Canada’s Best Small Investors 2007: A beautiful mind

If you believe that thinkers never accomplish much in the real world, you should meet Rob Morrison. He’s a quiet, analytical man who started out as a competitive chess player before becoming fascinated by the world of money. Over the past 25 years, while working from his computer in his comfortable Toronto home, he has thought long and hard about how to invest well. By putting his ideas into practice, he has grown his personal portfolio from a few hundred thousand dollars to more than $10 million. During the past decade, he has achieved an amazing 38.5% annual average return—a figure that beats every mutual fund in Canada by at least 15 percentage points a year.

How did he do it? Like many successful investors, Morrison searches for bargains. When he’s buying his clothes, he waits for them to go on sale. When he buys his stocks, he waits until the price drops below what he feels a company is really worth. But while that bargain-hunting approach is standard for any value investor, Morrison takes the notion one step further.

He loves the types of companies that give professional investors nightmares. His favorite targets are companies snared in multimillion-dollar lawsuits, or threatened with nationalization in unstable countries, or hit with seemingly unmanageable inventory control problems. One of Morrison’s companies just saw its main source of revenue ruled illegal and that’s fine by him.

You might think that a man who invests in such high-risk situations would be an intimidating brute. Morrison, though, looks more like a bookworm than a bruiser. He turns 51 in January, but he could still pass for a smart-aleck college kid. It might be his elfin face, long delicate fingers or the shirt collar that’s way too big for his long, thin neck. It might also be his attitude. At an age when many of us have settled into middle-aged complacency, Morrison is always thinking, always challenging conventional wisdom, even when it comes to the most banal of activities.

Take the simple act of boiling an egg. Morrison, a passionate environmentalist, thinks that most people do it the wrong way. They fill the pan with water and waste energy heating all that water to 100°C before they drop in the egg. Morrison prefers to pour just 1 mm of water into the bottom of the pan, turn on the heat, and add the egg right away. The egg, which is mostly above the water, is essentially steamed. “It makes a perfect egg every time,” says Morrison. “And it uses a lot less energy.”

Morrison’s egg-boiling strategy has nothing to do with investing, but it speaks volumes about why he’s a success in the stock market. Whether it’s boiling eggs or picking stocks, he never assumes that the usual way of doing things is the right way. By insisting that conventional wisdom is flawed, he often stumbles upon fascinating discoveries.

Morrison was born in 1957 to an affluent Toronto family. At a young age, he began to display a fine mind and a penchant for analyzing complicated problems. His first love was chess. Morrison was so good at this classic game of strategy that at 24 he found himself playing against Garry Kasparov, the best chess player in the world, at the World Youth Olympiad in Graz, Austria. Morrison lost, but says that as far as he knows, he’s the only Canadian to have ever played the Russian Grandmaster and World Chess Champion in a tournament game.

Morrison shone just as brightly at school. In 1980, at 23, he graduated with a degree in economics from the University of Toronto. That same year he bought his first stock. He had just landed a job as an equity analyst at Laurentian Financial in Toronto, and his boss had assigned him to study the airline industry. Morrison boned up on the sector and, eager to put his new knowledge to work, bought 100 shares of US Air (now US Airways) for his personal portfolio at just over $19 a share. He had crunched his numbers and figured the airline was worth far more than his purchase price. He was sure he was getting a bargain.

Unfortunately for him, the market didn’t agree. After his purchase, the stock dropped by more than a third to $12 a share. Still Morrison stuck to his assessment. Indeed, he felt US Air was even more of a bargain at $12, so he bought 100 more shares. Then the stock dropped to $10 a share, and Morrison thought that was crazy. According to his calculations, the stock shouldn’t be trading anywhere near that low.

Still he held on, and, little by little, the stock began to rise. When it finally edged back to $19, Morrison sold his entire stake, relieved to have gotten out without losing his shirt. “That’s when I made the mistake,” he says. “It’s one that young investors often make. The mistake is that you’ve suffered with a stock and then it goes back up and you have your first chance to get out for a little higher than your cost, so you do. In that case, I was relieved to get out at $19. After I did, it went up to $35.”

