Warner Bros.: How 5 Mental Models Turned Lonely Conviction into a Big Win

It felt lonely owning Warner Bros.

It felt lonely owning Warner Bros.

My former colleagues were telling me I might be wrong. An investor friend, whom I highly respect, had sold his shares. A hedge-fund media specialist didn’t want to touch it with a 10-foot pole.

The few people whom I knew who still owned Warner Bros. had only a small position.

Yet, I was getting increasingly excited. Charlie Munger once described a lollapalooza effect as one where multiple mental models converge – and I strongly felt that was the case here. Below are the five mental models I used that allowed me to build conviction to make the investment a large position and reap a huge profit for the Partnership that I manage, Silver Ring Value Partners.

1. Good Business / Bad Business Combination

This pattern recurs from time to time and is useful to have in your arsenal. The simplest form works like this:

Imagine a company has two unrelated businesses, division A and division B. Division A is a good business and makes $2/share in earnings for the company while division B is a bad business and loses $1/share. The net effect is that the company makes $1/share in earnings.

Occasionally, the market is lazy and just takes the $1/share in earnings and applies some multiple, let’s say 15x, to value the whole company at $15/share. Now imagine the company selling, or even just shutting down division B.

Suddenly, what used to be a company earning $1/share is magically transformed into one earning $2/share. Even if the multiple of earnings stays the same, you just got yourself a double.

In the case of Warner Bros., it had two excellent and profitable businesses, Warner Studios and HBO. It also had a secularly challenged, albeit still highly profitable, business, Cable Networks, that was in serious decline.

Add on top of this a hefty amount of debt and management with damaged credibility from a merger that failed to live up to expectations, and you can probably begin to understand why most investors did not want to touch Warner Bros. with a 10-foot pole.

2. Kinetic Energy vs. Potential Energy

This one is a simple model from physics. Imagine two balls. Ball A is on the ground and is not moving. Ball B is on top of a table and is also not moving.

Neither ball is moving – so each has zero kinetic energy.

However, there is a big difference between them. If Ball A receives a small nudge, it will likely only have a small amount of movement. However, if Ball B receives a similar nudge, it will drop all the way to the ground and possibly bounce much further than Ball A moved.

Some businesses are troubled and not much can reverse that. Other businesses have potential to bounce but need the right nudge.

In the case of Warner Bros. there was quite a lot of potential energy.

Its library of intellectual property was one of the best in the industry. The way it was currently being monetized wasn’t the only way, and it was quite likely that much more could be obtained over time.

Its brands were strong and gave the company permission to create new content that another company or a complete newcomer would not have. It also already had meaningful distribution relationships in place to monetize new content.

So, while the best path to convert the potential energy into kinetic energy wasn’t something I knew, I was quite confident that these assets could be worth a lot more with the right set of actions.

3. Unique Assets vs. Replaceable Assets

Some companies are replaceable. If they were to disappear, nobody would care all that much. Their customers would easily satisfy their demand elsewhere.

A much smaller portion of companies are unique. They cannot be easily replicated, even with substantial time and money. Those are the ones that are the most valuable.

If you combine unique assets with high demand for the company’s products or services and it being strategically valuable to one or more other companies, now you have a great setup for a potential auction.

As I had written to my partners several times in my quarterly letters, Warner Bros. was just such a company. I had specifically mentioned the possibility of a takeover with an auction among several large strategic acquirers as a meaningful possibility.

Of course, I could not know if or when such an auction would occur. However, I could comfortably say the likelihood of one for Warner Bros. was far higher than for your typical company.

4. Long-Term Options Can Be Wildly Mispriced

Value investors tend to shy away from stock options. There was a point in time when that was my approach as well.

That’s not wrong, but over time I realized that I was avoiding options out of ignorance about how to use them appropriately within an intrinsic value framework. So, I started reading and thinking and came up with several ways that I now use options, still quite sparingly, to improve the Partnership’s returns.

Before you get the impression that I use call options all the time or that you should too, let me be unequivocally clear: call options have one enormous downside. Shortened time horizon.

As an investor, you would much prefer to have time on your side rather than working against you. When you own a good, well-managed company, time is generally on your side since it gains value over the years.

Not so with call options – their value decays with time. If you decide to stop there and never buy a call option in your life, I don’t think you will be making a huge mistake. However, if you are willing to work to understand in what circumstances their benefits outweigh the shortened time horizon, you can occasionally improve your returns.

Just be careful – you truly need to have a solid grasp of all the factors involved to make sure that you are making a positive expected-return investment, rather than just gambling on a lottery ticket. With that in mind, here are the basics.

Most stocks only have short-dated call options, under a year. The largest stocks in the U.S. also have something called LEAPs, which are basically call options that can sometimes have an expiration date more than 2 years into the future. That is still a shortened time horizon, but nowhere near as short as if you needed the stock to move in a matter of a few months.

These options can also sometimes be wildly mispriced in a way that a large stock would rarely be. Without boring you too much, market-makers price call options based on something called the Black-Scholes model. It assumes that the price fluctuations are random around the current price, with a small increase in the likely price over time equal to the risk-free rate.

