The Three Levers

“Give me where to stand, and I will move the Earth” – Archimedes, as attributed by Pappus of Alexandria

There are two types of investments I like. One is a company with underpriced or unrecognized optionality. For example, in 2015 Nintendo traded at just 5-6x trough EBIT after the underwhelming releases of a few consoles. The company had a lot of positive optionality from 1) the potential release of a new hit console akin to the Wii or DS, or 2) monetization of their vast IP library. In the following years, both options went in the money with the release of the Switch and Super Mario Bros Movie, helping fuel a 10x rise in the stock over the last 10 years. 

The other type of investment I like is one where the three levers of value creation have a chance to be applied. These are 1) rising earnings 2) rising multiple and 3) declining number of shares outstanding.  (If I am missing any please let me know!) The great thing about the levers is they are multiplicative, not additive. So that if earnings increase 2x, the multiple doubles and shares outstanding fall by half the effect is an 8x increase in the share price (2 x 2 ÷ 0.5 = 8). And the wonderful thing about the first two levers is they are often working together – rising earnings leads to rising multiples.

Nearly every company in the Hosomichi portfolio has the potential to benefit from the first two levers. They trade at low multiples of current earnings and profits are expected to significantly increase.

Unfortunately, I have yet to meet a Japanese management team that fully embraces the concept of the third lever – shrinking share count. For most managers, deploying cash flow to grow the business is natural. Returning it to shareholders, whether via dividends or buybacks, is tantamount to declaring defeat on your ability to allocate capital. And while shrinking the share count helps shareholders, it does nothing for employees, customers, suppliers and the status of managers (assuming limited stock ownership levels). If I ever run across the type of management team who will take on debt to buy back stock when shares are severely depressed, I will most likely invest.

Focusing on these three levers is another way to say I am a value investor. If all three work in my favor, the results are fantastic, but if only one of them is applied, that is generally enough to generate a respectable return.