Chapter 123 - Santa Monica Partners Letters to Partners 1982-2021: 40 Years of "Pink Sheet" Investing
Today’s Chapter is based on the book “Santa Monica Partners Letters to Partners 1982-2021: 40 Years of "Pink Sheet" Investing” by Lawrence J. Goldstein.
Lawrence J. Goldstein is the President and General Partner of Santa Monica Partners, L.P., an investment partnership he founded in 1982. He is known for his unique investment strategy focused on "Stocks Overlooked or Ignored by Otherwise Intelligent Investors," a phrase he trademarked. Goldstein specializes in investing in small, undiscovered, and often thinly traded companies that are typically overlooked by institutional investors and mainstream market participants.
Here’s what I learned:
Don’t Follow The Crowd
"Don’t follow the crowd, let the crowd follow you.”
— Philip Fisher
One of the most distinctive elements of Lawrence J. Goldstein’s investment strategy is his focus on stocks that are often overlooked or ignored by the mainstream investment community. As a matter of fact, Goldstein believes that great returns can be done by investing in small, closely held companies trading on the pink sheets, lacking analyst coverage, or characterized by low liquidity; all attributes that would scare away institutional investors. By targeting these types of neglected securities, Goldstein can take advantage of market inefficiencies and is able to purchase companies at a significant discount.
His strategy is often contrary to the common behaviour among institutional investors, which is why it is so successful. He explains that “Contrary to popular belief, institutional investors are not interested in making money, earning income, protecting purchasing power or preserving capital. Rather they are more interested in being in the pack of other similar institutional investors. If everyone loses money it is fine for the institution to lose money; they just do not want to lose the most and be alone at the bottom of the list of their peers.”
“As usual, you can look for us to march to the beat of our own drummer and not in lockstep with the band that is so attune to the market averages.”
— Lawrence J. Goldstein
This herd mentality creates opportunities in the less visible segments of the market, where Goldstein finds stocks that others overlook. This advantage also stems from the lack of competition in these markets, allowing Santa Monica Partners to acquire positions below their intrinsic value. Goldstein mentions that “We feel we have a large advantage because those neglected areas of the market are where we hunt. This allows us to find and buy into companies when they have been overlooked by others. When those companies are discovered by others, significant multiple expansion can occur.”
This philosophy of looking for overlooked companies off the beaten path quickly became one of Santa Monica Partners’ trademark approach to investing. As Goldstein mentioned, “Since we have used this phrase to describe our investment philosophy for so long, over 30 years, you may have noticed starting this past July we began to display the phrase overlooked or ignored by otherwise intelligent investors as our trademark wherever the name of our partnership appears.”
However, Goldstein explains that in order for these companies to unlock their true value, it requires a catalyst (i.e. uplisting, stock splits, etc.) which does not always happen quickly. A concrete example of this is his investment in Oshkosh B’Gosh. Goldstein recalls that “During the June quarter, as expected, Oshkosh B’Gosh did in fact split its shares effectively 20 for 1. This was followed up in early May with a public offering at $25 per share and a NASDAQ listing. The stock moved into the mid $30s and recently settled down in the low $30s. Our adjusted cost is in the mid teens. This was a classic case of a stock, by virtue of creating more shares, moving from inactive obscurity in the pink sheets to a degree of notoriety and trading activity on NASDAQ and in the process more than doubling its market value.”
“Given our long-term focus, however, when the time comes and a catalyst to bring out value arrives—and it almost always occurs if you are willing to exercise great patience—rewards can be great.”
— Lawrence J. Goldstein
This concept of investing in overlooked companies reminds me of what we have previously learned from Howard Marks on the power of second-level thinking. In his memo “I Beg to Differ”, Howard Marks summarizes the basic idea behind second-level thinking as follows: “In order to outperform, your thinking has to be different and better.”
This is also a reminder on the importance of finding a game where the odds of winning are in your favour. By investing in companies that institutional investors avoid, the competition is less fierce and it is often easier to find great investments. As Charlie Munger once said, “How do you beat Bobby Fischer? Get him to play you any game except chess.”
“Remember, your goal in investing isn’t to earn average returns; you want to do better than average. Thus, your thinking has to be better than that of others – both more powerful and at a higher level. Since other investors may be smart, well informed and highly computerized, you must find an edge they don’t have. You must think of something they haven’t thought of, see things they miss, or bring insight they don’t possess. You have to react differently and behave differently. In short, being right may be a necessary condition for investment success, but it won’t be sufficient. You have to be more right than others ...which by definition means your thinking has to be different.”
— Howard Marks
Be Patient!
“The stock market is a device for transferring money from the impatient to the patient.”
