(Published: January 30, 2017 at 12.00 P.M. EST)
We are pleased to interview Michael Lee of Hypotenuse Capital Management LLC, an investment advisory firm based in Los Angeles, USA. Set up in 2013, his firm invests in publicly-traded securities in the United States and abroad. Michael focuses on finding exceptional management teams, running outstanding companies, to invest in.
The interview is in podcast and transcript formats.
Podcast of Interview with Michael J. Lee
Transcript of Interview with Michael J. Lee
1. Hi Michael. Trust you are doing well. Could you please tell us about your professional background?
Michael Lee: Sure, I’ve sat in a lot of seats in the world of finance. I spent time working for an investment bank advising on mergers, acquisitions, restructurings and leveraged finance deals. Then I moved over to the buy-side working for a private equity firm before switching again to working at a deep value long-short hedge fund. I spent six years at that fund before moving on and starting up my own hedge fund.
2. Great. So, Michael, in your career, you’ve been on both sides of the table, which is the sell-side and buy-side – investment banking, private equity and investing in public equities for some other firm, and finally, founding your own firm in 2013. Surely, the diverse experience / roles would have helped you shape into a diligent investor and gave you an edge in some way?
Michael: I’m not sure I could quite call it an edge, but I think there is a value in learning any business from a lot of different angles and perspectives. There’s also value in gaining access to fundamental skills that you will need to ultimately succeed at what you’re setting out to do.
You don’t see players making it to the NBA without knowing how to dribble or shoot a free throw. Well, similarly, you can’t expect to make it in the investing world if you don’t understand how to read a balance sheet or calculate free cash flow.
So much of fundamental investing is still like an artisan “craft” business – like making violins or fine wine; it is still a business that is best learned under the tutelage of a good mentor. You have to spend time working in the craft, learning how to read documents, structure transactions and analyze opportunities and you must do it many times in a variety of situations over many years to become proficient. Like poker, you can learn the basics of investing in five minutes, but it can take a lifetime to master.
2 a. What were your key takeaways from each of your earlier roles?
Michael: Banking gave me the basic skills of understanding accounting, analyzing and reading financial statements and understanding how deals come together. Private equity taught me more about how to think about what constitutes a good business and how to structure transactions and balance sheets. Working at a hedge fund helped me to understand nuances of being a public markets investor. So, for example, I learned a lot about market psychology as well as how to approach short selling and more complex investing techniques such as stub trades, derivatives, etc.
3. That surely sounds like very rich exposure in your career, Michael. Your profile also covers working for other organizations, across domains, and finally setting up your own outfit. How has entrepreneurship suited you? Given that you face additional responsibilities – not just managing client monies, but also overseeing the admin, legal, accounting and taxation issues. Has this ever proven to be a tight-rope walk for you? Does this leave you with adequate time for investment research, trade execution and client interactions-cum-marketing?
Michael: I have gotten a lot of joy out of striking out on my own, setting up my own business and defining my own investment philosophy and style. You are right though – with this freedom comes quite a lot of responsibility. None of the functions you mention are really a tight-rope walk per se, but one does need to be thoughtful about how to tend to those issues both efficiently and effectively. We have some good people, systems and procedures in place that allow me to keep a handle on the operations side of the business, while still focusing the vast majority of my time on research.
4. Okay. Michael as far as I know, hypotenuse is “the longest side of a right-angled triangle, opposite the right angle”. How did you end up choosing this name for your firm? What does hypotenuse stand for, for your firm?
Michael: When I set out to find a name, I knew that I wanted something that would represent a universal concept or symbol. When you take a step back, there is no more universal language than the language of numbers: Mathematics. It doesn’t matter if you’re from Azerbaijan or Alpha Centauri, the natural universe still reveals itself to us in numbers. So, to me there is a sense of immutability that comes from a mathematical concept such as a hypotenuse.
The triangle is the most robust structural shape in engineering and design, so I think there is a sense of strength and durability in the word.
Finally, the hypotenuse also happens to be the shortest distance between any two given points in a Cartesian plane, so for me there is a connotation of efficiency and deliberate direction embodied in that word.
5. Your firm’s mission statement is “to seek out exceptional organizations led by extraordinary individuals and invest in them intelligently.” This sounds quite similar to the Warren Buffett philosophy. Who exactly influenced your investing philosophy, Michael?
