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June 24, 2021

Source: Ben Graham Centre for Value Investing Newsletter - June 2021

Hardev Bains is the President and Portfolio  Manager of Lionridge Capital Management.  Hardev spoke with Ben Graham  Centre’s Newsletter about his experience being a  value investor.

What has been the single greatest key to  Lionridge’s success? 

I guess first of all the question is if there is one  single thing. I would say one of the factors is the  firm itself was entirely built around a single  philosophy. As opposed to investment sales  organizations that are always coming up with  different things that are sellable, we just stick to one  thing. So we specialize in something I have a lot of  conviction in.  

Another success factor is being an independent  firm. That gives me and the firm independence to  practice value investing in a very pure way which is  not always easy to do. The institutional  environment you are in can put constraints on how  you manage money, especially if you want to be a  contrarian of sorts, having the independence to do  that is a big advantage. 

You had a variety of experiences in banking  and law before you founded Lionridge. What made you want to pursue this  entrepreneurial venture? 

Well, the entrepreneurial side came from a lot of  my experiences where I dealt with entrepreneurs  and I also worked for one entrepreneur in particular.  I just found that whole thing very inspiring of taking  something where you know you can do well, or that  you think is a useful service/product to provide and  then building something with that. So it was really  a combination of being inspired by entrepreneurs that I had observed or studied or worked for and  then also being committed to value investing and  wanting to do it in a pure environment. 

“The institutional environment  you are in can put constraints on  how you manage money,  especially if you want to be a  contrarian of sorts, having the  independence to do that is a big  advantage.” 

You have had a career in finance spanning  all the way back to 1994, including  experience at AIC. What are some of the  key lessons you took away from that  experience that you’ve applied now at  Lionridge? 

Going back to the entire finance experience, one of  the key lessons is – and this just sort of comes if  you’re in any industry or if you’ve been in the  business world long enough – in this world you have  to be very skeptical of the information people  provide you with. You really have to question  sources, question biases and motivations of the  people or organizations providing information, and  just don’t take everything at face value. Also, in a  different aspect of finance, one thing I’ve taken  from that is that risk management is really a crucial element to any form of managing assets whether  it’s business or investment assets. Really having a  focus on managing risk as well as creating and  growing profits is very important. 

“You really have to question  sources, question biases and  motivations of the people or  organizations providing information, and just don’t take  everything at face value.”

This question is from a student perspective.  You have spent part of your career in law  and on the corporate finance side before  going into investment management. I can  say for all of us that we are likely to start on  a similar path with the ultimate goal of  going into the management side. So, I was  wondering if you had any advice on those  early couple of years and what type of  mindset to approach them with? 

Well, I would say in the early couple of years, it’s  really important to get into a situation of being in a  professional or business setting and just learning  how to handle yourself, your time, and the work. 

And then prove yourself, demonstrate yourself to  be a reliable and levelheaded person. You’d asked  about my switch from law to finance. As a young person, it’s very good to be flexible and not get  locked into something just because you initially  pursued that. And not a lot of lawyers make a  switch into finance. When I was a young lawyer, I  really didn’t practice very long, but it did give me a  window into the finance world, which I found very  interesting. That’s what led me to just make a  wholesale shift and move into pursuing a career in  this field. 

Do you look up to or follow any investors,  both when you were young and up to now?  Amongst them who are your greatest  mentors and how have they impacted your  career? 

That’s a great question. And what’s interesting is I  came into investing solely because I got attracted  to the idea of value investing. It wasn’t the other  way around. I didn’t get into the investment world  and then find value investing. Now, I came into  finance without really knowing about value  investing. But I started in different areas of finance, initially in corporate finance and merchant banking.  This is going to sound very cliche but, I literally got  interested in this because I read an article about Buffett and I didn’t know much about him at the time – and I’m going back to the late nineties now. I read  about his approach and I found it very interesting. And I pursued it and started reading more. And  information was a lot harder to come by back then.  I remember I literally had to go downstairs in the  office complex I worked in and there was a  bookstore and I bought the Roger Lowenstein book on Buffett. And I read that over a weekend. Then I  had to go back to the bookstore, buy another. Now  of course you can get all kinds of neat stuff online.  That led me to value investing and reading up on  people like Warren Buffett. I used to go down to  Omaha for the annual meeting – I still go on  occasion but, for many years, I went every year – I  think I’ve been about 15 or 16 times, and you would  find a community of other value investors down  there. 