Morrison says his first major lesson as an investor was that you shouldn’t worry if your stock drops like a stone after you buy it. If you’ve done a proper assessment of its worth and you believe in it, stand by that assessment. Don’t sell just because your stock has taken a beating; sell when your calculations show that a stock is fully valued in comparison to its likely future earnings.

Morrison learned his second major investing lesson in 1984. His teacher was Valero Energy, an independent oil refining company that had just developed a new “catalytic cracker” that could turn a dirty, sludge-like refinery by-product called residual fuel oil into pure gasoline.

Morrison bought his first Valero shares at about $18. Then the British coal miners’ strike slammed into the coal market and residual fuel oil suddenly became a sought-after replacement fuel. “It was unbelievable,” recalls Morrison. “The market was horribly distorted by this strike and Valero was losing money hand over fist.” Morrison’s stock plunged, but he stuck to his assessment and bought even more shares on the way down. Valero went as low as $4 before the strike ended and the market got back to normal. This time, however, when the stock recovered to $18—Morrison’s original purchase price—he didn’t sell. He waited. The stock shot up to $32 and he made a mint.

Morrison’s experience with Valero was a great reminder of lesson No. 1. He had stood by his initial valuation, and he was rewarded for his persistence. But Morrison also learned an important second lesson: it’s easier to stand by your falling investments if they are leaders in their industry, especially if they have a unique advantage over their competitors. If the advantage is real and provides a sustainable increase in profits, your company will be rewarded for that advantage, even if it runs into bumps along the way.

“I could give you a list of companies that I’ve owned, in a whole variety of industries, where I can point to something in which they were a leader,” says Morrison. “I first learned about that approach by reading Competitive Strategy, a book by Michael E. Porter. He talked about the whole matter of ease of entry and ease of exit within industries. Basically you want an industry with high barriers to entry, and low barriers to exit.”

By this time it was 1988. Morrison’s personal investing was going well, but he was growing weary of the groupthink and office politics he often encountered at work. “At the end of the day, I discovered that I wasn’t really a Bay Street person,” he says. “I’m not really a team player. I realized that I wanted something new.”

Morrison was 31. He could have looked for a new job in finance, but he wasn’t sure that was what he wanted after so many years spent on solitary, analytical pursuits. “Investing and chess are very good for the ego if you’re good at them,” he says. “But it’s not clear that either one is good for developing a sense of one’s self—or developing social skills. I felt that there was something missing from my existence, and I came upon the thought that I wanted to be better educated in the humanities.”

Morrison decided to go back to the University of Toronto, this time to pursue a degree in English literature. He ended up completing a masters in the subject, as well as part of a Ph.D., before growing tired of the pursuit. “I wanted to learn about the humanities, and I did, but I wasn’t really passionate about it,” he says. “Force of will can carry you a long way, but a more effective motivation is that you really enjoy what you’re doing.”

Morrison decided that what he really enjoyed was investing. Besides, he was really, really good at it. By the later half of the 1990s his portfolio was already closing in on $1 million, and Morrison decided to become a full-time investor. Soon afterwards he made the investment of a lifetime.

It started with a tip from a friend who worked in the high tech industry. The friend was impressed with a company in San Diego called Qualcomm. It was developing what would eventually become one of the two leading cell phone technologies in the world, called CDMA. Morrison looked into the company and “became quite confident that this was a company run by high-energy, passionate geniuses.” In late 1996 he bought almost $200,000 of the stock and advised another friend to buy in, too.