Michael: Yes, you’re right to point out that Warren (Buffett) has left an indelible imprint on my style as has Charlie Munger. Another major influence has been Peter Kaufman. There are some great books on the subject of looking for great companies. “Quality Investing” and “The Intelligent Fanatics Project” are two more recent ones that come to mind. Those are some of the pivotal books and characters, but on top of those, there are maybe a couple dozen more books and countless other leaders, articles, speeches, etc. that have all become part of the fabric of my philosophy today.
5 a. The question may sound a cliché, but how exactly do you screen exceptional organizations? What are your criteria for judging leaders as “extraordinary”?
Michael: You know, screening for these types of firms and leaders is really where I think fundamental investors can distinguish themselves from the herd. You know as well as I do, that there are practically infinite computing resources that could be applied to an algorithm that will make a lot of the work we have historically done as analysts completely trivial. Quantitative ability will not be enough to distinguish an individual human analyst in a world that has massively scalable resources that can be brought to bear on calculating quotients and standard deviations.
But can a machine screen for leaders who are really great at inspiring other people? Could an algorithm detect whether or not a company has a strong culture of cooperation? Could a computer identify the next Steve Jobs, Henry Ford or Herb Kelleher before anyone else realizes they will be hugely successful? Is a computer program able to figure out what constitutes a business’s “moat” and then derive what will make it durable and defensible?
I don’t think we have quite enough time to get into everything that goes into my own screening process. But let me offer up one framework for your trainees and readers to contemplate. Most of Wall Street likes to focus on the bottom line: EPS, EBITDA, ROIC, ROE – you pick the acronym. Well, as Charlie Munger likes to say: “invert, always invert.” And as Henry Ford pointed out, it’s the customer that really pays the bills.
There’s no P&L statement that actually starts with “profit”. The first line of any income statement is REVENUE. The customer makes everything possible. The customer pays for inventory, for salary and wages, for R&D and marketing. The customer pays for interest and taxes and ultimately for whatever returns the shareholders garner once you deduct all of the above.
So, now when you stop and consider the implications of this and you start thinking about the companies that have enjoyed incredible success, frequently it is the companies who first live in service to their CUSTOMERS and NOT the shareholders that end up doing extraordinarily well. And by extension, it is the leaders who understand this primacy of the customer, who go on to build incredible organizations dedicated to serving their customers; these individuals stand head and shoulders above the rest and build outrageously successful businesses. But the reality is that most of Wall Street does not view the world in this way.
Absolutely, Michael. I would like to mention my own philosophy in my training venture Beyond Quant InvestTraining. I too believe in going beyond the quantitative aspects like the numbers you mentioned – be it EPS, EBITDA or ROE, and looking at the finer aspects of the business to find out the winners.
Michael: I think that’s very wise of you.
5 b. Thank you. Coming to my next question – Who are the exceptional leaders in your view, within the unlisted space, since that’s where not so much is known in the public domain, as much as is known about the listed space?
Michael: I think this is a really great question, because some of my best learning about leadership has come from studying leaders outside of the realm of publicly-traded businesses. A great place to look is the world of sports, because it is such a perfect laboratory experiment for leadership.
In professional sports, you have extraordinarily competitive leagues with rules designed to level the playing field. You have lots of egos and personalities intertwined in complex and emotional interpersonal dynamics. Crucially, sports also give us tangible and measurable outcomes that allow us to sort out what works and what doesn’t and therefore we can conduct some basic quantitative analysis. And we thus have the luxury to just go and look at these outcomes, and there are these crazy outliers in the data that immediately jump off the page.
So, if you just go look at who the most successful sports coaches over the years were, and you start reading about their leadership styles and philosophies, the universe just starts to reveal itself to you. Patterns and common traits start emerging. Charlie (Munger) and Warren (Buffett) often talk about pattern recognition. Well, you read up on enough great coaches and you start recognizing these patterns in sports and then you turn the microscope to business and sure enough, a lot of the same patterns emerge there too. And why wouldn’t the recipe for a high-performance football or basketball team work for a high-performance manufacturing or service company? And by the way, you could also look at the history of great military or political leaders as well, but sports are so interesting because of all the leveling factors I mentioned.
Any resourceful person listening to this interview will be able to use this as a starting point and go do the work it takes to discover these patterns and ultimately derive a method for identifying exceptional leaders themselves.
6. Sure. Sports and investing – great analogy, Michael. Are you a value investor or a growth investor, or a blend of both? Would you stick to a certain philosophy, or style, regardless of market cycles? For instance, value investing may not be very successful in bull markets, when asset prices are inflated, and not many bargains are to be found.
