that a firm full of long-term value investors has chosen to judge how much the market likes asset management firms within a six-year 'long' time period since its IPO. Furthermore, it is my view that the firm should not sell itself simply because the stock has not performed well. Moreover, this statement by Oaktree's management, that Oaktree is undervalued provides proof that the 'premium' to market value paid by Brookfield is meaningless. Also, in selling itself to Brookfield, which is itself listed, Oaktree doesn't necessarily resolve this issue; perhaps Oaktree is simply hunting for excuses for selling itself. Secondly, I feel cheated by the fact that Oaktree's management will continue to own and operate the company independently. When I initially purchased my stake, internal ownership gave me confidence that I was in the same position as Mr. Marks. Now I find that is not quite true. I am able to understand why Brookfield may insist on the managers' owning a stake in Oaktree. However, this raises concerns over the conflict of interest facing Oaktree's executives: by selling the public's shares at a discount to fair value, Oaktree could secure a better price for its managers in the future. This would directly place management's interests before those of the minority public unitholders. 

I am sure that Oaktree has the legal grounds for their actions. Yet, Mr. Marks and his team are wrong to sell. They were certainly not capable of negotiating the best possible deal to benefit minority public unitholders, who do not have significant voting rights.  I have suffered a great personal loss - lost a role-model - if Mr. Marks has chosen to place his personal interest above what is morally right. Thus, I should be delighted if Mr. Marks were to directly address these concerns in an explicit manner. Perhaps he could start by publicising the terms of his future liquidation. Otherwise, people should take note; if Mr. Marks' firm is willing to put itself above minority shareholders, someday Oaktree will be willing to place itself above investors too.

A reflection on the importance of probability, outcome, and expected return.

Why probability alone is useless, the challenges posed by tail outcomes, and our inability to determine distributions.

It’s All About Expected Return

I am currently reading Nassim Taleb’s Fooled By Randomness. Early on, Taleb makes an important distinction between probabilities, and expected returns. This is particularly key when there is an asymmetric distribution of outcomes. 

Here is a brief summary of Taleb’s example. Taleb considers the stock market. For the purposes of the example, say there is a 70% chance the market (index) will go up, and a 30% chance the market will go down. Using these probabilities - without considering the outcomes - we would arrive at the conclusion that one ought to invest in the index. Now let us take the same odds, and attach outcomes to each probability; there is a 70% probability that the market will go up by 1, and a 30% probability that the market will go down by 10. In the following table, expected return is calculated:

Probability	Outcome	Expected returns
70%	1	0.7
30%	-10	-3
	Total expected return:	-2.3

The expected return is -2.3, suggesting that it would be wiser to short the index. This is because if I were to make this decision - in the same theoretical conditions - an infinite number of times, I would only be able to generate a positive return by doing this.

Low Probabilities and Finite Deaths

Whilst I have just used Taleb’s example to show that expected return is a more useful metric than probability, I must strike a cautionary note. This is because in reality, we do not always have the ability to repeatedly make the low probability bet in this example. In effect, it is possible for you to make decisions that are correct on an “expected return” basis and still suffer an “unacceptable outcome”. This is because we can only make a finite number of ‘bets’. If the more likely outcome were to occur in each of your ‘bets' you could lose all capital. This would be a finite death. Thus, perhaps it is best to invest only when the probability and expected return are both in your favour.

We have now discussed how investing solely in low probability events that can be justified on an expected return basis could result in an indigestible outcome. However, it must be said that ignoring tail risks (of very low P) that have a great magnitude could have equally - if not more - devastating consequences. In my post about Confidence Game, I distinguish between improbability and impossibility. This is an important distinction, because events with very low probabilities can produce unacceptable outcomes when they do occur. 

Effectively, it is important to consider low probability events in a careful, balanced manner as they may be associated with unacceptable outcomes.

Imagining Odds and Outcomes

In the example Taleb refers to, there are two definite probabilities, and two specific outcomes. This serves the purpose of illustration; however, assuming that things are as easily predicted in reality, would be a grave mistake. 

In reality, we must begin by coming up with a range of outcomes. This itself is very challenging. Now, after we have determined a range of outcomes, it is important to attach a probability to each outcome. It is very difficult to attach accurate probabilities. People normally overestimate the amount by which things will change in a year, and underestimate the magnitude of change that can be achieved through slow, steady progress in a decade. This is just one systematic error we are prone to making. 

Imagining the outcomes, and then attaching probabilities to these outcomes is an art form. It must be undertaken with diligence, caution, and an awareness of the difficulty of the task. Investing does not reward ‘accuracy’ - indeed some say this is impossible. Instead, it pays you for (i) being right about the ‘story’ of a business, and (ii) seeking a margin of safety.

Value vs. Growth

Investing is often divided into value investing and growth investing. This is wrong.

Value investors “believe” in buying assets for less than they are worth today. Growth investors “believe” that investing in fast-growing companies is more important than investing in companies at a discount to real value.

