A Concern about Edelheit

In a previous post ("You pick the next post"), I mentioned I was thinking of writing a post about a concern I had about Aaron Edelheit's investment process. Perhaps that wasn't the best choice of words. I think Edelheit's general strategy of trying to buy obscure North American companies trading at single-digit multiples to his estimates of their forward earnings makes sense (although, as I've mentioned elsewhere, post-October there may be a better balance of risk versus reward in looking for currently profitable companies trading at low earnings multiples). Edelheit's track record is also impressive. The concern I have, which was prompted by a couple of his recent blog posts, is about whether Edelheit maintains an appropriate level of skepticism in his interactions with the management of the companies in which he invests.

ThinkEquity's 8^th commandment of research (See the previous post for the other nine, "ThinkEquity's Ten Commandments of Research") is relevant here:

5 Independent Sources for Each Initiation of Coverage.

We will have regular dialogue with company management, but they will always see the glass as "half full."

One of the challenges of investing in micro-cap companies is that there are often few, if any, independent sources of information on the company, so an investor is more reliant on information supplied by the company itself (e.g., its SEC filings, conference calls, etc.). Because of that, it's important to maintain a level of skepticism when evaluating forward-looking statements by management. This is easier said than done, particularly after one has invested in a position: we all like to believe our initial thesis was right, and this can compromise our objectivity in evaluating information subsequently.

In fairness to Edelheit, he seems to limit his investments to companies where the managers put their money where their mouths are, by buying their own stock (e.g., Nasdaq.com shows that Destiny Media's insiders have been buying their company's stock over the last year).

These were the two posts that made me question Edelheit's level of skepticism, "Excellent Video on Car Bailouts", and "Adversity and Underprivilege". In the first post, Edelheit wrote approvingly of an appearance by New York Times columnist Tom Friedman on CNBC, and in the second post, Edelheit wrote approvingly of an essay by Malcolm Gladwell. Friedman and Gladwell are both highly-influential, best-selling writers, but they tend toward glib oversimplifications. A healthy level of skepticism is warranted when reading them. In his recent posts on Friedman and Gladwell, Edelheit's apparent credulity made me wonder if he has been similarly credulous in evaluating statements made by managers of the companies he owns. Of course, it's reasonable to assume that he is more rigorous in his vocation of investing than in his avocation of blogging, but since he is blogging eponymously, he may want to consider whether his recent posts may have raised the same concern in his clients or potential clients who read his blog.

For a skeptical take on Tom Friedman's commentary about the Detroit automakers, see my recent posts "Iraq, the Automakers, and the Limitations of Technology", and "Great Moments in Business Journalism". For a skeptical take on Malcolm Gladwell, see Michiko Kakutani's review of Gladwell's latest book, "Outliers", in the New York Times. Below is an excerpt from Kakutani's review.

Both [of Gladwell's two previous bestsellers, "The Tipping Point" and "Blink"] use PowerPoint-type catchphrases (like the “stickiness factor” and “the Rule of 150”) to plant concepts in the reader’s mind. And both project a sort of self-help chirpiness, which implies that they are giving the reader useful new insights into the workings of everyday life.

“Outliers,” Mr. Gladwell’s latest book, employs this same recipe, but does so in such a clumsy manner that it italicizes the weaknesses of his methodology. The book, which purports to explain the real reason some people — like Bill Gates and the Beatles — are successful, is peppy, brightly written and provocative in a buzzy sort of way. It is also glib, poorly reasoned and thoroughly unconvincing.

Iraq, the Automakers, and the Limitations of Technology

As the security situation in Iraq has stabilized, and economic issues have dominated the news, Iraq has gotten less attention recently in the media. Yesterday was an exception, as the New York Times reported that the Iraqi government's cabinet had approved a status of forces agreement with the U.S. ("Pact, Approved in Iraq, Sets Time for U.S. Pullout"). The photo above, of Iraqi policemen celebrating with an American soldier, is from the article. According to iCasualties.org, U.S. military casualties, Iraqi security force casualties, and Iraqi civilian casualties have all dropped significantly over the last year.

Before the security situation in Iraq had stabilized to this level, casualties across the board were much higher and most of the U.S. casualties were caused by improvised explosive devices (IEDs). The Defense Department formed an anti-IED task force and threw money, resources, and personnel into it to deal with the problem. Last year, the Washington Post published an excellent four-part series on this effort ("Left of Boom: The Struggle to Defeat Roadside Bombs"). The phrase "Left of the boom" refers to efforts to disrupt the IED enterprise before the bombs were planted -- tracking down IED makers, ambushing IED planters, etc. No short summary will do that series justice, but one point it made dealt with the limitations of technology in dealing the problem. New technologies did help ameliorate the situation, but there were no panaceas, and many of the more effective approaches weren't technological in nature. For example, the last article in the series noted,

The "Mark 1 Human Eyeball," as troops sardonically call it, is more adept at finding IEDs than any machine. Studies to determine which soldiers made the best bomb spotters found that "it's those who hunted and fished and were much closer to their environment," an Army scientist reported.

[...]

Other unconventional initiatives include "human terrain teams," made up of anthropologists, social scientists and sundry experts who advise brigade commanders on tribal structure, local customs and cultural nuances. A preliminary assessment last month of an HTT in eastern Afghanistan concluded that the team had "a profound effect" in reducing "kinetic operations" -- gunplay -- and had even discerned that a local village would help stop Taliban rocket attacks against U.S. troops in exchange for a volleyball net.

More broadly, the successful (so far) counterinsurgency efforts in Iraq, although aided by technology (e.g., hand held fingerprint scanners, reconnaissance drones, etc.) have relied more on 'left of boom' approaches that are attuned to local politics (for detail and insight on this, see, for example, David Kilcullen's posts on the Small Wars Journal blog. Dr. Kilcullen, a retired Australian army officer and counterinsurgency scholar, has served as a counterinsurgency adviser to the U.S. in Iraq and Afghanistan).

What brought this to mind recently -- the frequent lack of technological panaceas to complex real world problems -- was a column by Thomas Friedman last week about Detroit in the New York Times ("How to Fix a Flat"). In that column, Friedman wrote,

Any car company that gets taxpayer money must demonstrate a plan for transforming every vehicle in its fleet to a hybrid-electric engine with flex-fuel capability, so its entire fleet can also run on next generation cellulosic ethanol.

Lastly, somebody ought to call Steve Jobs, who doesn’t need to be bribed to do innovation, and ask him if he’d like to do national service and run a car company for a year. I’d bet it wouldn’t take him much longer than that to come up with the G.M. iCar.

Friedman, before he became sought after as an expert on energy policy, was better known as an expert on the Middle East (he was for the war in Iraq before he was against it). Here though he seems to underestimate the technological challenges in designing an innovative new car (see, for example, "Tesla's Wild Ride"), and not acknowledge the extent to which Detroit's problems are political and not technological, i.e., being trapped between the Scylla of UAW labor costs of $73 per hour and the Charybdis of federal CAFE regulations that require automakers to build small cars that don't have the profit margins to make up for the high labor costs¹.

¹Friedman does note in passing the Big Three's high labor and health care costs but quotes an environmental lobbyist asking why GM didn't lobby for Hillary Clinton's proposal for nationalized health care. How that would have assuaged GM's retirees, who were already eligible for a national health program (Medicare) when they reached age 65, but preferred the more generous plan their union had negotiated, he doesn't ask.