Michael: I increasingly am of the view that both labels are a bit absurd. No one would describe themselves as an “overpaying investor” or a “declining asset investor.” I’ve yet to meet an investor who buys things they think are overpriced, or that will depreciate in value. And it’s only the rare special situations investment that involves betting on how fast the ice cube will melt or how many puffs you can get out of a cigar butt. I believe the more important distinction is between INVESTING and SPECULATION.
Speculation is what happens when you try to predict what earnings multiple will prevail at some point in the future, or whether or not a buyer is going to come acquire your company.
Investing is the process of deploying capital based on an expectation of earning foreseeable cash flows that that capital will produce over time. Irrespective of the market cycle, I personally try to stay closer to the investing side of the spectrum than the speculation side.
Of course, there are times during the cycle when INVESTING opportunities are scarce, but the nice thing about having a concentrated book is you only need one or two good ideas, not a hundred.
7. Yeah, the fewer the merrier, huh, Michael? Matthew Peterson of Peterson Capital Management, whom I interviewed recently, mentioned you and he said you’ve done some work in child psychology. So I was just wondering, how has the understanding of child psychology helped shape your approach to value investing?
Michael: Haha, well it might be an overstatement to say I’ve done “work” in child psychology, but I will put it this way… Matt’s a really great guy and I am really glad I met him soon after I moved to Los Angeles. We share a lot in common including the fact that we both have kids. Now, before I had kids, I thought I knew what it would be like raising kids. You hear younger people say this all the time: “Oh, when I have kids, I will never let them do X.”
But like so many things in life, you really can’t understand what it’s like to do something until YOU DO IT YOURSELF. And, particularly in the investment management world, people like to believe that they are calm, collected, intellectual, reasonable, rational beings. And by extension, we want to believe that the rest of the world around us is made up of similarly calm, collected, intellectual, reasonable, rational beings. Well, at least that’s how I wanted to think of the world earlier in my career.
Having a kid was something of an epiphany, particularly when my son reached the age of two, because the mind of a toddler is really like a window into the true inner-workings of the human brain. The mind of a two-year old, while capable of some rational thinking and logic, is overwhelmingly dominated by the emotional part of the brain. Some people like to call this our “lizard” brain because we inherited it from our biological ancestors.
This is the part of our brain that implements the “fight or flight” instinct when we sense danger. It’s the part of our being that feels anger and pleasure, fear and love. And this is why toddlers are so prone to tantrums. They quite literally are not capable of controlling their emotions because their mind is primarily driven by their non-rational lizard brain and their rational pre-frontal cortex has not developed sufficiently yet.
So, in looking for strategies on how to work with the mind of a toddler, my wife and I both have spent a lot of time reading and learning about behavioral and developmental psychology. We found an amazing parenting coach and working with her – she has opened our eyes to this vast realm of knowledge about how the mind works. Through learning some of these strategies on how to deal with a two-year old throwing a tantrum, I started to have these revelations that, “Hey, these truths about the human mind don’t just apply to toddlers, these are truths about humans as a SPECIES at large.“
And when you start to understand these very fundamental biological ways in which the mind works, you begin to understand more and more things about how groups and organizations and societies work too. So, when you can understand these fundamental interactions at a very micro level, it can absolutely lead to a much more holistic view of something much more complex, like how an effective leader works with a team of professionals and how an exceptional company culture comes together.
And this comes back to this idea that there’s the way we think we WANT the world to work and there’s the way that the world REALLY works. If you try to understand the way the world REALLY works, then I think you are on your way to being a pretty good investor.
8. That’s very interesting thoughts on applying child psychology to investing, Michael. Since you do not rely on sell-side research, how do you go about identifying promising ideas?
Michael: I can’t say that there’s one single method that generates the majority of my ideas. Sometimes it comes from running a screen or reading a newsletter or idea website. Sometimes it comes from reading publications or listening to podcasts like this one. Some of the best ideas come from just talking to good friends I respect and admire. The source of the idea doesn’t matter as much as the process by which you sort the good ones from the bad.
8 a. Alright. For the stocks that you do like, do you build elaborate earnings estimates and financial models? You’ve worked on Wall Street before, so I just wondered.