Both schools of thought have some merit; you must own businesses which are trading below what they are worth to be able to generate any return. It is also important to own businesses which will, at the very least, exist in the future, if not grow, if you want to be able to generate returns over long time-periods. 

Indeed, as Howard Marks says, ‘All investors try to buy value – that is, to buy something for less than it’ll turn out to be worth’. One might say that Value investors are focussed on the present and can’t help having to deal with the future, whereas Growth investors are focussed on the future, and are compelled to consider the present. Marks believes that the choice isn’t one of value vs. growth but one of “value today” vs. “value tomorrow”. 

Principle 6

This is a continuation of my reflections on 'Factfulness' by Hans Rosling. Whilst I finished reading the book almost a year ago, I was unable to complete my series of posts. Through these posts, I am attempting to draw principles which are applicable to the world of investing, from the eye-opening book.

The Size Instinct 

Learning 1: The Size Instinct and Noises.

In Factfulness, Rosling says that by "Paying too much attention to the individual visible victim rather than the numbers can lead us to spend all our resources on a fraction of the problem." He also says that "We tend to assume that all the items on a list are equally important, but usually just a few of them are more important than all the others put together."

In today's world, there is an unprecedented level of access to information. In some sense, this should make investing harder. Theoretically, as more information is readily available in the public domain, the market value should converge to the fair value more quickly; hence, there are fewer market inefficiencies that can be exploited. Whilst this has occurred, the above description of the efficiency resulting from easy access to information is not complete. This is because with our unprecedented levels of access to information we have also gained an unprecedented level of access to noise. 

Thus, it is very important not to be non-discriminatory when we are trying to follow current events. Indeed, several newspapers print over twenty pages every day. They simply do not have the time to produce high-quality, balanced, in-depth analyses every day. Instead, some print eye-catching headlines, and produce superficial and provocative recounts of ongoing events. Whilst these stories may be entertaining, they elevate these noises to a pedestal of significance. Hence, reading these stories could lead you to make poorer investment decisions. So, be more discriminatory when you are reading, and choose your sources of information carefully. That way, you will be better able to keep things in proportion and focus on those things that are really important. As a solution, Hans Rosling suggests the 80/20 rule; the idea is that one should focus on trying to understand those 'items on a list', that account for 80% of the total. 

Whilst we must strive to filter through the noise, I must strike a cautionary note. We must remember that our pre-existing views and biases may influence our classification of "noise". Indeed, this could be dangerous as it may lead you to ignore literature which would force you to test - and defend - your perspective. Thus, it is important to actively seek out literature and people with an alternative views. This will likely help you make better investment decisions.

Learning 2: The Size Instinct and Market size.

Rosling states that "The world cannot be understood without numbers. And it cannot be understood with numbers alone." This is certainly true in the investment world. Indeed, several fundamental value investors would argue that "investing is more art than science". This is because it is about "Narrative and Numbers"; any numbers we use in a financial model are the output of assumptions, which must be set in a story. Whilst numbers are very important, using just numbers can lead you to make grave mistakes in valuation. For example, you may say that because a company has grown at 15% p.a. it will continue to do so. However, if you have not thought carefully about your story, you may forget to account for the capital expenditure needed to produce that growth. Or, you may say that a company (in the USA) , which has been growing at 60% p.a. , will grow at 6% to perpetuity. To do this you would have to fail to realise that this would mean that it would account for the entirety of the US economy - which grows at roughly 3% - at some point in the future. 

We have said that numbers are very useful; however, some types of numbers are more useful than others. Indeed, Rosling says that "Amounts and rates tell very different stories," and that "Rates are more meaningful". Whilst this may not necessarily be true in all circumstances, it is true for investing. Even value investing, which is about 'present' value, can't help dealing with the future. Thus, before one decides what a company is worth, one must try to determine its future: "What is happening to the market as whole? Within this market, how is this company's market share going to change? "  Present market share - whilst it is still important - is less important than future marketshare. How the environment in which a firm operates is changing is of utmost importance. This is because, as I have said before, understanding structural changes in an industry offers opportunities, or - at the very least - helps avoid losses. 

Thus, when you are next using numbers, make sure to (i) base them on a story; and (ii) try to use rates and changes as opposed to absolute quantities.

Facebook: Why it may be a BUY!!

I have decided to initiate a long position in Facebook. Facebook stock has fallen dramatically in price over the last few months. This precipitous fall can be largely attributed to an escalating scandal around Facebook’s alleged mismanagement of user data, concern about the effects of this ‘breach of trust’ on user engagement, and fear of a brewing regulatory backlash against Facebook’s business model. In this post, I will attempt to evaluate some of the significant risks in Facebook, and then explore why I think it is a buy. There are two questions to consider: (i) Is it available cheap? and (ii) is it a good quality business?

Good Price?

