Geoff Gannon December 26, 2005

On Conviction and the Value Gap

Recently, Tommy Hilfiger Corp (TOM) accepted an offer of $16.80/share from private investment company Apax Partners. Not long after hearing this, I was talking to someone who I had suggested the stock to almost a year ago. I asked him if he still had his shares. “No”, he said – he’d already sold.

Now, it would be easy to let the blame for this rest solely upon the impatience of that investor. However, I have to admit I deserve the lion’s share. You’ll rarely be successful buying a stock on someone else’s advice unless you understand the logic behind the purchase. I did a god awful job of explaining the logic behind buying shares of Tommy Hilfiger.

I never believed Tommy Hilfiger was a great company. Nor, did I have any illusion it would perform well in the long – run. I simply recognized that the company was selling for less than it was worth. All the profit from such a purchase would be derived not from the firm’s ongoing success but from a one time increase in the stock to close the value gap (between the market price of the stock and the intrinsic value of the business). As you can see on the right side of this three year stock chart for Tommy Hilfiger, that’s exactly what happened.

My mistake was confessing my lack of confidence in Tommy’s future prospects, without adequately explaining why this investor needed to hold onto those shares. I should have insisted upon showing him a balance sheet and statement of cash flows; I should have explained to him why the intrinsic value of the business still exceeded the market price despite the firm’s mediocre prospects. I didn’t. I just told him it was cheap, but it wasn’t a company I had any confidence in going forward. That was a terrible mistake.

Whenever you make a stock purchase for yourself or (in my case) when you recommend a stock to someone else, you have to clearly and simply state the argument that the intrinsic value of the business far exceeds the going price. In the case of Tommy, that argument was very clear to me, but not to the investor I was talking to. That’s because while estimates of Tommy’s discounted future cash flows were etched into my mind by the process of research and analysis, I never explained to this poor investor why there are times when the purchase of a mediocre or even sub par business can make sense.

I could have, and should have, taken the statement of cash flows and Tommy’s market cap, written them down on a piece of paper, and circled the value gap that was so clear in my mind. I didn’t. Remember, clarity and honesty are essential to good investing.

You can purchase a stock expecting your returns to come entirely from a one time run up that erases the value gap. As long as you’re honest with yourself – that is, you admit you’re investing in a mediocre company – and you have the courage and conviction to hold the stock until that value gap is erased. A great company can continue to beat the market year after year as it deploys the capital from its retained earnings and continues to earn extraordinary returns on that capital. Obviously, a mediocre business can not do this. However, a mediocre business can be a suitable investment, if, and only if, the valuation gap is wide enough and the investor is honest enough.

Learn from this investor’s mistake. His purchase of Tommy Hilfiger wasn’t the wrong move. It was just made for the wrong reasons. You’re not going to have the conviction to hold a stock unless you were convinced by the argument to begin with.