Michael: The short answer is no. In that former life you mentioned, I built my fair share of elaborate and intricate forecasting models. I think there’s a lot of energy that goes into building these very precise forecasting engines and at the end of the day, you really just need to understand the fundamental drivers and which way the current is flowing. For me, if I can’t do most of the math in my head, I usually just end up putting it in the “too hard” pile.
9. Sure, so “keep it simple”, really. You have built up a mental model which advocates “buying high quality companies at a low price”. If you were really not to compromise on either (quality or price), would you not be left with a relatively small universe of stocks?
Michael: Yeah, absolutely. My criteria boil the ocean down to very few actionable ideas at any given point in time, but I am perfectly happy with that. Again, this is the benefit of having a concentrated portfolio. I would much rather be invested in one incredible idea that I understand down to its core, than spread myself over a hundred different things I barely understand.
It’s always better to emphasize quality over quantity. I mean, no one goes out there and says – “Hey I want to own a hundred really mediocre houses.” Art collectors don’t go out and say – “Hey, I’m going to buy a hundred paintings, but I only want the so-so ones.”
9 a. How many U.S. companies do your figure, would meet these basic filters at this point in time, given the rally in the markets, and with the Dow having scaled Mount 20,000 this week?
Michael: I can’t with a straight face tell you I’ve combed thoroughly through every publicly traded security available out there. However, my perspective is that if you really want to generate exceptional returns, then you need to look for exceptional opportunities. If your screening criteria are only eliminating 50% of the investable universe, how can you expect to generate better than 5th decile returns? In other words, having a screen that leaves you with just a couple of ideas may actually be a good thing.
10. Alright. What are your general views on MicroCaps? As the book “Intelligent Fanatics Projects” says – “all great companies started as small companies”. Have any MicroCaps managed to get past your stringent filters so far, or where you came across exceptional leaders?
Michael: I am agnostic as to market capitalization and the size of our fund gives us a great degree of flexibility and agility that larger funds might not have. We own some of the very largest cap companies on the planet and also some incredibly modest enterprises with market caps less than $20 million. I would say it is harder to find really high quality leaders at small companies for a variety of reasons. But when you look hard enough and ask the right questions, you can find unique and inspiring individuals who I think in ten or twenty years, other people will look back and say – “Wow, if only I had known about this guy back in 2017.”
11. Sure. Michael, I’ve always believed that we can all learn from mistakes – particularly those of others’. Could you possibly quote a couple of examples, where your investment thesis did not play out the way you anticipated, and what are the lessons you learned from these?
Michael: Yeah, I think that’s a really good habit. Well one thing that amazing leaders all seem to share is that they don’t fear failure. In fact, they don’t think of failure as failure at all, but an opportunity to learn and improve. I believe some of my biggest failures have also been my greatest blessings, because they taught me something about myself or about how the world really works. This insistence on exceptional leadership has come about because in the past, more often than not, when an investment goes sour, it is because the people at the top were not great leaders but were in fact quite mediocre.
For example, we had a large investment in a small U.S. consumer lending company and I thought it was going to be a huge home run because we were buying it at a huge discount to tangible book value and the book was all really short-term, very liquid consumer loans. Turns out, I overestimated the management’s capabilities because I was so enamored with the apparently cheap valuation. Well, unfortunately, none of the things you would want from a good leadership team happened. Their operations struggled and they found themselves closing more and more branches. Their stock languished but they didn’t engage in obvious capital allocation strategies like buying back the stock. Sure enough, I eventually found myself unwinding the position at a substantial loss. Yet, I’m still glad I had that experience, because it taught me never to tolerate a mediocre management team again.
12. Yes, management is what makes or break any company, obviously. You have also mentioned, to quote you, “We would rather invest in a single exceptional idea than spread ourselves thinly over a hundred marginal ones.” That would lead you to concentrated holdings. How has the experience been so far – presumably you’d be free of the stress of tracking an unmanageable number of portfolio companies, as a result?
Michael: No matter what your profession might be, I think it’s prudent to know one’s own limitations. I have this friend, who has an incredible eidetic memory. One time he asked me and some friends to shuffle a deck of cards and hand it to him. He quickly flipped through them in less than a minute, put them back in the box, and had us put it in a drawer. After a couple of hours of unrelated conversation, he asked us to take the deck out again and he proceeded to recite the cards in order back to us, without looking. He got every single one right. I might have a chance of keeping 10 cards straight, but not 52.
13. Alright, fair enough. You have a positive view on a Canadian Energy Services firm. What are the services this company provides, and is the view based on the oil prices firming up, or other reasons? Is this a contrarian call? Also, can you describe the other special situations opportunity?