For two long years, not much happened. Morrison had made his initial buy at about $2.30 a share. (All share amounts and prices have been adjusted for subsequent splits.) Qualcomm’s stock would sometimes shoot up to $3 or $4, but would always fall back to $2.50, largely because two telecom giants, Ericsson and Nokia, were developing a competing technology called GSM and were accusing little Qualcomm of patent infringement. The fight came to a head in early 1999. “Believe it or not,” says Morrison, “it was going to be a complex patent case determined by a Texas jury.”

Morrison predicted that when the case was resolved, Qualcomm’s stock would soar. He felt that even if the company lost, just getting the patent issue settled would clear the air.

Morrison was right, but he didn’t realize how much the impending dot-com bubble would supercharge an already astounding recovery. Ericsson decided to settle out of court in March, and Qualcomm’s stock started to head up. As it climbed past $4, Morrison’s friend called him asking if he should sell and get out with double his money. “Don’t you dare,” said Morrison.

By mid-April, Qualcomm’s stock had climbed to $10. By August, it was at $20. By November it hit $30, by December, $60. As 1999 ended, Qualcomm peaked at $88 a share. Morrison held on all the way up. By then Qualcomm accounted for more than 70% of his portfolio. He started to sell. When the dust settled, he’d turned a $200,000 investment into $3 million and earned a one-year annualized return of 554%.

Some investors might have treated themselves to a party, but Morrison was more interested in finding another big winner. He decided to invest a big part of his newfound wealth in Jo-Ann Stores, a drab 64-year-old chain of fabric and craft shops based in Hudson, Ohio. If Qualcomm was flashy and high-tech, Jo-Ann was the precise opposite.

“I first stumbled on Jo-Ann Stores in an article in Forbes magazine in 1998,” says Morrison. “At the time, I thought it was an interesting story, but I didn’t think it was particularly cheap. So I just watched it for a bit.” Jo-Ann Stores was struggling to install a “just-in-time” computerized inventory system and the stock plunged from $13 to $7. At $7 a share, Jo-Ann was Morrison’s type of company: a proven industry leader with a long history of profitability that, for various reasons, was being hammered by the market.

Morrison started buying in 2000. Jo-Ann’s stock continued to swoon. It hit bottom at about $3 in early 2001, and Morrison invested all the way down. By mid-2001 Morrison was seeing signs of recovery, and in August that year he bet the farm on Jo-Ann.

It was a gutsy move—and a masterstroke. Toward the end of 2001, as Jo-Ann Stores sorted out its inventory problems and secured new financing, its shares rose from $3 to $6. By late summer 2002, they were in the mid-$20s. Later that year, when Jo-Ann hit the high $20s, Morrison began to sell. At that point he had 94% of his holdings invested in the stock.

How could he bet nearly everything on a single distressed company? Morrison says he protected himself the best way he knew how—by paying much less for a good company than he knew it was worth. He had researched every aspect of Jo-Ann Stores. He had even driven to the U.S. with a friend to check out a dozen locations and chat with the sales staff.

Morrison began his analysis by ascertaining that Jo-Ann Stores had about $80 a share in sales. He then looked back at the margins that the company had achieved in the past to see what kind of profit it could earn on those sales if margins returned to normal. He calculated that it should be able to earn $2 a share. Assuming the stock should trade for about 12 times earnings, he figured the shares would be fairly valued in the mid-$20s. And so it turned out. When Jo-Ann Stores hit that point in late 2002, he began to sell, making an annual return of 140% on his investment.

In addition to supplying him with millions of dollars in profit, Jo-Ann Stores taught Morrison his third, and most important lesson: the importance of looking for good companies in trouble. By trouble he doesn’t mean missing an earnings target. He means natural disasters, lawsuits or serious political strife. The truth is, Morrison had been following this rule all along. He had made his most profitable Valero buys during the period it was depressed by the coal miners’ strike. He had made his most profitable Qualcomm buys when it was threatened with a huge lawsuit.

Morrison now focuses nearly all his attention on such troubled companies. His portfolio typically includes no more than 15 holdings and most of his money is concentrated in his top half-dozen or so ideas. He is fearless about leveraging his own money with borrowed funds if he believes in an investment.