Data scandal

There are a few reasons why the scandal - and ensuing concerns - may be overblown. Whilst I am not delusional enough to believe that Facebook is not at fault, I suspect that the extent to which it has mismanaged data is being exaggerated: a headline about how Facebook is selling your personal information will obviously attract more attention than a headline which says that some of Facebook’s practices could potentially be considered to be unethical. Indeed, I think that this scandal will pass. There are two reasons for that. Firstly, the rate at which people moved past the VW emissions scandal suggests that people have a tendency to be forgiving if companies resolve ethical issues. Thus, the impact of the data scandal on user engagement may be less significant than it is perceived to be - provided Facebook resolves issues. Secondly, any regulation arising from the data scandal will only benefit Facebook. It is likely that regulation will legitimise and entrench the data economy. Rules will make it harder for start-ups to enter the space occupied by Facebook (that is the space of a social network, which generates cash by selling targeted advertising products). 

Despite my confidence that the current scandal will not necessarily weaken Facebook’s hand, there are two reasons to be more reserved when one is dismissing the impacts of the data scandal. Firstly, Facebook, which - unlike VW - relied upon the network effect to build its platform, may be unwound by the same forces. Secondly, Facebook may be subject to steep fines for its misuse of data. 

Changing user habits

Whilst the scandal is certainly not to be ignored, as a long-term investor, I am more concerned about Facebook’s ability to retain and monetise user engagement across its different platforms. There are ‘shorter-term’, and longer-term concerns in this regard. 

In the short-term, as people are shifting from posts to (1) personal messaging, (2) stories, and (3) video content, Facebook must rapidly alter its business model. Facebook has already begun to address these issues - Facebook has started placing advertisements in Instagram’s stories feature, and has also launched IGTV (Instagram TV) so users can share video content. The success of these two changes is difficult to assess, but I am inclined to believe that Facebook can deal with these two changes (2 & 3). The shift to personal messaging is more concerning. I struggle to understand how Facebook will be able to deliver targeted advertisements without making people feel that their privacy is being invaded. However, there are at least two positives in this regard as well. Firstly, Facebook has an established personal messaging offering in WhatsApp (they have the users). Secondly, the monetisation of WeChat in China - which I do not fully understand - suggests that Facebook should be able to find a creative solution to this issue as well (they should be able to monetise this existing user base). Overall, I think that Facebook should be able to create more value, as it begins to monetise Instagram, and potentially WhatsApp. They will have to be careful not to over-advertise though, as this may put-off users.

In the longer term, there are two concerns I have. Firstly, with generational changes, people tend to move from one social network to another. For example, people moved from Facebook to Instagram, and may make another shift as time goes on. Thus, generational changes may pose a risk to Facebook: children may not want to use the same social networking platforms as their parents. Secondly, there may be a technological shift - a step change - in the way people share information. However, this is (i) probably very far in the future, and (ii) something Facebook will be able to adopt and adapt to - if it is not leading this change.

Management concerns

The mismanagement of people’s data raises questions about the company’s value system. This may be partly responsible for the decline in share price. However, there is reason for hope. Facebook - by reducing the number of polarising, and provocative posts - is watering down users’ feeds. The reduced availability of ‘juicy’ content could negatively impact user engagement. This may be evidence of Zuckerberg and co. sacrificing the short-term for the long-term. Getting rid of such content may indeed enable the company to grow in a more ‘clean’ manner. Thus, this helps to restore my confidence in Facebook’s management.

Overall
From a valuation perspective, whilst I have not tried to use a D.C.F model, I am fairly confident that Facebook is cheap. A high-growth company with substantial earnings is trading at only 19x P/E.

Good Quality Business?

If I am going to make a long-term investment, I want to buy a good quality business at a good price. So far, I have considered the challenges facing Facebook, and explained why I think that they are less significant than people might think. These factors are very important, as they explain why my view on the company is different to that of the current consensus - the risk-factors considered and my evaluations of these factors explain why I think Facebook may be available at a good price. But, if I am going to make a long-term investment, I must now decide whether it is a fundamentally good business. 

There are two reasons why I think Facebook is a good quality business. Whilst neither is particularly insightful, I think they provide a rudimentary base for thinking about Facebook. Firstly, Facebook’s platforms serve a fundamental purpose. People - being the social creatures they are - need to have a means to communicate with each other from afar, and companies must advertise in order to promote their offerings. Secondly, with a growing world population, rising amounts of free time and increasing internet penetration, the potential market is continuously expanding. Thus, I think Facebook is a good quality business.

Conclusion

I think that there is a range of possible futures for Facebook. I also think that amidst the flurry of recent bad news, people have become overly negative on Facebook. Facebook is not a risk-free investment by any means, and there is a chance that I am being over optimistic. But, I think that despite being challenged, it is a good long term investment. Indeed, it is made more so by the fact that they are investing capital in other projects as well (eg: Oculus, e-commerce). 

Facebook will test my emotional resilience in the time to come. I hope I will live up to the challenge.