TC and MC (the blog authors) discussed investing in Philly Shipyard (PHLY on Oslo Börse) a while back, and one counter-argument for not investing was that this company would not exist without the force and subsidies of the Jones Act. As such this company could not be labelled as a genuine value-add for society or customers.
Many value investors have mentioned they do not (generally) invest in companies that do not genuinely add value to their value chain or society. Usual suspects are cigarettes, gambling, time-share rentals etc. In different ways, these companies prey on humanity’s weaknesses (respectively addiction and ignorance). Another close to home company I like to use is Edenred (rearview mirror high and stable ROIC ‘great’ company that through regulation in France and Belgium enjoys operating in an oligopoly for a product that is fiscally advantaged but ultimately destroying value for society in TC’s humble opinion).
In different ways, these companies prey on humanity’s weaknesses.
However, I will explain why I have come to believe this rule is not (as) applicable to investments like Philly Shipyard ASA.
The great danger of investing in the above businesses is that they optically look like great companies from a rear-view mirror perspective (and near future perspective, with high and stable ROIC). Indeed, human weaknesses are time-invariant, or favorable (but questionable) regulations create a stable subsidized high ROIC, and these companies are generally valued as ‘quality’ by the market.
If the valuation multiples reflect quality this also means the investment only works out if the company is still flourishing 10 years from now (unless one is relying on future greater fools). The problem is that investors are very bad at predicting the future more than five years out. Once public opinion turns against these companies’ (the timing is highly uncertain), the valuation can tank towards liquidation value. I think I sketched an investment that has unknowable (immeasurable) uncertainty to the downside.
Value investors should prefer the inverse type of uncertainty. I believe immeasurable uncertainty vs risk is not often enough discussed, which is why I recommend having a quick read through The Dhandho Investor.
Why I made an exception and invested in Philly Shipyard
We have been following Philly Shipyard since Nov. ’16. Philly traded comfortably below liquidation value, and we found there was clarity that the Jones Act would not be repealed in the medium term (see also Trump’s slogan). Philly’s management seemed to have cared well for shareholder value in the past, and even a repeal of the Jones’ act could have accelerated the (liquidation) value realisation, locking a small profit or loss. In other words, the Jones Act regulation was not a large risk factor by virtue of the valuation. The upside was that there was a decent ~ >50% chance that this company could soon be valued on a going concern basis once a new shipbuilding contract would get signed (in that case it would be worth 2.5X – 4X).
Clearly it is always important to assess a company’s true value-add to stakeholders. However, I hope to have made a convincing argument that this factor’s weight in decision making is dependent on the context (“great company” / “cigar butt” valuation?). In case of cigar butt valuation, this factor is not on top of my checklist.
It is only through thinking about real-world case studies that I have found the courage to deviate from value investing dogma. Honestly, this is dramatic, as I only have one remaining personal example of a deviation worth sharing (in a next contribution).