That’s not a bad way to price a short-term call option on a fairly-valued stock with no events. That statement contains the ingredients on when you might want to investigate a LEAP:

• A meaningfully undervalued stock

• Long-dated options

• An event that has a good probability of acting as a catalyst to close the price/value gap

In the case of Warner Bros., I had all three factors in my favor:

• The stock, near $10 this summer, was trading at less than 50% of my estimate of intrinsic value

• It had LEAPs available

• Management had just announced plans to spin-out the cable networks (the ‘BadCo’ from the first mental model) which meaningfully increased the probability of the gap between price and value closing.

Without going into all the details, which perhaps could be a topic for another time, I was able to get greater than 10:1 risk/reward on options with longer than a year until expiration. Inverted, you can think of it as I would have needed less than a 10% chance for Warner Bros. to trade at my estimate of its value for the investment to be justified.

While I can’t tell you that I can precisely quantify the probabilities, all my analysis pointed to the odds being far better than that.

5. The Auction Spiral

I gave a talk some time ago at an investing conference where I sold $100 for $120. How?

I learned this from Prof. Max Bazerman when I attended Harvard’s Behavioral Finance seminar as a young analyst at Fidelity Investments. There, I watched in amazement as a seasoned investment professional paid $25 for a $20 bill.

With inflation and all, I decided to scale things up to $100, but kept everything else the same. There are only 6 rules for the auction:

I. All bids are binding - no tears

II. Bidding starts at $5

III. Bidding goes up in increments of $5

IV. No collusion or talking of any kind

V. Winner gets the $100 bill and pays his bid

VI. Second-highest bidder pays his bid and gets… nothing

If you think about it for a moment, you will realize that once two bidders are locked into a battle with both bids above $10, the second bidder faces the following payoffs:

A. Lose $10 (or whatever their latest bid was) or

B. Pay $5 to get the $100 bill

In Game Theory geek-speak, there is no stable Nash equilibrium where the bidding ends – the auction should in theory run forever, or at least until someone is either mentally or financially exhausted.

You might wonder why would anyone ever even bid in such an auction? A fair question. I remember that when I was a participant in the Harvard seminar and the auction was kicked off, two conflicting thoughts raced through my head:

“Hmm, I can get $20 for only $2, me like.”

“I don’t understand how this works.”

To me, if I don’t understand something then I don’t invest, so I didn’t bid. But people are human. There were quite a few bidders in that room of seasoned investors, and soon enough two of them had locked horns to the bitter end.

Prof. Bazerman assured me after class that he had run this auction hundreds of times and had always gotten more than $20 for his $20 bill. He didn’t let me down, as when I ran my version 20+ years later I only stopped at $120 for the $100 bill to avoid embarrassing a paying conference attendee too much.

How does all of this apply to Warner Bros.? We value investors assume there is only one valuation mental model that applies: intrinsic value.

It works like this: a business is worth $X, and that value acts as a gravitational pull on the market price. Over time, sometimes sooner and sometimes later, the gap between the market price and $X will close.

That model is a good one and applies to most investments. However, it is not the only one. The Auction Spiral model is equally potent when it applies, and there are other models, such as George Soros’ reflexivity, that can govern price behavior as well.

When it became clear to me that there were at least two serious, deep-pocketed bidders for Warner Bros., the model governing the outcome for the price shifted from:

What is Warner Bros. intrinsically worth as a stand-alone company?

To:

What is the highest bidder willing and able to pay to own Warner Bros. based on a combination of financial, personal, and behavioral bias considerations?

A simpler way of putting it is the prize was no longer ownership of a company, but an alpha-billionaire’s ego. I will let you imagine what that might be worth.

At this stage my approach was to manage risk and give up some upside to lock in most of the gains that could be justified under an intrinsic value framework. After all, as powerful as the Auction Spiral is, there is always some risk that something – politics, a market event or some unknown personal dynamic will cause the auction to abort early.

We were able to lock in an amount of profits that would still be fair to describe as ‘huge’ in percentage terms for the Partnership. At the same time, I left a small, single-digit option position that was a bet that the auction would take what seemed the most likely path to me: two titans battling it out in ever-increasing bids.

That’s where we are at the time of this writing, with that second, small position having already resulted in additional substantial gains for the Partnership.

Conclusion

I have been very open about some of my investing mistakes, as well as the lessons that I learned from them to improve my process. I think it’s equally important to celebrate successes and to use them to reinforce the right mental models.

In a market environment where many are excited about the latest trend or paying enormous prices for rapidly growing (for now) companies, the huge win for the Partnership in Warner Bros. has a clear message:

Value investing, when implemented well, still works.

It doesn’t mean that it will work 100% of the time – nothing does. Nor does it mean that it can be implemented in a lazy, mechanical way by simply looking at valuation and little else. However, when combined with the right mental models and implemented thoughtfully, this experience reinforces my confidence that despite the doubts cast on it by many in this frothy market environment, value investing is here to stay.

Please leave a comment below, I read and respond to every one. And if this article helped clarify your thinking, please restack it to help others.

Disclaimer: Not financial advice, for educational purposes only. The author may own any securities mentioned or referred to in the article and may change his or the Partnership’s position in any way he sees fit without any update provided to the readers.

About the author

Gary Mishuris, CFA is the Managing Partner and Chief Investment Officer of Silver Ring Value Partners, an investment firm that seeks to apply its intrinsic value approach to safely compound capital over the long-term. He also teaches the Value Investing Seminar at the F.W. Olin Graduate School of Business.