While most Bay Street analysts shy away from companies embroiled in political strife, Morrison believes that such situations can be a gold mine for small investors who are willing to do the necessary analysis. Take PetroKazakhstan. Originally a Canadian oil company called Hurricane Hydrocarbons, it was renamed PetroKazakhstan in 2003 because nearly all its operations were in that troubled Central Asian country. Morrison began looking at the company because it was trading far below what seemed reasonable, given its balance sheet and reserves. He discovered that its price was depressed because the company was in danger of being nationalized by the Kazakhstan government. “That meant it was really a politics story, more than an oil story,” says Morrison.

Morrison decided to do a political analysis. He read up on the company and the country and discovered that while several parties were interested in acquiring PetroKazakhstan, the most likely buyer was the Chinese government. “I felt that the Kazakhstan government would have no problem thumbing its nose at PetroKazakhstan, but it would not thumb its nose at the Chinese government,” says Morrison. He poured money into the oil company while it was trading in the mid-$30s and made a small fortune in August 2005 when PetroKazakhstan was bought out by China National Petroleum Corp. at more than $60 a share.

Morrison’s experience with PetroKazakhstan demonstrates that there are areas where individual investors can have an edge over the pros. “Institutional investors often don’t want to own a stock that can be an embarrassment,” he says. “I call that the reputation factor. Even if an investment is essentially betting a dollar on a coin toss where you get $10 if it comes up heads and 50 cents if it comes up tails, they won’t go near it. Because if it comes up tails, there’s an added cost to them in terms of the firm’s reputation.”

Since his success with PetroKazakhstan, Morrison has continued to buy companies in unusual situations. For instance, he’s investing in Gold Reserve, a U.S.-based firm that owns promising gold and copper mines in Venezuela. “The risk here is whether Hugo Chávez is going to try and turn Venezuela into another Cuba,” says Morrison. “Well, maybe. But so far, the company has been very positive about its dealings with the Chávez government.”

Another example is tiny ESI Entertainment Systems in Burnaby, B.C. The thinly traded company provides payment processing services to the gaming industry, most notably to Internet poker sites. Unfortunately for ESI, payment systems for U.S. online gaming sites were shut down last October by Washington’s crackdown on Internet gambling. ESI’s stock plunged so low that it began trading for even less than the cash on its balance sheet.

At that price, it’s a steal—but only, of course, if the U.S. law shutting down ESI’s core business is lifted. “I bought some ESI a little while ago at 40 cents,” says Morrison, “because I think that there are good reasons for the law being reversed. I think the U.S. will eventually allow Internet gaming, it will just be regulated.”

Other stocks that Morrison likes include CEVA, a technology licensing company in San Jose, Calif., that Morrison calls “the Intel of digital signal processor core licensing,” and Belzberg Technologies. Belzberg, based in Toronto, provides brokerages with computerized trading systems, especially for options trading. “I think it’s an extraordinarily well-managed company,” says Morrison, “but it has very little following.”

Given his millions, Morrison lives a surprisingly low-key life in Toronto with his wife. He has many interests, including history, psychology and politics, and occasionally attends local seminars. He’s also passionate about environmental issues. He takes the subway or bus if he can, and when he has to drive, hops in his Honda Civic Hybrid. He tries to avoid flying, so as not to produce unnecessary carbon emissions, and when he’s shopping, he still loves a good deal. “I don’t spend much money,” he admits. “I’m not investing to become a big spender. If anything, I kind of abhor much of the profligacy that I see around me.”

He doesn’t have any kids to leave his money to, so why does he invest, if it’s not for the money? “Some of it is just the satisfaction of understanding something that the market has failed to understand,” he admits. “And yes, it does have a game aspect.” In the end, asking Morrison why he invests is a lot like asking him why he plays chess. He plays for the sheer thrill of the game. And, naturally, to win.