— Warren E. Buffett
As mentioned above, Goldstein believes in investing in overlooked companies which requires patience in order for their value to unlock. In fact, he once said “I believe that neglected stocks win hands down over longer periods of time and with less risk. Clearly, patience is the key to investing successfully in our kinds of securities.” As such, he frequently advocates for a long-term perspective, emphasizing to his partners in his shareholder letters that true value creation takes time. As he once wrote, “My belief of course is that patience is a virtue to be rewarded.”
By having a long-term perspective, Goldstein is able to ride out market volatility without panicking. He recognizes that short-term price fluctuations are inevitable but he doesn’t let them distract him from his long-term goals. Similarly, he reiterates to his partners that “Riding out the volatility and noise is essential to successful long-term investing. Put another way, we must keep control of our stomachs (though others around us may not) when sailing through stormy seas.”
By consequence, Goldstein practices an investment methodology that prefers holding investments for the long haul and allowing them to compound over time. By consequence, Santa Monica Partners have an “extremely low turnover [of companies in the portfolio] is the norm for us, of course, as 'buy and hold' is not just my preference and practice, but something that permeates my very being.” This low turnover not only reduces transaction costs but also allows him to defer capital gain taxes, further enhancing returns.
“For all we are concerned with is the long-term beyond the horizon. When we invest we like to think in terms of forever. We can care less about a quarter or a year and rather focus on the far away pot of gold on the distant horizon. Sometimes we reach it sooner because of the occurrence of a value-creating catalyst. Most of the time it is because the company over time just grows like a weed or like topsy and in the fullness of time we reach the horizon and the great value realization outs.”
— Lawrence J. Goldstein
For Goldstein, patience is not about idleness but about allowing compounding to work its magic. He cites examples like Balchem, a stock that became a “92-bagger in 20 years,” and Compass Knowledge, which quintupled in value in just two years. These gains were only possible because Santa Monica Partners held these investments through periods of stagnation and volatility, trusting that their underlying value would eventually surface. As Goldstein once said, “Patience and courage too is also important so as to be able to look across the investment valleys and beyond the peaks in order to make and be willing to hold on long-term to achieve what may be very successful and at times extraordinary investments.”
“Once in a blue moon you find one which is really a great one but to the ignorers ‘too small’ or ‘too closely held’ or its variations ‘doesn’t trade enough’ or is ‘illiquid’ or too this or too that. In almost all cases these companies don’t deserve their undervaluation. How do we as investors profit? Value will out in time. It always does.”
— Lawrence J. Goldstein
This concept of patience in investing reminds me of what we have learned from Seymour Schulich who understood the importance of patience and resilience in order to achieve wealth and success as an entrepreneur. In fact, Schulich warns that it is important to be resilient and patient in order to succeed in business. He states that “It usually takes five to ten years to build a successful business, even in industries like oil or mining, where quick strikes can happen.” This perspective is crucial for aspiring entrepreneurs who may expect immediate results. Schulich’s wisdom reminds us that great businesses are not built overnight; they require time, effort, and resilience to flourish.
“He that has no patience has nothing at all.”
— italian proverb
Great opportunities come to those who are patient, hence why Schulich prefers to take a delayed gratification approach even in entrepreneurship. He challenges us to adopt a long-term mindset, focusing on sustainable growth rather than quick wins. And in business, Schulich recommends in having a big cash reserve since you’ll never know when you have an opportunity to strike gold. As he states, “One other very important aspect of patience in business is maintaining a cash reserve, so you have the money on hand to exploit those opportunities when they occur.” This advice is particularly relevant in times of economic uncertainty, where having liquid assets can provide the flexibility needed to seize advantageous opportunities.
“The best opportunities come to those with patience, courage, and a cash reserve.”
— Seymour Schulich
Similarly, Charlie Munger is also a prominent figure that has always been a big proponent of delayed gratification. He believes in the importance of patience and being prepared to act at scale when a great opportunities arise. As he once said, “If you’re glued together and honorable and get up every morning and keep learning every day and you’re willing to go in for a lot of deferred gratification all your life, you’re going to succeed.”
Munger gave a great example of delayed gratification: How he earned $400 million from reading Barron’s magazine. Munger had been reading Barron’s magazine for more than fifty years, but found only one actionable idea in it. He bought a cheaply valued auto parts company at $1 per share and sold a few years later at $15 per share, earning him $80 million in profits. Munger then gave this $80 million to Li Lu who turned it into $400 million. This story is a great example of the significance of extreme patience, deferred gratification, and the display of strong decisiveness at the right moment.
“People who arbitrage time will almost always outperform. The first order thought of instant gratification is a crowded path, ensuring mediocre results at best. Delayed gratification, which requires second order thinking, is less crowded and more likely to get results.”
—Shane Parrish
Bet On Owner-Operators
“Show me the incentives and I will show you the outcome.”