Michael: The Canadian company is called Total Energy (TOT.TO) and they have three key divisions. The smallest is a contract drilling business where they drill wells on behalf of E&P clients. The second is an equipment rental business that rents out almost anything required to run an oil or gas drilling site, for example: rig mats, generators, lighting, storage tanks, etc. The third business is a compression and processing equipment manufacturing business. They have an interesting mobile compression package that makes it easier for their customers to deploy compression horsepower to the right location at the right time.
I actually don’t really care where oil prices go with this investment. All that matters is whether or not we need oil and gas and whether or not we need to take it out of the ground. We’ve been operating at extremely low rig utilization rates for almost two years now. This could persist for a while longer but not indefinitely. At Total Energy, we have an extraordinarily capable operator and an exceptional capital allocator at the helm. He has time and again produced fantastic results through several energy cycles over many years. I love having someone like him as a steward of our capital, because I have faith that he will compound it at prosperous rates for years to come.
On the special situation. We have two special situation investments that share many characteristics. Both of them were trading at a discount to cash on hand when we found and bought them. Both of them had very large reserved deferred tax assets on the balance sheet and neither of them had material revenue generating operating businesses. Now, these “NOL shell” companies aren’t all that uncommon, they actually pop up with some frequency. What is uncommon is to have a chief executive who actually knows how to intelligently deploy the capital. Well, both these companies were either going through a proxy battle or had recently undergone a management transition. We were able to get an audience with the new CEOs in both cases and thus get a very intimate understanding of how these individuals ticked. We were able to get comfortable with entrusting with a sizeable chunk of our own capital to these individuals. One of them is already working out very well, as he has deployed all his available capital and the jury is still out on the other but I am optimistic he’s going to find something very intelligent to do somewhere down the road.
13 a. Michael, just a side question about the oil investment. Have you looked at Offshore Helicopter Chartering businesses? Again, the same theme of crude oil prices moving up. A couple of stocks like Bristow (BRS) look a bit promising to me, trading at half its book. What are your thoughts on that segment?
Michael: Yeah, I think it’s an interesting space. It’s been some time since I visited a company like Bristow. My general perspective is that I sometimes find it hard to figure out why I would rather be invested in an offshore oriented business, rather than an onshore business. I think you just need to be thoughtful about what are the relative advantages and disadvantages of those two different operating paradigms.
14. Okay Michael, fair enough. You invest in the United States and abroad. Given the humongous number of U.S.-listed companies, across industries and market capitalization levels, how much share of your fund’s AuM (assets under management) would you consider allocating to other markets? Which other markets are on your radar and how do you research stocks in those markets?
Michael: In the same way that I’m market cap agnostic, I’m also geographically agnostic. However, overseas investing gets trickier for a lot of reasons. There’s currency risk, and there are hedging methods available to deal with that, but what about geopolitical risk? Language becomes a significant barrier and cultural norms vary widely from country to country. You also have variances in trading restrictions, disclosure requirements and tax policy. All of this makes investing abroad very complicated. So, as a consequence, most of what we actually end up doing ends up being in North America. I’m always open to looking at stuff overseas but usually the bar is higher and it’s much harder to get all the way through the process. The times I have invested in foreign domiciled companies were usually through an ADR. I will say that those who can do a good job of navigating the risks of international investing probably have much greater upside potential than those of us who invest mostly in the U.S.
15. Okay. That brings me to the last question for the day, Michael. Your returns you say “have been and will be volatile”. What is the profile of investors that you look out for, for your fund? How long do you expect them to stay invested, on average?
Michael: Yeah, in a perfect world, the duration of our funding would match the duration of our assets; and our ideal holding period for our assets is forever. This being the case, one of the primary attributes I am looking for in a partner is patience. The ideal partner is one who not only is comfortable with our one-year rolling lockup, but who is excited to be a part of building something exceptional over the course of several decades. If someone starts asking me for daily NAV or monthly liquidity, it’s probably not going to be a very good fit.
So again, “holding period being forever” is very much the philosophy followed by Warren Buffett. So, it’s quite nice to know that you’ve not only read Warren Buffett, but you are one investment manager, who’s actually practicing himself what Buffett’s been preaching. It’s a pleasure, Michael to know your views, and I am sure my readers, my audience will gain new, unique insights from the wisdom you with us today, and for that, I am thankful to you.
Michael: Thanks so much for having me.
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