The Mullet Discount

I’m often asked if I meet with management of the companies I analyze. I typically do not. Given the large number of stocks I follow (300 name possible buy list), traveling the country visiting corporate headquarters simply isn’t practical. However, I will call management when I have questions. My questions are usually relatively simple and are meant to help me better understand the company’s profit cycle.

While I’m sure one-on-one meetings with management has its benefits, there are risks as well. CEOs in particular can be very charismatic people. Many are simply enjoyable to be around and are likable. It’s often a reason they made it to the top of their organization, especially if the business has a strong emphasis on sales and marketing.

I’ve also found when I spend the time and money visiting a company, I’m more inclined to want to recommend the stock. In other words, the higher the sunk costs on an investment idea, the higher the risk decision making is influenced. This is a risk analysts should be aware of even without visiting a company. It’s harder to say no to an investment idea you’ve worked on for several weeks versus a few hours.

Early in my career when my possible buy list was much smaller and I was encouraged to travel, I met with CEOs and management teams more frequently. I was working in New York, which provided me with access to many management teams. During my first few meetings as a buy-side analyst, I remember being a little uncomfortable. I was only 25 years old and was asking experienced and accomplished CEOs questions that often challenged their corporate pitch. And as young analysts often do, I sometimes asked some really stupid and inappropriate questions.

I remember having lunch with the founders of a chain of Papa John’s restaurants. They had accumulated a large number of franchise stores and were going public. I’ll never forget it. We were just seated for lunch and I found myself sitting next to the CEO. Here was my chance to prove I had what it took to be a world-class equity analyst. But no, it wasn’t to be. I had to open my mouth and ask a completely irrelevant and idiotic question.

As a consumer of Papa John’s pizza, I was always curious about the nutrition content of the giant tub of butter they distribute with each pizza. As an analyst trying to prove himself in front of his peers, one of my first questions of a real live CEO was, “So how many grams of cholesterol are in that tub of butter?” I immediately knew it was a stupid question. The CEO didn’t even respond. Instead, he gave me this look that said, “Who let this punk kid in here? And why is he sitting next to me?” I didn’t say another word and left after finishing my complimentary and delicious decaf (side note: Roadshows have the best coffee! Coincidence or does Wall Street really want us wired so we make rash decisions?).

Although I eventually learned to ask more appropriate questions, I continued to find a way to stick my foot in my mouth. I remember a CEO giving me an energetic pitch on their company’s growth plans. It was as if he was reading me a script from an infomercial. I’m not sure exactly why, but I felt comfortable pointing out the obvious. So I looked at him with a smile and said with a friendly tone, “You’re so full of $#^@.” Fortunately, instead of punching me, we both had a good laugh. I was a little embarrassed by my abrupt comment, but he was full of $^#% and we both knew it. Once it was out in the open, we were able to have a very productive conversation.

There’s nothing wrong with promotional CEOs, as long as you know you’re being sold. Some of the best companies are managed by successful salespeople. Their business and industry may require it. Furthermore, properly communicating a business strategy is an essential role of the CEO. The more educated investors become, the more comfortable they will be allocating capital to the business. Companies with an attractive cost of capital have competitive advantages. In addition to higher equity compensation for employees, a high valuation and low cost of capital benefits a company’s merger and acquisition strategy (not to mention avoiding being acquired). Furthermore, companies with lower cost of capital typically have more financial flexibility and are considered lower risk business partners.

One of the things I really like about following and analyzing a relatively fixed opportunity set, is over time I get a good feel for the management teams of each business. Who are the charismatic promoters, who are the detailed accountants, and who are the book-smart engineers? They’re all different and require different analytical filters. It’s our job as analysts and investors to sort out management personalities and adjust our valuation assumptions accordingly. It’s also important to know your biases. You may like the promoter, or you may like the boring no-nonsense CEO. We all have our favorites, so we need to be careful applying discounts and premiums to management teams based on likability instead of capability.

Speaking of investor biases, several years ago there was a company that I really liked, but seemed to be out of favor with investors. It was a great business with a strong balance sheet and consistent free cash flow. When I started my research I couldn’t understand why the business was selling at such a large discount to my calculated valuation. What was I missing? I had a theory. The CEO had a very noticeable and thick Southern accent. When he said “percent” it sounded like “purrrrCENT”. You can imagine how many times a CEO says “percent” on a long conference call. To this day, I believe investors were applying a Southern drawl discount to their stock. Considering I grew up in Kentucky and proudly sported a mullet throughout most of my wonder years, I didn’t apply a similar discount. In fact, given the high-quality nature of the business, I applied a premium (lower required rate of return). Eventually its valuation gap closed, making it one of my larger winners on a purrrCENTage basis. In conclusion, while investor management biases can be a risk, they can also lead to opportunity!