If I look at the list of people who’ve presented to  your class, I mean, frankly, it’s a little bit humbling  for me because a lot of them are the people I  looked up to and a few of them I’ve met and had  conversations with over the years. And it is very  useful to follow different value investors because  there’s different approaches within value too. I’m  going to talk about that a bit tonight as well. And  you always want to see what they’re doing and  follow the commentaries when they publish them.  

Many of the investors I’ve followed, and many  who’ve presented to your class, have written books.  I’m sure you’ve all read many of those books. And  a lot of them are good on a technical side of things.  A lot of them are very good on the anecdotal side  of things. But for young people like yourselves  getting ready to start your career, I would say one  book I would really recommend, and you probably  all know of it anyway, is Guy Spiers’ book (who’s  been a past presenter to your group). He really  gives some interesting lessons that he learned the  hard way on the realities of the finance world and the lessons he learned. I really recommend reading  his book. 

Other than that, is there any advice you  would have for students looking to enter  the financial services industry to set  themselves up for a good career? Also, what are some questions they should ask  themselves now to determine if this is the  right path for them? 

First of all, in terms of advice, if you’ve come to the  decision that this is what you want to pursue, you  have to be patient. Because the reality is if you  decide today that this is what you want to do, it’s  very unlikely that your first job is going to be in  value investing. And it’s not because you’re not  good enough to be in it, or it’s not that you don’t  know enough to come in at an entry level, but as  you will find out in a very frustrating way, if you do  want to pursue it, true value firms are few and far  between, and the reality of these businesses is that  they’re very scalable. 

So, once a firm’s got a team in place it’s not very  often that they need to add new people, it is not like  the investment banking world where every year  they bring in a certain number of people because  every year a certain number of people go out the  other door. My point being is, it’s unlikely that your  first job will be in value investing – I’m not saying  don’t pursue it, pursue it if it’s your passion, but just  getting out there in the work world in any kind of professional capacity is good experience itself in developing good habits and work ethic. 

Ideally, you can do anything involving financial  analysis, and that means it could be on the sell side or it could be buy-side elsewhere in a non-value  situation. It could be on the commercial banking  side, corporate banking side, credit analysis, it  could be within a company in a corporate financial  department, treasury department, there’s all kinds  of roles that can lead you to a spot with a value  investing firm. And you have to be patient and even  kind of creative. And in terms of starting to do your  own investment research, frankly, you’re already learning the basic concepts. 

If you’ve taken intro accounting, which I assume you all have, then you can work your way through  a financial statement. You can start following  companies on your own, even if you don’t have the  capital to invest in them, just doing it on your own  and finding ideas. Look at what other investors are  owning, do reverse engineering of their portfolios,  do all this stuff yourself. And then in the meantime,  start working on your CFA and then a lot of it is  being the right person at the right time, but the  more you spend time doing those things the better the odds you’re going to be the right person. If you’re truly committed, you make an effort to do the networking over time and meet people in the  industry, et cetera. And if you really want to do  value investing you will eventually do it. But your  first job probably won’t be in it, but don’t get  discouraged by that. 

This question revolves around candidates  who look to join your firm. What qualities  and skill sets do you look for in these  candidates? What are the common  mistakes first year analysts typically make? 

Well we don’t necessarily need someone who is  some finance superstar. In fact, the amount of pure finance theory someone has in their heads can  often work against them in terms of effective  investing. But we’re obviously looking for people  who seem bright, eager, have a good attitude, have  confidence, and have demonstrated ability. If you  have a commerce degree, there’s a level of  assumption that you can read financial statements  and be comfortable working with numbers, et  cetera. So a lot of it is really just attitude. Any kind  of evidence that a person’s got a good work ethic  and attitude and that sort of thing. Obviously, an  interest in the firm is key. And then again, a lot of it  is just timing. 