— Charlie Munger
One interesting thing constantly mentioned in Lawrence J. Goldstein’s shareholder letters is his insight that the most successful investments in the Santa Monica Partners’ portfolio have been in companies led by owner-operators, individuals who manage and hold significant stakes in their businesses. This insight of his was inspired by the research done by Murray Stahl who suggested that owner-operators bring a level of dedication, alignment of interests, and strategic foresight that drive exceptional long-term compounding, making them a key ingredient in wealth creation.
In fact, Goldstein explains that “Over the last 53 years we have invested in many closely held companies which until now I never thought to categorize as owner-operator companies, investments or stocks. But that is exactly what most of our closely held and inactively traded successes have been. I’m going to go back and examine all of them one of these days. Intuitively I can tell you such companies have been our biggest winners compounding at very high double digits and earning us thousands of percent in profit over long periods of time.”
Furthermore, Goldstein also studied previous companies that performed extremely well on the stock market such as Wal-Mart, Microsoft and Teledyne. He believed that the main common theme of these companies are that they are led by owner-operators. In fact, Goldstein believes that investing in owner-operators lead to better returns than the S&P 500.
“I began looking at companies like Wal-Mart at the time when Sam Walton ran the company and he owned most of the stock, or Hewlett-Packard, in the days when Mr. Hewlett and Mr. Packard ran the company or Microsoft in its Bill Gates era or Teledyne in its Henry Singleton era or Apple Computer in its two Steve Jobs incarnations. I absolutely promise you, if you did that calculation, you would never buy the S&P. What I’m telling you is that the bulk of the return of the indices—and not just in the United States, but in all nations—the bulk of the return was earned by these owner-operators.”
— Lawrence J. Goldstein
As such, it is not surprising that investing in owner-operators is a key requirement in Santa Monica Partners’ investment philosophy. In fact, Goldstein writes that the ingredients for long-term compounding and wealth creation are straight forward:
Competitive advantages that allow for superior margins, predictable market shares and high returns on capital.
Continuous capital reinvestment (paying a dividend goes against the goal of wealth creation).
An attractive price/value relationship at the outset.
Executives who manage the business aggressively and conservatively with the incentives of ownership.
This reasoning can be explained by the fact that owner-operators are more likely to make decisions that are in the best long-term interests of the company, even if those decisions are unpopular in the short term. They also tend to be more focused on building long-term value rather than maximizing short-term profits. This is, in my opinion, a perfect example of the power of incentives.
As we have previously learned from Charlie Munger, the most important mental model to understand comes from psychology: the power of incentives. And yet, he believes that not many people understand how powerful incentives are.
“For instance, I think I’ve been in the top 5 percent of my age cohort almost all my adult life in understanding the power of incentives, and yet I’ve always underestimated that power. Never a year passes but I get some surprise that pushes a little further my appreciation of incentive superpower.”
— Charlie Munger
As investors, it is often advised to invest in companies where management have skin in the game and Lawrence J. Goldstein confirms this thought process. In fact, as shareholders, it is important to invest your money with management teams that also have most of their assets invested in the company, as you can be sure that their interests are aligned with you.
Similarly, Munger explains how important incentives are in running a business. My favourite example on the power of incentives from Munger come from Federal Express:
“The heart and soul of the integrity of the system is that all the packages have to be shifted rapidly in one central location each night. And the system has no integrity if the whole shift can’t be done fast. And Federal Express had one hell of a time getting the thing to work.
And they tried moral suasion, they tried everything in the world, and finally somebody got the happy thought that they were paying the night shift by the hour, and that maybe if they paid them by the shift, the system would work better. And lo and behold, that solution worked.”
— Charlie Munger
Charlie Munger also provided an interesting case study on how Les Schwab tire store was able to come out ahead despite competing with the bigger tire companies such as Goodyears and later on, with huge price discounters like Costco and Sam’s Club. How did he do so? Munger believes that a big part of this is due to the fact that he “must have a very clever incentive structure driving his people. And a clever personnel selection system, etc.”
Beyond the Book
Read "Second-Order Thinking: What Smart People Use to Outperform" by Farnam Street
Watch "Howard Marks - Second Level Thinking" on YouTube
Read "The Surprising Power of The Long Game" by Farnam Street
Read "The Power of Incentives: The Hidden Forces That Shape Behavior" by Farnam Street
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Fascinating article on owner-operator investing! The Balchem example is particularly compeling - a 92-bagger in 20 years is extraordinary and demonstrates the power of patient capital allocation when management has skin in the game. The emphasis on finding companies where executives manage with the incentives of ownership really resonates. These aligned incentives often lead to prudent capital allocation and long-term value creation rather than short-term earnings management. Thanks for highlighting this often overlooked investment strategy!