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Lessons From The Collapse of Flybe

There are only two things investors can control when it comes to investing in the public equity markets.

Firstly, the price paid for the security you have decided to include in your portfolio and secondly, costs. Virtually everything else is uncontrollable (apart from when you sell, but for the purposes of this example, that falls under price paid as they are both interlinked).

We don’t know how long it will take for a company to reach our estimate of intrinsic value if it ever does. And we have to place a tremendous amount of trust in a company’s management to operate in the best interests of shareholders.

The quality of management

Management is, what I believe to be, the most prominent uncontrollable risk investors face. It is easy to avoid companies that look distressed. It is easy to avoid companies that look overvalued. It is easy to avoid businesses in cyclical industries with poor profit margins and commoditised products. However, it is challenging to evaluate the quality of management, and there is always an element of uncertainty investors have to deal with when backing any management team.

I’m not just talking about CEOs and Chairmen/women. This uncertainty extends across the entire management hierarchy particularly CFOs and non-executive directors who are supposed to act as shareholders’ eyes and ears.

No skin in the game

The high-profile collapses of three separate UK-listed companies over the past 12 months underscore just how vital it is for investors to trust the managers of their businesses.

Conviviality Retail, Flybe and Patisserie Valerie stand out because they collapsed so quickly, giving most shareholders little or no time to get out. Conviviality Retail and Patisserie Valerie collapsed so quickly most shareholders have been wiped out.

Flybe is in the process of being rescued with a last-ditch takeover offer at just over 1p per share, a fraction of the 16p per share the stock was changing hands for the day before a bid emerged.

I’m not that familiar with Patisserie Valerie and Conviviality, but I have been following the Flybe case closely for the past several years and owned the stock until last year. Fortunately, I decided to sell as part of a portfolio clean-up exercise just before it started to become clear just how quickly the business was going downhill.

Avoiding boiled frogs

Steven Wood, CFA, is the founder of Greenwood Investors, an investment partnership focused on distressed, deep value and special situations, a fund that I follow closely, and one that until early last year owned Flybe.

According to GreenWood’s year-end letter to investors, the firm ended 2018 with a small loss thanks, in part, to its investment in Flybe (mostly offset by an exceptionally well-timed investment in retailer Ocado).

Greenwood is always looking for ways to improve its investment process. At the beginning of 2018, Steven and team decided that they would initiate a new rule by the firm would re-underwrite any position that is not generating alpha by the first year, “with a completely refreshed set of assumptions.” After reviewing all of its legacy positions using this approach, the firm decided to dump its position in Flybe at the beginning of 2018, realising a substantial loss. As it turns out, this was the right decision. The stock has since fallen a further 80% since.

Following the Flybe disaster, Greenwood has decided to add two further criteria to its stock selection checklist, rules designed to try to help it avoid similar situations in the future, as Steven explained in his “Boiled Frog Prevention” blog:

“Flybe prompted two additional criteria we’ve added to our ranking framework to evaluate the quality of a company. As mentioned before, we believe the qualitative aspects of a company will drive the results towards the top end of the range of possible outcomes. The two new criteria we’ve added are analyzability and an assessment of the board.

Analyzability was already implicit in our process of only investing after thorough research confirmed our assessment of the range of possibilities, quality criteria, and the expectations gap. Yet it’s also important to realize how knowable many of these assumptions are…In a messy Brexit scenario, we wouldn’t be surprised if the pound dropped to parity with the US Dollar. Sure, it’s an extreme and lower-probability scenario, but it’s no longer a >6 standard deviation possibility. Incorporating parity exchange rates into Flybe’s model puts the entire operation deeply in the red.

Similarly, the board at Flybe left a lot to be desired, and even left a lot of money on the table. Only six months before its shares collapsed, the board rejected a take-out bid at what would have most likely been 60x the price it accepted a couple quarters later (which we learned today was a ceremonial penny). The board had zero skin in the game, and behaved as such.”

These criteria, as well as the addition of an annual re-underwriting process, are part of Greenwood’s attempts to avoid becoming a boiled frog — a reference to a story Charlie Munger once told in one of his famous lectures.

Munger referenced the findings of a scientist, who found that when frogs were placed into a pan of boiling water, they would jump out. However, if the frog was put into a pot of cold water, and the water was slowly brought to the boil, they wouldn’t notice and would, subsequently boil (this has since been disproven).

You might be reading this thinking, “what does this have to do with investing?” The answer to that question is a lot.

Investors can become boiled frogs if they don’t pay attention to the companies they own. Flybe might have looked like an attractive investment three years ago, but over the past few years, the company’s financial situation has deteriorated significantly. Investors who held on for the duration boiled.

Greenwood’s solution to this problem is to pay more attention to management, and re-underwrite holdings every year.

As investors, we will never achieve a success ratio of 100% of spotting businesses before they fail, but we can skew the odds in our favour. Greenwood is trying to do just that.

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