I get lots of really good people contacting me and  sending resumes on a regular basis. And any one  of them would be perfectly worthy. But if you don’t  have the spot, you don’t have the spot. And as I  was saying earlier, openings are few and far  between, but those are the basic attributes we  would want. I would imagine anyone coming out of  Ivey with the HBA is going to have those attributes  generally speaking. And in terms of mistakes, we  don’t really put analysts in a position where they  can make sort of big decisions that could cause big  mistakes. And so it depends on how you define mistake. Analysts will come up with ideas and  express opinions and I might not agree with them. But that’s not a mistake per se. If you want to use  the word mistake, I would say the biggest drawback  one sees in a new person out of school is they’re coming out loaded with a lot of theory that can be very focused on the science of it. 

There’s always a science to it – We’re based in  realities and the mathematics of the value of cash  flows and all that, but there’s an art to it too. It’s not  just art, but it certainly isn’t just science. So it’s not  like there’s magic formulas where you just plug in  data and they show you the investments to buy.  There’s a lot more nuance to it, again, developing  that nuance comes with time. 

We see a common theme in the investing  world nowadays of having really high  commission fees for capital management.  But Lionridge’s philosophy of zero  commission charges is unique in that way.  How has that come to be, and how has it  affected the fund throughout its life? 

First, I would say that I appreciate the extra credit, but it actually isn’t really that unique. The  investment management side tends to be  management fee-based as opposed to transaction commission-based. So in that sense we’re just  following the general industry norm in investment  management. But it is important nonetheless, the  fact that we don’t get paid for doing transactions creates a better alignment of interests with the  clients. 

I have no motivation to buy something or sell  something because that’s not how I make money. I  always tell clients, the only way I can increase my  revenues from any individual client is to either get  good enough returns that they want to give me  more money or grow the size of their money that  they have with me. And so I think they’re pretty happy with me having those kinds of incentive. 

“We’re based in realities and  the mathematics of the value of  cash flows and all that, but  there’s an art to it too. It’s not  just art, but it certainly isn’t just  science.”

Last April you noted in the middle of the big  April sell-off that the market was still  overvalued based on the metrics you look  at. Since then the market has not only  rebounded but surpassed pre-pandemic  levels. I wanted to get your take on this and  whether it has caused any difficulties in  finding opportunities for Lionridge? 

Absolutely. We went into the beginning of 2020  with quite a lot of cash, about 35%. I was very busy looking for opportunities but did not find a lot. I  came out of that with about 25% cash in late March.  So yes, I was able to put some money to work and  found some new opportunities but overall it wasn’t  like the equity markets were on sale by any means.  Since then, our cash has gone back up, firstly  because of a stock I turned around and sold in two  months because it went up 30%, which was  heartbreaking to me because I wanted to hold on  to this company for years. So I went back to 28%  very quickly. Then of course for the rest of the year,  the cash went down not because I was putting it to  work but because the market was going up. Due to  recent sales, we’re back up to about 30%. So that’s  been the dynamic.  

I don’t base my cash position on some kind of  estimate of what I think the markets worth, I am just  looking for profitable opportunities. I don’t care  what the markets are worth, if I could find the right  30 stocks I would be fully invested. So at the start  of 2020 when I was at 35% cash, it was not  because I had some magic formula. It was a  byproduct of the fact that we had been through a  bull market and I had been doing more selling than  buying. The fact that I had 35% cash was a  symptom of markets being high, but markets being  high weren’t a decision factor in me having that  much cash. 

Then we went through Q1 and it appeared to me  that by the end of March, as dramatically as the  markets had come down, they were still not cheap.  Maybe we went from being quite overvalued to a little overvalued. After that it was becoming even  more overvalued. You’ve probably heard from  many people that it’s been a tough while for value  investors… absolutely. The last couple of months  have been a lot better, but it certainly has been  hard to find opportunities. Evident through our cash  position. 

