Weekly Thoughts: Context is King
Here is something that caught our eye this week:
Context is King
We have been thinking recently about the limits of algorithmic decision-making. In the last 24 months, Chenmark has acquired six operating companies. Each boasted a minimum ten-year track record of consistent revenue growth and profitability and in each case either the entire management team stayed on board or we facilitated the hiring of a talented CEO eager to lead the next stage of the company’s development. However, these transactions are structured as asset sales which, while appealing from a liability management perspective, requires the creation of a new legal entity that does not carry with it the operating history of the acquired company. The result is that even a common credit check shows each “new” acquisition as mere weeks old with absolutely no history (financial, tax, legal, etc.) to convey good standing or stability. So, while we could paint an exciting picture of a holding company that is profitably growing revenue at triple digits rates by partnering with decades-old operating subsidiaries with established management, we also can’t get approved for a fuel card program with a local provider because our corporate credit history doesn’t meet the age requirements of the underwriter’s software.
As anybody who has been in a similar situation knows all too well, the solution to the problem outlined above is often to “talk to a human.” The hope is that there is a role for nuance and qualitative judgement once an actual person can be involved in the underwriting process. However, this framework is decidedly counter-trend. Businesses that seek to operate at scale to need to create systems to make decisions quickly and that requires some type of rule-based architecture. For the most part, these systems are highly effective, but our recent experience has reminded us that idiosyncrasies still matter. Since we have recently spent considerable intervals on hold waiting to “speak to a representative,” we had time to read further about the extent to which context may be devalued in an increasingly algorithmic world.
One piece that caught our eye was a large-scale survey of technology experts, scholars, corporate practitioners and government leaders by the Pew Research Center and the Elon University’s Imagining the Internet Center, which noted that “Algorithms are often elegant and incredibly useful tools used to accomplish tasks. They are mostly invisible aids, augmenting human lives in increasingly incredible ways. However, sometimes the application of algorithms created with good intentions leads to unintended consequences.” One of the chief concerns outlined by the Pew Research was that “humanity and human judgment are lost when data and predictive modelling become paramount.”
On a recent episode of the Invest Like the Best Podcast, David Gardner, founder of The Motley Fool, noted the importance and potentially undervalued role of qualitative analysis when making stock picks. In recent years, the rise of automated strategies has increased the appeal of financial metrics since these serve as excellent inputs for sophisticated algorithms. In contrast, it is far more difficult, as Gardner notes, to model for executive talent, despite the fact that few would argue a world-class CEO is highly correlated with future returns.
All of the above resonates with the Chenmark team since we believe that the stories behind raw data matter. Call us old-fashioned, but when meeting with a company for the first time, we believe it is imperative to talk about context – to understand the team, their story, and their motivations, before moving onto the financial statements. For instance, are high margins due to sharp management or a lack of reinvestment in future growth? Is subpar top-line growth due to lack of owner engagement or to fierce competition? Our approach is based on the belief that success and opportunity can take many forms, and that the evaluation thereof requires an open mind.
Of course, the flexibility we seek is inherently not scalable, which is why it does not exist in the mass market, since organizations of a certain size are comfortable filtering out the special flowers to avoid the rotten weeds. While our recent administrative headaches have led to frustration with the analytical rigidity of certain large organizations, we also recognize this very rigidity may create the opportunity to discover systematically undervalued assets and capitalize accordingly. Ultimately, we welcome the rise of algorithms because they ensure a healthy regard for context will be ever more rare, even if it means we have to develop a new strategy for buying gas.
Have a great week,
Your Chenmark Capital Team