Hiding in Plain Sight

Tom Macpherson

Camouflage is an incredibly interesting area of research. Most people think of it as a means to blend into the background making it harder to be seen. In most cases, one is looking to passively blend into the environment. Techniques such as color matching, disruptive coloration (similar to camouflage seen on WWII shipping), and seasonal alteration (white smocks for winter campaigning) represent this method. This area of camouflage represents the vast majority of peoples’ views on the topic.

What makes the concept of camouflage so interesting is that the previous examples are only half of the possible solution. In their own way, they represent a passive approach. Another way to create camouflage is to actively create confusion in the processing of vision-induced data. Here the aim is to provide a pattern that – when seen by the naked eye – creates conflicting thoughts in the mind of the observer. The right eye is in conflict with the left eye creating a breakdown in interpreting what one believes they are seeing.  An example of this is motion dazzling. A zebra is a great example of this technique. The bold white and black coloring – when seen at a high speed – creates confusion with predators over speed and direction. This difference between passively seeking to blend in versus an active creation of confusion can make the difference between life and death in the animal kingdom.

I bring this up because companies are often faced with a similar dichotomy. Some add value in un-sexy business lines like industrial parts supplies. In this field, Fastenal (FAST) is a company that blends into the general markets with its wide-moat business creating enormous free cash flow and high returns on equity, assets, and capital. These companies are hard to identify sometimes. Management is focused on running the business and uninterested in being on the cover of the Harvard Business Review. Their passive (and mostly unintentional) camouflage provides value investors an opportunity to scoop up gems after an awful lot of sifting.

Conversely, there are companies that actively seek to disorient investors with active camouflage efforts such as “great” marketing slogans (“Impossible is Nothing[1]”), nonsensical business descriptions, (“paradigm shifting”, “game-changing”, or my personal favorite “creating synergies”), and remarkably opaque financials such as off-balance sheet special purpose entities (SPE), inflating earnings (popular!), accelerating revenue recognition, and counting non-existent inventory.

What makes these companies so successful in the beginning is that their camouflage is quite effective. They are – for lack of a better term – financially engineered zebras (if you are tired of hunting unicorns, I suggest this type of proverbial big game hunting). Using Valeant Pharmaceuticals (VRX) as an example, the company created an entirely new model in drug discovery, development, and distribution. By purchasing generic drug manufacturers with products beyond their exclusivity date (e.g. generics) and products treating orphan (or therapies with less than 50K patients) diseases, they raised prices at breathtaking rates. Having convinced themselves their efforts were providing a better experience for patients and HCPs, VRX camouflaged its efforts as providing drugs at “fair prices”. Yet this form of passive camouflage (“no reason to look here…good drugs…good prices…move along) was combined with the more egregious active forms as well. The constant drumming of Valeant’s new business paradigm based on lack of business valuation (“we don’t invest in businesses, we invest in management”), lack of understanding the basic industry requirements (“R&D is a loser’s game”), and a warped financial[2]model. Like the proverbial squid squirting its ink in an attempt to confuse its predator, Valeant attempted to confuse investors with a host of active camouflage techniques. Alas, much like our squid that runs out of ink, Valeant ran out of ways to confuse its investors and the stock market in general.

The Art of Seeing Reality

For investors, the challenge is how to see companies for what they are, without being distracted by camouflage. I would suggest three (3) questions you should ask of any potential investment. While seeming quite general in their appearance, they are in fact questions that get to the root of any business’ long-term viability.

What does the company actually do?   

You might laugh at this, but there have been many companies where investors couldn’t answer this question. For instance, what was Enron’s business? Most knew it was an “asset light” model based in energy services, but beyond that most couldn’t make head nor tails what CEO Jeff Skilling was talking about on his conference calls. In almost every case, companies like Enron camouflage their actions as providing a “new paradigm” or “disintermediation” of traditional business models. In such examples, the company’s services add value to only one audience – themselves. In a study by Nintai Partners in 2011, we found the fewer the words needed to describe the business in general indicated a higher investment return.

How does the company make money?

Some companies have gone from cradle to grave not making a dollar in profit. Think of Pets.com. Others started out losing enormous amounts of cash but have built up into profitable businesses. Think Amazon. Then there are companies that don’t really make money but camouflage their chicanery through financial engineering.  You’d think it would be more difficult to hide this type of behavior with SEC reporting requirements and Wall Street analysts. But they rely on the ruse of the zebra – confusing the mind into believing they are an industry paradigm-shifting juggernaut. Think Enron.

How does the company add value to its customers?

Ask yourself whether the company adds value by providing answers to their clients’ most important issues. Not many great long-term investments’ strategy is to provide no value to their customer. Yet a company like this pops up every so often. Take a look at Valeant again. By raising prices by 1,000%, which of their customers received value from these actions? Patients? Doctors? Managed Care? The answer is it’s a very small list with one name – starting in V and ending in T.

Conclusions

The ability to use camouflage is both a benefit and a risk in the financial markets. On the good side, excellent companies (unless you are Berkshire Hathaway) generally find a way to keep their head down, focus on allocating capital, and growing the business. This passive form of letting the record speak for itself has made it possible to pick up some hidden gems over the years. Conversely, the ability to actively create camouflage can be used to deceive shareholders, confuse regulators, and fool the markets. By creating a simple process that cuts to the core of each potential investment can sometimes (but not always) assist you in avoiding the worst blow-ups. Otherwise you may fooled into thinking you are the predator when you are, in fact, the prey.

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DISCLOSURE: The Nintai Charitable Trust – which I used to manage – was a holder of FAST. I do not know its current status in their portfolio.

[1] We shouldn’t just poke fun at Adidas. Dr. Pepper’s slogan of “It’s Not for Women!” was perhaps the worst in a deep pool of candidates.

[2] Actually Valeant only wins the silver medal for healthcare financial innovation. In 2002, Elan Pharmaceuticals looked to capture all revenue from its products but place their respective R&D “off-budget”, moving it to a small joint venture holding company. It didn’t work for Enron, and it didn’t work for Elan.

 

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