“If you understand the dynamics of investor psychology and are not subject to them,  that’s half the battle.” 

You mentioned that “this summer was a  great example of a common emotional  factor that drives bull markets – fear of  missing out (“FOMO”)”. Would you say  keeping discipline within this environment  is easier said than done / were there  moments of temptation within some  sectors that you thought were only  “modestly overvalued” during the initial  bear market? 

I personally don’t have an issue with it, but there’s  a couple of reasons for that. Firstly, it has to do with  my own temperament, I’m just kind of wired  differently. When things are going up, I get cautious, when things are going down, I get interested. I’m  not particularly disciplined in other areas of my life, but when it comes to investing I am. If you understand the dynamics of investor psychology  and are not subject to them, that’s half the battle. 

Going in the opposite direction, are there  any investments that you’ve missed over  the years and what have you learned from  them? 

For sure, it still happens, but you can’t beat yourself  up over those. In terms of lessons, just because  something may be a good idea and looks like a  value opportunity, if the company’s not in your  circle of competence and you can’t truly get your  head around the business story, what the  projections mean, what the company will look like  in 5-10 years – that’s a good reason not to buy. So  you take a pass, and the stock goes up, but you  can’t look in the rear-view mirror with regrets.  

The other lesson is that if you have to move on.  The worst thing you want to do is chase missed  opportunities. A lot of that comes with experience.  In the beginning you’re going to want to spend  more time on an idea, but with more experience  and judgement, you come to realize you don’t have  to understand 100% of the story, you can get to 75-80%, and you can more quickly make a decision.  

What I’ve learned is once you have the comfort  level, make the decision, don’t wait. Markets are  eventually efficient, and opportunities don’t last  forever. 

How do you recommend investors build  the discipline to delay investing when there  may be an external pressure to buy even  while opportunities are sparse? 

It’s easy to delay or avoid buying if you don’t have  any money (laughs). You all have the skillset to  take a stab at estimating intrinsic value. There’s  nothing really stopping you from doing that. But  over time you develop more confidence and  judgement on your valuation which really comes  with time. Even when you’re in a position where  you don’t have capital to deploy, you can still follow  companies, follow what other investors are doing,  and reverse engineer a list of what stocks you think  could be a good buy for different reasons. You can  kind of run a notional account on your own – nothings stopping you from doing that. 

“If the company’s not in your  circle of competence and you  can’t truly get your head around  the business story, what the  projections mean, what the  company will look like in 5-10  years – that’s a good reason not  to buy.”

Have there been any times where  maintaining a value focus (i.e. keeping 30%  in cash recently) has caused issues with  your investors? How have you dealt with  being one of the last few self-proclaimed  value investors in a world that increasingly  cares less about price? 

I wouldn’t say it’s all clients, but some clients. It  gets more frustrating too, because when you have  good clients even if they are loyal clients to you, they’re always getting approached by advisors and  brokers. And as soon as it comes up, you know, I’m  the guy with 30% cash, that gives our competitors  something to jump on. I would say, we have gotten many more clients than we’ve ever lost, so  something’s working. But it is a challenge, which is  why not a lot of people hold a lot of cash. 

We’ve seen a shift in assets under  management, from active strategies to  passive strategies in terms of ETFs and  things like that. How do you view that at  Lionridge and what impact do you think  that has on market efficiency? Do you think  that there may be an opportunity for value  investors to take advantage of? 

I think eventually it’ll provide opportunities. The  whole passive investing thing has also coincided  with more money coming into the equity markets.  That, plus a number of other factors, have inflated  asset values. So that’s made it more challenging for value investors in the past few years, but the  pendulum swings both ways. So I think the level of  money that’s coming into passive strategies will  also cause a lot more volatility swinging the other  way. It certainly doesn’t make markets more  efficient by having money going into passive  strategies. 

