Peter Kennan On His Philosophy To Deep Value Investing With A Corporate Finance Twist

If I get an idea, I’ll start on Bloomberg using the ‘FA’ function and look at the latest set of results. Sometimes, I’ll read a brokerage report, just to make sure I’ve got the numbers right. Then I’ll try and construct a general thesis with valuation. I’ll look at the upside, what’s the risk, what are the potential events, etc. Depending upon the situation, the next step might be a call to management or, more likely, contact independent experts and other external sources.

How would you describe the “uniqueness” of your investing strategy?

PK: It’s the corporate finance aspect that is unique. In Asia, just buying and waiting does not work. You could be waiting for ten years or more, and your investors will lose patience. Many of the investors I speak with are very skeptical of the “buy and wait” strategy in Asia. The central component of the strategy, the part that pulls it all together is the event aspect. It’s not your typical investment catalyst or event. It’s a corporate finance process, and you have to have a high level of confidence that it’s going to happen. I like a situation where I am going to be right, or wrong. The ones that are trickier are the ones where the timing of the events is less clear. I like the situation to break one way or another. I like to see a potential end to a situation. I also like to have the size of the company such that we can become one of the biggest shareholders. I can then have better control over the outcomes.

Do you think there are sectors or industries right now in the market that offer outsized returns over the long term?

PK: Our horizon is two to three years, so we’re looking to get involved in a company at a particular turning point in its life as opposed to through the cycle. Having said that, I think it’s far safer if we are involved in industries that have reasonable returns through the cycle. For instance, offshore vessels do have (and have had) attractive returns on capital compared to commodity shipping, which never has.

Personally, I feel commodity shipping is difficult just because you’re still in an industry that has poor supply control and has historically not had attractive returns. That’s a bad starting point unless you’re buying below steel value and you’re going to liquidate the company, scrap the vessels and collect the cash. We often invest in out of favor sectors. At the moment, we have mining equipment, and we have offshore vessels. So we do have a commodity element, but not straight commodity plays. The good thing about mining equipment is, the miners just have to keep mining. The equipment eventually wears out, and there’s only one material supplier which is Caterpillar.

Similarly, with offshore vessels, there’s a correlation with oil and gas prices. However, you don’t have full exposure to oil and gas. We have a company that’s in the rubber industry, and the cyclicality has caused that to become a great opportunity. They are building a business, and they’ll end up the largest rubber company in the world where they’ll supply 30% of the rubber to the major tire companies. They will become a professional supply chain business. The rubber industry has never had that. The rubber industry has always been full of various layers to the supply chain owned by different people and everybody punting the rubber price. They are driving industry change, so it’s an interesting situation around that particular industry. The cyclicality has created an attractive entry point opportunity.

How would you describe your value discipline once you find a company worthy of investment?

PK: The primary thesis is to limit the downside. If I’m wrong I don’t lose much — it’s a “heads I win, tails I don’t lose too much” philosophy. On the upside, we’re looking typically to invest at half of fundamental value. At the moment, we’ve got a bunch of things in our portfolio that are much cheaper than that with around 3-4x upside. However, 1x upside is sufficient. Even a little less if it’s very safe. We expect to realize value over a two to three-year timeframe. And if it happens to be three years, that’s 33% gross IRR. That’s our target return. So anything with a 20-30% valuation discrepancy, I’m not interested. It’s just not enough.

Regarding position size, I try not to differentiate too much at the get-go. A 10% position is a standard position for us. If it’s very compelling, meaning there are some short-term events, I might go to 15% on day one. I much prefer to have eight A-Class positions than have thirteen positions where I’ve got three or four B-Class positions in there. And then what happens is interesting because typically one company will go through an event by itself and nothing else will happen in the portfolio. When an event happens all of a sudden a 10% position can be 20% of the portfolio. And the effect can be magnified if I have a 4% or 5% position due to a price decline, and I buy more to go back to a 10% position. If the price just goes back to its original investment price, we’re quickly at 20%. At the moment, we have three positions at ~20% of the portfolio and some that are 8-10%.

As far as your position sizing goes, with the 10% position you mentioned earlier, do you buy the whole lot at the initial point or do you scale it over time? 

PK: Typically we establish at least a 5% position, and then we wait and see. Then it just depends on the timing of events, and the position of the overall portfolio. One big question for us is, “Once you’ve invested and the stock falls, how much does it need to fall by before you aggressively reload?” So we have some rules around that, e.g, it needs to fall 30%-35% before we start to reweight. If you re-weight too often, you compound your mark-to-market entry losses.

With that said, what would you say is one of the top mistakes that investors make as it relates to investing?

PK: It’s interesting what you said before. I like to describe two classes of people as Howard Marks has: First Level Thinkers and Second Level Thinkers. I think there are a lot of people out there that just don’t do their homework and hence aren’t doing a proper job. When the price falls, they believe the market price is telling them something. The volatility can easily spook them out of their positions. It’s an emotional reaction to share price coupled with first level thinking.

It’s all fear and greed and human error that results. I think deep value is hard to market and for people to use as a strategy. As much as people intellectually know a mark to market loss (particularly at year end) is not a real loss, emotionally they feel as if they have lost. Intellectually they know it’s not so, but the emotion just takes control. It takes confidence and perseverance to punch through that. And that’s what I do and what most of my investors do. Still, I’m continually surprised that there are some very experienced and sophisticated people out there who still crack on this point.

Speaking of mistakes, what would you say is one of the worst investments you’ve ever made, what happened there and could you give us a little bit of a backdrop?

PK: We put on about three or four positions in Hong Kong in 2011. Partly, I was trying to find additional ideas to expand the portfolio and not to be quite so concentrated. This was mainly in response to marketing challenges. There’s a general view that more ideas make investors feel better due to the potential for additional positive things to happen in the portfolio. My fundamental analysis on the downside of these positions was right, so we didn’t lose much money in any of them. However, the upside just didn’t happen. Three of them, in particular, were in China where management was very slow moving. In theory, there was a lot of value. It could be crystallized, but we didn’t have the right events to crystallize it.

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