When I first started in the business in the late  nineties during the tech boom, one of the Canadian market darlings was a company called Nortel. Nortel had been around for a long time; it was this  boring company that made telephones and  telephone equipment and stuff. And then it got into  the whole tech boom and without getting into  details, it turned out to be a bit of a sham in terms  of their accounting and how they were showing  growth. But the point being is when that story  started getting legs, what happens in a country with  a shallow market like ours, where a lot of managers  had a passive strategies, suddenly when Nortel  goes from being a fraction to 1% of the index, they  all have to buy. And that pushes up the price higher.  

Then it’s 2% in the index. Now they all have to buy  more, et cetera. That’s what we saw last year with  Shopify. It’ll be interesting to see how that story  ends. That’s also what we saw with Valeant. 

My point is that I think the increase in passive  investing presents more inefficiencies in the  markets. Those inefficiencies are what gives  investors like me opportunities, but they don’t give  us opportunities all the time. Right now, those  inefficiencies have caused guys like me to pull some hair out or have my hair go more gray than it  was two years ago.  

Bringing up Valeant and these other  companies leads well to our next question,  which is how do you go about evaluating  management and for retail investors, what  are some tips for us to evaluate  management when we don’t have access to  a lot of the same tools that institutional  investors have? 

It’s a good point. First of all, regarding managers  who are spending time with management, there’s  nothing wrong with that, but the benefits of that can  be a little overblown. There’s actually an investor  psychology phenomenon where when investors do  meet with management, they might tend, just for that reason, to develop an overly positive view of  the management. When I used to work for a larger  company and spent more time going to  conferences and the like, and you would see these  people presenting and you could always get into  the conversations with them during the smaller  breakout sessions or informal coffee break  conversations. At these large companies, they’re  going to be very polished and also very controlled  about what they say, partly because of legalities.  They can’t just talk about anything because of  insider trading and regulatory rules. So the point  being, it’s very hard to tell, just from having a  conversation or a sit-down meeting in someone’s  office, that some person is a good manager.

But the kind of things that you can look at are  available to you. First of all, just look at what the  company’s done under current management over  the last number of years. Does it make sense?  Have they acted rational and are good capital  allocators? Are they people who are growing for the  sake of growing, or making moves just for the sake  of generating interest and pumping up the stock  price, as opposed to moves that are really good in  the long term for the shareholders. You obviously  want to avoid companies where the people running  it have a checkered past, which you can readily find  out these days. And the reality is when you’re  dealing with mid cap and large cap companies  those people are already under quite a bit of  scrutiny before they even get the job let alone while  they have it. So it’s really more involved in vetting  management with very small cap companies.  

I was wondering if there’s any geographies  where you found uncharacteristically high  returns or any geographies that going  forward, you’re very bullish on. 

That’s a great question. In terms of companies we  invest in, we tend to stick to those domiciled in  mature developed markets. I think that economic  opportunities are definitely still with the emerging  markets in terms of growth. What I don’t want to do,  and some managers do this, is to zero in on a given  emerging market and try to learn what are the best  local companies in that market and buy some of  those because many developing markets don’t  have the most reliable legal systems or the  

standards for accounting or high levels of market  integrity. What I do want to do is to find companies  that are located in established markets but are in a  good position to do business in those emerging  markets, are already doing business in them and  are well-positioned to grow their businesses in  them. So that’s how I look at global investing and  that can even be US or Canadian companies. 

There’s a million different ways to think  about risk. And you’ve mentioned  previously that one thing you’ll do is model  out the most conservative baseline of the  company. Is that one keyway that you  manage risk? And is there anything else  that you suggest we think about when  thinking about risk and an investment? 

Well, the first thing is what not to think about. Don’t  worry about short-term volatility in price. I don’t look  at that. In terms of risk management, I’m looking at  the inherent characteristics of the companies we  buy and what the risks are to the businesses.  Looking for companies that are well established  competitively, have a strong profitability, have good  balance sheets and are well-entrenched  competitively. 

And those stocks are going to tend to be less  volatile anyway, but that’s not a factor. So really, we’re looking at business risk of the companies.  What are the competitive threats, what’s going on  with the business, what are their end markets, what  are their substitutes? Do you guys in business school still talk about the Porter model of strategic  analysis? That’s useful stuff that’s more important  to me than anything I learned in the capital markets  theory. We look at the business risk and we look at  the financial risk of the company. Things such as  liquidity in the balance sheet, the access to capital,  the need to access capital. If a company’s business  plan is based on continuingly being able to issue  stock in the stock market, that’s a pretty risky  situation. I don’t want that. I want companies with  good balance sheets. 

“What I do want to do is to  find companies that are located  in established markets but are in a good position to do business in  those emerging markets, are  already doing business in them  and are well-positioned to grow  their businesses in them.” 

And then I’m also looking at valuation because  what you pay for a company versus what it could  be worth intrinsically is crucial. The best you can do  is kind of come up with a reasonable range of  valuation and then ask yourself, how does the  current price compare to that? And of course a big  factor of risk management is to make sure that the  price you’re paying is reasonable, no matter how  good the company is. That doesn’t mean it has to be cheap in terms of general, back of the envelope  kind of value metrics, but using a range of valuation  methods does the current price make sense? And  that gives you downside protection. 

I think that’s a good segue into the topic of investment philosophy. In past  conversations, you mentioned Buffett and  Ben Graham. They’re two different schools  of value investing. Deep value versus  quality companies. Has your investment  philosophy changed over time? I know one  that is rising is growth at a reasonable price.  Has your investment philosophy stayed  true to the characteristics that Ben Graham  talks about and do you still think that’s  relevant today? 

I have all the respect in the world for Ben Graham,  but I believe it may be difficult nowadays to  replicate what he did. That was at a time when he  had an information arbitrage, when they were just  companies trading at liquidation values or below  liquidation values. People weren’t paying attention  the way they would now. Those opportunities have  been arbitraged away in the market. So, it is more  difficult to do the Ben Graham kind of investing. And it comes with more risks. The term cigar butt  investing, I don’t know if you’ve come across that term, it’s not some great going concern business,  but it’s like some old cigar you found on the street  corner – there’s still a value because there’s 50  cents worth of puffs left in it and you can get it for a dime. The idea that you have a company and it  could be a declining company, but its assets are  worth X dollars and you can buy them for cents on  the dollar. Even if your analysis is right, you better  hope that by the time the company gets liquidated  that the asset value hasn’t eroded. I don’t even  know if you can really do that these days. I don’t  even try, but it’s more of a shotgun approach.  

So, you own a whole bunch of these because statistically, enough of them will do better. That’s  not our thing. And then there’s some approaches  that are much more quantitative. Where the  method is simply to buy the lowest bottom quintile  in terms of price to book or whatever, and own a  large number of companies and statistically they  will do better than the markets. That’s actually one  of the approaches that we studied when I was at  Ivey. We didn’t have your course. We didn’t have  Dr. Athanassakos, unfortunately. So that’s why it  took me a lot of years to actually get interested in  investing because of what we were taught and I’m  not slagging the school because so much of the  stuff we learned in finance was crucial and critical.  But I remember the one course we had in investing,  it was more of this quantitative stuff.  

I think I’m getting away from the question, but even  from the beginning, I understood there are  important takeaways from Ben Graham. As we talk  about those chapters 8 and 20, it’s more of the  perspective. First of all, the concept of Mr. Market  being a moody person. If you can take advantage  of Mr. Market’s mood, you can make money.  

Secondly, the whole idea of price versus value is a  relevant concept we learn from Graham. But I generally focus on going concern value as  opposed to liquidation value and I believe it’s a  lower-risk way to invest.  

What are some of the best things that we  can do as students to learn more about  value investing? Were there any kind of  resources that you came across that you  thought were really valuable when you  were studying this? 

Well there’s some good books to be read, like the  first book about Buffett. It’s by Roger Lowenstein,  that’s worth a good read. Snowball’s not bad either.  You’ve probably come across that one. That was  the later book that was written about him by Alice  Schroeder. Read Munger too. But read about  businesses too, and be interested in businesses.  Just study businesses, and coming from Ivey,  you’re already coming with a good grounding for business analysis. Ultimately, stocks are pieces of  businesses.